Often such questions are only asked when a client has received a winding up application from a creditor which the company can’t afford to pay.
However the time for taking effective steps to protect a client’s key business assets and family wealth from insolvency risk is before any insolvent event occurs.
Once a company becomes insolvent – meaning the company is unable to pay its debts as and when they fall due – the duty of the directors to act in the best interests of the company becomes owed to the company’s creditors, not just its shareholders.
Causing an insolvent company to enter into transactions which prejudice the interests of creditors is therefore a breach of directors’ duties. It may also expose company advisers who recommend such transactions to accessorial liability.
Additionally, insolvency triggers the personal liability of directors for debts incurred by the company if it continues trading, as well as triggering the voidable transactions provisions in the Corporations Act that enable liquidators to bring court proceedings against company directors and related parties to claw back unfair preferences and uncommercial transactions.
Asset protection checklist for clients
We’ve prepared the following checklist to assist you in advising your clients about their exposure to insolvency risk, together with some protective measures to manage that risk before an insolvency event occurs:
- Has your client documented, secured and registered on the Personal Property Securities Register (PPSR) all related-party funding provided to the business?
Securing related-party lending is a powerful yet inexpensive asset protection tool.
If insolvency strikes, a related-party creditor holding a valid security over the company’s assets:
- enjoys priority for the payment of its debt ahead of the company’s unsecured creditors
- has a good defence to any unfair preference claims a liquidator may otherwise bring; and
- has the power to take possession of, or appoint a receiver over, the business’ assets.
Loans should be documented on commercial terms, including a commercial interest rate, and with provision for further advances in the discretion of the lender, ensuring all future funding is picked up without the need for new agreements.
Security should be put in place before, or at the same time, funds are advanced, followed by registration on the PPSR within the applicable time periods. There is a 6 month waiting period from the date of registration on the PPSR before a security interest given by a company to a related party will be effective to secure existing indebtedness.
- Do your client’s financial statements disclose problematic related-party debit loan accounts?
The significance of related-party debit loan account balances on a company’s balance sheet, and the manner in which they expose family wealth to the fall-out of a liquidation, is often only fully appreciated by a client when a liquidator is appointed.
The liquidator will demand repayment of such balances and, if payment is not forthcoming, bring proceedings against the family members or related entities who owe the balances.
Debit loan balances on a company’s balance sheet should therefore be closely monitored and managed. Unchecked they will rapidly accumulate over time if, for short term tax reasons, a company is in the practice of lending its profits instead of declaring dividends.
Loans that are advanced should be documented on Division 7A terms, not just to comply with Division 7A, but so they are not repayable on demand if a liquidator is appointed.
Loans to related entities or family members who own substantial assets should be avoided altogether.
- Are your client’s critical business assets owned in a separate structure from the operating entity?
Ownership of critical business assets in a separate structure can quarantine them from the insolvency-related risks that arise out of the conduct of the business.
The asset-owning entity should enter into a formal licence agreement with the operating entity on commercial terms, including payment of a fee or royalty, with a right of termination by the licensor in the event of the insolvency of the licensee.
This is most effective when the critical business assets for operating the business are comprehensively identified. Such assets typically include intellectual property rights such as copyright, trade secrets, know-how and branding.
- Do you and your client regularly review your client’s structure to make sure it continues to provide strong asset protection?
Keeping up-to-date (and meaningful) financial accounts is essential for maintaining the effectiveness of the asset protection provided by your client’s structure.
Accurate and timely financial information will enable any weaknesses in the balance sheet, such as any problematic debit loan balances, to be quickly identified and remedied or managed.
Indeed where a company does not have up-to-date accurate accounts, it will be presumed to be insolvent under the Corporations Act.
All businesses face insolvency risk. Yet it is a risk which is more often ignored than managed. Appropriate legal and accounting advice is essential for a client to manage insolvency risk. If protective measures are taken early, a client’s key business assets and family wealth can be protected if an insolvency event occurs.
Demian Walton, Insolvency & Reconstruction Partner, Rigby Cooke Lawyers