Who’s Debt is it Anyway?

Have you ever thought of the legal status of your loan from your company if it is overdrawn and the business fails due to tax or other debt? This issue was the subject of a recent very interesting decision of the High Court.

The Background

A couple formed a company owned by family trust 98%, 1% each by the husband and wife. The wife was not a director. The accountant set up a current account in the name of the husband and wife which was then overdrawn when the company went into liquidation.

The husband filed for bankruptcy and the liquidator sought to recover the overdrawn current account from the wife. The drawings from the company had been used to meet family costs such as food, school fees and lifestyle.

The wife was allocated a salary each year along with the husband.

From time to time she signed business papers when asked by the husband but she never saw the business mail, had no idea of the state of the finances and had no active involvement in the running of the company.

Importantly, the wife never discussed the accounting arrangements (including the joint current account) with the accountant and never entered into any formal arrangement with the company to borrow the money. That is, she never agreed to incur a debt.

It was the husband who drew funds from the company, paid the family costs and ensured that the family was provided for. For her part, the wife assumed that all was well with the company as how else was the husband providing for the family? She simply assumed that it came from income.

The result

Justice Fogarty found that the wife had no contractual obligation for the debt, that is, she was not liable for it. Even though this was a closely held family company, it was a separate legal entity and there was no agreement by the wife to borrow. In the same way that a person could not be liable for a bank overdraft without entering into “commercial affairs in New Zealand would fall into disarray”.

Fogarty J disagreed as no arm’s length commercial party would rely on a spouse to bind another and the principle should apply to shareholder current accounts.

Your financial statements can label things however you wish - at the end of the day it is the legal position that matters. This case highlights the importance of understanding the implications of actions and provides both opportunity and warning.

As the husband was bankrupt the liquidator got nothing except a bill for the wife’s costs to defend the liquidator’s claim.