Why are you a director? Part 1

You are a senior employee in a small and successful pty ltd company.

You have just been offered a modest percentage of equity, either given to you or to buy in for, as either an incentive package or as part of a succession plan.

You like the idea of sharing in the profit and having a better title on your business card. You don't really mind that your boss retains the majority interest, control at board and shareholder meetings, and the final say on all business decisions.

The prospect of an industrial accident, corporate insolvency, employee fraud, adverse tax assessment or global recession has not (yet) entered your head.

So why are you a director?

Corporate Trustee Companies

One type of problem I often encounter in practice are disputes between shareholders in corporate structures. These problems are usually exacerbated when there are other complicating elements, such as subsidiary companies or associated trusts.

It seems that more often than not, the shares in trustee companies does not reflect how units in the relevant unit trust are owned. I have encountered many instances where 4 "partners" had 25% of the units in a unit trust each, but the shares in the associated trustee company were all in the name of only one of the unitholders. This means that the controlling unitholder can sack the other 3 unitholders as directors of the trustee company at any time, as well as deal with things like bank accounts, signing contracts, etc all in the name of the trust and without recourse to the others.

In most cases, the oppressed unitholders have a legal remedy, but must go to Court in order to do so. Importantly, many of the statutory rights and remedies available to shareholders are not automatically available to unitholders in trusts.

As with most of these issues, the right advice at the startup stage can save a fortune in legal fees down the track. I have no idea how the corporate divorce rate compares with the marital variety, but I suspect that they are at least comparable enough to make a corporate "pre-nup" (a shareholders' or unitholders' agreement) a wise investment.

Not a Guarantee

I am constantly surprised at the number of company directors that have no idea how many personal guarantees they have given on behalf of their companies, or to which suppliers they have been given.

At its most basic level, a guarantee is a promise to pay or be liable for the debts of another.  Today, most financiers and other providers of commercial credit (such as landlords and trade suppliers on terms) require that directors of small proprietary limited companies as a condition of advancing credit.  This is used to protect them against company insolvency.

Given that one of the primary reasons that businesses choose to incorporate is to take advantage of "limited liability" (ie the "Ltd" part of the company's name), providing personal guarantees effectively surrenders this advantage and opens up the asset base of the director to a company creditor.

However, what really does my head in is the number of directors that have no idea who they have made this sort of promise to.  In the event of a company insolvency (which is the point that the guarantee is going to be relied upon by a creditor), it is almost impossible to structure some protection for directors if they do not know who they have personally promised to pay.

I have seen otherwise prudent directors become bankrupt from such an oversight.

Ideally, directors should avoid giving personal guarantees at all.  In the real world, however, you can at least mitigate the risk by keeping good records of who you have given guarantees to and constantly monitoring the trading activity with these entities.

Depending on your trading record and your bargaining position, it is also possible to request that previously given guarantees be returned.

Am I my company's keeper?

Let's start with an old chestnut that can often take on a different form in the current economic climate: the definition of a company "director".

As most people are aware, company directors are responsible to their company and its shareholders via a variety of duties, principally those arising under the Corporations Act.  What isn't generally known is that the definition of a director is extremely broad and isn't just restricted to people who are formally appointed as a director.

Section 9 of the Act can be summarised as defining "director" as follows:

(a) a person appointed as a director; or

(b) a person who is not appointed but nevertheless (i) acts like a director or (ii) has their instructions or wishes carried out by those who are appointed as directors.

Naturally, there are exclusions protecting professional advisors (like lawyers) and those with a business relationship with the company or its directors (like a bank).  (For obvious reasons, the second limb is the vaguest aspect and hence the source of considerable litigation.)

So what has all of this legal mumbo jumbo got to do with GFC?

Well, often when small companies experience financial difficulty, erstwhile silent shareholders or investors start to insist on having more say about the running of the company without necessarily becoming directors.  In most cases, these people do not wish to expose themselves to the liabilities that go with being a company director - particularly the duty to prevent insolvent trading.

However, depending on the level of control, investors that flex too much muscle and have too much say in the internal management of companies may find themselves being considered "directors" of the company by a Court in a claim for breaches of directors duties.

Likewise, well meaning friends and family members of directors have also been found to have acted as directors without being appointed as such, particularly with start up companies by younger directors.

The warning signs can be found in the Act.  Ask yourself: is company X accustomed to act in accordance with my instructions or wishes?  If the answer is not a definitive "no", you may need to seek legal advice.

Test blog.  Not sure where all of this will end up...