What are the Common Claim Risks — and How to Manage Them
Choosing a company business structure is designed to protect directors from personal liability during insolvency or restructuring.
However, the debts company insolvency deals with can fall on the director’s shoulders in certain circumstances, which can cause significant stress and concern.
Many people believe they might lose their home in these circumstances, but the good news is, statistically, you probably won’t.
To ease the unease, here we look at company insolvency in more detail and explore the most common director liabilities that could arise. We’ll also examine how these claims can be managed in two insolvency situations: restructure and liquidation.
Understanding Company Insolvency
Company insolvency is a legal state where a company cannot pay its debts as they fall due or has liabilities exceeding its assets.
When a company becomes insolvent, it may face legal action from creditors who are seeking to recover the debts owed to them.
Under Australian law, there are three main types of company insolvency:
- Small Business Restructuring (SBR)
- Voluntary Administration
- Liquidation
Small Business Restructuring is a fast and cost-effective process that allows eligible companies to reduce their debts to the ATO and other creditors by as much as 90%.
For companies that are not eligible for SBR, Voluntary Administration (VA) is a process in which an independent administrator is appointed to oversee the company's affairs and try to restructure its debts and operations to avoid liquidation.
Liquidation, on the other hand, involves the orderly winding up of a company's affairs and the sale of its assets to pay its debts.
Types of Debts Involved in Insolvency
Various types of debts may be involved in company insolvency, including:
- Trade debts - Debts owed to suppliers for goods or services purchased on credit.
- Tax debts - Debts owed to the Australian Taxation Office (ATO) for various taxes such as income tax, GST, and PAYG withholding.
- Employee entitlements - Debts owed to employees for unpaid wages, superannuation contributions, and other entitlements.
- Loans - Debts owed to banks or other financial institutions for loans or lines of credit.
- Lease and rental arrears - Debts owed to landlords for rent or lease payments.
- Court-ordered debts - Debts owed as a result of court judgments or fines.
It’s important to note that some debts, such as secured debts, may take priority over other unsecured debts in insolvency proceedings.
Common Debts That Can Lead to Personal Liability
Of the debts involved in company insolvency, four key ones commonly lead to directors’ liabilities.
Personal guarantees
A personal guarantee is a legal agreement in which a company director agrees to be personally responsible for the company's debts or obligations.
By their very nature, these types of debts, which include loans, finance agreements and often trade credit agreements and premises leases, can lead to personal liability.
ATO director penalty notices (DPNs)
A director penalty notice is a formal notice issued by the ATO to directors who have failed to meet their company’s tax obligations.
If a 21-day DPN has expired or there’s a period of non-lodgement leading to lockdown DPN for BAS (GST/PAYG) or super, the director becomes personally liable and may face legal action.
Director (Div 7A) loan account balances
Often accountants set up drawings accounts for directors to take their pay rather than as an employee. Other times, directors might dip into the company to top up their wages or use the company bank account as their own.
This is fine when times are good. But if there aren’t enough funds to pay creditors as well, the directors may have to pay the loan back.
Insolvent trading
Determining insolvency can be quite difficult. However, for every insolvency appointment, there’s a period of insolvent trading.
Insolvent trading isn’t often pursued, but when it is, the claims can be substantial, potentially totalling the unpaid debts owed to all your company creditors.
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Additional director liability risks
Other types of activities that create personal liability risks for directors include:
- Breaches of director duties
- Uncommercial transactions and preference payments
- Illegal phoenix activity
- ATO preference recoveries
- Building licence loss
- Unfair dismissal
Managing Personal Liability Claims in Insolvency
Managing director liability claims in insolvency can be a complex and potentially costly process. If you’re facing a liability claim, it’s important to seek professional advice as soon as possible.
Here’s a detailed look at how the four common director liability claims may play out and how they can be dealt with:
When saving your company with a restructure
A restructure may reduce your company's debts; for example, a Small Business Restructure (SBR) has an average 85% debt reduction. But, if directors are liable for personal guarantees and expired or lockdown DPNs, restructuring won’t fix this.
There’s no escaping DPN liability other than with an insolvency appointment such as a Part IX (9) Debt Agreement, personal insolvency agreement or bankruptcy.
For personal guarantees, the outcome may depend on your personal financial position. If your personal financial position shows you can’t pay the guarantee debt in full, you may be able to negotiate an informal arrangement to pay less than the full debt and/or pay by instalments over time.
Saving your company has the added benefit of continuing to generate cash that can be used to pay down these debts over time.
The good news is that director loans and insolvent trading aren’t pursued if your company successfully restructures its debts. However, they’re still relevant.
Your appointed restructuring practitioner or administrator will consider the amount that may be recovered from these claims in the hypothetical scenario that the restructuring is unsuccessful and the company enters liquidation.
When closing your company with liquidation
In liquidation, the same position applies to personal guarantees and DPNs. However, things change for director loans and insolvent trading.
A liquidator will nearly always issue a demand for a loan account. Whether they pursue insolvent trading and other claims can vary.
Just because a liquidator has claims doesn’t mean they’ll necessarily recover money to pay company creditors if the claims are pursued.
Liquidators can approach insolvent trading, loan accounts, and other claims differently depending on the circumstances. They may:
- If they have sufficient funding from the company assets or creditors, pursue the claim all the way to court proceedings or until the claim is settled.
- Demand payment and accrue time on a speculative (no win, no fee) basis, possibly going as far as court proceedings or until the claim is settled.
- View it as not commercially worthwhile pursuing due to the significant costs involved which may exceed the expected legal recovery and take no further action.
If you do get pursued, you generally have five options for responding to a liquidator’s demands:
- Pay the claim in full
- Offer to settle the claim for less than the full amount
- Dispute the claim
- Provide details of your personal financial position to help the liquidator in assessing if you have the financial capacity to meet a successful claim
- Do nothing, in which case the liquidator will decide whether to pursue the claim further
It’s important you seek legal advice regarding which path is best.
Be Proactive to Minimise Exposure to Liability
The prospect of director liabilities in company insolvency can be daunting. However, it’s crucial directors are aware of their legal and ethical responsibilities to protect themselves and their businesses.
By taking a proactive approach to managing insolvency and seeking expert advice and guidance, you can minimise your exposure to liability and safeguard your personal finances and reputation.
If you’re worried about insolvency and facing company director liability, see how we can help with our Instant Online Assessment, or get in touch with our team of debt solution specialists today on 1800 861 247 for professional, non-judgmental support and advice.
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