Tuesday, 08 October 2019 11:16

Failure To Maintain Statutory Records

All companies must keep company records, minutes, resolutions and a share register. This article discusses what is required and what can happen when there is a failure to maintain company, statutory and financial records.

Failure to keep accounting records and to comply with Section 194 Companies Act 1993 can render director(s) liable to conviction for an offence.

Failing to maintain books and records may cause a presumption of insolvency and directors could be held personally liable.

Companies have an obligation to keep company records under S189 of the Companies Act 1993. Minutes, resolutions and financial statements must be maintained for the last 7 years. S190 of the Act requires that the records must be kept in a written form or in form or manner that allows the documents and information that comprise the records to be easily accessible and convertible into written form.

Shareholders Resolutions

Best practice dictates that an annual shareholder resolution recording that the shareholders have received special purpose financial statements, prepared by the directors for compliance purposes, and believe these adequately meet their needs for information is recommended.

The purpose of such a resolution is to record that shareholders have received the taxation statements and to record that these adequately inform them of the progress of their company. These resolutions overcome any dispute at a later date, particularly where the directors and shareholders are not all the same people.

Shareholders also should approve the remuneration paid to the directors (even or often the same) when they record they have received the special purpose financial statements. Shareholders should also approve any major transactions as defined, by special resolution.

Directors Certificates of fairness are required for Director/shareholder remuneration and for interest on loans to/from shareholders.

Register of Directors Interests

If you are a registered office, you are required to maintain an Interests Register in the statutory records for each company.

The Register is required to disclose the directors:
• interests in company transactions, including those where the relationship is indirect, which may include other directorships or trusteeships (includes the initial issue of shares on formation (S. 140)
• use of company information (S. 145)
• share dealings, including the directors’ own holdings or holdings by trusts of which he/she is a beneficiary (S. 148)
• remuneration and other benefits (S. 161)
• indemnity and insurance (S. 162)

The Companies Act 1993 envisages an annual disclosure by way of entry to the register.

Company Constitution

If the company has a constitution this must be kept at the registered office.

Share Register

A company must maintain a share register that records shares issued, shareholders names and addresses’ and the number of shares held. The details of all shareholders and movements in shareholdings must be maintained for the last 10year period.

Financial Statements

Good records help business management. Financial records must record and explain company transactions and comply with generally accepted accounting practice. Companies have different reporting requirements depending on annual revenue and assets.

Large New Zealand and large overseas companies must file annual audited financial statements under the Companies Act 1993. Smaller businesses must maintain financial statements unless it is not part of a group and has not derived income of more than $30,000 and not incurred expenditure of more then $30,000.

A company falling below these thresholds must still keep tax records and employer records.

Director Duties to Maintain Books and Records

The obligation to keep accounting records is codified under section 194 of the Companies Act 1993. A breach of accounting requirements under Section 194 and 189 may constitute a default or breach of duties under Section 301. The potential liability for failing to keep books and records can be significant and is avoidable. Directors may face court action from the company, shareholders or creditors for failing to keep proper records. The Court can order compensation and hold the director personally liable.

Personal Liability following Company Insolvency

A director can be held personally liable (s300(1)) if a company is unable to pay all its debts and has failed to comply with its duty to keep accounting records (s194) or (if applicable) to keep financial statements (s201 or 202) and the Court considers the failure to comply has contributed to an inability to pay all its debts or has resulted in substantial uncertainty as to the assets and liabilities.

Poor records hinder a liquidators’ ability to investigate company affairs. The lack of records can mean there is no way for a company of determining the likelihood of an impending insolvency. This breach can support a reckless trading action.

In the liquidation of Global Print Strategies Ltd (in liq) v Lewis (2006) the directors knew there was no adequate accounting system. The Court said that a director cannot be heard to say “I did not realise we were in such a pickle, because we did not have any or adequate books of account.” The Court held it was fundamental that books must be kept and directors must see to it that they are kept.

 

Companies cease trading for many reasons including technological change, competition, ill health, directors’ retirement, ongoing financial problems, or simply because the company has sold its business or assets and serves no further purpose.

When a business is profitable, a business can cease to trade following sale of its business or sale of its business assets and can resolve to wind up via a section 318(1)(d) procedure (known as the “short form removal”) or follow a formal solvent liquidation. In current New Zealand law, solvent liquidations are advanced to distribute capital gains and capital reserves tax free and to provide more certainty of finality.

In insolvency, directors have a legal obligation to cease trading in accordance with insolvency laws and to ensure they do not breach directors’ duties. Failing to do so, can have significant consequences for the directors personally.

What happens when a company ceases to trade?

When a company ceases to trade, business stops, trading accounts are closed, employees are terminated and assets are realised and distributed. There can be a surplus or a deficit arising.

Solvent Companies

If trading has ceased voluntarily in a solvent company, directors and shareholders resolve to wind up the company. Surplus funds from the sale of assets are distributed among shareholders after all creditors have been repaid. A final tax return is filed and then following tax clearance, an application can be filed with the Registrar of Companies for company strike off. This is a short form removal. In larger companies or where large capital gains have been realised, a solvent liquidation is advanced.

Insolvent Companies

If a deficit is anticipated on windup and where the directors/shareholders do not plan to top up the shortfall, an insolvent voluntary liquidation should be advanced so that an independent practitioner appropriately deals with the distribution of assets taking into account priorities established by legislation. This adds some independence and avoids directors inadvertently preferring certain creditors who then face claw back later when liquidation is advanced by a creditor.

What should happen to a company that is risking trading insolvently?

The Shareholders should look to appoint a liquidator, or the board to appoint an Administrator (if the company is worth rescuing). The practitioner appointed then deals with the company’s affairs and assesses whether it can be rescued or sold as a going concern or wound up. Under a rescue/restructure some staff may be maintained and the business may continue often under a new structure. Sometimes a director or manager has the opportunity to buy back the assets from the liquidator or administrator or receiver in a new entity. This is often called a “hive down”.

If business rescue isn’t an option, assets are sold to repay the company’s creditors as far as possible, following a strict order of priority set out in the Companies Act 1993.

Creditors’ claims when a business has ceased trading or faces liquidation

If you are a creditor of a company that has ceased trading, you need to find out the circumstances in which the business has ceased to trade. If it’s solvent and being wound up, you should be contacted by the director(s) and you should make a claim by providing evidence of your debt to be paid. If trading has ceased due to insolvency and an insolvency practitioner has been appointed, you should contact the liquidator or Administrator to register as a creditor and file a formal claim (if the practitioner has not contacted you). The liquidator will assess your claim and arrange to pay creditors from available funds in the order of priority set by the seventh schedule of the Act.

Creditors of a Company facing strike off from the Companies Register

If you are owed funds, and the company that owes you is facing strike off by the Registrar (often for failing to file an annual return), you can object to the strike off by objecting on the Companies Office website:

https://companies-register.companiesoffice.govt.nz/help-centre/closing-a-company/objecting-to-the-removal-of-a-company/

If you suspect the company has or had assets, or there has been some untoward dealings, as a creditor you can apply to the Court for the appointment of a liquidator after following a proper process. The liquidator can investigate and take recovery action. As the applicant creditor, your applicant Court costs are preferential and rank in priority to the distributions to unsecured creditors.

Creditors of Companies struck off the Companies Office Register

To take action to recover against a struck off company, you must apply for the company to be restored to the Register first. This involves a formal application to the Registrar of Companies and you will need to provide evidence of the debt due. Once reinstated follow a formal demand process.
The two most common ways of restoring a company are as follows:
1. An application made to the Registrar under section 328 of the Companies Act 1993 by a:
o shareholder/director,
o liquidator/receiver, or
o creditor of the company.
Note | This process can take up to six to eight weeks to complete.

2. An application made to the High Court under section 329 of the Act. This option could be considered if there is some urgency to your application such as a property settlement. This is also the only option available if the Registrar received an objection to your section 328 application.

For more information on the implications of a company ceasing to trade, call one of the team at McDonald Vague Limited. We offer no obligation up to one hour free same-day consultations and can quickly assess your best options.

The Tax Working Group at recommendation 61 have said for closely held companies, that IRD should be granted the ability to require shareholders to provide security to IRD if debt is owed by the shareholders to the company and the company owes debt to IRD. This enhances the position of IRD in insolvency and essentially breaks the corporate veil.

Accountants need to monitor the current account positions of their clients and ensure that dividends and salaries are being declared to ensure current accounts are not overdrawn.

Recommendation 61 provides:
61. that, for closely held companies, Inland Revenue have the ability to require a shareholder to provide security to Inland Revenue if:
(a) the company owes a debt to Inland Revenue.
(b) the company is owed a debt by the shareholder.
(c) there is doubt as to the ability/and or the intention of the shareholder to repay the debt.

The impact on companies will vary. For many it will make no difference – for example, public companies, those whose directors/shareholders only receive tax paid salaries, those who annually declare a return and pay tax and where salaries equate to the amount of drawings taken, and those who pay tax and make distributions to shareholders fully imputed.

For closely held companies that routinely have a low taxable profit and material non cash tax deductible expenses resulting in cash surpluses that are paid to shareholders without the shareholders declaring income, issues will arise.

Accountants need to be more proactive for their clients and ensure current accounts are managed.

For more information refer to the following links:

https://www.simpsongrierson.com/articles/2019/tax-working-group-offer-security-to-inland-revenue

Tax Working Group Interim Report

https://taxworkinggroup.govt.nz/sites/default/files/2018-09/twg-interim-report-sep18.pdf pg. 111.


The Government’s response to the recommendations of the Tax Working Group – 17 April 2019

https://www.beehive.govt.nz/sites/default/files/2019-04/TWG%20Government%20response%20table.pdf

https://taxworkinggroup.govt.nz/sites/default/files/2018-09/twg-bg-3987029-minutes-19-july-2018.pdf (page 6)

Wednesday, 19 September 2018 08:56

Personal Liability In Company Insolvencies

A question that will often arise in discussions with the directors and shareholders of companies facing financial difficulties is what their personal liabilities are.

The initial response to the question is, if the company is a limited liability company, you are not personally liable for the debts of the company BUT… and it is a reasonably big “BUT” because there are a number of ways in which an individual can become personally liable in relation to an insolvent company.

The purpose of this article is to identify some of the ways in which you can become personally liable and the steps you can take to avoid or mitigate that liability.

Personal Guarantees:

It is common for trade suppliers to require the directors of a company seeking to open a credit account with them to provide a personal guarantee (PG). To be enforceable, the terms of the guarantee must be in writing, must be brought to the guarantor’s attention and must be signed by the guarantor as accepted. The terms of the PG are often incorporated in the trading terms and conditions for the account so be careful to read ALL the small print before you sign the acceptance at the bottom of the page.

Generally, the guarantee will require the guarantor to settle the debts of the company to the supplier from personal resources if the company fails to do so.

If the company is placed into liquidation, the creditor can make a call on the guarantor to meet their obligations under the guarantee without having to wait for the liquidation process to be completed.

You can try to avoid providing guarantees however you may have to if you want a credit account with that particular supplier. You could also seek to limit the guarantee to a specified maximum amount.

Shareholder’s Current Account:

A shareholder’s current account records the advances made to the company by the shareholder as credits and the drawings taken out of the company by the shareholder for personal expenses as debits.

It is common for directors and shareholders who work in a company business to take drawings rather than paying themselves a wage or salary with PAYE and other payroll deductions taken out and declared to the Inland Revenue Department.

Providing the accounting process is followed properly, there is nothing wrong with doing this.

The problem arises if the company is insolvent and the shareholders have taken out more than they have put into the company. An overdrawn shareholder’s current account is a debt owed to the company and is payable on demand. As it is an asset of the company, a liquidator would seek payment of the overdrawn amount from the shareholder concerned.

If you take more funds out of the company than you put in it creates a liability. To mitigate that liability, make sure your accountant attributes an annual salary to you in your current account when completing the annual financial reports for the company. This will require you to declare that salary in your personal tax return and pay tax on it.

Director’s Duties:

The Companies Act 1993 (‘the Act”) sets out the duties and obligations of a director to the company and, if the company is insolvent, to its creditors.

Those duties are set out in sections 131 to 137 of the Act and include the duty to –

  • Act in good faith and in the best interests of the company (s. 131);
  • Exercise a director’s powers for a proper purpose (s. 133)
  • Not trade recklessly by agreeing, causing or allowing the business of a company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors (s. 135);
  • Not agree to the company incurring an obligation that it will be unable to perform when due (s.136); and
  • Exercise the care, diligence and skill that a reasonable director would exercise in the performance of duties as a director (s.137).

If a director breaches one or more of those duties and obligations, they can be held personally liable for some, or all, of the company’s debts.

To avoid the potential liability, make sure you know what your duties and obligations are, who they are owed to and how that position can change depending on the financial state of the company.

Tax debts

The failure to pay GST, and PAYE, and other payroll deductions that have been taken from an employee’s wages, to the Inland Revenue Department can lead to a prosecution being undertaken by the IRD and result in the company directors being held personally liable for the debts.

The penalties imposed on conviction for failing to pay on the taxes deducted from employee’s pay can be severe, including terms of imprisonment.

To avoid this potential personal liability, keep a separate tax account into which you put all GST and payroll deductions payable to the IRD and make sure you pay it on when due.

If you have cashflow issues, then you may be eligible to apply to the IRD for hardship relief or an instalment plan. Acting early will reduce your potential personal liability.

Phoenix Company

The Phoenix Company provisions of the Act were put in place to ensure that, if a company fails, the directors cannot just set up a new company with the same name, or a similar name (a phoenix company), and carry on trading without their creditors or suppliers being aware of what has happened.

The director of a failed company is banned from operating a new company with the same or similar name for a period of 5 years unless they have the permission of the Court or one of the exceptions set out in sections 386D to 386F apply.

The 3 exceptions referred to are –

  • The issuing of a successor company notice; or
  • A temporary trading period allowed whilst application is made to Court for approval; or
  • Where the phoenix company has been known by the failed company’s pre-liquidation name for at least 12 months and it has not been dormant during that 12 month period.

If the director of a failed company sets up a phoenix company and does not have Court approval or meet the requirements of one of the exceptions, then the director can be found personally liable for debts of the phoenix company and could also, on conviction on indictment for the breach of the Act, be liable to fine of up to $200,000 or imprisonment for 5 years.

To avoid falling foul of the phoenix company provisions, make sure that you obtain good professional advice on whether your proposed course of action will be in breach of those provisions and what needs to be done to correct that position.

You can restructure and trade with the same or similar name, if you follow the right steps.

Conclusion:

There is the potential for liabilities of your insolvent company to become your personal problem if you have not paid attention to your duties as a director of the company or you have used funds from the company in breach of your obligations.

If you would like more information on your personal position and how you can best protect yourself from personal liability, please contact one of the team at McDonald Vague.

Colin Sanderson

September 2018

Friday, 13 November 2015 13:00

Delinquent Directors

With power comes responsibility, and the duties imposed on company directors are extensive and onerous. Whilst business is brisk and revenues swell, breaches of directors’ duties often go unnoticed and without serious repercussions. When fortunes change, a director’s conduct, even years before, can come under close scrutiny from various quarters. As matters go from bad to worse, these parties include shareholders, creditors, receivers, liquidators and regulatory enforcement.

Section 126 of the Companies Act 1993 (“the Act”) widely defines directors; effectively including shadow and silent directors, as well as those who although not duly appointed, exercise certain powers of a director.

Calling to account

Under the Act, liquidators have extensive powers to investigate the affairs of failed companies and the conduct of its officers. They can also seek recovery of funds or property where companies’ officers have acted improperly.

It is important to note that although a director may be guilty of breach of duty or law, a liquidator will be more concerned with recovery of money or property lost as a result of that breach, than looking to have the director sanctioned.

After selling or realising company assets, liquidators turn to other avenues of recovery such as:

  • Recovery of insolvent transactions - simply put, claw back of preferential payments to creditors which were made whilst the company was insolvent, and
  • Recoveries against directors for breach of their duties.

After the recent Supreme Court decisions in Allied Concrete Limited v Meltzer (SC 51/2013); Fences & Kerbs Limited v Farrell (SC 80/2013); Hiway Stabilisers New Zealand Limited v Meltzer (SC 81/2013) [2015] NZSC 7, recovery actions under the insolvent transaction regime have been limited. On the other hand liquidators are increasingly focussed on potential recoveries for breach of directors’ duties.

Directors duties under the Act

The Act details various directors’ duties: some individual and some collective. Furthermore, certain decisions require higher approval from shareholders through special resolution, such as for major transactions or directors’ salaries.

Directors’ duties include but are not limited to the following:

  • “Section 131 Duty of directors to act in good faith and in best interests of company
  • (1) Subject to this section, a director of a company, when exercising powers or performing duties, must act in good faith and in what the director believes to be the best interests of the company...”
  • “Section 133 Powers to be exercised for proper purpose

    A director must exercise a power for a proper purpose.”

  • “Section 134 Directors to comply with Act and constitution

    A director of a company must not act, or agree to the company acting, in a manner that contravenes this Act or the constitution of the company.”

  • “Section 135 Reckless trading

    A director of a company must not—

    (a) agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors; or

    (b) cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.”

  • “Section 136 Duty in relation to obligations

    A director of a company must not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so.”

  • “Section 137 Director’s duty of care

    A director of a company, when exercising powers or performing duties as a director, must exercise the care, diligence, and skill that a reasonable director would exercise in the same circumstances taking into account, but without limitation,—

    (a) the nature of the company; and

    (b) the nature of the decision; and

    (c) the position of the director and the nature of the responsibilities undertaken by him or her.”

  • “Section 194 Accounting records to be kept

    (1) The board of a company must cause accounting records to be kept that—

    (a) correctly record and explain the transactions of the company; ...”

Penalties and consequences of breach of director’s duties

The Act imposes criminal penalties up to a maximum of five years imprisonment or $200,000 for certain serious breaches of duties by directors.

Whilst fines accrue to the Crown, a liquidator is more concerned about what can be recovered for the company, and will petition the Court for orders under sections 300 and 301 of the Act.

Section 300 of the Act allows the Court to order directors personally liable for some or all the debts of a company for failure to keep proper accounting records. That is subject to the proviso that such failure contributed to the cause of the company’s failure.

Section 301 applies to a variety of relevant people, and includes directors for breach of their duties. Under subsection 301(1)(b) the Court may order a director:

“(i) to repay or restore the money or property or any part of it with interest at a rate the court thinks just; or

(ii) to contribute such sum to the assets of the company by way of compensation as the court thinks just;”

As the focus of this article is on breaches of directors’ duties generally, we have set out the facts and findings from two recent cases where liquidators have sought orders under section 301.

Recent cases: Section 301 of the Act

Two recent cases we will consider are:

  • Morgenstern v Jeffreys [2014] NZCA 449, and [2014]NZSC 176, and
  • Alpha Box Property Holdings Limited (in liquidation) v Wiekart [2015] NZHC 1257

Morgenstern v Jeffreys [2014] NZCA 449

Morgenstern was the sole director and shareholder of Morning Star Enterprises Limited (“MSE”), primarily through which he had been a successful property developer. Another of his companies was Morning Star (St Lukes Garden Apartments) Limited (MS St Lukes) which undertook a $67,000,000 development in St Lukes Auckland. The first phase of the development was successfully completed in 2005, however the second phase stalled during 2006, due to resource consent issues, which were not fully resolved until 2008. The delay ultimately caused major losses on the project.

MSE came under financial pressure in 2007, and Morgenstern, who’s shareholder current account was overdrawn by $1,776,336, sold his 99% and another’s 1% shareholding in MS St Lukes to MSE for a total consideration of $3,500,000, crediting his current account in payment.

There was no formal valuation done on the shares, and the price was determined after an informal valuation of land, building and future development, by the financial manager of the St Lukes project.

As to the value of the shares, Morgenstern admitted under cross-examination that his shares had no actual value when he sold them in 2007, but asserted that they would have the necessary value once the project was completed. MSE in fact sold the same shares in 2008 for $1.

The Court of Appeal affirmed the findings of the High Court with regard to Mr Morgenstern’s breaches of director’s duties, that:

  • Firstly “Mr Morgenstern breached his duty under s 131(1) of the Act by failing to act in good faith and in the best interests of MSE in putting his own personal interests in satisfying his current account ahead of the interests of MSE.” Further, that he “did not honestly believe the sale to be in the best interests of MSE.”[44-46]
  • Secondly “Mr Morgenstern was in breach of his duty under s 135 not to agree to or cause or allow the business of MSE to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.”[47]
  • Thirdly that Mr Morgenstern breached his duty of care under section 137, in that his actions:
  • “fell well short of the standard to be expected of a reasonable director. ...the company’s recordkeeping was deficient.. failure to produce timely accounts;... omission to ratify the share sale, as a major transaction, by special resolution... the most egregious omission was Mr Morgenstern’s failure to obtain an independent share valuation by a suitably qualified person.”

The Court of Appeal stated the applicable legal principles as follows:

“[55] There is no dispute that the duties imposed on directors by ss 131, 135 and 137 are owed to the company and require directors to act in the best interests of the company. A director must not put his or her personal interests ahead of those of the company. The duties arise regardless of the size of a director’s shareholding and role in the company.”

Alpha Box Property Holdings Limited (in liquidation) v Wiekart [2015] NZHC 1257

Alpha Box Property Holdings was part of the Circle Group of companies. Mr Wiekart was Alpha Box’s only director and shareholder. He was also a shareholder and director of the other companies in the group, along with another director, Mr Saunders.

Alpha Box traded in residential properties. Its business slowed to a point when in late 2007 it ceased operations. Over approximately six months Alpha Box’s last settlements came through, during which time the company made several payments to other group companies totalling $1,021,692.83. Mr Wiekart maintained that the payments were reimbursements of expenses paid by the other companies on Alpha Box’s behalf. The payments by Alpha Box had left the company without funds to pay $108,947.79 GST incurred in its final six months of trading, to the IRD (the company’s only creditor in the liquidation).

In her judgement Justice Peters noted the other Circle Group companies had liabilities over which Mr Wiekart and Circle Group fellow director Mark Saunders and his parents had personal guarantees. Her Honour also found the payments to those companies were not reimbursements but unsecured and undocumented loans.

Justice Peters found Mr Wiekart guilty of breaches of sections 131(1), 133, 135(b) and 137 of the Act. In paragraph [42] her Honour found that Mr Wiekart:

  • had not acted “in good faith and in what he believed to be the best interests of Alpha Box, and Alpha Box alone”, and
  • “did not exercise his power to make advances for a proper purpose”, and
  • “failed to exercise the care, diligence, and skill that a reasonable director would have exercised in the same circumstances…”

Justice Peters then made an order pursuant to section 301 of the Act that Mr Wiekart repay the full amount of $1,021,692.83 which he had caused to be paid by Alpha Box. This was in spite of the debt owed to the IRD being considerably lower, and acknowledging that the net surplus after payment to the IRD, the liquidators’ fees and costs had been paid would revert to Mr Wiekart.

Conclusions

From the above case law and given the requirements of the Act, it is important for directors to know their responsibilities and duties both in terms of the Act and their company’s constitution. Sound risk management policy will have checks and balances to ensure directors’ duties are complied with; not only for the benefit of the company, its shareholders and creditors, but also to avoid subsequent personal liability for directors’ actions.

The solvency test is not required to be met each day a company trades.  It is required for certain transactions including distributions and dividends and requires the company to demonstrate it can meet two tests.  These tests are the trading solvency/liquidity test and the balance sheet solvency test.  

To satisfy the solvency tests, a company must be able to pay its debts as they become due in the normal course of business; and the value of its assets must be greater than the value of its liabilities (including contingent liabilities).

One objective of the solvency test is to control all transactions that transfer wealth from a company.  In a liquidation context, where transactions have occurred when the company did not satisfy the solvency test, creditors may be able to recover from directors personally.

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The solvency test 

The solvency test consists of two parts:

  1. Trading solvency/liquidity - the company is able to pay its debts as they become due in the normal course of business; and
  2. Balance sheet solvency - the value of the company's assets is greater than the value of its liabilities, including contingent liabilities.

The Companies Act 1993 requires that in some situations directors sign a solvency certificate.  Sometimes this considers only the ability to pay debts as they fall due.  

The situations requiring a signed solvency certificate are: 

  • Distributions by the company for the benefit of a shareholder, including a dividend, and incurring a debt to or for a shareholder's benefit, solvency to apply before and after distribution ;
  • Share purchases;
  • Share redemption options being exercised;
  • Financial assistance to acquire share is offered by the company;
  • An amalgamation; and
  • 20 days prior to a Solvent liquidation.

The considerations

Directors need to consider all circumstances that the directors know or ought to know that affect the value of the company's assets and liabilities.  In the case of contingent liabilities consideration is required to be made on the likelihood of the contingency occurring and any claims the company may reasonably be expected to meet to reduce or extinguish the contingent liability.

Contingent liabilities to be factored in

Contingent liabilities can impact a solvency certificate and impact the validity of a distribution.  If directors are aware of a contingency, action must be taken to determine projected costs and probable outcomes.  Directors must be realistic when assessing solvency and take reasonable steps to obtain all information relevant to forming an opinion.  The Courts have confirmed the solvency test should be applied with a sense of commercial reality.

Contingent liabilities can include obligations under guarantees, letters of credit, bills of exchange, current or pending litigation, eg. leaky building claims, performance bonds, leases, tax assessments, deferred purchase agreements and underwriting adjustments.

Section 4(4) of the Companies Act 1993 - Meaning of Solvency Test - says:

"In determining, for the purposes of this section, the value of a contingent liability, account may be taken of -

  1. The likelihood of the contingency occurring; and
  2. Any claim the company is entitled to make and can reasonably expect to be met to reduce or extinguish the contingent liability". 

Risk of personal liability

Directors who do not fulfil their obligations under the Companies Act 1993 are subject to penalties and personal liability. The liability of a director will be determined by his or her involvement in the decision.  Failing to vote on a board matter should be carefully considered as directors are collectively responsible for any decision made by the board.

Directors should ensure all workings support solvency certificates and contain all necessary information and support for decisions made.  This detail can provide vital defence when a liquidator challenges a distribution made.

Directors should be aware that they should not sign a certificate as to solvency if there is doubt as to the existence of reasonable grounds for such belief.  If they do not take reasonable steps, they can risk being held personally liable for any non-recovery of the distribution made to the shareholders.

Directors can rely on information and professional or expert advice, but only if they act in good faith, make proper inquiry or have no knowledge such reliance is unwarranted (Section 138 of the Companies Act 1993).

Section 56(3) of the Companies Act 1993 - Recovery of distributions - says:

"If by virtue of section 52(3) or section 70(3) or section 77(3), as the case may be, a distribution is deemed not to have been authorised, a director who -

  1. Ceased after authorisation but before the making of the distribution to be satisfied on reasonable grounds for believing that the company would satisfy the solvency test immediately after the distribution is made; and
  2. Failed to take reasonable steps to prevent the distribution being made, - 
    is personally liable to the  company to repay to the company so much of the distribution as is not able to be recovered from shareholders".

Under Section 56, a distribution may be clawed back from the shareholders unless the shareholders received the distribution in good faith, without knowledge of the company's failure to satisfy the solvency test, and the shareholder has altered their position in reliance on the validity of the distribution and it would be unfair to require repayment in full or at all.  As the tests are cumulative, failure to satisfy any of the above will likely result in clawback of distributions. 

When can directors be held personally liable?

Directors can be held personally liable in the following circumstances:

  • They fail to complete a solvency certificate when it is required;
  • The procedure for authorising the relevant transaction has not been followed;
  • Reasonable grounds for believing that the company would satisfy the solvency test did not exist at the time the solvency certificate was signed; or
  • Between the date of approving the transaction and its date of execution, there has been a change in circumstances in relation to the company's ability to meet the solvency test but the distribution occurs anyway.

Apart from the obvious consequences of clawback, any director who signs a certificate knowing that it is false or misleading commits an offence and is liable on conviction to a fine not exceeding $200,000 or imprisonment not exceeding five years.  A director who votes in favour of a distribution, but fails to sign a certificate to the satisfaction of the solvency test also commits an offence and is liable on conviction to a fine not exceeding $5,000.  The risks are too high to not take reasonable care. 

Conclusion

If a company is marginally solvent, directors need to take particular care to satisfy themselves, for certain transactions, that the transaction is properly authorised and that the company will meet the solvency test immediately after the transaction is implemented.