Directors’ liability for company debts

Five areas your clients need to understand.

The roles and responsibilities that come with being a director can quickly turn into liabilities in the event of insolvency appointments. Being a company director is not for the faint-hearted, especially when the ship is starting to sink. Understanding obligations and director duties is critical as ignorance is seldom an acceptable defence.

This article outlines the following five main areas of potential liability:

1. insolvent trading compensation claims

2. unreasonable director-related transactions

3. loss of employee entitlement claims

4. PAYG taxation debts and superannuation contributions

5. personal guarantees.

The three main differences between these areas of liability are:

1. who has the right to make a claim

2. whether or not a company must be in liquidation

3. how the liability arises.

Insolvent trading

A company director could face an insolvent trading claim if the company incurs a debt it can't pay when the director knew or should have known that the company was insolvent. A liquidator or creditors may initiate these claims under section 588M and 588R of the Corporations Act 2001 respectively. A claim can be made for compensation for losses resulting from insolvent trading. The amount claimable is equal to that of the debt incurred when the company was insolvent, as long as the debt remained unpaid at the time of liquidation.

A director can be held financially responsible for the exact amount of debt incurred while the company was insolvent. However, the court must officially order this after the liquidator has proven the claim's elements. Directors have defences available, which include:

• they took reasonable steps to prevent the company from incurring the debt

• they weren’t managing the company at the time due to illness or other good reason

• they had reasonable grounds to expect that the company was solvent.

Liquidators have a six-year window from the liquidation’s start to initiate court proceedings for an insolvent trading claim—and not just issuing a demand.

Unreasonable director-related transactions

Transactions involving directors, their close associates, or nominees can also pose a liability risk. If the transaction would result in an unreasonable outcome, the director may be liable to compensate the company for the loss incurred. The test is if a reasonable person in the same situation wouldn’t have entered into the transaction when considering how the company obtained any benefit or suffered a detriment. Or when considering how the parties to the transaction benefited.

A liquidator can demand compensation for an unreasonable transaction under section 588FDA of the Corporations Act.

Loss of employee entitlement claims

Directors could also face liability if they intentionally diminish company assets that should go toward priority employee entitlements. The amount recoverable is the total unpaid entitlements resulting from the transaction. These transactions are known as agreements or transactions to avoid employee entitlements.

A liquidator can demand compensation for the amount equal to the reduced priority employees’ entitlements when section 596AB and section 596AC of the Corporations Act are activated.

PAYG tax and superannuation

Failure to remit pay as you go (PAYG) withholding tax and superannuation contributions when due can also hold directors personally liable. Directors may also be liable if the Australian Taxation Office (ATO) needs to refund monies to a liquidator under the unfair preference provisions (under section 588FGA of the Corporations Act). That is, if a liquidator forces the ATO to return money, directors become liable to the ATO for that amount, as well as any costs the ATO is ordered to pay to the liquidator. Liability extends to anyone who was a director at the time of the original payment to the ATO, not simply at the time the company was wound up.

The ATO has the director penalty notice (DPN) regime at its disposal for PAYG, net GST tax debt[1], and superannuation guarantee charge (SGC) amounts. The debt owed under a DPN is a separate personal liability owed to the ATO and survives the company liquidation—the ATO can even issue a DPN after a company has entered into a liquidation or voluntary administration appointment. To read up on how DPNs work, click here.

Personal guarantees and credit cards

Personal guarantees are legally binding commitments made by directors to creditors regardless of insolvency status. These commitments are independent of insolvency appointments, but one exception applies: they cannot be exercised during a voluntary administration appointment.

In certain circumstances, a liquidator may also pursue a director personally for “guarantor” preferences, if payments are made to creditors whose debts have been personally guaranteed (section 588FH of the Corporations Act). These provisions also extend more broadly to related entities.

Lastly, beware of corporate credit cards and their implications relating to personal guarantees by the named card holder.

[1] Includes Luxury car tax (LCT), and wine equalisation tax (WET)