Michael Reid, managing partner, Meston Reid & Co

Much has been reported in the media over the past few months about a company obtaining a bounce-back loan and the directors not using it for the intended purpose of preserving the economic entity.  

For example, there have been reports of a director negotiating a bounce-back loan and, being well aware that there is no personal guarantee should it fail to be repaid, withdrawing the monies and using them for personal purposes.  

Doubtless there will be further comment as more misappropriations of government money are uncovered, however, the focus here is on the more traditional loan arrangement i.e. involving a director’s personal position and what can happen when formal insolvency incepts.

Many companies, perhaps at the outset of trading activities or when there is a cash flow challenge, obtain money from a director to finance the business.  

This is perfectly normal. The annual balance sheet reflects the director as a creditor and, if appropriate, will disclose whether interest is paid on the loan, security provided etc.  

However, a difficulty can arise when a company finds itself in financial distress and formal insolvency appears inevitable.  

A huge temptation is created when a director thinks that he will lose his/her own money if the company is liquidated and there is some cash (or readily realisable assets) within the company.  The conflict of interest is that the director should be acting in the interests of all stakeholder groups rather than simply his/her own, and not repay the loan to the detriment of other creditors.

If liquidation follows shortly after the loan has been repaid, the liquidator has legal authority to pursue the director under the unfair preference rules for recovery of the money.  Further, there are reported cases of directors being banned from acting as a director of a limited liability company because of a loan repayment preference.

While it is easy to say that the responsible director should accept that he/she is a creditor like everyone else and be part of the unsecured creditor dividend programme, the reality is that a director tends to repay the loan and wait to see what happens.  An understandable course of action – but the wrong one to take.

On occasion, a director has obtained security for the loan in which case further investigation is required about how the security was provided, who authorised it, when it was created, etc.  This can give a director a higher ranking in terms of a dividend payment and in all such cases, careful review is required lest a preference has been created that requires to be challenged by the liquidator.

A common scenario in a liquidation is an overdrawn director’s loan account i.e. the director has taken cash from the company, planning to repay it at some point in the future, but never quite doing so.  

Experience shows that when a director follows this path, one can become accustomed to a lifestyle beyond the receipt of a regular mix of salary and dividend, and find it difficult to repay the cash.  

If this carries on for a few years and HMRC are not particularly diligent at pursuing the company, the loan can quickly become unmanageable.

When the liquidator arrives and asks the director to repay the overdrawn loan in order to create dividend prospects for creditors, some awkward discussions can ensue, particularly when a director advises that he has withdrawn a substantial sum and has not told his wife about living beyond their means.  

Imagine the scene when the diamond and Gucci-clad wife realises that her lifestyle will have to change (and not for the better) with the consequent requirement for some of the family assets to be sold in order to settle the loan account.

Typically, the liquidator will try to be as reasonable as possible once the loan account has been calculated and, for example, allow the director an opportunity to view the loan account calculation before agreeing the balance.  

At its worst, the liquidator may have to bankrupt the director for recovery of the loan but this is always seen as a last resort.  

Payment by instalments is encouraged if a lump sum repayment is not practical.  In order to assess the position, a liquidator will ask the individual to provide an income/expenditure statement and an asset/liability analysis in order to agree a repayment profile.  

All very worrying for the director and not what he/she wants to address after the company has folded and the income stream ceased. At the end of March, HMRC took the step of helping directors by issuing a Director’s Loan Account Factsheet which reflects the points raised in this article.

In conclusion, whether a director has an overdrawn loan account, or is a creditor of the company, when financial challenges present themselves that may result in liquidation, great care must be taken and specialist advice sought. Don’t be scared to ask.

KeyFacts Energy: Commentary