Geoff Hardy: Dropping into red brings out managers' true colours

Managers of privately owned companies can be loathe to give up their lavish lifestyles during a downturn. Photo / Babiche Martens

It usually takes an event like the 2008 global meltdown to expose the worst corporate abuses.

We mostly associate this particular recession with the collapse of the finance companies and the loss of investment savings that went with it.

Many of those collapses were merely due to risks coming to fruition, and their owners and managers have been unfairly maligned.

But in the more blatant of cases, the owners and managers either misled and deceived investors from the outset, or eventually diverted public funds into their own private projects without authority.

The Securities Commission, Serious Fraud Office and the Companies Office are thankfully pursuing the worst excesses and bringing the perpetrators to justice.

However, bad behaviour is not confined to those who have public money at their disposal. Recessions also test the ethics and morality of owners and managers of smaller, privately funded companies.

The problem is that they become accustomed to a certain privileged lifestyle, and are extremely reluctant to give it up despite the dramatic decrease in profitability of their companies.

There simply isn't enough money to go around, and since they don't want to reduce their share, someone else's share has to reduce.

In a company-run business, there are only two suitable candidates to force this involuntary sacrifice upon. One is the company's creditors and the other is its shareholders.

Chiselling your creditors can be done in a variety of ways.

The least sophisticated method is simply to suspend payments to all creditors (except the ones you really need to do business with), buy more time with a host of excuses, put up as many obstacles as you can in front of anyone who attempts to recover their debt from you, and pay only those who really put the heat on you, at the courtroom door.

At the other end of the scale are the sophisticated schemes that are intended to leave your creditors picking over the carcass while you escape with the loot. A typical example of this is the phoenix company scam.

Phoenix company schemes work like this. The shareholder/directors of company ABC Ltd decide to shed themselves of their creditors. They form another company XYZ Ltd.

They then change the name of ABC Ltd to LMN Ltd, and at the same time change XYZ's name to ABC. This is done in secret, discoverable only by those who search the Companies Office register, and happen to notice that the names of the companies have changed.

All other details such as registered office, directors and shareholders remain the same, deliberately so.

The shareholder/directors then find a friendly liquidator. They negotiate in advance for the payment of the liquidator's fees and for the purchase by the new ABC Ltd of the old ABC Ltd's core trading assets at a fire sale price.

They then put the old ABC Ltd (now named LMN Ltd) into voluntary liquidation, leaving its creditors with nothing but a claim against the net proceeds of the sale of the core trading assets, which are often paid in instalments by the director/shareholders over a lengthy period.

Very few people, particularly ABC Ltd's ongoing customers, are any the wiser. That is the whole idea.

Everyone, except the creditors left in the lurch, think that ABC Ltd is exactly the same entity that they traded with in the past, blissfully unaware that the director/shareholders are not exactly as creditworthy as they appear.

An alternative to chiselling your creditors is chiselling your fellow shareholders. Shareholders are entitled to all the surplus profits of the company after the creditors have been paid.

Majority shareholders who control the company can simply cut off the income stream to the minority shareholders by paying themselves excessive salaries, making over-priced investments in personal projects, and building up reserves rather than paying out dividends.

The minority are then effectively shut out of active participation in the company. Shareholders' and directors' meetings are dispensed with, as are all of the formalities prescribed by the Companies Act except for those that are inescapable, and the flow of information to the minority shareholders dries up.

At the more blatant end of the scale are scams such as the "hive-down". This is intended to defeat selected creditors and shareholders alike.

Those in control of the company simply transfer its business and assets to another company that they own.

Although this can be done legitimately, the "just do it" brigade never bother to observe the proper formalities.

They either take the assets and pay nothing back to the original company in return, or they get some bogus back-of-the-envelope valuation done to justify paying what is in reality a massive undervalue for the assets they have acquired.

But it's not all bad news for the creditors and shareholders who have been left out in the cold. There is a host of remedies available to them and forms of leverage they can use against the corporate bullies.

For example, promoters of phoenix company schemes can now be made personally liable for the unpaid debts. And majority shareholders can be held to account for breaches of their statutory duties or unfairly prejudicial conduct against minority shareholders.

So if you are in that situation, don't despair. You don't have to take it lying down.

* Geoff Hardy is the principal in Madison Hardy, a specialist commercial law firm in Auckland.