Generally, if a contract is entered into by a company and that company has breached the contract, then only the company will be liable and not its directors. Directors are not generally liable, because the company is regarded as a separate legal entity or ‘person’, distinct from its directors and members. The protection of directors against liability is commonly referred to as the ‘corporate veil’, as courts do not generally look behind the ‘veil’ to ascertain who is liable.
However, in some circumstances, courts can ‘pierce’ or ‘lift’ this corporate veil. When this occurs, the separate legal personality of the company is disregarded and the directors and shareholders can become personally liable for breaches of contract and debts incurred by the company.
Examples of when directors can become personally liable are:
1. Insolvent Trading
The most common circumstance where the court will look behind the company and to its director is in cases where a director has engaged in insolvent trading.
Under section 588G of the Corporations Act 2001 (Cth) a director is under a duty to prevent the company from incurring debts if there are reasonable grounds for suspecting it is insolvent. Therefore, under certain circumstances, directors can be liable for debts incurred by a company when that company is unable to repay those debts as and when they fall due.
The Corporations Act notes that those directors who are found to be trading whilst insolvent are liable to pay compensation to the company of an amount equal to the loss or damage suffered by unsecured creditors. Further, civil penalties and criminal charges may also apply against a director if there was dishonestly involved in incurring the debts.
2. Personal Guarantees
In some contracts, personal guarantees are provided by the director should the company fail to meet its contractual obligations. These are most commonly seen in business loans, financial arrangements and leases. These clauses are extremely significant and proper advice as to its consequences should be sought prior to signing. These clauses effectively dispose of the ‘corporate veil’ and a director can be sued directly for the breach.
However, certain personal guarantees can ‘cap’ a director’s liability in the event of the company’s default, such as the amount or type of loss recoverable or remedies available. The wording of the guarantee is important, if the clause is too wide or ambiguous in respect of the particular breach, the court may rule that a director remains fully liable.
3. Uncommercial Transactions
Directors may also become personally liable where a company enters into a transaction that proves detrimental to the company and the transaction is director related. Examples of these transactions include when property or securities are transferred to a spouse, friend or related company and the transaction provides no benefit to the company. For example, transferring a property for less than market value.
If a breach of contract has occurred and there are minimal or no assets in the company or directors name, the court or liquidator can set aside those transactions where a director has knowingly assisted in transferring the asset. Liquidators and courts can pursue these uncommercial transactions up to two years prior to the winding up of the company.
De facto or shadow directors
It is important to remember that both de facto and shadow directors have the same statutory duties and liabilities as appointed directors and can be held liable for breaches of directors’ duties. This is the case regardless of whether they are recorded on the ASIC register or not.
Tips for Directors
- Directors should be aware of which legislation covers the activities of the contract and company. Directors should also seek advice on the obligations and duties imposed on both the company and themselves. Further, regular financial health checks are conducted on the company and other procedures are developed in order to minimise risks of the company breaching any of its liabilities.
- Seek advice on any indemnity clauses contained in contracts and where possible, try to limit director liability in such clauses.
How can Sharrock Pitman Legal help?
For further information on director liability in instances where the company has breached a contract, feel free to get in touch. We have an Accredited Specialist in Commercial Law and our experienced Commercial Litigation team is able to advise and assist you. Please contact us on 1300 205 506 or by email at litigation@sharrockpitman.com.au.
The information contained in this article is intended to be of a general nature only and should not be relied upon as legal advice. Any legal matters should be discussed specifically with one of our lawyers.
Liability limited by a scheme approved under Professional Standards Legislation.
Caroline Callegari is an Associate Principal and leads our Disputes & Litigation team. She has an advisory and advocacy practice in the following areas: Commercial Litigation, corporate and personal disputes, debt recovery and, insolvency and bankruptcy matters. Caroline can be contacted on (03) 8561 3324.
