Should you use a company?
New Zealand is a country full of business opportunities; it has very few barriers when it comes to doing business. Anyone can do business at any time. When your annual income is less than $60,000, you do not even need to register for GST.
Many of our clients have a notion that doing business means one needs to have a company. This can be said to be deeply entrenched. Many people follow suit, but not many people ask why or carefully consider the pros and cons of setting up a company.
It is not necessary to set up a company in order to conduct a business, and using a company might not always be a wise choice.
1. What is a company?
In order to discuss the pros and cons of setting up a company, we need to firstly understand out what is a company and why this concept exists.
Humans probably started to conduct business after the concept of property ownership was invented. But the concept of the company is relatively new considering the tens of thousands of years’ history of human civilisation. Before the advent of the company, most people conducted business in their personal capacity or partnership.
There is always risks involved in doing business. Conducting business in one’s personal capacity means that person will have to bear all the risks. If the business fails, the business owner often loses his assets to creditors. This risk has led business people to be careful not to invest in high-risk and high-reward endeavors.
At the same time, in pre-company era, it was difficult to raise funds to invest in large-scale projects. The traditional way of cooperation is partnership. Partners not only have to contribute financially, but usually have to be personally involved too. It is often not easy to keep checks and balances in place between partners who have difference level of personal involvement.
At the end of midde-ages, the development of navigation technology made it possible for European explorers to reach other side of the world. It was the dream of many European businessmen to get the slice of the of the trans-ocean trade pie. But most had no ability or were not willing to take the risk of engage trans-ocean trade on their own. Against that background the Dutch East India Company was established in 1602. The Dutch East India Company is often considered the first real company. The idea was that people can put the money together, invite professionals to operate the venture, and then pay dividends to all shareholders. However, If the venture fails, shareholders lose only the money that they had invested.
The Dutch East India Company was very successful. It instantly occupied trans-oceanic trade all over the world. The success of the Dutch East India Company made the British feel the pressure of competition and they quickly established the British East India Company. In the following two hundred years, European countries quickly controlled the world’s resources through powerful trade. Many colonial developments and wars were actually caused by the expansion of the British East India Company, which shows its strength at that time. It also proves that the company’s business model has brought unprecedented success to the business world.
The success of the company concept is mainly because it makes investors more willing to take risks. The more risk, the higher the reward. Although some companies end up failing, and some creditors of the failed companies end up failing to recover their money, from the economic perspective of the entire society, the advantages of company trading outweigh the disadvantages.
Over the past 400 years, the company’s business model has been constantly evolving and improving, but its purpose has not changed – to reduce the risk for the business people. If a company fails, it will be liquidated, and the creditors cannot recovery money from the company’s shareholders.
2. Will you be able to take the advantage of a company？
In theory, for the company structure to reduce the risk for the shareholders it will inevitably increase the risk of the company’s creditors. Since not everyone is stupid, plenty of ways have been invented to reduce the creditor’s risks. In reality, small business are difficult to obtain any real advantage from being a company, most potential creditors of the company will make the business owner personally liable.
We had a client who owned a coffee shop business for a few years and later decided to stop operating it due to changes of personal circumstances. However, he was unable to sell the business in time because the market was ideal at the time. He was then forced to close it down. He thought that because it was run by a company, having the business failing would not affect him personally. But It turned out that he had personally guaranteed almost everything. From the lease of a shop, which was over a hundred thousand dollars a year, to supply contract of dairy products. His shop had an unpaid invoice of several thousands of dollars from the dairy product supplier. That supplier had been in the business for a long time and sued him personally. This client came to us when he was sued. By this time, the only way to avoid bankruptcy was to pay the invoice.
Not only suppliers and landlords will require personal guarantees, other entities such as banks often require other forms of security which we will not cover here.
It is worth mentioning that even in the limited liability company model, the director of the company has a series of personal responsibilities. For example, the company must not be allowed to continue trading when it is insolvent, which concerns reckless trading, and the company’s financial statements must be prepared in a timely manner.
One of the biggest director’s duty’s case in recent years was the Mainzeal case. The directors of the collapsed construction company Mainzeal were sued for reckless trading. Those directors include former Prime Minister of New Zealand, Dame Jenny Shipley. The four directors were found to be liable for 36 million dollars payable to the liquidators who sued on behalf of the lost out creditors of the company. The Court found that the Mainzeal company had been trading while the balance sheet was insolvent for many years, resulting in huge losses to creditors (the creditor’s loss may exceed 110 million).
This case highlights a point worth noting: that is, Dame Shipley is not an irresponsible person, but Mainzeal’s business structure was very complicated. Dame Shipley herself may not be very clear whether the company was losing money. The Court order that Shipley and the main director and founder of the company, Mr Richard Yan, to pay 6 million dollars to the liquidators. About one sixth of the total judgment sum. Obviously her culpability was relatively minor compared to the order directors. Even so, the Court held her accountable. Most people would have no way of coming up with $6 million. Fortunately, Shipley has professional indemnity insurance, which would probably cover the judgment.
When a company is insolvent, the Inland Revenue Department will come to collect tax debts, too. We had a client who operated a cleaning business through his company for several years. It was not a profitable business and the expenses were high. The client did not have much left at the end of the day. He thought he was able to deduct all the expenses. However, some expenses were not actually deductible. Later, the company was wound up and was liquidated. The IRD, through the company’s liquidator, sued him personally for breaching various responsibilities as a director, and claiming a sum of more than $400,000. The total turnover of the business across the few years of its existence barely adds up to that amount. We defended our client on various legal grounds and that gave our client a breathing window of about two years. In the end, he was ordered to pay about 150 thousand dollars, which was almost less than a third of the amount claimed. The point of this story is that even if you operate as a company and if you do not fully comply with the provisions of the company law, you may end up having to pay for the company’s tax debts personally. This kind of thing doesn’t only happen in large and complex companies like Mainzeal, it can also happen to small businesses and working class people.
3. Company laws are complicated
A company is fundamentally a complicated structure: the interests of different stakeholders need to be balanced, and the laws governing it have evolved accordingly over the past 400 years. The company laws in different countries are not the same. Although in Commonwealth countries, company laws are similar. After their respective independence, each has its own unique culture and social structure so that each has evolved their company laws with some unique provisions. Companies in New Zealand are regulated by the Companies Act 1993. There are 402 sections under this Act. In addition, there are many legal principles derived from the case law. As an ordinary person doing business, it is impossible to fully understand these laws.
There are approximately two provisions relating to director’s duties, and when you apply them to real life there are infinite permutations. But no matter how small your business is, your responsibilities are the same.
Many clients think they can sit back and relax so long as they have engaged a professional accountant, they will take care of all the company law obligations. However, this is not the case. Most accountants are rather conservative, they often choose to follow the client’s instructions. Therefore, the accountants will be doing things according to your wishes; and you may not be given the advice if you do not ask for it. More importantly, accountants often do not have litigation knowledge (nor do they need it), and they cannot tell their clients what the consequences might be if you don’t follow the rules. When a client sees the “consequences” the first time, it is often when they receive statement of claim issued by lawyers for the liquidators or creditors. When they see the claims, they often get overwhelmed and feel like collapsing. For example, that client I mentioned earlier, his company did not even make as much money as that he was being sued for. Those of our clients who have received claims for breaching directors’ responsibilities, without exception, all had engaged professional accountants.
In addition to the complex company laws, a company’s operating model itself is also complicated. We have a number of clients who were successful business people in China, they come to New Zealand and wish to do business here but usually have little knowledge of New Zealand law and company law. They would set up companies in New Zealand on the advice of friends, but do not really operate under the usual company model. We have seen several cases where the business owner, instead of appointing a CEO to manage a business and they themselves maintaining the position of sole shareholder and at least a co-director, appoints another person, usually a Chinese migrant who has been living in New Zealand for several years, as the company’s sole director and shareholder. As a result, when there conflict eventuate between the owner and the director/shareholder, it is really complicated for the owner to take back the company. Because that appointed person was the shareholder and director during their tenure, although their actions were without the owner’s consent or permission, and it was still very hard to reverse them.
About the Author:
Daniel Zhang is a partner of Advent Ark lawyers, he leads litigation/disputes resolution team. Daniel has appeared before the District Court, the High Court and the Court of Appeal. There are 26 New Zealand’s Senior Courts’ Judgments on Ministry of Justice’s official website where Daniel appeared as counsel.
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