Companies in distress

Your considerations, options and pitfalls

Guiding your company through financial distress is challenging. Directors have a duty to a broad range of stakeholders and must be aware of their personal obligations and exposure when navigating through challenging times.

Here we outline some of the key factors for directors to consider when in financial distress, your options, obligations and consequences for directors breaching their director duties and obligations.

Navigating your company through a financially challenging time requires an awareness of the implications for the decisions you and the company make. This booklet provides a brief outline of the following key aspects for directors to consider:

1. Be aware of when you are deemed to be a director, even if you are not formally appointed but act in that role
2. Understand your duties and obligations, beyond compliance with general and specific rules applying to your company
3. Key indicators of when you are in financial difficulty
4. Types of external administration
5. Consequences for breaching director duties and obligations

The information on this page is not an alternative to seeking proper legal and financial advice in respect of your company's affairs. There are serious penalties for, among other things, allowing your company to trade while insolvent. If your company is in financial distress or if you are uncertain as to your company's position you should seek independent legal and financial advice as soon as possible.

Who is a director?

A director is not only those persons who are formally appointed as a director, but includes anyone acting in the position of a director, or anyone whose instructions or wishes are customarily followed by the directors of the company even if they are not validly appointed. This can include those persons acting with great importance and who, for example, have influence over the board of directors and they are accustomed to act to that person's instructions or wishes.

Any person who falls within the above definition will be subject to the same director duties and obligations and so you must be aware of your responsibilities and the penalties for breaching your duties.

Your duties and obligations

Director duties comprise general law and statutory duties, in addition to the general and specific rules applying to your company.

General law duties require directors to, among other things, act in good faith, avoid conflicts of interest, exercise powers for a proper purpose, retain their discretion and to exercise reasonable care, skill and diligence.

Statutory duties in accordance with the Corporations Act 2001 (Cth) provide a requirement that directors, officers, and sometimes employees, must, among other things:

• Exercise their powers and discharge their duties with a degree of care and diligence that a reasonable person would (s.180)
• Exercise their powers and discharge their duties in good faith in the best interests of the corporation and for a proper purpose (ss.181, 184)
• Not improperly use their position to gain an advantage for themselves or someone else or cause a detriment to the company (ss.182, 184); and
• Not improperly use information obtained as a result of their position to gain an advantage for themselves or someone else or cause a detriment to the company (s.183, 184)

Directors also have a positive duty to prevent the company from incurring any debts if they are aware (or a reasonable person in a like position would be aware) that the company is insolvent or will become insolvent if the debt is incurred. A company also has an obligation to keep written and financial records that correctly record and explain its transactions and financial position and performance, and that would enable true and fair financial statements to be prepared and audited.

Breaches of these duties may give rise to civil and/or criminal penalties that may lead to personal liability and/or a conviction. Simply resigning as a director does not alleviate you from any historical liability arising from when you served as a director.

Indicators of financial difficulty

Directors are required to be constantly aware of the financial position of the company and therefore, an awareness of signs of stress is critical to avoiding the need for external administration, or if necessary, making the decision to put the company into external administration.

Signs that your business may be in financial distress include, but are not limited to:

• Poor cashflow, including ongoing losses, increasing debt and build-up of creditors
• Incomplete financial records, a lack of forecasts and budgeting and the absence of a formulated business plan
• Letters of demand, summonses, winding-up notices and judgements
• Special arrangements with creditors for delayed payment
• Overdue taxes, including superannuation arrears
• Banking facilities expiring, breach of covenants and withdrawal of banking support

The above indicators are not exhaustive and every company's affairs need to be considered on a case by case basis. If any of the above indicators are present, further investigations may be necessary and you need to be aware of your position and understand the options available to properly exercise your powers in accordance with your obligations and duties.

There are a number of options available to companies where financial stress is identified early. These include:

• Restructuring the company’s operations
• Refinancing the company’s debts; or
• Changing the company’s strategy and business focus

Whether any of the above options are suitable to your company must be assessed on a case by case basis.

In circumstances where it is too late to execute a turnaround of the business as a consequence of the company's financial affairs and/or your duties and obligations, directors must be aware of the types of external administration available.

Whilst one of the key stakeholder groups directors are responsible to are the company’s shareholders, as the business enters into the “twilight zone” the directors must give equal, if not greater, consideration to the creditor stakeholder group.

Types of external administration

The appointment of an external administrator is most commonly by way of:

• Voluntary administration – upon a resolution that the company is insolvent, or likely to become insolvent, the director(s) appoint the voluntary administrator to, among other things, resolve the company’s direction. If the creditors do not resolve to enter into a deed of company arrangement, then usually a resolution is passed by the creditors to liquidate the company
• Liquidation – an appointment by resolution of the director(s) and shareholder(s) that provides for an orderly wind-up of the company’s affairs for the benefit of its creditors
• Receivership – commonly by way of a secured creditor, who holds security over the company’s assets, appointing a receiver to realise the assets subject to the appointment for the benefit of the secured creditor

The consequences of external administration are varied depending on the type of appointment. The powers of the director(s) may be suspended where an appointment is made, but are dependent on the form of the appointment.

A director should seek advice before making an appointment or in circumstances where an appointment is made by a party other than the directors.

Consequences for breaching director duties

A breach of director duties may give rise to a number of civil penalties (up to $200,000) and criminal penalties (up to $360,000 and/or 5 years imprisonment). Compensation proceedings, on an uncapped basis, are also available in addition to civil penalties. Ultimately, directors may be faced with consequences including bankruptcy and a ban from them acting as a director for a period of time.

What to do if your business is in financial difficulty?

Directors should immediately seek advice from a qualified professional in respect of their individual circumstances and those of the company. As a director is personally liable, advice should be sought even if the company's other directors do not agree.

A proactive approach to dealing with financial distress provides the best chance for the company to improve its financial position, to avoid the need for external administration and to avoid any directors breaching any of their duties or obligations.