Liquidation—the ugly side for directors

If it sounds too good to be true: it really is! 

All too often we hear stories of directors not properly advised of what happens in a liquidation scenario. It is imperative that when companies are facing financial challenges, the directors seek proper advice to fully understand the potential ramifications against them. If severe enough, it will lead to the likely bankruptcy of the directors. We often hear the line ‘had I’d known that—they would have looked at different options’, but typically the advice offered by uneducated, inexperienced, and potentially ‘dodgy advisors’ is that the liquidation will make all of the problems go away. That is simply not true!

To give some educated, experienced, and qualified guidance on directors and the effects of insolvency, I list the more common issues that directors must fully contemplate before deciding to wind up their company.

Personal guarantees

This may seem like an obvious one, but it is often not properly considered.

Just to be clear, a personal guarantee is a document signed by a director that guarantees the debt incurred by the company. This means that should the company fail to pay that debt; the creditor can rightfully seek payment directly from the director. Frequently, directors are unable to determine which creditors actually hold a personal guarantee, because their paperwork is not in order. Once a company goes into liquidation, creditors holding personal guarantees will pursue the directors to pay the outstanding company debt. The creditors that will almost always have a personal guarantee include, a financing bank, a landlord, and any major suppliers.

Company secured creditors—the banks!

A bank that has provided finance to a company will almost always have a personal guarantee along with a mortgage over any real property the directors own, as additional security. When the company is unable to pay its debt to the bank and insufficient funds in a liquidation, the bank will call upon the guarantees and mortgages. Ultimately, if the directors don’t pay the debt the bank will most likely enforce the sale of any real property offered as security with all proceeds going to the bank until their debt is satisfied in full. Most securities are held over the home, which leaves the directors homeless.

Caveats—charging clauses over property

Most personal guarantees include a ‘charging’ clause. It provides a ‘charge’ for a creditor, in the event of non-payment, to place a caveat over any real property owned by the director. This makes these creditors a ‘secured creditor’ over any real property owned by the director. The creditor can lodge a caveat over this real property, and if necessary, commence legal action to enforce their caveat, which may ultimately lead to a statutory trustee being appointed over the real property. The statutory trustee will sell the property and distribute the funds, firstly to the secured creditors (mortgagee and caveat holders) with the surplus funds (if any) being paid back to the property’s owners. Clearly, these clauses are a very powerful tool for creditors, and one that directors need to be acutely aware of.

Directors loan accounts

We are increasingly seeing director loan accounts in use. Directors seem to make the conscious decision (often after receiving advice) to only pay themselves a small salary (or even none) and simply take company funds as a directors’ loan account. The advantage is that directors don’t have to remit any pay as you go (PAYG) to the Australian Taxation Office (ATO). However, in a company liquidation, the first thing that the liquidator will identify is an outstanding loan account and immediately demand repayment. Often it is a significant amount outstanding and the liquidator is obligated to recover the loan account.

Insolvent trading

Liquidators have recourse over directors with insolvent trading claims. Our website details how these claims work (click here), but ultimately, a liquidator conducts investigations to determine the point the company became insolvent and then determine the value of unpaid debt incurred after that date. This amount is what the liquidator can pursue the director to pay personally.

Director penalty notices (DPNs)

A director penalty notice (DPN) allows the ATO to seek payment of unpaid company Pay as You Go (PAYG) withholding and superannuation from a director. Again, our website details how these DPNs work (click here). Directors must be extremely mindful of DPNs, particularly if they have outstanding business activity statements (BAS) and superannuation guarantee charge (SGC) reporting obligations as they can already be automatically liable for a portion of the outstanding PAYG and superannuation. If directors are issued a DPN, immediately seeking appropriate advice on what they should do, is vital. If they ‘put their head in the sand’—the problem will only get worse.

Section 588FDA actions

Section 588FDA of the Corporations Act 2001 gives liquidators the power to pursue a director for an ‘unreasonable director related’ transaction. To determine whether a transaction may be considered ‘unreasonable’ the liquidator must establish the following:

• The payment or transfer of property was made by the company, securities were issued by the company, or the obligation was incurred by the company to make such a payment or disposition.

• The payment or disposition was made to a director, a close associate of a director or a person on behalf of the director, or close associate of the director.

• It may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction when regarding the benefit and detriment to the company.

This provides a liquidator with quite a wide scope to pursue company transactions and they will closely look at any transactions made to the directors’ close associates (usually family).

Section 588FGA liability

This liability is almost always overlooked by directors and their advisors when considering a company winding up. If a liquidator determines the company made a ‘preferential payment’ to the ATO, they will take appropriate action to recover it. If the liquidator is successfully obtaining a court order for the preference payment against the ATO, section 588FGA of the Corporations Act outlines that the directors become liable to the ATO for the PAYG component of the preferential payments. So, should a liquidator recover a preference from the ATO, the ATO can make a claim against the directors for the PAYG portion of the preference.

QBCC builder licences

In Queensland there are serious ramifications for a director of a company that holds a Queensland Building and Construction Commission (QBCC) builder licence. We have an in-depth article on this issue (click here). In summary, if the director (or former director in the previous 12 months) holds a QBCC building licence and the company goes into administration or liquidation the QBCC considers this an ‘insolvent event’. This means the director will be classified an ‘excluded individual’ and be banned from holding a building licence for three years. Should the director be a director of a second company that goes into administration or liquidation, the director will be banned for life from holding a QBCC builder licence. These are very serious ramifications and can hugely impact the director’s ability to earn an income in the future.

QBCC deed of covenant

Liquidators have recourse under companies that holds a QBCC building licence, with a ‘deed of covenant’. These deeds are signed by directors (usually years before any liquidation) to meet the QBCC’s minimum financial requirements as a licence holder to make up any shortfall. If the company is placed into liquidation and a deed is in place, a liquidator can immediately demand payment of the deed’s defined amount from the director. It also provides the liquidator with the power to place a caveat on any real property the director owns, which effectively puts the liquidator into the status of a ‘secured creditor’. If the debt is unpaid the liquidator can commence legal action to appoint a statutory trustee over the real property. They will then sell the property and distribute the funds, firstly to the secured creditors (mortgagee and caveat holders) with the surplus funds (if any) being paid back to the property’s owners.

Director banning—section 206F

Section 206F of the Corporations Act gives the Australian Securities and Investments Commission (ASIC) the power to disqualify a director for up to five years if the person is a director (or a director within the 12 months) of two or more companies that have been placed into liquidation in the previous seven years. We are seeing ASIC becoming more proactive on this front and taking more action to ban directors under section 206F.

Breaches of directors’ duties

Liquidators are required to investigate into company affairs for the period prior to the liquidation. Part of these investigations include reviewing the director’s actions to determine if they breached any of their director duties. The relevant sections of the Corporations Act are:

• Section 180: Care and diligence—civil obligations

• Section 181: Good Faith—civil obligations

• Section 182: Use of Position—civil obligations

• Section 183: Use of Information—civil obligations

• Section 184: Good faith, use of position and use of information—criminal offences

If a liquidator determines a breach of any of these sections, they will lodge a report with ASIC under section 533 of the Corporations Act. ASIC will review the matter and if deemed appropriate, take action to prosecute the directors.

Summary

As can be seen above, there a many forms of potential exposure for directors of a company that goes into liquidation, some of them are very serious and may have a significant adverse effect on the director. Evidently, it is imperative that directors seek proper advice from trusted advisors. The bad advisors out there are touting the message ‘once the company goes into liquidation all of your problems will go away’. This is morally wrong and simply not true!