Who is liable - company or director?

"We operate through a company so my personal assets are safe, right?" The answer is "it depends".
We're talking about a limited liability company. That is the common understanding. That the liability of the company is limited to the assets of the company. Which is why so many people think its a good idea to operate their business through a company, and why most large businesses operate through companies.

It all makes sense so far. I mean, why would you put all your assets at risk when you can operate through a separate legal entity, and then if something goes wrong it'll all be okay. They'd have to chase the company, not you.

The problem with all of this is that, yes, the liability of the company is limited to the assets of the company. But there are some fairly major asterixes to throw in at this stage. They come particularly under the guise of personal guarantees and director's duties.

Lets look at personal guarantees first:

In my experience it is almost unheard of for a private company to be able to lease premises or borrow from a bank unless the obligations of that company are being guaranteed by someone who has something to lose.

Put yourself in the landlord's position. Why would the landlord let you near his property if you aren't prepared to back your company up? At the least, the landlord will want to know that the tenant company is financially sound. But just in case something might happen to the company, the landlord will want to see the people behind the business put themselves on the line. That usually means the directors of the company. And just for good measure the landlord will want to be convinced that you've got some assets worth chasing, if he does have to chase you.

Likewise with the bank. Do you think the bank will lend your company any money if you're not prepared to guarantee the company's obligations to the bank? The answer is always going to be no. Thats just the way it is. And thats good because the money they lend - thats not actually their money anyway, it belongs to you and me and all the other people who put their money in the bank because its safe there. We don't want our money being lent to some random company that might be, might not be.

So you'll have to give a personal guarantee to the bank so your company can borrow the money it needs to make the business hum. And if you've got nothing much because you've transferred it all to the family trust (including your home), then don't expect to get any money unless the family trust gives the bank a mortgage over your home and a guarantee for the company's debt.

In other words, while your company (and not you) will be liable for the company's debts, that won't work with either the landlord or the bank. They will want a personal guarantee from you. Obviously the situation is likely to be different for a large company with a substantial asset base and cashflow, and where the shareholders are not the same as the directors.

Okay, you can live with that. So what about director's duties?

Fundamentally, if you are the director of a company your role is to make sure the company is financially sound and that it complies with its statury obligations. There are times where you, as director of the company, will be personally liable otherwise.

When can you be personally liable as a director?

In the following examples at least:

1. If you as director agree to or allow the business to be carried on in a way that is likely to cause "substantial risk of serious loss" to creditors of the company. You need to show that you have acted reasonably before taking decisions that might fall into this category. Have you studied the financials? Have you exercised judgment around the risks your decision might entail? What information have you considered? Can you rely on that information?
Can the company meet its obligations or is it technically insolvent? A company is technically insolvent if its liabilities are greater than its assets, or it can't pay its debts when they fall due. In the course of normal cashflow fluctuations, you'd be surprised how often a company dips into a position where it might be technically insolvent.
Reckless or insolvent trading puts the risk on you personally as a director, so beware.

2. If you as director do not act in good faith or in the best interests of the company. In the case of a private company, the best interests of the company should be the same as the director's best interests. But its not always the case. For example, what if company A (which you are director of and 50% shareholder in) enters into a contract with company B (which you are a major shareholder in through a blind trust)? How will the other 50% shareholder in company A feel if you don't disclose your interest and company A suffers a loss? Who will be liable for company A's loss? It could be you I'm afraid.

3. If you as director did not exercise the level of care, diligence and skill that is to be expected of a reasonable director. This can almost happen unwittingly if you are not careful. For example, is it okay for you to simply rely and act on advice you receive and blame the advisor if the things go wrong? Sometimes that will work but not always. It is not best practice and certainly opens the risk of you being found negligent in your role as director. Which means again, you could be personally liable, not the company.

So while it makes sense to operate your business using a limited liability company, there is a standard that you must adhere to when exercising the powers and duties of a company director. Being a company director is not just a cushy number.

We are constantly advising clients regarding these issues. Feel free to call me on 03 4500000 or email rem@prlaw.co.nz