Many businesses in New Zealand use a company structure to operate their business. The key benefit of using a company structure is that operating a company confines the risks of the business into the company rather than the individuals who run the company. There are, however, certain circumstances where a director can be personally responsible for the company's debts or could be sued for the company's actions. As a director, you will want to protect yourself and your personal assets from these risks. This article explores legal risks and situations when a company director may be personally responsible for the company's actions.
As is true for any business, a company will face risks and challenges while trading. These could involve taking on debts to finance the business, facing challenges with customers and suppliers, challenges with shareholders, or regulatory compliance issues, such as claims of false and misleading conduct in respect of its products.
What is a Company?
A company is a legal entity that is separate from its owners and directors. A company can take many of the same actions that an individual can take, such as:
- entering into contracts;
- providing services;
- suing others; and
- being sued itself.
Being a separate legal entity, a company will have its own bank account, IRD tax obligations and administrative requirements. From a legal and practical perspective, the company structure provides a degree of separation between the owner's personal bank accounts and company bank accounts. Creditors can usually only claim against the company's assets, not the personal assets of the company's owners.
The two key parties involved in a company are its directors and shareholders. Directors manage the day-to-day operations of the business and its affairs. Shareholders are the owners of the company, who hold a percentage of the shares in the company.
Usually, the shareholders only passively hold their shares in a company and are largely uninvolved in the company's day-to-day affairs. The directors are responsible for the company's actions and decisions and for any business risk. As such, directors need to ensure that they have complied with their directors duties and have acted in the best interests of the company. Otherwise, they may face personal liability for breach of their directors duties.
Directors of a company are legally responsible for certain duties they owe to the company. A director of a company must:
- act in good faith and in the best interests of the company;
- exercise due care, diligence and skill that a reasonable director would exercise in the same circumstances;
- exercise powers for a proper purpose;
- comply with the Companies Act and the company's constitution;
- not engage in reckless trading; and
- avoid incurring obligations unless the company will be able to honour them when required to do so.
It is important for business owners who are company directors to comply with these legal responsibilities. The duties to act in good faith and exercise due care and diligence require directors to act with a degree of commercial acumen in managing the business while being focused on its success and continuity. The duty to avoid reckless trading requires directors to ensure that if the company takes on any obligations (for example, taking out a loan), they must be sure the company is in a position to meet the demands of the loan.
A breach of any of the directors duties can result in penalties and personal liability for the directors. Silent or absent directors will not receive any leniency for a breach of their director duties. Therefore, it is important for all directors to be aware of these duties and actively take part in the company's business and understand its financial position.
Personal Guarantees and Secured Assets
Directors of small or newly established companies may have to provide personal guarantees for company debts. For example, a bank lending money to a business may ask a director to provide a 'directors' guarantee' to guarantee that the company will repay the loan. If the company cannot pay back the loan, the director's personal cash and assets will be at risk.
A company usually provides security for a loan over its assets, with the lender taking out a security interest over its assets. However, banks typically require both the directors guarantee and security interest to protect their position. A bank will want to ensure that they can first recover against the company, the company's assets, and then the directors' personal assets if the first two cannot fully recover the amounts under the loan.
Additionally, a company director may need to provide a personal guarantee under the terms of a contract. Examples of this could be a lease, franchise agreements and large-scale supply contracts. While you generally cannot avoid a personal guarantee under a lease, it is best to negotiate other types of contracts so that a personal guarantee is not included. Otherwise, you open yourself to personal liability if the company cannot honour its requirements under the contract.
For any personal guarantee, it is important that you are aware of the terms of the guarantee and seek independent legal advice.
Operating a business through a company means that the owners are separate from the company, and their risk is limited. However, there can be certain situations where a director is personally responsible for the actions of the company. To avoid situations where a director must personally front up for the company's business risk, directors must ensure they are familiar with their directors duties and seek legal advice regarding any personal guarantees.