Magazine article New Zealand Management

Limited Liability Companies -- How Protected Are You? Non-Compliance with Technical and Mundane Companies Act Procedures Means Some Directors and Shareholders Do Not Have the Limited Liability Protection They Thought They Had. Kensington Swan's Rodney Craig and Campbell Featherstone Outline the Steps That Need to Be Taken to Avoid This Predicament

Magazine article New Zealand Management

Limited Liability Companies -- How Protected Are You? Non-Compliance with Technical and Mundane Companies Act Procedures Means Some Directors and Shareholders Do Not Have the Limited Liability Protection They Thought They Had. Kensington Swan's Rodney Craig and Campbell Featherstone Outline the Steps That Need to Be Taken to Avoid This Predicament

Article excerpt

Byline: Rodney Craig and Campbell Featherstone

Have you ever found yourself in a situation where the product you thought you had turns out to be something quite different? Maybe it was a 'conservative' investment product that turns out to include 'collateralised debt obligations' (CDOs), or a mobile call plan that has fewer free minutes than you had been banking on.

Some company directors and shareholders are now finding themselves in a similar situation with their so-called 'limited liability' companies. They are discovering too late that their company structure has not provided them with the protection they thought it would.

Given the current economic climate and a string of recent cases, most directors are very conscious of the risk that they might be held personally liable if they allow their companies to carry on trading while the company is insolvent (so-called 'reckless trading'). As a result, directors are generally very cautious when their companies get into financial difficulty, and they won't wait too long before pulling the plug by either putting the company into voluntary liquidation or ceasing trading and waiting for the creditors to appoint a liquidator.

As a director who takes this sensible approach, you may think to yourself that it's under control -- you have a limited liability company, your other business assets are safe in separate companies, and you have complied with your responsibilities to creditors.

But do you really have the protection you think you have?

What many directors and shareholders do not fully appreciate is that a liquidator isn't just interested in reckless trading or other breaches of key directors' duties, but that they will closely examine the extent of the company's compliance with the technical and mundane procedures set out in the Companies Act, to see whether any amounts can be clawed back from directors, shareholders, or related companies.

The following scenarios might find you within the liquidator's crosshairs and where the protection of limited liability is unavailable. Fortunately, in most cases, there are simple steps you can take to protect yourself, and your assets, to ensure your company structure is strong enough to withstand the liquidator's challenge.

Payments to shareholders

Liquidators will closely examine any dividends or other payments made to shareholders.

Shareholders can be required to repay dividends if the company did not meet the 'solvency test' immediately after the dividend was declared or paid. Furthermore, if the directors did not follow the correct procedure when declaring the dividend or did not have reasonable grounds to believe the solvency test would be satisfied, then the directors will be personally required to repay to the company much of the dividend that is unable to be recovered from shareholders.

Whether or not a company meets the solvency test is not always clear -- the value of the company's assets must exceed the value of its liabilities, and the company must also be able to pay its debts as they fall due. Just because a company is cash-flow positive and profitable does not necessarily mean it meets the solvency test. The risk of failing the solvency test is often higher with under-capitalised trading subsidiaries that are funded through bank and/or shareholder loans, and/or where key assets are leased from other group companies.

The solution is straightforward, but easy to overlook. Directors should ensure that the company will meet both limbs of the solvency test immediately after declaring or paying any dividend.

Liquidators will not only look at clawing back historic dividend payments. …

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