If your continuing business has insufficient money to pay bills in the normal course of business – employees, suppliers, Inland Revenue – there’s a good chance you’re trading while insolvent. This is never a pleasant way to operate. We explore insolvency and who will ultimately end up being responsible.
Being insolvent from a business perspective is where:
- The business is unable to pay its debts (creditors) as they fall due and/or
- The business’ total liabilities exceed total assets (called ‘negative equity’ or ‘balance-sheet insolvent’)
It’s usually clear when a business cannot pay its debts – creditors will be chasing payment, Inland Revenue sends threatening letters for overdue taxes, your overdraft increases, employees aren’t sure if they’ll be paid.
Calculating negative equity, on the other hand, is more difficult. Estimates need to be made for the current market value of assets and liabilities. Here’s where it gets tricky – the examples below may impact the balance sheet, which could impact on solvency.
- The business purchased a warehouse 10 years ago for $750,000 and it’s now worth $1,200,000. The financial statements will usually record the asset at its purchase price, not the current market value.
- You have a lot of old stock sitting around that you know won’t sell, even at cost. Its value is lower than the value indicated in the financial statements.
- You’re not sure if some of your debtors will pay the business – they’ve been overdue for months and you’ve been unsuccessful in obtaining payment. Clearly, the original value in the financial statements isn’t recoverable and write-offs are needed.
- The business owes you (or family or friends) money, and it’s not urgent that they be repaid immediately.
- You have debt owing to Inland Revenue which has been accruing penalties and interest – these additional liabilities are unlikely to be recorded in your financial statements.
- After your financial statements are completed, you invest more money in the business.
- The business is involved in a dispute which, if lost, would require the business to pay the other party. This is a contingent liability and probably won’t be included in the financial statements because the case hasn’t yet been decided and the potential liability is unknown.
So, you’ve done the math, and concluded that the business is in fact insolvent.
Once insolvent, the business must not incur any additional debt by ‘trading recklessly’. This is the point at which you know that if you incur further costs, your creditors are unlikely to be paid in full. This can include buying an asset on finance, purchasing goods from suppliers, taking out a business loan, entering into a new lease agreement.
In short – it’s fraud, which isn’t a word to be taken lightly. You’re entering into a transaction knowing it cannot be completed due to the business’ lack of cash.
It doesn’t need to be reckless trading in the ‘normal course of business’ either. One-off transactions could also be caught – for example, entering into a lease agreement.
If the business is conducted under the umbrella of a company, it’s straight-forward. The company directors are responsible. In many small businesses, directors are often also shareholders. But it’s in your capacity as a director that you’re liable – not as a shareholder.
Shareholders own a company and appoint its directors. Directors are responsible for leading and overseeing the company. Over the last few years, the director’s role and responsibilities have expanded and been more formalised. The Companies Office provides great guidance at What it means to be a director.
The sole trader individual will be held liable for debts incurred when trading insolvently.
Businesses aren’t often operated through a trust structure, but if it does and continues trading while insolvent, the trustees are responsible. They have a duty of care to the trust’s beneficiaries – even more so since 30 January 2021.
A company is unlikely to be fined for trading while insolvent – if the company’s unable to pay its current debts, it’s not going to pay the fine. Instead, it’s the directors who are penalised. As an individual, the director’s personal assets are at risk and may need to be sold to cover the penalty.
If the business is insolvent, the sole trader is also probably insolvent having exhausted all financial options. As a sole trader cannot be liquidated, the bankruptcy process is probably the next step.
A trust is in a similar situation as a company – with negative equity, the trust can’t pay any fines. The trustees obviously haven’t acted in the best interest of the beneficiaries, so they’ll incur any penalties, rather than the trust itself.
It’s important to understand that directors and trustees have a responsibility to the business creditors, as well as to the shareholders and beneficiaries. So, the director could be sued by creditors and/or shareholders/beneficiaries.
Mr and Mrs Lewis became investors and then subsequently directors of a company. The company’s manager was Mr Grant, and his wife was another director. Following the loss of its key client, Mr and Mrs Lewis were made aware after a meeting with an accountant, that the company was in a situation of trading insolvently. Soon after, they found out that the company owed outstanding tax of over $163k to the IRD. A year later, Mr Lewis discovered that Mr Grant had been providing false invoices. Mr Grant was subsequently convicted of fraud.
The Court of Appeal concluded that even though the Lewises had not made a conscious decision to recklessly trade, this did not mean they were absolved from responsibility. The Court found that the Lewises had not paid proper attention to the financial affairs of the company, which had been trading on an insolvent basis for quite some time. It was held that a reasonable director would have recognised this “urgent need” some 15 months before the company was eventually put into liquidation.
In a later decision, the Court of Appeal required the Lewises to contribute $506,000 to the assets of the company by way of compensation.
Mr Johnston became a director and shareholder of NZNet, of which his friend for over 30 years, Mr Andrews, was the sole director. Mr Johnston sought legal advice before doing so, and completed significant due diligence on the company, including obtaining a significant volume of NZNet’s financial information. Initially Mr Johnston had no involvement in the management of the company. However, it soon became apparent that NZNet had substantial and unsustainable debts (including to the IRD). As a result, Mr Johnston gradually became more involved in the business over the course of nearly two years, seeking legal advice where necessary, to form a plan to pay creditors and employees’ wages, and gradually injecting money into the business to the tune of $460k. When Mr Johnston eventually stopped contributing and it emerged that employer deductions owed to Inland Revenue to the tune of $250k, he resigned as a director. Shortly after, NZNet was placed into liquidation leaving in excess of 25 creditors (including Mr Johnston) owing slightly above $1m
The Court held that Mr Andrews actively misled Mr Johnston over a substantial period of time. However, Mr Johnston was unable to avoid the responsibilities of directorship. It was held that Mr Johnston acted recklessly, but only from the date that a newer third director resigned (only two months before Mr Johnston resigned) on the grounds that NZNet was insolvent. The Court held that it was at that stage that Mr Johnston should have taken steps to stop NZNet from trading. Instead, he continued to liaise with Mr Andrews as to a strategy for continuing to run the business.
In terms of penalty, the Court decided that as his share of the penalty was less than NZNet owed to Mr Johnston, he was not required to repay NZNet. Mr Andrews was ordered to contribute $1m. The third director, who became a director for little under three months shortly before the company was placed into liquidation was ordered to contribute a sum of $83k to the assets of NZNet by way of compensation.
A doctor became a director of a company whose business was the management of private clients’ investments in foreign exchange markets, after being introduced to the business by an acquaintance, Mr Hitchinson, who was the only other director. The doctor guaranteed leases of the premises and equipment, did not have a day-to-day role in managing the business, and inquired weekly as to the state of affairs, relying on information provided to him by Mr Hitchinson. Mr Hitchinson began to take money from some investors to pay other investors’ returns and when the doctor became aware, he required Mr Hitchinson to resign as a director. The company was subsequently put into liquidation, and Mr Hitchinson was charged with defrauding investors of sums totalling US$297k.
The Court found that the doctor had essentially allowed Mr Hitchinson “free rein” over the control of the company. The appropriate question here was – what would a reasonably prudent director in the doctor’s shoes have done? While the doctor may have asked “all the right questions” the Court held that there was no basis upon which the doctor could test these answers. By not testing Mr Hitchinson’s verbal assurances, it was held that this was a “failure to control” him which created the environment that allowed Mr Hitchinson’s dishonesty to thrive. The Court held that the doctor had breached his duty of care to the company – due to his negligence in failing to control the company generally and in the “latitude” he provided to Mr Hitchinson.
The Court ordered the doctor to contribute a sum of approximately $320k, which being his share of the amount identified as being misappropriated by Mr Hutchinson.
Nobody goes into business intending to fail or to leave customers and suppliers in the lurch.
If you and your business are struggling to pay bills as they fall due and your loans are increasing, something needs to be done. This could be a change of management, implementing new systems, or closing down.
Trying to trade yourself out of insolvency rarely works without receiving professional advice. It’s also illegal. And yes, that’s meant to frighten you.
In some cases, assets tucked away in companies or trusts aren’t as safe as you may think.
As with many problems, acknowledging and quantifying the issue are the first steps. You may be completely overwhelmed financially and mentally, so the best decision could be leaving it in the hands of a liquidator. You’ll need to provide information and help the liquidator, but at least the problem is in one place, dealt with by one person.
If you’re worried about how your business is tracking please get in touch with your accountant or our Support team. We can help you with a plan and take a non-biased look at the business figures.