Asset Protection 1: Companies (2 March 2011)
This is the first of a series of articles about some of the ways in which a person’s wealth and business operations may be appropriately structured so that:
(1) their personal and family wealth is protected from the risks of their business activities; and
(2) key business assets are protected from the risks of litigation or other one-off adverse events.
Companies, registered debentures and discretionary trusts are the main building blocks of corporate structures that provide effective asset protection.
This article discusses the use of companies for asset protection purposes.
These articles are introductory and general in nature, and they are intended to assist readers to consider their asset protection needs and seek appropriate legal, accounting and taxation advice about their individual circumstances.
Limited liability
The important feature of a company, for asset protection purposes, is “limited liability”.
What this means is that the company’s shareholders are not (ordinarily) exposed to liability for the acts or omissions of the company, except to the extent of any unpaid share capital (ie any unpaid amounts they owe the company on their shares).
In the case of a private company, there is usually no unpaid share capital, and (for reasons discussed below) it is usually preferable to fund a company’s operations through related party loans, rather than with shareholder capital.
Limited liability has the effect that if a company breaches a contract, or fails to pay a debt, it is the company that is liable, and not (ordinarily) its shareholders or directors.
This enables the risks associated with a business to be quarantined within the company that conducts it. So, if Tom operates his business through a company, and the business fails, Tom and his personal assets will (normally) be protected from the business’s creditors, whose only remedy will be against the company. However there important exceptions and limits on this protection which are discussed below.
Often two companies are better than one. For example, an effective structure may involve one company owning the key business assets – such as intellectual property, premises, and plant and equipment – and then licensing the use of those assets to a second company which engages in the risky trading activity. If the second company runs into trouble, the key business assets will normally be protected in the first company.
Funding a company through related party loans
Funding a company through related party loans, rather than shareholder capital, results in the additional benefit of the related party creditor being able to vote, if the company becomes insolvent, for any deed of company arrangement that may be proposed by the directors.
A deed of company arrangement, which requires the vote of a majority of creditors in value and number, enables a company to settle all its debts by paying creditors (usually) a small percentage of what they are owed, avoiding the company having to be wound up and enabling the company and its business operations to survive.
The position of related party creditors is further improved where their debts are secured by registered debentures. This enables the related party creditor to appoint a receiver over the company’s business and assets if an event of default occurs. Registered debentures will be discussed in the next article in this series.
How directors can be liable for a company’s debts
A director can be held responsible for a company’s debts where the director has signed a personal guarantee or breached a duty to the company.
Banks and suppliers often require directors to give personal guarantees as a condition of extending finance or trade credit.
Finance applications to suppliers frequently contain “charging” clauses whereby the director “charges” – that is, effectively mortgages – all his or her present and future property in favour of the supplier, as security for any amounts which may in the future become owed by the company to the supplier. This gives the trade creditor the right to lodge a caveat on any land owned by the director, and it is obviously a good idea to avoid where possible giving personal guarantees and to negotiate the deletion of any charging clause.
An important example of the duties which, if breached, may result in a director being held personally responsible for a company’s debts, is the duty not to allow a company to trade while insolvent. If a company becomes insolvent, the directors must cause an administrator to be appointed in order to avoid personal liability for debts incurred after the date of insolvency.
The significance of this for asset protection purposes is that being a company director is a risky undertaking.
It is therefore preferable (subject to tax considerations) that personal or family wealth be owned by the director’s spouse (who is not a company director) or in discretionary trusts. Discretionary trusts are discussed in the third article in this series.
How other related parties (including directors) can become responsible for a company’s debts – debit loan accounts
The most common way in which related parties may become responsible for a company’s debts are debit loan accounts.
It is important to realise that debit loan accounts are not just numbers on a page. They represent amounts owed to the company by the loan account holders.
This means that if a company becomes insolvent and a liquidator is appointed, the liquidator will call up payment of any debit loan accounts, and may commence legal proceedings if they are not paid.
It is therefore very important that debit loan accounts be carefully monitored, and that legal and accounting advice be sought to ensure they are properly structured so as not to be payable on call if a liquidator is appointed.
Voidable transactions
Another common way in which related parties can become responsible for a company’s debts is if the company enters into “voidable” transactions.
These are the provisions in the Corporations Act that empower liquidators to “claw back” assets for the benefit of unsecured creditors.
A detailed examination of the different types of voidable transactions is beyond the scope of article, but the most important for related parties are:
- transactions for the main purpose of defeating creditors which were entered into within 10 years before the “relation-back” day (which is the day on which an administrator was appointed or a successful winding up action was commenced);
- uncommercial transactions (ie not for market value) entered into by a company with a related party within 4 years the relation-back day.
When re-structuring a person’s existing business and asset holdings, the risk of entering into “voidable” transactions needs to be avoided.
To minimise this risk, appropriate legal and accounting advice should be sought.
Generally speaking:
(1) it is usually preferable to transfer trading or risky activity away from entities which hold valuable assets, rather than transferring the valuable assets;
(2) when transferring assets, the consideration for the transfer should be market value, supported by an independent valuation; and
(3) alternative opportunities for asset protection should be explored with the client’s legal advisors, such taking advantage of rights of subrogation and exoneration or acquiring existing third party securities.
Conclusion
The company is a powerful asset protection tool, but there are important limits on that protection.
Appropriate legal, accounting and taxation advice should be sought to ensure that effective asset protection is achieved.
For more information about asset protection, do not hesitate to contact Demian Walton or David Lurie of our firm on (03) 8602 4000.
The content of this publication is intended only to provide a summary and general overview of the subject matter covered. It is not intended to be comprehensive nor does it constitute legal advice.
