Director's Liabilities for Company Debts
Can directors be liable for company debts?
Yes, and this may happen even when the directors have taken some remedial action to solve the company's 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 three main differences are:
(a) who has the right to take the claim;
(b) whether the company has to be in liquidation or not before the claim can be made; and
(b) how the liability arises.
In summary:
1. Insolvent Trading claims are made by a liquidator or creditors of a company, only when the company is in liquidation, and arise from a claim for compensation under the Corporations Act.2. Unreasonable Director-Related Transaction claims are made by a liquidator of a company, only when the company is in liquidation, and arise from a claim for compensation under the Corporations Act.
3. Loss of employee claims are made by a liquidator or creditors of the company, only when the company is in liquidation, and arise from a claim for compensation from a contravention of section 596AB of the Corporations Act.
4. Personal liability for taxation debts is to the Australian Taxation Office (ATO) and arise from the provisions of the Tax Act. The company does not need to be in external administration.
5. Claims under personal guarantees are made by the creditors holding the personal guarantees and arise from the guarantee document. The company does not need to be in external administration.
6. Corporate Trustee Claims arise from the provisions of the Corporations Act. The company does not need to be in external administration and the creditor may make the claim.
Who is a director?
Section 9 of the Corporations Act provides a broad definition of the term 'director' that includes appointed directors, but includes de facto and shadow directors. These are people who act in the capacity of a director albeit they are not appointed as such. That is, people 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 provides that directors have a duty to prevent a company from insolvent trading. Insolvent trading occurs when a company incurs a debt that it cannot (and does not) pay, at a time when the director knew or should have known that the company was insolvent. The director may be come liable to pay an amount of compensation equal to the amount of these unpaid debts.
Is a director automatically liable?
Liability arises automatically from the provisions of the Corporations Act, but in reality, the claim will have to be proven by the liquidator or the creditor making the claim. The liquidator does not need to issue any notices or demands to make the director liable for this claim (in contrast to the ATO having to issue director penalty notices to be able to collect tax debts - see below).
Are there any defenses available to directors?
Yes. Section 588H provides defenses that may be used by directors to defend these claims. Directors will not be liable 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; or
(c) they took all reasonable steps to prevent the company from incurring the debt.
What are "all reasonable steps"?
The Act gives the Courts some guidance by stating:
"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 or a liquidator to a company will minimize directors' exposure to insolvent trading, but may 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. Essentially it is the loss to the creditors for debts incurred during this period.
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.
For further information: Insolvency Resource Page: Insolvent Trading
UNREASONABLE DIRECTOR RELATED TRANSACTIONS
When is a director liable for this claim?
Directors will be liable to compensate the company for losses if they cause the company to enter into a transaction that may be classified as a director related transaction and was 'unreasonable' when considering the benefit of the transaction to the company.
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 considering:
(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.
Essentially if a reasonable person who was not trying to personally benefit from the transaction would not have entered into that transaction, it is likely to be classified as unreasonable.
How is a director made liable?
The director automatically becomes liable to compensate the company's liquidator for the amount of the transaction, but in reality the liquidator will have to prove the elements of the claim. The Act sets out the different types of relief available, but the type of compensation will depend on the type of the transaction.
What if the transaction was ordered by the court?
It does not matter whether a court 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.
What amount may be recovered?
The claim is for the amount of 'loss' suffered by the company because of entering into the transaction. Any extra consideration given by the company above that which would have been reasonable compared against the benefits received from the transaction can be recovered. 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 time period is applicable?
The transaction must also have occurred, or an act was done for the purposes of giving effect to the transaction, during the 4 years before the winding up began.
For further information: Insolvency Resource Page: Unreasonable Director Related Transactions
LOSS OF EMPLOYEE ENTITLEMENT CLAIMS
How can the director be made liable for these debts?
The liquidator or relevant employees have a right to make a claim against a director if the company entered into a transaction that reduced the amount of assets available to pay priority employee entitlements in a liquidation. These are described as an "agreement or transaction to avoid employee entitlements".
What causes a contravention of these provisions?
Section 596AB of the Corporations Act says:
"(1)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 cause the company to enter into one of these agreements or transactions and have the requisite intention in doing so. A contravention of this section activates section 596AC and gives the liquidator the right to make a recovery claim.
When does a director become liable for that claim?
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 if the transaction was ordered by the court?
It does not matter whether a court ordered that the transaction occur. If it fits within the requirements, the director will be liable under the section.
(2) Subsection (1) applies even if:
(a) the company is not a party to the agreement or transaction; or
(b) the agreement or transaction is approved by a court.
What amount may be recovered?
The amount of a claim is calculated as an amount equal to the 'loss' caused by entering into that transaction. The loss itself is limited to the amount of priority employee entitlements that cannot be paid due to reduction in the available assets caused by the transaction or agreement.
Avoiding Double Recovery
The Act provides that only the amount of the loss may be recovered and reduces the amount that may be recovered from any one director by the amount recovered from another director for these debts, whether under these provisions or under the insolvent trading provisions.
596AD Avoiding double recovery
An amount recovered in proceedings under section 596AC in relation to a contravention of section 596AB is to be taken into account in working out the amount (if any) recoverable in:
(a) any other proceedings under that section in relation to the contravention; and
(b) proceedings under section 588M in relation to the incurring of a debt that is linked to the contravention.
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 priority also extends to other parties that would have been entitled to priority claims under section 560.
What time period does the liquidator or employee have to make the claim?
The claim must be commenced within six years from the date of appointment.
For further information: Insolvency Resource Page: Loss of Employee Entitlements
TAXATION DEBTS
Can a director be liable for the company's tax debts?
Yes. Directors are exposed to the company's tax liabilities if the company fails to remit a tax installment or other deductions, and does not comply with a Director's Penalty Notice. Directors may also become liable if the ATO has to refund monies to a 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 payment of tax, 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 a penalty in the amount of the unremitted tax. However, the ATO is not able to collect that penalty at this time.
What if the ATO does not have details of the amount of tax due?
If the amount of the tax liability is unknown, an estimate of the debt may be made by the ATO and any 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 for these are debts. 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, all 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 separate liability from the company's liability. That is, both the directors 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 from a director can only occur after the director has been given written notice of the penalty in the form of a Director's Penalty Notice (DPN). Provided the director causes 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 due by the director (not the debt of the company) will be deemed remitted in full. That is, the director may avoid having to pay the penalty, but the company will still be liable for the original debt.
What if the director does nothing in the 14 days after the DPN is issued?
Failure to take one of the specified actions within the 14 days of the DPN being issued (usually mailed) will allow the ATO to collect the penalty 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. The Tax Act contains certain statutory defenses similar to the Corporations Act insolvent trading defenses. Directors have a defence if:
(a) because of illness or some other good reason [the director] 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 makes directors liable to the ATO for payments originally made by the company to the ATO and subsequently set aside as preferential and refunded to the liquidator. That is, if a liquidator forces the ATO to return money, the directors become liable to the ATO for that amounts, plus any costs that the ATO is ordered to pay to the liquidator.
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;
This section makes people liable if they were directors at the time of the original payment to the ATO, not just when the company was wound up or the original debt was incurred.
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 a debt over a certain period. The directors of the company - any person who was a director when or after the agreement was entered into - have the responsibility of making the company comply with the agreement and making all of the relevant payments.
If that agreement is breached, these directors 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.
For further information: Insolvency Resource Page: Director Penalty Notices
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 makes the guarantor liable.
What if the guarantor pays the creditor?
If a guarantor pays the creditor in full, they have the right 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 against the company 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 debts?
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 the company was acting as trustee of the trust;
(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.
For more detailed information:
Insolvency Resource Page: Director Penalty Notices
Insolvency Resource Page: Unreasonable Director Related Transactions
Insolvency Resource Page: Insolvent Trading
Insolvency Resource Page: Loss of Employee Entitlements
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: 22.2.2010