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How directors can prevent themselves being liable for their company’s debts

Written by: Michael Smyth

Article Overview: The reason most start up business owners decide to form a company is to protect themselves in the event that their business goes belly up. The so called “limited liability” protection offered by the company structure may psychologically persuade us to take more business risks than if we were trading on our own account. However, in times of hardship, limited liability may not be all its cracked up to be and business owners could end up being personally liable for their company’s debts if they fail out to carry their duties as a director properly.

How directors can prevent themselves being liable for their company’s debts

Your duties as a company director
If you have decided to incorporate your business the chances are that you will have appointed yourself a director of the company. In simple terms, your duty as a director is to ensure the company is well run. Part of that involves making sure that the company remains solvent.
There is a legal test for solvency of a company, namely:
1. The company is able to pay its debts as they fall due in the normal course of its business; and
2. The company’s assets are greater than its liabilities (including contingent liabilities).
So if your company fails either one of these tests, then technically it is insolvent.
Does insolvency always lead to personal liability?
Not every company will be solvent on every given day of the year and during any given period companies will swing from being insolvent to solvent. So, if your company is insolvent on any particular day it doesn’t mean that you will be personally liable as a director for any debts incurred on that day, in the past or in the future. That would ignore the practicalities of running a modern day business.
However, when times are tough (as they presently are) it should put you on your guard to ensure that there is an immediate prospect that your company will return to solvency. If you don’t, you could be liable for reckless trading.
What is reckless trading?
The law says that directors can be personally liable where they allow their business to trade in circumstances which could create a substantial risk of serious loss to its creditors (otherwise known as reckless trading) or if directors enter into obligations which the director believes the company will not be able to perform.
When a company becomes insolvent there is a potential risk to creditors that they will not get paid. However, there always remains the possibility that the company can salvage the situation and trade out of its problems. The law recognises that, so personal liability will not attach to a director where steps are being taken to trade out of the situation. However, a company can’t be in a position of trading out of insolvency forever, and at some stage the directors must bite the bullet and put the company into liquidation. If they fail to do so, then the directors risk reckless trading.
How long can you trade out?
Generally, a company can trade insolvent for several months before personal liability could attach to the directors. However, that assumes that the directors are taking proactive steps to manage the situation and reduce the risk to creditors. So what steps can a director take to trade out of a company’s problems?
How to trade out
Essentially, there are two things a director can do: get more money in or reduce the amount of money going out. In terms of the latter, the challenge is to reduce overheads. Generally, the biggest overhead in any business will be the wage bill, so redundancies could be one strategy adopted for reducing the monthly outgoings. To get more money in, the first port of call should be to collect any outstanding debts. If debtors have been allowed to get out of control, factoring your aged debts or putting them into the hands of a debt collection agency should be a priority. An alternative option could be to arrange loan finance, but that will probably require either putting up some form of security or demonstrating future cashflow. An injection of capital by the shareholders would achieve the same result, although that in turn may require the shareholders obtaining personal finance.
An alternative approach is to generate more sales. This will favour the mindset of the entrepreneur. However, generating additional sales will often involve investing in additional cost e.g. marketing, advertising etc. This is where the entrepreneur needs to be very careful to ensure she stays the right side of the reckless trading line. An objective assessment of the risk will need to be undertaken to ensure that not only is there a good return on the initial investment, but the sales cycle is short enough to fund that investment without the company getting into further trouble. Alternatively, there must be shareholder funds available to meet the initial investment until a positive cashflow situation emerges. Any director contemplating this method of trading out of financial difficulties should also consider adopting one of the other strategies mentioned above to avoid an allegation of reckless trading e.g. redundancies, debt collection etc.
When risk must stop short of recklessness
Most successful business owners will say that their success was founded upon taking risk. However, there is a very thin dividing line between taking risk and being reckless, as some directors have found out to their cost. So, if your company is technically insolvent right now, the best advice I can give is to speak to your accountant who can prepare cashflow forecasts and advise you whether your entrepreneurial spirit could get you into further trouble or save your company from liquidation.

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Article Tags: business owners, business risks, company structure, debts, liability protection, limited liability



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