Creditors of companies that fail are often shocked and angered by the ability of directors of the failed company to start up a new business and carry on as though nothing happened.

They cannot accept that they are suffering because of the losses they are facing whilst the people they see as being responsible for the losses appear to suffer no ill effects.

Who is at fault?

It is important to note that the debt owed to the creditor is owed by the company, not the directors personally.  A limited liability company has its own separate legal identity and it is generally only when the directors have given personal guarantees in favour of particular creditors that they become personally liable for the debts concerned.

Furthermore, company failures are not always attributable to actions of the directors.  Failures come about for a variety of reasons including economic downturn, natural disasters, default in payments from customers and major clients changing supplier.

Starting over

There is no automatic bar to a director of a failed company starting up a new business on the failure of the old one.

There are provisions within the Companies Act 1993 in respect to starting and operating phoenix companies within five years of the commencement of the liquidation of the failed company.

Section 386B(1) of the Companies Act 1993 defines a phoenix company as follows:

A phoenix company means, in relation to a failed company, a company that, at any time before, or within five years after, the commencement of the liquidation of the failed company, is known by a name that is also -

1. a pre-liquidation name of the failed company; or
2. a similar name

A pre-liquidation name means any name (including any trading name) of a failed company in the 12 months before the commencement of that company's liquidation.

A similar name means a name that is so similar to a pre-liquidation name of a failed company as to suggest an association with that company.

There are some exceptions to the rules regarding phoenix companies, for instance Court approval can be obtained (Section 386A(1)) or a Successor Company Notice can be issued (Section 386D).

You can see more detail regarding phoenix companies in the article on our website written by Peri Finnigan, Phoenix companies:  what exactly are the rules here?

What can be done to stop them?

Directors don't always just walk away unscathed by the failure of their company.

There is a personal toll in the stress that they have been under leading up to the failure, the personal loss they may have suffered through funds they had put into the company or through personal guarantees provided to financiers or suppliers, and the sense of failure that most feel when their company is liquidated.

Their actions will also be subject to scrutiny by the liquidator of their company.

Liquidators will investigate, among other things, the activities of the directors to establish if the directors have breached their duties.  This can lead to legal proceedings being taken against the directors if they are considered to have acted in breach of those duties and caused loss to creditors by doing so.

If found to have been in breach of their duties or reckless in their actions the Court can impose monetary penalties on the directors to the level it thinks is appropriate to the circumstances.

One of the statutory duties imposed on liquidators is to report to the Registrar of Companies where they suspect the company or any director of the company has committed an offence that is material to the liquidation against the Companies Act 1993, the Crimes Act 1961, the Financial Markets Conduct Act 2013, the Takeovers Act 1993 and the Insurance (Prudential Supervision) Act 2010.

The liquidators will also report to the Registrar of Companies on any director who they believe should be banned from being director because of the belief that their actions were wholly or partly responsible for the failure of the company or because they have had two or more failed companies in the previous five years.

Breaches of the banning orders and operating a phoenix company can, on conviction, lead to penalties of up to five years' imprisonment or a $200,000 fine.

In conclusion, whilst it may seem unfair that the directors of a failed company can just carry on with business as usual after the failure, there are provisions available to have them brought to task and penalised where appropriate.

It seems like a typically Kiwi thing to do - a couple of mates decide to go into business together and start up a company to operate the business.  Everything is split down the middle - each director owning 50% of the shares and all agreed on a handshake.

What could go wrong?

The recent liquidation of a small business shows just what can happen.  Things went well for the first couple of years.  Business was going okay and making a small profit but then things started to go wrong.

The relationship broke down between the shareholders and got to the stage where they couldn't agree on anything to do with the business including staff management and business direction.

Legal advisors became involved and an attempt was made to resolve the issues by one of the shareholders buying out the other's interest.  Unfortunately, they couldn't agree on the value of the business.

As a result, the decision was made and agreed to by both shareholders to liquidate the company.  The liquidation process was made more protracted and costly by the sniping between the shareholders leading to higher liquidation fees and therefore a reduced payment to creditors.

There are no guarantees of course but this situation may have been avoided, or at least the damage mitigated to a certain extent, if there had been a shareholders' agreement put in place at the time the company was incorporated.

Shareholder agreements usually include

A shareholder agreement is like a business pre-nuptial agreement.  It sets out the basis of the relationship between the shareholders and can include matters such as:

• Defining the type of business the company will engage in;
• How the business will be managed and who will be responsible for particular areas of management such as staff employment etc;
• What types of decisions can be made by individuals alone and what types need majority or unanimous agreement;
• How any of the parties leaving the business will be handled - what happens to their shares etc;
• How any disagreements or disputes that arise will be handled.

It can contain confidential information as, unlike a company's constitution, it does not have to be filed with the Registrar of Companies and be available for public viewing.

Shareholder agreements may also include

They may also cover:

• Non-competition restrictions;
• Appointment and retirement of directors;
• Professional indemnity insurance;
• Transfer of shares and pre-emptive rights;
• Disability and insurance - what happens in the case of a trauma or death to insurance proceeds - does it pay company debts or does it go to the estate?  Who is the policy owner?
• Shareholder approvals, consent and voting.

The complexity and size of the shareholders' agreement will depend to a certain extent on the size of the business, the number of shareholders involved and the areas to be covered.

It will be different for every company and shareholders should seek proper legal advice when putting together any such agreement and before signing one.

How McDonald Vague can help

We regularly see the result of fallouts between company directors and shareholders.  We would advise all company directors and shareholders to put together a Shareholder Agreement at the time the company is incorporated to avoid prolonged and unnecessary expense to shareholders and their creditors.

If your relationship with fellow director(s) and/or shareholder(s) is breaking down contact us for free and confidential advice to find out how we can help.

Alternatively, download our Free Guide to Avoiding Business Failure

Increasingly, we are using the Cloud to create, manage and store documents, such as through Xero, LinkedIn, Dropbox and Google. However, the Cloud is unique in that control of the documents passes outside of your physical possession and onto someone else's computer, which is often overseas.  

Consequentially, there are several issues that a business owner needs to be aware of. 

- How secure is your data and how much control do you have over it once it is in the Cloud?

Often, you will have no idea where the data is stored, you have no idea how the supplier is protecting your data, and occasionally, there is no ability for you to produce a back-up of the data you have stored in the Cloud.

Issues can ultimately arise, for example, when a local or overseas regulatory authority seizes servers containing your data (think Kim Dotcom and Megaupload), an employee emails a client database stored in the Cloud to the wrong party, where your provider goes bust (think Nirvanix), where your provider is hacked (think JP Morgan Chase), and when you are trying to recover that deleted document.

- What happens if your service provider ceases to provide the Cloud service?

The internet has seen large numbers of businesses bomb, such as webvan, eToys, Kiko and Wesale (have you heard of them?!!!!).  The question therefore ultimately becomes, can you easily export your data to another comparable service for ongoing use, and is there another comparable service?

- Do you retain ownership of your data once it is in the Cloud?

This is about you retaining ownership of your documents, and it has been well publicised by the media.  There have been arguments over who owns the data when you use Google or Facebook, for example.  Can someone else use your emailed photograph in an advertisement? Ownership of your Xero account may correspondingly be with your accountant, not you. With the cost of legal action, possession may ultimately be nine tenths of the law. 

- Can you check who has viewed or altered your data in the Cloud?

This is about confirming who did what and when with your documents.  Particularly with financial information, there should be some form of audit trail available to confirm who, for example, created an invoice or payment through internet banking. Does your software allow this, or do you need to purchase tracking software and retain backups of core documents? 

- Are you complying with legal requirements when storing documents in the Cloud?

Generally speaking, you are legally required to store and produce documents in an easily accessible form for seven years under, for example, sections 145, 189 and 190 of the Companies Act 1993.  However, we often find ourselves deleting documents within six months to fit within size restrictions set by our IT administrator.  This may include expense invoices in support of your income tax return, which may come back and bite you if the Inland Revenue Department comes knocking.

Directors and employees also have a legal duty to restrict external access to company information to protect against, for example, insider trading or industrial espionage.  Are you inadvertently or accidentally sharing material company information with suppliers, and the supplier's other customers, thorugh the use of Dropbox?  Are company documents being stored in an account under the name of another legal entity? 

- Can documents stored on the Cloud be used to enforce your legal rights?

This is about making sure that the documents that you have can be used to enforce your rights.  For example, how do you confirm that the scanned contract was created at the mentioned date?  What happens if someone alleges that they never signed it and it is a forgery? 

Inadequate record keeping or data loss will not necessarily lead to the failure of a business.  However, it will ultimately make life more difficult.  At the end of the day, documents such as cashbooks, invoices and contracts, all increasingly stored in the Cloud, form a key basis of a business.  Their loss can also form the basis of a claim against a director by their company, a liquidator or a regulatory authority.

We therefore recommend that all businesses consider information management and security as a key aspect of their business, in the same way that marketing and accounting, for example, is considered at management level.  Many large businesses have a "Company Information Officer" and/or "Compliance Officer" to complete this.  In smaller businesses, the internal or external company accountant can take on the task.

McDonald Vague is commonly employed by businesses, their advisors and their financiers to provide corporate governance and forensic accounting services, and this is an increasing issue for our clients.  We are happy to provide further advice in this area upon request.

There are approximately 500,000 small to medium-sized enterprises (SMEs) in New Zealand, most operating without a formal board.  Often there is no separation between family, management and governance.

An increasing amount of our work at McDonald Vague is involved in providing independent reviews focusing on restructuring and governance with the aim of helping companies lay the foundations to grow in to larger, more profitable businesses and avoid the mistakes we see time and time again. 

Why an independent review?

Typically, the need for an independent review is initiated when a particular issue or concern is identified.  This can provide an opportunity to introduce a sound corporate governance process that can not only solve the issue or concern itself, but set the business up for long-term sustainable and profitable growth. 

Be proactive

If your client's relationship with its financier and creditors is strained or the company is stagnating an independent review from a restructuring specialist may be the first step to unlock the business's full potential.  More often than not our recommendation will be to implement corporate governance.  This may include an independent board member who can cast a whole different lens on the business. 

What is an independent review and what does it entail?

McDonald Vague offers two types of reviews - a Snap Shot Independent Accounting Review and a Full Independent AccountingReview. 

Snap Snot Reviews are fast, independent and often cost-effective way of turning a business around if the recommendations are implemented.

The report will include the following: 

• Review of the business's cashflow projections and short-term needs;
• Review of assets and security;
• Assessment of the business can be improved;
• Review of governance;
• Recommendations.

Full Independent Accounting Reviews offer a comprehensive review of the financial health of the business and recommendations on how to improve or restructure it.

An engagement approach will typically involve: 

• Review of historical performance of the business;
• Determining the current financial position and short-term needs of the business;
• Determining an understanding of its operating activities, key drivers and commercial/contractual arrangements impacting financial performance of the business;
• Security analysis;
• Forecast projections;
• Sensitivity analysis;
• Benchmarking;
• Understand and assess the business's:
  • Strategy;
  • Financial projections;
  • Utilisation of available resources/cash;
  • Industry issues and any potential future significant impacts;
  • Management capacity/capabilities;
• Recommendations.

Corporate governance

Sometimes a business's corporate governance doesn't keep pace with the size of its turnover and exposure to a bank or financial institution.  It is important to have a sound corporate governance policy, clear strategic direction and be as transparent with your financier as possible.

Challenges for implementing governance often include:

• The cost of engaging a consultant;
• The uncertainty of the return on investment;
• Where to find the right people to add value to their business;
• Limited ability to attract high quality directors;
• Owners may have to deal with interpersonal conflict and family conflicts;
• Tough decisions will need to be made to improve the business.

A way of easing into improved governance is by bringing on board an independent consultant who can attend and observe board meetings.  This may then expand into an advisory board role.

An advisory board allows business owners access to independent opinion, along with strategic advice and expertise in an environment where they can discuss important business issues.  Advisory boards aim to benefit the business by better equipping the owners with the information needed to make significant business decisions. 

How can we help?

Our skill base is in diagnosing issues, deploying commercial solutions, and advising underperforming or distressed businesses. As a mid-tier chartered accounting firm specialising in restructuring, we are well placed to offer a co-ordinated, cost-effective service to companies facing financial challenges. 

One of McDonald Vague's experienced staff members can be appointed to an advisory board or through our network of business advisors.  We can recommend suitable independent advisors with the right skills to enhance a company's performance.

Did you know that not using the Personal Property Securities Register (PPSR) could expose your business to unnecessary risk? 

Despite the fact that the online register celebrated its 10th anniversary in May this year, a surprising number of small business owners are not aware of the reduced financial risk that comes with registering security interests on the PPSR. 

Registering your security interest on the PPSR may give you a better chance of recovering a debt if your debtor defaults. (Note:  Suppliers of stock need to register before delivery and suppliers of equipment need to register within 10 working days of delivery). 

What a lot of people don't realise is registering on the PPSR is a valid defence against Insolvent Transaction (voidable preference) claims. 

To date, you or one of your clients has probably never had to pay money back to a liquidator on a debt you have already collected.  If you do it's going to hurt as it feels like you are being penalised for doing your job properly! 

Insolvency Practitioners are increasingly using Insolvent Transactions as their only means of recovering funds for creditors. 

What is an Insolvent Transaction? 

Insolvent Transactions can only arise when the debtor goes into liquidation and are covered in Section 292-296 of the Companies Act 1993. 

A transaction is voidable on the application of the liquidator if: 

• At the time the payment was made the company was unable to pay its due debts; and
• The payment was made within the specified period (up to two years prior to commence of the liquidation); and
• The creditor received more than they would have been likely to receive in liquidation.

We are suggesting that if the company was unable to pay its debts within terms of trade, and if the payment was made in the specified period, it may be pursued as an Insolvent Transaction but if you have registered a specific security to cover your supplies (a purchase money security interest "PMSI") then you will have a valid defence. 

The reason for this is that the payment was simply settlement of a PMSI with a "super priority" and that consequently the secured creditor received no more than they would have been likely to receive in liquidation. There were no creditors with a higher priority.   

Please be aware that this has not been tested in Court.  There are ways in which a liquidator may seek to challenge this. 

As insolvency practitioners, McDonald Vague constantly sees what happens when people do not register on the PPSR correctly, or don't use the PPSR at all.  We can assist in mitigating the risk of Insolvent Transactions for you or your client losing priority to another creditor by implementing a PPSR policy.  We can also review terms of trade to ensure there is a right to register a PMSI or a General Security Agreement before goods are supplied. 

Call Tony Maginness for a free consultation about registering on the PPSR and terms of trade.

McDonald Vague are solution providers for businesses at risk, and specialists in business recovery. We often deal with liquidations where the director has continued to trade an insolvent company. In many of those cases, prior to liquidation the director/shareholder has increased the mortgage on their house and advanced further capital for a short term cash flow fix without taking out any security for that advance. If funds are advanced to the company, the director/shareholder should seek legal advice on obtaining security and registering that security on the Personal Property Securities Register prior to the advance.

CONCERNED ABOUT YOUR PERSONAL LIABILITY?
TALK TO US IN CONFIDENCE

• If you are concerned your business maybe be trading while insolvent;
• or are worried about you personal liabilities as a director if your company goes into liquidation,
• Contact us now for free, confidential, expert advice.
• The sooner you contact us the more options are open to you.

This email address is being protected from spambots. You need JavaScript enabled to view it.

Iain McLennan

Director

Phone: (09) 303 9512

Mobile: 021 664 556

Email: This email address is being protected from spambots. You need JavaScript enabled to view it.

A director must not allow the company to enter into any transaction which could create substantial risk of serious loss to creditors. The penalties for doing so are severe and include making the director personally liable for the debts of the company without any limitation of personal liability. Directors can avoid that personal liability by acting promptly and not increasing the exposure to creditors. Directors may also face prosecution by the Inland Revenue Department ("IRD") for failing to pay over PAYE deductions or GST. The IRD is taking an increasingly tough stance in this area, and bringing numerous prosecutions. Examples of such prosecutions can be found in media releases on the IRD website.

A company director has a responsibility to seek specialist advice if the company fails to meet either of the two limbs of the solvency test. To satisfy the balance sheet test, the value of the company's assets must be greater than the value of its liabilities, including contingent liabilities. The primary focus of the liquidity test is that the company is able to pay its debts as they become due. It is essential to recognise that the company must meet both limbs of the test, not just one.

Often a business facing insolvency can be restructured. In some cases a Creditor Compromise can be entered into, pursuant to Part 14 of the Companies Act 1993. Please see our article Company creditor compromises - worthwhile or not? on this subject.

If a company can not pay debts when they fall due this should trigger action by the directors. A director should not wait for a statutory demand, a winding-up application or for a secured creditor to appoint a receiver.

We deal regularly with companies that not only struggle to pay debts but also have negative net asset positions. Those companies may have suffered from a bad debtor, a downturn in the economy, competition, or lack of capital. Often liquidation is the only option for such companies. Placing a company in liquidation is as simple as liquidators consenting to act and the shareholders signing a resolution. For more information on the liquidation process, please visit our Liquidations page.

We find that businesses subject to risk have common warning signs such as the loss of a key account, unrealistic assets on the balance sheet, increase in staff turnover, slow stock turn, rising debts and slowing growth, price cutting, extended credit terms and large bad debts.

These symptoms do not necessarily mean that a business is on its last legs. If any of these signs are caught early enough, they can be turned around so that the business can end up stronger in the long run.

The director should be wary that he or she will be held accountable if proper action is not taken at the date they knew or should have known that the company was insolvent. It is our recommendation that advice is sought earlier rather than later to reduce the financial culpability of the director for trading recklessly and the risk of financial loss to creditors.

DISCLAIMER
This article is intended to provide general information and should not be construed as advice of any kind. Parties who require clarification on issues raised in this article should take their own advice.

The following are some issues which tend to crop up on many of our liquidations.

Vehicles claimed by directors

A minor, but often emotive issue, is the car "owned" by the director. The director states it is their car, and it is registered in their name. Registration, however, does not prove ownership and if the car is in the company's accounts and shown on the depreciation schedule, the liquidator will fulfill one of their principal duties by taking possession of the car and selling it.

Share capital not paid up

Under modern company law, shares have no nominal value. Too many times we hear that if a company has 1,000 shares then there is an obligation on the shareholders to pay $1,000. This is not the case. The consideration for shares is determined by the board of directors pursuant to Section 47 of the Companies Act 1993. If a 100 share company goes into liquidation and the directors have not determined the consideration for the shares, there is a risk that the liquidator will take a stance that the consideration for the shares should have been $1,000 each and will instigate legal proceedings accordingly.

Tools of trade - machinery etc

These are a little like the car. The director/shareholder regards them as theirs. They have built them up over the years and owned them in the period when they were a sole trader. Unfortunately, these too may be in the company's accounts, usually for one or more of three reasons:-

• So that the accountant can claim depreciation on them
• To help pay up the share capital
• To wipe out an overdrawn shareholder's/director's current account

Again, the liquidator will insist on taking control of these items and selling them.

Personal guarantees

Unfortunately for directors (but not for creditors), limited liability is often negated by personal guarantees. Few directors are conscious of the guarantees they have signed. Such personal guarantees can lead to a director becoming bankrupt. Some common situations where personal guarantees are required are as follows:-

• The bank
• Hire purchase and leasing agreements - a personal guarantee is usually required
• The landlord - lease documents invariably include a personal guarantee
• Trade creditors - the catch here is in the application for credit. This often has a personal guarantee incorporated into it and the director scarcely realises what they have signed

The big bluff

A creditor states they are holding a personal guarantee. A guarantee to be effective must be in writing. Ask for a copy of it. It may not even exist.

Construction companies

Did the director build themselves a house and charge the kitchen and laundry and roofing material to other jobs? The liquidator tends to find out about such matters.

The accountant's or solicitor's lien

Where an accountant or lawyer is owed money and the liquidator requires their files, that professional can claim a lien over them. The Companies Act 1993 provides that in such circumstances the liquidator must agree to accept a preferential claim of 10% of the total value of the debt, up to a maximum amount of $2,000. The important thing here is to claim a lien before handing over the books. If the books and records are simply handed over on request it is too late afterwards to claim preferential status.

Conclusion

Liquidation is a tricky business, and the issues involved are often more complex than they may appear at first sight. We are always available to discuss with accountants, lawyers and their clients any issues they have in this area.

Note: This article was written by Jonathan Barrett who has subsequently left the firm.

DISCLAIMER
This article is intended to provide general information and should not be construed as advice of any kind. Parties who require clarification on issues raised in this article should take their own advice.

Usain Bolt flashed through the 100 metres at the London Olympics in 9.63 seconds - a new Olympic record. Imagine the uproar there would have been if, at the end of the race, the officials had asked, 'What is the current record?' only to be told, 'I don't know. It's not written down anywhere. From memory it's about ....'

Accurate records need to be kept for many different reasons, and in relation to companies the requirements are set out in the Companies Act 1993 and also the Tax Administration Act 1994.

Accounting records to be kept - Section 194 Companies Act 1993

The board of a company must cause accounting records to be kept that -

• Correctly record and explain the transactions of the company; and
• Will at any time enable the financial position of the company to be determined with reasonable accuracy; and
• Will enable the directors to ensure that the financial statements of the company comply with section 10 of the Financial Reporting Act 1993 and any group financial statements comply with section 13 of that Act; and
• Will enable the financial statements of the company to be readily and properly audited.

The section goes on to describe the type of information that the accounting records must contain and this includes details of money received and spent each day and the matters to which it relates, a record of the assets and liabilities of the company and, if the company's business involves dealing in goods, a record of the stock bought and sold.

The records must be kept in English or in a form or manner that is easily accessible and convertible into written form in English.

If the board of a company fails to comply with these requirements every director commits an offence and is liable on conviction to a fine of up to $10,000.

However, the problems don't necessarily stop there for the director of a company that has failed to maintain proper accounting records, as Selvathas Ariyathas discovered in a recent case decided in the High Court in Auckland (Walker v Ariyathas HC AK CIV-2011-404-1894).

If a company goes into liquidation the liquidator may seek an order pursuant to Section 300 of the Companies Act 1993 making the directors personally liable for all or part of the company's debts.

If the Court considers that the failure to keep proper records has -

• Contributed to the company's inability to pay all of its debts; or
• Resulted in substantial uncertainty as to the assets and liabilities of the company; or
• Substantially impeded the orderly liquidation

Then the Court may, if it thinks it proper to do so, declare that any one or more of the directors and former directors of the company is or are personally liable for all or any part of the company's debts and other liabilities.

In Mr Ariyathas' case the Court made an order that he was to pay the liquidator $998,505 plus interest and costs.

But keeping proper accounting records isn't only about compliance with the law. The records are a very important tool for company directors to use in their day-to-day operation of the company.

A director should, at any point in time, be able to refer to the accounting records to establish how their business is trading and whether or not there are issues that need addressing. Without proper records a director can not tell, with any degree of certainty, if the company is trading profitably and has sufficient cash flow to meet its liabilities.

The complexity of the records and the manner in which transactions are recorded will depend, to some extent, on the size and nature of the company but the basic requirements will remain the same.

If a company does not have a proper accounting system in place then its directors should seek advice from its accounting professional, or contact one of our business recovery specialists for advice. In the long run it could save the company and also save its directors from personal liability.

There is a requirement under the Tax Administration Act that a company's accounting records are retained for at least seven years from the end of the tax year or the taxable period that they relate to.

Company records

There are various other records that a company is required to keep at its registered office. These are set out in Section 189 of the Companies Act 1993 and include -

• The company's constitution (if it has one)
• Minutes of all meetings and resolutions of shareholders and of directors within the last seven years
• An interests register
• Certificates given by directors under the Companies Act within the last seven years
• The full names and addresses of the current directors

As with the accounting records, it is an offence to fail to comply with the requirements of Section 189 and both the company and its individual directors may be liable.

Conclusion

It is essential that directors protect both themselves and their companies from potential liability, and ensure that they have the financial information available to properly manage their business. We recommend that all directors look at Sections 189 and 194 of the Companies Act 1993, or discuss them with their professional advisors, to ascertain the type of company and accounting records that they need to keep.

We are happy to discuss any of the issues raised in this article. Please contact the author or any of our Partners or senior staff members.

DISCLAIMER
This article is intended to provide general information and should not be construed as advice of any kind. Parties who require clarification on issues raised in this article should take their own advice.

With the recent activity in high profile prosecutions of company directors by the Serious Fraud Office ("SFO"), we thought it opportune to revisit a case in which our firm was involved highlighting the point that it is not only the high profile directors that pay a heavy penalty when events do not go according to plan.

We pinpoint some useful tips for your clients who may be considering taking on a governance role in a company for which they do not necessarily have all of the prerequisite skills or experience.

The judgment for FXHT was released on 9 April 2009.

This case concerns a foreign exchange investment broker. The elements of the case involved fraud, breaches of directors' duties and ultimately the need to define the role and responsibilities of non-executive directors.

The defendant was a non-executive director in the company (by profession he was a medical practitioner). The defendant absolved all responsibilities to the executive director. He did however sign on behalf of the company, an employment contract, that required the executive director to report directly to him.

The defendant allowed the executive director to have sole charge of the running of the company, including being the only signatory to the cheque account. Directors' meetings were never held, no accounting records were ever maintained, no budgets or plans existed and segregation of duties were non-existent.

As a consequence, the executive director committed fraud whilst in charge of investors' funds. The defendant relied upon the executive director's "vast experience" which amounted to learning about Forex trading on a rugby trip.

No checks were made into the background of the executive director. If checks had been carried out, even the most basic of enquiry would have revealed that he had been involved in suspected fraudulent activities in South Africa.

As a consequence, the executive director faced seven counts of theft brought by the Serious Fraud Office in relation to these matters. The court in its judgment, found against the non-executive director for $300,000.

The message is clear for all professionals, when advising their clients who may be considering taking on directorships involving companies in which they have no experience-:

• Be fully aware of the financial situation of the business at all times;
• Ensure basic controls are firmly in place
• Attend all board meetings;
• If they do not have experience, they must be prepared to find out;
• Seek advice where possible from experts in the industry;
• Understand the risks and rewards associated with the industry.

Unless the clients are prepared to take on these responsibilities and put in both the time and effort required they should either:

• Decline the directorship;
• Take out expensive insurance protection;
• Be prepared to face the extremely punitive consequences if things go pear shaped.

In conclusion, we are left with the opening statement of Justice J Venning:

"This case highlights the risk of a director becoming involved in a company whose business is outside the director's expertise. It also highlights the risk to investors who pursue high returns in speculative investments such as foreign exchange. It has led to loss by all parties concerned."

As an addendum to this article it is also pertinent to note that this case ultimately resulted in a successful prosecution by the SFO against the executive director, concluding with a term of imprisonment. This, however, was of little help to the non-executive director who ultimately paid the financial penalty.

Note: This article was written by Roy Horrocks who has subsequently left the firm.

DISCLAIMER
This article is intended to provide general information and should not be construed as advice of any kind. Parties who require clarification on issues raised in this article should take their own advice.

Our clients sometimes express frustration and disbelief when directors of insolvent companies form new companies, often trading as normal, especially when these new companies then also fail.  A frequent question is along the lines of "surely this can't be legal?". In this short article we seek to clarify the law in this complex area.

It is important to understand that there is no general prohibition on directors starting out again, even with an essentially identical business which has risen from the ashes of the old, like the mythical "Phoenix".  Instead the law seeks simply to ensure that suppliers are not misled or confused as to which entity they are dealing with, and are aware of any insolvency and also any related sale of assets to a new company.  It is then up to those suppliers to make an informed decision as to whether to provide credit to the new entity.

The 'phoenix company' rules were only introduced into the Companies Act in late 2007 at Sections 386A to 386F.  They are slightly complicated, and perhaps not very well understood.

What the law says

A phoenix company is defined as one that has been known by the same, or a similar, name or trading name as a company in liquidation (at any time before or within five years after the date of liquidation).  A person cannot be a director of a phoenix company within five years after the insolvent company's liquidation without the court's approval, with one major exception.  This is where the phoenix company has bought the business from the insolvent company's liquidator or receiver, and the directors notify all creditors of the insolvent company of this situation in writing.  There is a strict 20 working day deadline to issue a 'successor company notice' (or apply to the court for a dispensation).

A further exception is where the phoenix company has already traded for at least 12 months prior to the insolvent company's liquidation with the same/similar name or trading name.

Should a company/person commence under a phoenix arrangement prior to or shortly after the liquidation of the failed company, that company/person must apply to the Court for an exemption from prohibition within five working days after the commencement of the liquidation of the failed company.  A recent case has shown that this deadline will be strictly enforced.

Where the rules are not followed at all, it is possible that suppliers end up trading with one company without being aware that the previous company has failed.  This is particularly an issue when trading is conducted on behalf of an entity that is described as "trading as", and the original entity is not formally liquidated, leaving a supplier potentially without any agreed trading terms with the new entity.

Penalties for non-compliance

There are severe penalties for breach of the phoenix company rules - a fine of up to $200,000 or up to five years in jail. These penalties also apply where the phoenix entity is an unincorporated business.  The directors will also be personally liable for all debts incurred by the phoenix company.  It is therefore essential that directors follow the rules, and take specialist legal advice should they find themselves in this position.

When the rules do not apply

The rules do not apply in the case of a solvent liquidation, as there will have been no loss to creditors.  More problematically, however, they do not appear to apply where a company is in receivership but not liquidation.

They also do not apply if the new company has a completely different name (and also trading name).  This is why it is always important to enquire as to who is behind a new customer, and perform your own checks including company and director searches.  It is very easy to search on the Companies Register by director name, and this will list all current and past directorships.

Where a business has already been sold pre-liquidation to a phoenix company, as liquidators we review the price paid and whether this reflected fair value.  If not, we may be able to bring a claim against the phoenix company under the Companies Act provisions regarding transactions at an undervalue.

Conclusion

The phoenix company rules provide some clarity for creditors, assuming of course the rules are followed.   Where a creditor suspects that there is a phoenix situation and the proper procedures have not been followed, they should discuss this firstly with the company's liquidator and also their own lawyer.   They may then be able to hold the directors personally liable for any unpaid debts of the phoenix company, and also make a complaint to the Registrar of Companies leading to prosecution.

Great care is still required by businesses when being asked to supply a new customer, especially when they know or suspect that the directors have a history of insolvency behind them.   We are happy to answer any questions creditors and their advisors may have on specific situations they are dealing with.

DISCLAIMER
This article is intended to provide general information and should not be construed as advice of any kind. Parties who require clarification on issues raised in this article should take their own advice.