What are the personal liability risks for company directors?

When a business owner is advised on their structure, many will either find themselves with a company operating as Trustee of a trading trust or a company trading in its own right.  . While tax implications are usually the key reason for this decision, we often speak to directors who are under the impression that as a director of a company, regardless of the structure chosen, they cannot be held personally liable for any debts that company may accumulate. 

While this view has popular appeal, it can give false comfort and lead to unpleasant surprises for the director should events unfold that causes company obligations to fall on their shoulders.  

Below we set out some of the potential personal liability risks for directors.  Read on to understand what these common traps are and how to avoid them. First, we’ll cover some of the foundational definitions before delving further. 

What is the definition of a company?

According to ASIC, “a company is an entity that has a separate legal existence from its owners”. Legally, a company has the same rights as a person – it has its own obligations and liabilities that are distinct from those of a director. A company can incur debt, sue and be sued. Money made by the business belongs to the company and one of the requirements is that directors must complete an annual declaration of solvency.

What is the definition of a director?

A director is the person responsible for ensuring that a company runs within the compliance requirements set out by the Corporations Act 2001. A director is not suddenly obligation free once a company stops trading. Depending on the circumstances, they may remain responsible even after it ceases trading and has been deregistered.

What are the general rules of liability?

Broadly, debts incurred by the company are a liability of that company. It does not automatically become the director/s personal debt unless under specific circumstances. Generally, company debt will become a personal liability of a director if they have failed their director duties – ie have not been compliant with the Corporations Act or if they enter into a contractual relationship obligating themselves (eg sign a personal guarantee to a creditor in support of the company’s debt). 

While beyond the remit of this blog, its worthy to note that in nearly all Australian jurisdictions, there is also a positive obligation on directors to exercise due diligence in relation to work health and safety (WHS). Directors can be personally liable for breaches of this duty and the penalties extend to possible imprisonment and very substantial fines.  The same also applies to environmental obligations where the EPA has the power to recover proceeds of environmental crime from current/former directors and related body corporates if a company is found guilty of an offence.

What liability do shareholders have?

Put simply: shareholders are not liable for company debt. The only liability they can incur is for any unpaid amount of their shares. For instance if an individual  owns 100 shares valued at $0.50, then they must pay the $50 to that company if the amount is outstanding. If it becomes apparent that the company is guilty of misconduct, the shareholder can in no way be held personally liable.

What is illegal phoenix activity and how does that fit in?

Phoenix activity was made illegal to stop directors transferring assets from an insolvent business into a new company, for either no payment or at an uncommercial value to another company (that often performs the same service as the insolvent one) and resuming trade with a fresh balance sheet to avoid paying debts or facing personal liability. This is a good example of why directors can remain personally liable for a company’s misconduct, even after it ceases trading.

Illegal phoenix activity can carry criminal charges, leading to imprisonment and large fines for the directors or any persons involved in orchestrating illegal phoenix activity.  Particular interest is given to these parties, often referred to by regulators as “Untrustworthy Advisors” or “Bad Actors” involved in these transactions .  Both the Australian Financial Security Authority and ASIC has written specifically on this topic of untrustworthy advice which can be found here and here.

The evolution of director liability in Australia

Directors’ liability within the Australian business landscape has witnessed significant evolution over recent decades, encompassing a surge in legislative measures influencing the scope of directors’ personal accountability. This intricate transformation underscores the necessity for legislators to tread the fine line between protecting directors and ensuring fair market participation. The historical foundation of limited liability extended to company directors underscores the rationale that by shielding directors from potential personal debt, an environment conducive to entrepreneurial ventures is nurtured. The underlying philosophy is that fostering such activities contributes to broader economic prosperity. Conversely, the counter argument contends that even within free market economies, a degree of protection for all stakeholders is imperative.

What are the common director liability traps?

Several common pitfalls emerge when directors become personally entangled in legal liabilities. These include:

• Director penalty notices (DPNs) issued by the ATO for tax debt and superannuation obligations
• New director tax exposures
• Unfair preference payments
• Insolvency
• Director loans and drawings
• Personal guarantees – often intertwined with bank financing and landlord commitments
• Company credit cards.

Director Penalty Notices (DPNs)

The authority granted to the Australian Taxation Office (ATO) to issue Director Penalty Notices (DPNs) to company directors has been extended since its initial introduction in 1993. This mechanism renders directors personally liable for outstanding taxes that fall under these three categories: pay as you go (PAYG) withholding, superannuation guarantee charge (SGC) and GST (incl Luxury Car Tax and Wine Equalisation Tax amounts). If PAYG and GST amounts disclosed in the DPN had been unreported to the ATO for over three months past the lodgment due date or in the case of SGC not reported by the due date, directors are unable to evade personal liability by opting for company administration or liquidation. Although these changes have been in effect for a relatively short duration, their impact on directors’ personal liability positions is already apparent.

Further reading on DPNs and the option available can be found here.

New Directors

Before you become a company director, check if the company has any unpaid or unreported PAYG, GST or SGC liabilities. As a new director you can avoid becoming liable for director penalties that were due before your appointment, if within 30 days of your appointment, you ensure the company does one of the following:

• pays their debts in full
• appoints an administrator
• appoints a small business restructuring practitioner
• begins to be wound up

Even if you resign as a company director within the 30 day period, you will still be liable for the company’s unpaid PAYG withholding, net GST or SGC liabilities that were due before your appointment.

Unfair preference payments

In instances where liquidation goes ahead and the ATO has been paid off in preference to others, company directors automatically indemnify the ATO against specific components of the repaid sums. The liquidator can in fact recoup that unfair payment, leading to scenarios where directors bear personal liability for that debt.

Personal liabilities for insolvent trading

Simply put, under the Corporations Act, a director cannot incur a new debt if the company is trading while it is insolvent. If a new debt is incurred and that debt remains unpaid when the company goes into liquidation, the director may become personally liable for it. Underpinning this assessment is the cash-flow test, which ascertains a company’s ability to fulfill financial obligations as they accrue. While legal proceedings often lead to settlements prior to reaching the courtroom, the specter of insolvent trading remains a persistent apprehension for directors.

An extension to this aspect of personal liability is where directors have breached their director duties and have prejudiced the interests of the Company’s creditors.  Where directors breach their duties, liability can follow.

Director loans and drawings

A significant liability pitfall pertains to loan accounts established between directors and their companies. Often stemming from director drawings or personal expenses, these transactions bypass PAYG withholding tax. Essentially a loan or drawing to the director is when they are paid money from the company over and above (or instead of) their wage. This loan or drawing needs to then be paid back to the company. If the director fails to do it, these loans become recoverable by liquidators in cases of company insolvency.

Personal guarantees

Sometimes a creditor will require the director or third party to sign a personal guarantee when entering into business with the company. It usually means that if the company incurs a debt that it cannot pay, that guarantor (director) is personally liable.

Company Credit Cards

An often-overlooked personal responsibility that directors and their staff should be aware of pertains to company credit cards. As most credit cards are issued to individuals, while the company typically covers the card’s expenses, the credit card provider will hold the individual accountable for settling the outstanding balance. Additionally, even when a credit card is issued in the company’s name, the standard terms and conditions typically stipulate that the cardholder bears personal liability for both the company’s and their own debts.

ESG

Directors duties around Environmental, Social and Governance (ESG) are rapidly evolving.  No longer is ESG the domain of the large listed corporates and will increasingly be important to all business operations including SME’s.  For larger corporates however, with the introduction of the Sustainability Standards issued by the International Sustainability Standards Board reporting on ESG initiatives, particularly around climate change, these will be expected to be followed from as early as 2024.  Failure to report may see prosecution of directors of breaching these requirements.

Need help?

The trajectory ahead suggests a landscape devoid of liability relief for directors in Australia. The integration of legal awareness, entrepreneurial zeal, and astute decision-making remains pivotal in ensuring directors effectively navigate the intricate web of liability. If you or your client need help with personal liability matters, we urge you to call us before taking any action. This is a complicated and highly legislated space that requires true expertise.

We at Brooke Bird are always available to provide honest and considered advice.