Directors' liability when companies fail to pay debts when due

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.

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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.

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