COVID HAS TAUGHT US THAT ANY BUSINESS SHOULD BE PREPARED TO DEAL WITH SUDDEN FINANCIAL SHOCKS.

Before Covid, many Australian business owners assumed that nothing could ever suddenly go wrong. They had no contingency plans for what happened when their businesses were devastated by Covid. Now that the dust has settled, the lessons of the last two years should be applied to put plans in place to protect businesses and their owners from sudden shocks.

Be ready – liquidation can happen suddenly

When a company runs out of money, it may need to be put into liquidation quickly. Otherwise, directors can become personally liable for tax debts of the company. Creditors can also force a company into liquidation by issuing a 21 day statutory demand. If a company keeps trading after it becomes insolvent, the directors can become personally liable for the company’s debts.

Some businesses were hit hard with Covid and went into liquidation before getting their accounts and other affairs in order. When the liquidators went through the books, they found fertile ground to make personal claims on the directors, including calling in loans accounts created when directors had previously taken money from the company.

Directors’ debts to the company

In many small and medium businesses, the directors take money from the company throughout the financial year which is recorded against the directors’ loan accounts. When preparing the year-end accounts, the accountant creates book entries to record these payments as dividends or salary, to bring the loan accounts back to zero.

That all works well while the company is trading profitably. However, if the company goes into liquidation, these loan accounts are debts which the directors must pay to the company. It is usually too late to claim that they are really records of remuneration, rather than loans.

Companies’ debts to directors

Many small to medium enterprises are funded by money contributed by the directors, sometimes raised by taking out a loan on their homes. When the company goes into liquidation, these loans owing to directors have no more priority than any other debt of the company. In well over 90% of cases, liquidators pay nothing to unsecured creditors. The result is that the money the directors have contributed to the company is lost.

The solution is to register a charge over the company in favour of the directors. This is like a mortgage on a house. If the company goes into liquidation, the secured directors stand near the front of the queue of creditors. The result is that, if there are any available funds, the directors will receive those funds before any other unsecured creditors. The secured director’s loan is also useful if the liquidator threatens to sue the directors, as any money the liquidator recovers will probably go back to the directors.

The Covid experience reminded us that these securities need to be in place well before the company faces insolvency. If the directors are owed money by the company, then register a charge, it will be invalid against the liquidator if the company goes into liquidation within the following 6 months.

Conclusion

Step should be taken now to protect the directors from an unexpected financial shock, no matter how prosperous the business appears to be. When you put on a seatbelt you don’t expect to have an accident, but it is still a good idea to be safe.

For more information  contact Tim Somerville  or Andrew Somerville on (02) 9923 2321.