Remuneration of directors in insolvency situations
Directors of companies are entitled to receive money from their company, such as salary or wages, bonuses, fringe benefits and loans.
There are strict statutory requirements relating to the process by which the directors can be paid money from the company. These requirements have been imposed to recognise the directors’ position of power within a company, the position of potential conflict when the director authorises payments to him/herself, and to impose on the director additional checks to reduce the chances of unfair payments.
Nevertheless, it is still common in New Zealand, especially amongst small to medium size companies, that directors take drawings (be it for service of running the company in lieu of salary or in addition to the salary), or receive a salary, without complying with the mandatory statutory processes.
In such circumstances, any monies paid to a director could be treated as a loan repayable on demand.
While there are some directors who still manage to avoid liability for not following the proper processes, with the third parties becoming more aware of such practices, more directors start facing consequences. For example, if the company becomes insolvent and is placed into liquidation, the liquidator in almost all cases investigates and demands repayment of the funds, or if there is a shareholder dispute, often the other shareholder causes the company to demand immediate repayment of funds, or the Inland Revenue Department demands repayment of unpaid tax on the drawings taken from the company.
Interestingly, 63% of companies in New Zealand fail. On that basis, the risk is more than marginal.
Directors commonly misunderstand the concept of drawings.
Drawings are funds taken by directors (who are also shareholders) from the company for personal use and benefit. When directors take drawings from the company, and/or introduce funds into the company, this is treated as a running loan account between the company and the director.
Unfortunately, a large number of directors still believe that since they are in charge of and run the company, they are entitled to receive payments by way of taking drawings. In certain cases, this practice occurs due to the director’s ignorance of the legal requirements, in other cases, intentionally to avoid payment of the income tax.
However, if the director’s current account with the company is overdrawn (ie, the amount of funds taken exceeds the amount of funds introduced), then the difference is treated in common law as a loan that is repayable on demand. From tax perspective, it is treated as an interest free loan that attracts a fringe benefit tax.
If the directors engage in the practice of taking drawings throughout the year, it is important that when the annual accounts are completed, a salary is declared in order to offset the drawings. However, the statutory requirements for authorisation of salary (outlined below) still need to be followed to avoid personal liability. Further, once a salary is declared, the directors become liable for personal income tax on that amount.
If the drawings are not offset with the salary, there is risk that a liquidator (in the case of an insolvent company), or a business partner (in the case of a business prone to shareholder disputes) might later demand repayment of these funds from the director. Further, the IRD reviewing the company’s accounts might demand payment of the fringe benefit tax. Such demands could go back to years of drawings made by the company and could result in financial hardship for the director.
Salary, wages and other monetary benefits
Section 161 of the Companies Act 1993 creates strict processes for authorisation of payments to directors. These processes have to be followed by all companies registered in New Zealand, including companies having only one director and/or shareholder (as is commonly misunderstood amongst directors).
In brief, s 161 provides that:
- The board must authorise remuneration or provision of benefits to a director;
- The board must forthwith enter the authorisation into the interests register;
- Directors who vote in favour of authorisation must sign a certificate stating that in their opinion the making of the payment or the provision of the benefit, is fair to the company, and the grounds for that opinion.
Section 161 further establishes that where the three elements of authorisation and certification were not complied with, or where no reasonable grounds existed for the opinion to make the payment, the director is personally liable to the company for the amount of the payment, or the monetary value of the benefit.
Personal liability may be avoided in circumstances where the director demonstrates that the payments of benefits were fair to the company at the time they were made, however, the onus of proof in that instance is on the director wanting to avoid liability.
Unfortunately, in New Zealand, non-compliance with s 161 is common.
If liquidators are appointed, and the requirements under s 161 were not met, they will likely take the view that such a salary/monetary benefit is repayable on demand. Below are examples of proceedings brought by liquidators of companies under s 161 against directors.
National Trade Manuals Ltd (in Liquidation) v Watson
National Trade Manuals Ltd was placed into liquidation by the IRD. The liquidators sought to recover sums paid to the director by the company. The director received a salary from the company, and the following resolution was purportedly made:
“By credit to his current account shareholders remuneration for the 2005 year of sufficient monies to clear any debit balance in his current account at 31/3/05 or, $10,000.00 whichever is the greater figure.”
The resolution was held by the court to be defective as it did not satisfy the requirements of s 161 (National Trade Manuals Ltd (in liquidation) v Watson HC Auckland CIV-2005-404-007335, 20 September 2006). Specifically, there was no certificate stating that the payments were fair, or the grounds for that opinion. The legal effect of non-compliance is that the director to whom the payments were made was found to be personally liable to repay the payments or the monetary value of the benefits, except to the extent that the director could prove the payments or benefits were fair to the company at the time they were made.
The issue of ‘fairness’ was dealt with by the liquidators by allocating a salary of $1,000 per week to the director and deducting that from the amount being sought. Consequently, all other funds transferred to the director by the company were ordered by the court to be returned to the company in liquidation.
Madsen-Ries v Petera  NZCA 103
This was an appeal against a decision of the High Court that salaries paid to Mr and Mrs Petera by Petranz Ltd (in iquidation) were fair to Petranz when paid. The issue on this appeal was whether the High Court, in reaching that conclusion, gave appropriate consideration to the very poor financial situation of Petranz at the time the remuneration was paid.
Petranz was a road transport business. It operated three trucks and specialised in moving containers. Mr Petera drove one of the trucks and Mrs Petera looked after the administration.
The appellants, the liquidators of Petranz and Petranz itself, sued Mr and Mrs Petera as Petranz’ directors and shareholders. They claimed various breaches of duties and a debt due from Mr and Mrs Petera under the overdrawn current account (as shareholders) and for unfair remuneration (as directors).
The High Court judge first found that the Peteras owed Petranz a total of $140,134 on their overdrawn current accounts. The judge, however, declined the appellants’ application for the repayment of directors’ remuneration. The judge went on to find the Peteras had, as alleged, breached duties they owed under the Act, including s 135 duty not to trade recklessly. The judge also found that they had failed to keep proper accounting records as required under s 194 of the Act.
The Court of Appeal rejected the liquidators’ approach as they were effectively claiming that the Peteras were liable for all creditors and liquidation costs as a result of breaches of director duties, and on top of this, for the amounts they were paid under the current account and as a salary. In the Court of Appeal’s view, this involved double counting.
The Court of Appeal held that the Peteras were able to retain amounts they were paid as a salary (and paid PAYE on) regardless of non-compliance with s 161 of the Act because the amounts were considered to be fair to the company. This is because:
- PAYE was paid, meaning the debt to the IRD did not become larger;
- Mr Petera worked 60–70 hours per week overseeing the operations and driving a truck;
- Mrs Petera worked about 20 hours per week attending to the administrative requirements of the company;
- The company gained full value from the work carried out by the Peteras;
- In the circumstances, the salaries were fair to Petranz.
The Court of Appeal held that ‘fairness’ needs to be assessed from the prospect of the company, and not creditors. However, if directors take money while trading recklessly (or breaching another duty), they may be liable pursuant to a breach of duty cause of action.
Some directors still believe that since they manage a company, they are able to determine the way they receive salary or other monetary benefits from the company.
With the creditors, insolvency practitioners, business partners and the Inland Revenue Department becoming more aware of this practice, more and more directors face severe consequences for failing to follow the proper processes for authorisation of payments.
It is important that business advisers, accountants and lawyers working together with the directors of small to medium size companies emphasise the importance of following the proper processes for authorisation of payments to directors.
Brent Norling firstname.lastname@example.org is Director of Norling Law Ltd and specialises in restructuring and insolvency, debt collection, security enforcement and civil litigation.
Last updated on the 5th October 2018