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Director's Liabilities

Can directors become liable for company debts?

Yes, and this may happen even when they have taken some remedial action to solve the financial problems. The areas of potential liability discussed in this paper are:

(a) Insolvent Trading Compensation Claims
(b) Unreasonable Director-Related Transactions
(c) Loss of Employee Entitlement Claims
(d) Taxation Debts
(e) Personal Guarantees
(f) Directors of Corporate Trustees

What are the differences between these claims?

The main differences are:

(a) who has the right to take the claim;
(b) whether the company has to be in liquidation or not; and
(b) how the liability arises.

In summary:

1. Insolvent Trading claims are made by a liquidator or creditors of a company and arise from a claim for compensation under the Corporations Act;

2. Unreasonable Director-Related Transactions are made by a liquidator and arise from a claim for compensation under the Corporations Act;

3. Loss of employee claims are made by liquidators or creditors of the company and arise from a claim for compensation from a contravention of section 596AB of the Corporations Act.

4. Personal liability for taxation debts are made by the Australian Taxation Office (ATO) and arise from the provisions of the Tax Act;

5. Guarantee claims are made by creditors holding personal guarantees and arise from the guarantee document; and

6. Corporate Trustee Claims arise from the provisions of the Corporations Act.

Who is a director?

Section 9 of the Corporations Act provides a broad definition of the term "director" that includes the usual interpretation of appointed directors, but includes "de facto" and shadow directors, being people that act in the capacity of a director. That is, you do not have to be formally appointed as a director of a company to be liable for some of these claims.

INSOLVENT TRADING

When is a director liable for insolvent trading?

Section 588G of the Corporations Act states that directors have a duty to prevent a company from insolvent trading. Insolvent trading occurs when an insolvent company incurs a debt that it cannot pay, and the director knew or should have known that the company was insolvent at the time. The Act makes a director liable for an amount of "compensation" equal to the unpaid debts incurred and provides for civil and criminal actions.

Is a director automatically liable?

Liability arises automatically from the provisions of the Corporations Act, but in reality, the claim may have to be proven by the liquidator. The liquidator does not need to issue any notices or demands to make the director liable for this claim and commence collection (in contrast to the ATO having to issue director penalty notices).

Are there any defenses available to directors?

Section 588H provides statutory defenses for directors. Directors do not contravene the insolvent trading provisions if they can establish:

(a) they had reasonable grounds to expect (an actual expectation) that the company was solvent;
(b) they did not participate in management because of illness or some other good reason;
(c) they took all reasonable steps to prevent the company from incurring the debt.

These separate items are explained in the Fact Sheet on Insolvent Trading.

What are "all reasonable steps"?

The Act says:

"the matters to which regard is to be had include, but are not limited to:
(a) any action the person took with a view to appoint an administrator of the company; and
(b) when that action was taken; and
(c) the result of that action."

The appointment of a voluntary administrator to a company will help to minimize directors' exposure to the insolvent trading provisions, but will not eliminate a claim for debts incurred before the appointment.

What amount may be recovered?

The claim is for compensation for losses resulting from insolvent trading. The amount of the claim is equal to the amount of debts incurred through the period that the company was insolvent and remain unpaid at the time of liquidation.

What time period does the liquidator have to make the claim?

The liquidator has six years from the date of appointment to commence an action against a director for insolvent trading.

UNREASONABLE DIRECTOR RELATED TRANSACTIONS

When is a director liable for this claim?

Directors will be liable to compensate the company if they enter into any transaction within the relevant time period before the liquidation that may be classified as a director related transaction.

What is a director-related transaction?

The types of transactions caught under these provisions are:

(a) payments of money made by the company;
(b) conveyances, transfers or other dispositions by the company of property of the company;
(c) the issue of securities by the company; or
(d) the incurring by the company of an obligation to make such a payment, disposition or issue (including contingent obligations).

To be "director-related", the transaction must involve one of the following types of people:

(i) a director of the company;
(ii) a close associate of a director of the company;
(iii) a person on behalf of, or for the benefit of, a one of a director or close associate.

What is a "close associate"?

A close associate is defined in section 9 as

a relative or de facto spouse of the director; or
a relative of a spouse, or of a de facto spouse, of the director.

What makes a transaction unreasonable?

A transaction is unreasonable if a "reasonable person" in the same circumstances as the company would not have entered into the transaction when having regard to:

(a) any benefits that the company may have obtained because of entering into the transaction;
(b) any detriment to the company because of entering into the transaction;
(c) any benefits to other parties to the transaction because of entering into it;
(d) any other relevant matter.

What makes a director liable?

The director automatically becomes liable to compensate the company's liquidator for the amount of the transaction. The Act sets out the different types of relief available to the liquidator, but the type of compensation will depend on the type of the transaction. Commonly the liability will be disputed and the liquidator will have to prove the claim in the courts.

What time period is applicable?

The liquidator must show that the transaction was entered into after the commencement of the Corporations Amendment (Repayment of Directors' Bonuses) Act 2003. It must also have occurred, or an act was done for the purposes of giving effect to it, during the 4 years ending on the relation-back day; or after that day but on or before the day when the winding up began.

What amount may be recovered?

The extra consideration up to that which would have been reasonable can be recovered from the director or close associate. That is, if an asset was sold for undervalue to a director, the director will have to pay extra consideration to that which would have been reasonable for that asset.

What if the transaction was ordered by the court?

It does not matter whether a courts ordered that the transaction occur. If it fits within the requirements, the director will be liable under the section.

(3) A transaction may be an unreasonable director-related transaction because of subsection (1):
(a) whether or not a creditor of the company is a party to the transaction; and
(b) even if the transaction is given effect to, or is required to be given effect to, because of an order of an Australian court or a direction by an agency.

LOSS OF EMPLOYEE ENTITLEMENT CLAIMS

What is the purpose of this section?

The liquidator or employees have a right to recover property or compensation from directors if they enter into transactions that reduce the amount of assets available to pay priority employee entitlements. These are known as an "agreement or transaction to avoid employee entitlements".

What causes a contravention of these provisions?

Section 596AB of the Corporations Act says: "A person must not enter into a relevant agreement or a transaction with the intention of, or with intentions that include the intention of: (a) preventing the recovery of the entitlements of employees of a company; or (b) significantly reducing the amount of the entitlements of employees of a company that can be recovered".

A director contravenes this section if they enter into one of these agreements or transactions. A contravention of this section activates section 596AC and gives the liquidator the right to the recovery.

When does a director become liable?

A director becomes liable to either the liquidator, or in some circumstances an employee, if they

(a) contravene section 596AB in relation to the entitlements of employees of a company; and
(b) the company is being wound up; and
(c) the employees suffer loss or damage because of: (i) the contravention; or (ii) action taken to give effect to an agreement or transaction involved in the contravention.

What amount may be recovered?

An amount equal to the loss or damage may be recovered from the director as a debt due to the company. The loss is calculated as the amount of priority employee entitlements that cannot be paid due to the transaction or agreement.

What happens when monies are recovered?

As the loss is calculated on the priority employee entitlements, the Act gives employees priority to any compensation recovered by the liquidator. This also extends to other parties that would be entitled to claim instead of the employees under section 560.

TAXATION DEBTS

Can a director be liable for the company's tax debts?

Yes. Directors are exposed to liabilities if a company fails to remit the tax installment and other deductions and does not comply with a Director's Penalty Notice. PAYG withholding a mounts are the most common type of debt involved in these claims.

Directors may also become liable to the ATO if they have to refund monies to the liquidator under the unfair preference provisions (section 588FGA of the Corporations Act), or when the company enters into and breaches a section 222ALA (ITAA) repayment agreement.

What are the director's responsibilities?

At the due date for the tax payment, the director must cause the company to:

1. pay the amount deducted;
2. enter into an arrangement with the ATO for payment of the amount;
3. appoint a voluntary administrator to the company; or
4. wind up the company (within the meaning of the Corporations Act).

If the director does not do one of these things before the tax is due, they will become personally liable for the unremitted tax.

What power does the ATO have?

The ATO can recover amounts of unpaid tax from the company. If the amounts are unknown, an estimate of the debt may be made and recovery action may be based on that estimate. An estimate is only made after the due date for payment has passed and when the returns have not been lodged.

The company is automatically liable as these are debts of the company. The director is also personally liable, but the amount cannot be collected until the ATO takes further steps and allows the director another chance to take remedial action.

What does the ATO have to do to make a director liable?

Nothing. If a company fails to pay its tax debts by the due date, the directors automatically become liable for a "penalty" equal to the unremitted amount or the estimate calculated by the ATO. The penalty is referred to as a parallel liability, as it is a distinct and contemporaneous liability to the company's liability. That is, both the director and the company owe the full amount separately. Payment of one amount, however, will reduce the amount of liability of the other.

Can the ATO recover the amount from the director without further action?

No. Recovery can only occur after the director has been given written notice of the penalty in the form of a Director's Penalty Notice. Provided the director caused the company to adopt one of the above four choices set out in that notice within 14 days of date of the notice, the penalty to the director (not the debt of the company) will be deemed remitted in full.

What if the director does nothing in the 14 days?

Failure to take one of these actions within the 14 days will make the director personally liable for the penalty and allow the ATO to collect the amount from the director.

The Commissioner is not entitled to recover from a person a penalty payable under this Subdivision until the end of 14 days after the Commissioner gives to the person a notice that:
(a) sets out details of the unpaid amount of the liability referred to in subsection 222AOC(1), (1A) or (2) (whichever relates to the penalty); and
(b) states that the person is liable to pay to the Commissioner, by way of penalty, an amount equal to that unpaid amount, but that the penalty will be remitted if, at the end of 14 days after the notice is given:

(i) the liability has been discharged; or
(ii) an agreement relating to the liability is in force under section 222ALA; or
(iii) the company is under administration within the meaning of the Corporations Act 2001; or
(iv) the company is being wound up.

Are there defenses available to the director?

Yes. Statutory defenses exist under the Tax Act which are similar to the Corporations Act insolvent trading defenses. It is a defense if:

(a) because of illness or some other good reason he or she did not take part in the management of the company at the time the remittance was due to be paid;
(b) the director took all reasonable steps to cause the company to comply; or
(c) no such steps could have been taken.

What about preferences recovered from the ATO?

Section 588FGA of the Corporations Law operates to make directors liable to the ATO for payments originally made to the ATO and subsequently set aside as preferential and refunded to the liquidator. That is, if a liquidator forces the ATO to return payments, the directors again become liable to the ATO for those amounts.

The Act states:

(1) This section applies if the Court makes an order under section 588FF against the Commissioner of Taxation because of the payment of an amount in respect of a liability under any of the following provisions of the Income Tax Assessment Act 1936 :
(aa) section 220AAE, 220AAM or 220AAR;
(a) section 221F (except subsection 221F(12)), section 221G (except subsection 221G(4A)) or section 221P;
(b) subsection 221YHDC(2);
(c) subsection 221YHZD(1) or (1A);
(d) subsection 221YN(1);
(e) section 222AHA;

Those people who were directors at the time of the payment to the ATO, not just when the company was wound up, become liable to the ATO.

As the liability arises from the refund or a preferential payment, the company must be in liquidation for this section to apply.

What about section 222ALA repayment agreements?

Sometimes companies enter into repayments agreements with the ATO under section 222ALA of that Act. This is a formal agreement to allow the company to repay the debt over a certain period. The directors of the company have the responsibility of making the company comply with the agreement and making all of the relevant payments.

If that agreement is breached, the directors of the company will automatically become personally liable for any amounts that remain unpaid under the agreement. This liability arises under the ITAA and the ATO does not need to issue any notices or make any demands to make the directors liable. They will generally just issue a demand for payment.

(1) If a company incorporated under the Corporations Act 2001 makes an agreement with the Commissioner under section 222ALA of this Act, the persons who are directors of the company from time to time must cause the company to comply with the agreement.

(2) If the company contravenes the agreement by failing to pay a specified amount on or before the specified day, or by contravening a special condition, each person who was a director of the company at any time during the period beginning on the day when the agreement was made and ending on the day of the contravention is liable to pay to the Commissioner, by way of penalty, an amount equal to the balance payable under the agreement.

PERSONAL GUARANTEES

What is a personal guarantee?

A personal guarantee is a binding agreement entered into by a third party (in this case a director) and a creditor of the company where the guarantor agrees to pay the debts of the company to that creditor, if the company does not pay them.

Does an insolvency administration disrupt this agreement?

No. A personal guarantee is a separate third party agreement between the director (the guarantor) and the creditor. Nothing that happens to the company, or any action by an administrator or liquidator, will disrupt that liability. The only exception is that a personal guarantee cannot be exercised in the period of a voluntary administration, but can be exercised immediately after that period ends.

Does the creditor need to do anything to make the guarantor liable?

No, the guarantee document itself make the guarantor liable.

What if the guarantor pays the creditor?

If a guarantor pays the creditor in full, they get to "stand in the shoes of the creditor" under a right of subrogation. This effectively replaces the creditor with the guarantor and the guarantor will have the same rights as the creditor. The important factor is that the creditor must have been paid in full for any right of subrogation to exist. This right does not exist partially.

What is the amount of the liability?

That depends on the guarantee, but typically it will be the full amount owing to the creditor by the company.

When do directors usually enter into personal guarantees?

Directors commonly sign guarantees when they enter into a credit agreement with a supplier. The guarantee is commonly in the terms and conditions or sometimes will be a separate document. Guarantees are also part of any funding package from banks and other financial institutions.

Does the company have to be in liquidation for a claim to be made?

No. As the guarantee is a separate agreement between the director and the creditor, the company does not been to be in liquidation, or even insolvent, for the guarantee to be exercised.

DIRECTORS OF CORPORATE TRUSTEES

What is a corporate trustee?

It is a company that acts in the capacity of a trustee of a trust.

When are directors liable?

For the director to be liable under these provisions, the following general circumstances must be present:

(a) The company must be acting as a corporate trustee of a trust;
(b) There must be an unpaid trust debt in the name of the company that was incurred while acting as trustee;
(c) The company must not be entitled to be fully indemnified against the liability out of trust assets (even if there are not sufficient assets) because of one or more of the following:

(i) a breach of trust by the corporation;
(ii) the corporation's acting outside the scope of its powers as trustee;
(iii) a term of the trust denying, or limiting, the corporation's right to be indemnified against the liability.

The main factor is that the corporate trustee, the company, cannot be entitled to be indemnified from the trust assets. If the company does have a full indemnity this section will not apply. However this will not eliminate a potential claim for insolvent trading.

Is a director automatically liable?

Yes. The liability is generated by statute, thought it is common for directors to dispute the claim. Section 197 states:

(1) A person who is a director of a corporation when it incurs a liability while acting, or purporting to act, as trustee, is liable to discharge the whole or a part of the liability if the corporation:

(a) has not, and cannot, discharge the liability or that part of it; and
(b) is not entitled to be fully indemnified against the liability out of trust assets.

This is so even if the trust does not have enough assets to indemnify the trustee. The person is liable both individually and jointly with the corporation and anyone else who is liable under this subsection.

What amount may be recovered?

The amount is equal to the amount of the debts that are in the name of the corporate trustee and cannot be met from the assets of the trust.

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

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Last Updated: 8.2.2008