So, you operate your small business through a company. Do you understand how it must operate and what is required of you?

Are you a sole director of a company through which you operate your business or are you a co-director of a family-owned business with your spouse or partner?  It is very tempting to consider the company as being simply an extension of “you” or your family and to regard some or all of the obligations on company directors, required by the Corporations Act 2001 (“the Act”) and by ASIC, as either not being applicable to you or as being expensive and unnecessary “red tape”. Not so! Here are a few things (but not everything!) you should keep in mind.

We frequently help clients buy or sell small, medium and large companies which operate financial services and many other types of businesses.  Occasionally, it becomes obvious from the beginning that a few people don’t quite understand what is involved in being a director of a company and, if they are a purchaser, what they will be required to do once they take over control.  Sellers might wonder why they have trouble finding a buyer for what might have been a profitable business for them, but where potential buyers do not proceed after doing some initial due diligence.

So, firstly, some basic things to understand:

The company does not own its own shares

The shares in company are owned by its shareholders and so a company cannot sell its shares – the equivalent of selling itself.  The shareholders do not need to be the directors (although with small businesses they usually are) – that is, it isn’t essential that a director is a shareholder – and vice versa.

The company is a separate entity

The company has its own identity, separate from its directors and shareholders – with a unique ACN (and usually ABN) – which allows it to hold property and assets (both tangible and intangible (e.g. copyright and other IP), operate and make agreements and contracts on its own behalf, be a trustee and (amongst other things) pay tax on its own income.  The company itself is liable for its own actions, complying with its agreements and to pay its tax.  Unless there are indemnities or guarantees provided by the directors or shareholders (which are often required), only the assets of the company itself are at risk if it is sued for a breach.  Certain statutes attribute personal liability to directors – but generally only where they have failed in their duties or obligations as directors.

The company is not the same as the business

A business operated by the company is an asset constituted by such things as its own accounts and documents, its client lists and records, its systems, knowledge and know-how.  The business assets can be sold independently of the shares in the company.  The proceeds of the sale of the business are payable to the company whereas the proceeds of the sale of the shares (which would automatically transfer ownership of the business) are due to the shareholders.

The obligations of directors

The primary responsibilities of directors are to the company – that is, to act in its best interests and not their own.  Usually, the interests of the company coincide with those of the shareholders – but not always.  Obviously, it is in the best interests of the company to comply with all relevant laws and regulations, although doing so may not always be what the shareholders prefer or what the directors believe is financially advantageous.

Other important obligations include:[1]

• acting in good faith, with reasonable care and diligence for proper purpose
• avoiding conflicts of personal interest and not using company information improperly
• statutory duties – financial services laws, consumer and privacy laws, OH&S, environmental and preventing insolvent trading
• maintaining proper and complete records
• acting within the company’s constitution.

Directors’ obligations are on all directors

Does the company operate on the basis that a spouse or domestic partner is a “passive”, “silent” or “non-executive” director and one director has all of the control and worry of running the company and its business and makes all of the decisions?  Those other directors that think that the “managing” director has all of the control, and consequently bears all of the responsibility for what the company does – are unfortunately mistaken.  All directors are taken to be responsible for the acts of the company and its obligations, whether or not they have actively participated in the management of it.  It is not a defence for any director to say: “I didn’t know what the other director(s) was doing”.  This clearly poses a significant problem for domestic partners, employee directors or non-participating directors who find themselves kept “out of the loop” in relation to the operations of the company – or who voluntarily choose not to take an active role in the activities of the company.

Record keeping

It might seem obvious, but it is essential for directors to ensure that (at least) the basic requirements relating to the company’s financial transactions are recorded (this may be in electronic form).  Similarly, minutes of decisions relating to important company affairs (called resolutions) must be recorded and kept and then implemented in accordance with the company’s constitution.  Even where there is a sole director, resolutions must be recorded.

ASIC document lodgements[2] – including annual returns – must be made in a timely manner.

Where it goes wrong and what happens

1. Inactive directors

Leaving all decisions to another director (whether as a result of personality dominance, coercion or otherwise) will not absolve passive, silent or inactive directors from their duties and obligations.

Such directors are likely to be prosecuted by ASIC, fined and/or banned from being directors.

2. Inadequate or false record keeping

Where there are seriously deficient books and records, not only will the company be liable to be fined but the directors might be at risk of prosecution as well.  For example, where the mandatory financial reporting lodgments with ASIC have not been made for 7 years or more, a company may be deemed to be insolvent and, whether or not it was actually insolvent during the period, the directors could be prosecuted for insolvent trading.

False records will be a criminal offence, and the director(s) dealt with under the criminal law.

3. Conflict of interest or lack of good faith and proper purpose

A director must not cause the company to do something which is not in the best interests of the company (even where there is no significant detriment to the company), but from which that director (or another) receives a personal benefit, for example, a loan (documented or otherwise) to a director for which the company receives no appreciable benefit. That action is likely to be a conflict of interest.

It doesn’t matter if the director(s) genuinely considers the company’s assets to be their own property or believes that their personal benefit is of some benefit to the company, the director(s) is unlikely to be acting in good faith and in the company’s best interests.

Such director(s) is likely to be prosecuted by ASIC, fined and/or banned from being directors.

4. Trading whilst insolvent

When the company’s cashflow slows or dries up, the strong temptation is for the director(s) to try to trade a company out of its difficulties but, unless there is an injection of funding or documented arrangements made with its creditors, the director(s) must cause the company to cease operating.  The appointment of an external administrator may attract a moratorium which could allow the administrator to trade out of its difficulties or make a formal Deed of Company Arrangement with creditors accepting reduced sums in satisfaction of their debts.  Otherwise, a liquidator must be appointed – either voluntarily or by a creditor.

Directors who allow a company to continue to trade (whether or not the level of indebtedness increases or decreases) in circumstances where the company cannot pay all of its debts as and when due, are likely to be prosecuted by ASIC, fined and/or banned from being directors.

5. Proxy or sham directors

A person who agrees to act in the role of a director (and does) whilst taking instructions and directions from another person or entity without actually exercising their own consideration, judgment and skill, is risking prosecution, a fine and a banning order – even in circumstances where:

• there is no significant detriment to the company;
• the person giving directions is not ineligible to be, or has not been banned from being, a director;
• there is no illegality in the activities of the company and the business it transacts; or
• the conduct of the company is otherwise exemplary.

Some dos and don’ts:

If you are a director of a company in Australia:

• Do not treat the company as being the same as “you”. Remember that what you cause the company to do must be in its best interests even if those interests do not align directly with your own.
• Do make sure you have an adequate understanding of the obligations and requirements of directors. Ignorance is not an excuse.
• Do Not think that your company is too small for ASIC to be concerned about. It isn’t!
• Do make sure you undertake all of the duties and obligations of the role of a director as far as they relate to your company.
• Do Not simply guess at what is required of you as a director. Near enough is not good enough!
• Do make sure the company’s record keeping is adequate and seek qualified assistance and/or appropriate software for the purpose.
• Do review all documents to be lodged and Do not rely solely upon documents prepared by others (including in-house or external accounts staff)
• Do not be tempted to trade whilst the company is not able to pay its bills on time
• Do not allow employees (or any other people from outside the company) to make important company decisions or perform duties which should be undertaken by you as director.
• Do keep out of ASIC’s steely gaze because, once you or your company is in it, it becomes difficult to avoid.

This is very selective and incomplete commentary on what is a huge topic, and so, please contact Tim Dixon, Special Counsel, of our commercial team for specific advice or assistance on this article or any other commercial-related issues.

[1] Core duties are set out in sections 180-183 of the Act.

[2] These vary according to the nature and size of the company.

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Author: Tim Dixon (Special Counsel)