A company director may face the tough decision to personally fund their company to keep it afloat or drive its growth. This is a reality many small business owners know all too well. While this approach carries inherent risks, taking the right precautions upfront can minimise those risks and limit personal exposure, ensuring that lending money to the company doesn’t lead to unwanted financial pitfalls.
While a director’s decision to personally loan money to their company carries potential hazards, certain steps can be taken by a director to minimise the hazards particularly by ensuring that the director takes appropriate security for any funds advanced. If a loan made by a director is unsecured and the company is subsequently wound up, then chances of repayment are very slim.
Entry into a Loan Agreement
Although entering into a Loan Agreement may seem like an obvious first step, directors (particularly directors of small companies) routinely advance money to their company without entering into a loan agreement. Proper documentation of the loan will clearly establish the legal relationship between the director as lender and the company as borrower, as well as clarity on the terms of the loan, including any agreed repayment schedule, the interest rate, and the loan amount. In the absence of a written loan agreement, the nature of the loan may be complex to identify and may be viewed as an investment.
Obtaining Security
A security interest is only as useful as the assets that a company owns to satisfy that interest. This means that even if you do obtain security for the loan, if the company does not have any assets in the event of liquidation, there will be no way for the company to honour your interest. There must be careful consideration as to whether the loan would be recoverable if advanced by a director.
The most common security is to obtain a mortgage over any real property owned by the company. Any mortgage should be registered on the title of the land through the New South Wales land registry, as a registered mortgage provides greater priority compared to an unregistered mortgage.
Types of Security Interests
Security interests can come in various forms, like leasing goods, hire purchase deals, or agreements that involve a fixed or floating charge. One of the most common ways to secure assets today is through a General Security Agreement which is a legal document allowing a lender to claim a borrower’s assets if the loan isn’t repaid. The General Security Agreement creates a security interest in both the present assets of the borrower, and the future assets of the borrower.
Personal Property Securities Register (PPSR)
If a loan is secured by property of the company that is not real property, directors will need to register the security interest on the PPSR. The security should be registered at the time of, or shortly after the loan is made, because if another creditor also has a secured loan registered on the PPSR then the earlier registration has priority over the later.
Ensuring your security interest is registered before making further advances
To secure priority, a PPSR registration against a company must occur within 20 working days of signing the security agreement. Best practice is to register the interest promptly to maintain priority. Notably, a security interest created within six months of liquidation will be void as against a liquidator if the funds were advanced before the security interest was granted. To avoid losing priority, lenders should ensure the security interest is registered on the PPSR before advancing any further funds to the company.
Deeds of Priority
Seeking priority against other secured creditors may be practically difficult, as large creditor interests are likely to refuse. However, it is always worth negotiating priority. A deed of priority can be drafted to confirm a director’s priority over other secured creditors. The deed can either confirm the standard rule that an earlier loan has priority over a later loan, or stipulate what the agreed priority will be between lenders.
This ensures there is no confusion or conflict between creditors in the event the company is wound up and secured creditors cannot agree on an order of priority.
Advances of funds used to meet employee obligations
The Corporations Act 2001 (Cth) sets out certain additional protections for unsecured loans. Section 560 provides that where a person loans money to a company and that money is used to make payments relating to employees, such as wages, superannuation contributions, leave of absence or termination of employment payments, then the person who loaned the money will have the same priority as priority creditors with outstanding employment payments. This has the effect of giving that loan priority over unsecured creditors.
Key Takeaways
- Directors should always draft a formal Loan Agreement to clearly define the terms of the loan, including repayment schedules, interest rates, and the loan amount, to avoid confusion and ensure legal clarity.
- The roles of the director and the company can become blurred, leading to informal lending practices. It’s essential to distinguish between personal and company finances to prevent the loan from being mischaracterized as an investment.
- Obtaining security over company assets is key to protecting the loan. However, security is only effective if the company has assets to satisfy it in the event of liquidation. Ensure that the security interest is backed by tangible assets.
- To maintain priority over other creditors, security interests should be registered on the Personal Property Securities Register (PPSR) within 20 working days of signing the security agreement.
