Failing to pay debts has far-reaching consequences - but there is often a solution available.
The New Zealand Government's Insolvency & Trustee Service noted that in the 2015-16 financial year, they managed 3,871 personal and 148 corporate insolvencies. There were many more corporate insolvencies handled by Insolvency Practitioners. While it doesn't happen every day, many New Zealanders find themselves unable to pay their debts every year and often for a director of a company, this is because of a failed company and company debt being subject to personal guarantees.
For company directors, this doesn't just result in a liquidation of the company or the restructuring of their business - in some circumstances, it can also mean their personal assets are at stake and they may be facing bankruptcy proceedings.
When directors make a personal guarantee
A guarantor is someone who legally assures creditors that debts will be repaid. The guarantor of a company agrees to repay all the business' debts if the company fails to meet its obligations - this is a role directors often assume in order to secure supply under trade terms.
More often than not, directors are asked to sign the trade terms as director and also as guarantor. Many suppliers seek the security of a personal guarantee and also for suppliers of stock or lenders a specific or general security over the assets of the company.
When is a director liable for their company's debts?The granting of a guarantee means placing at risk personal assets, like the family home (if the home is not already protected under a Trust structure). Some diligent creditors may also seek guarantees from the family trust when they are aware the director has no personal assets. It is not uncommon for the bank to require securities from the family Trust where the family home is in Trust.
A company that becomes insolvent can face an insolvency procedure such as liquidation or receivership, while an individual can face personal bankruptcy. The liquidator of an insolvent company will investigate directors' duties, which can lead to recovery being sought from the directors personally.
Suppliers who hold personal guarantees can pursue directors for company debts guaranteed by them when the company has not or cannot pay (after gaining the necessary judgment in Court). If the director has no assets or limited means to pay the guarantees, the director may also face an insolvency procedure and/or bankruptcy.
Insolvency & Trustee Service data shows that in 2015-16, 6 per cent of personal bankruptcies were due to a personal guarantee, whether for another individual or arising from a business obligation. This can even have a spiralling effect where a guarantor's other business must be sold or serious action taken - something that occurred in one per cent of 2015-16 liquidations.
Accountants should be fully aware of when a director has a personal guarantee in place, and whether the personal assets will cover the company's debts. If there are any doubts as to a director or company's financial security, it may be time to sit down with a CAANZ accredited, NZ insolvency and business recovery professional such as McDonald Vague.
When directors breach their duties
Under the Companies Act 1993, directors have numerous rights and responsibilities with regard to their business. They must abide by both the Act and any constitution belonging to the company, and (as per Companies Office guidance) must not:
- Act in a dishonest manner or with intention to mislead or defraud
- Act against the best interests of the company
- Act without taking reasonable care
- Act in a way that creates a significant level of risk for creditors (also known as reckless trading)
- Enter into obligations they cannot meet
- Enter into transactions at undervalue or for excessive consideration in self interest
- Agree to distributions when the solvency test is not met
Directors who conduct reckless trading could be personally liable for debts incurred.
As the Financial Markets Authority points out, directors who conduct reckless trading could be personally liable for debts incurred. The duties under the Companies Act 1993 are far-reaching, and advisers should be up to speed ensuring their clients are meeting their obligations at all times.
When a company trades while insolvent
Under the Companies Act, a company is insolvent if:
- "The company is able to pay its debts as they become due in the normal course of business; and
- The value of the company's assets is greater than the value of its liabilities, including contingent liabilities."
When any one of these limbs are not met, a company must rectify the position through capital introduction, investors, company restructure or turnaround options (such as company compromise or voluntary administration) - or cease trading altogether.
If directors fail to take steps and instead take unjustified risks which create significant loss to creditors, there can be serious personal consequences for them. This can include civil penalties and even criminal charges or imprisonment.
The FMA has conducted many criminal cases against directors - particularly in cases where the directors failed to inform shareholders they were insolvent.
When directors don't have the right insurance
There are insurance products available for directors and officers that can cover costs arising from legitimate business risk/wrongdoing. This can cover initial costs owed to creditors, as well as legal costs that occur due to protracted court disputes over payment. These products do not cover fraud related matters and dishonesty, or even all risks - professional advice is required to make the best decision.
Dealing with insolvency and liability requires care and empathy.This could include claims from employees, shareholders, regulatory authorities or even costs due to a liquidation process. Early action creates the best result. With insolvency and business recovery/turnaround specialists on the case, it can be possible to conduct a restructuring or turnaround. A creditors compromise, for example, appeases the requests of the party owed money and treats all creditors without unfair preference.
Tackling liability in the right way
As advisors and accountants, it is important to address these issues without judgement and with empathy. Companies and directors fall into financial difficulties for any number of reasons - Insolvency & Trustee Office data shows that reasons for insolvency range from legal action and guarantees to sudden unemployment, relationship breakdowns shareholder disputes, the loss of key personnel, and changes in technology.
While serious, approaching a director who may be personally liable requires a great deal of care, respect and professionalism. It is these difficult conversations that McDonald Vague & Partners excel in. Our specialists have decades of experience assisting directors and companies through financial hardship in the simplest way possible, providing alternate solutions and frameworks within a business can help it continue to exist or to exit.
To begin one such discussion, contact our team today.