Who pays and who doesn't pay when a company fails?

A Directors' Penalty Scheme may help limit the financial losses of employees and other parties when a company fails, writes Professor Lisa Marriott.

Professor Lisa Marriott

The liquidation of restaurant chain Wagamama has been recently reported, with the company entering liquidation leaving employees unpaid for wages, holiday pay and bonuses.

There are hundreds of similar cases every year in New Zealand. While it would appear there may be some resolution to the Wagamama case (as the UK franchise owner is reportedly offering some recompense), this is an unusual outcome in cases like this.

In many situations when a company enters into liquidation, there will be no franchise owner or other third party willing to reimburse those left out of pocket.

In the Wagamama case, it has been reported as "wage theft". This is not an unfair representation. In cases like Wagamama, company directors are using funds that do not belong to them to help with their cash-flow.

One of the key problems with liquidations in New Zealand, highlighted by the Wagamama case, is that company directors have little incentive not to use withheld funds to continue to trade.

When company directors continue to operate beyond the point where the company is financially viable, it can take considerable time – sometimes up to a year – for the company to enter into liquidation (either voluntarily or compulsorily). This increases the financial risk for those who continue to work with, or for, that company.

Typically, non-compliance with tax laws results in some form of civil or criminal action, which, if the offender is found guilty, results in some form of punishment. However, there are situations where non-compliance may not result in a negative consequence, such as when companies enter liquidation and, as a result, withholding taxes that have been deducted are not paid to the government.

Unlike some other countries, New Zealand company directors are not automatically liable for certain tax debts (such as pay-as-you-earn deductions, GST, pension contributions and other amounts withheld from employee salaries) if that company is wound up.

In other countries, directors may be held liable for these taxes if the company enters into insolvency, as these payments are held in trust by the company for the government or employees. Moreover, it is these taxes that a struggling entity may use for funding operational activity when in a position of financial distress.

My suggestion is we adopt a directors' penalty regime for taxes withheld. How this would work is when a company director cannot pay their tax obligation as it falls due, that director has a short period (usually 21 days) to either settle the obligation or enter into voluntary liquidation. This provides time for the director to find alternative funding.

However, if funding is not available, it provides a limited period where the company can continue to operate using, in effect, other people's money. If a company's director does not do one of these things, on day 22 they automatically become personally liable for the outstanding debt.

This is not a new idea. Australia, Canada and the UK all have schemes where directors may be personally liable for certain company tax obligations, in addition to the usual provisions that exist through company law (such as where there is fraudulent activity).

It isn't only the potential losses to employees (or tax revenue) that is problematic in these situations.  There is the potential impact on sub-contractors (who don't get paid and therefore can't pay their staff) along with other suppliers.

The key advantage of a Directors' Penalty Scheme is it limits the amount of time a director can continue to operate without either taking action to resolve the situation or taking some personal financial liability for decisions made. Remember, those who have the most knowledge of how a business is performing are the directors. A directors' penalty scheme can help align the incentives of the director with those of other affected parties.

There will be arguments that this will destroy incentives for entrepreneurial activity. This is valid. However, when incentives encourage company directors to engage in risky behaviour where others bear the financial impact, we need to question whether the current policy settings are optimal.

Data I received under an Official Information Act request showed the majority of the 3,598 company liquidations in 2015/16 were initiated by Inland Revenue. The average tax for these 1956 companies that went uncollected was $107,771, with a total tax amount owing of $210,800,000.

We don't want to force viable businesses to close when they have short-term cash flow issues, but if the only source of funding available to an enterprise is withheld funds, this is a signal that there may be issues with the viability of that enterprise. And, of course, directors have a choice. If they know this is a short-term funding issue, they can choose to keep operating and pay their tax at a future date.

The outcome of adopting a directors' penalty scheme would be to provide a greater level of protection for those who are most vulnerable in situations such as the Wagamama case.

Would the directors of Wagamama have continued to operate if they were personally liable for at least some of the debts of the company? That's impossible to answer, but some deterrence in the form of a Directors' Penalty Scheme may have limited the financial losses of employees and other parties.

Read the original article on Stuff.