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Risk redoubts: keeping a stable asset base, through good times and bad.

The corporation has been established. The management team is in place. The mortgage for the building has been finalized. The equipment is leased and functioning. The employees have been hired and trained. The company is in business and ready to succeed.

But what if it doesn't succeed?

This isn't an option that most business owners and their executives wish to consider. But if you don't consider it--and plan for such a contingency--you could be at risk of losing not only your business assets, but your personal assets as well.

The statistics are telling. In 2001, the latest year for which statistics are available, approximately 14,000 businesses in Canada took formal insolvency proceedings. Additionally, an untold number of businesses simply closed--many as a result of insurmountable financial obstacles. So you can't afford to take a chance. No one can afford to risk everything they own.

In fact, there's nothing preventing every, small- to mid-size business owner, shareholder and director from implementing certain risk-reduction strategies today that would provide them with invaluable protection should their businesses ever experience financial difficulties in the future. There is, however, one provision: these strategies must be implemented before financial problems arise. The optimal time to get underway is as soon as you launch a business.

Secured investment

A variety of federal and provincial legislation governs which parties will have priority, over the assets of a debtor. For creditors, the objective is to ensure that they secure the highest priority over other creditors.

Generally speaking, creditors fall into one of three classes: trust, secured and unsecured.

Often, in a bankruptcy or restructuring, there is only enough money to repay the mast and secured creditors. Retained earnings and share capital, which represent shareholder equity in a business, are the last to be paid out of a company's assets that are distributed in the event of liquidation. Thus, unless these assets are secured in some way, the owner of a failed business will generally have to kiss this equity goodbye. Business owners who invest money in their businesses should therefore obtain some sort of security for their funds.

Security over personal assets is governed by The Personal Property Security Act (PPSA), which, in most cases, requires a security agreement and registration under PPSA. With this in mind, if you or your family or friends invest money in your business, these funds should be secured by way of a security agreement. This is a document that secures payment of an obligation upon default by enforcing the security interest against the collateral.

PPSA applies to any transaction that creates a security interest in personal property arrangements. There are three versions of PPSA in Canada: the Western model, used in Manitoba, Saskatchewan, Alberta, British Columbia and the Territories; the Ontario model; and the Atlantic model, used in New Brunswick, Nova Scotia, Prince Edward Island and Newfoundland.

The general rule for all of these PPSAs, however, is that the "first to perfect" (i.e. register a financing statement under the PPSA or hold possession of an asset as collateral) usually has priority over other security interests. Therefore, if shareholders, officers, directors or related parties provide funds to a company without a security agreement, in the event of the company's demise, they would be last in line to receive the remaining assets.

When the funds are secured, on the other hand, the lenders become secured creditors and ascend the hierarchy. Similarly, security over land or buildings under the Mortgages Act is generally determined by order of registration, which determines priority.

Directors' liability

While directors of a corporation are not generally liable for the debts of the corporation, there are a number of federal and provincial laws which impose personal liability for certain employee payments and government remittances. These include:

* unpaid wages (depending on provincial law);

* employee source deductions;

* goods and services taxes; and

* provincial sales taxes (depending on provincial law).

These liabilities can add up to significant personal financial risk, so it's important to obtain liability insurance sufficient to indemnify directors for this risk. This is especially important for directors who aren't involved in the day-to-day business; liability insurance will ensure that these obligations are met by the company.

Timely remittance payments

Both federal and provincial legislation create deemed trusts for outstanding obligations owed to the Crown. The concept of these deemed trusts is that property owned by a corporation is held in trust for the benefit of these governments. Therefore, a deemed trust gives the government a priority over the claims of secured creditors.

Since financial institutions usually require a personal guarantee from principals of a company to which they loan funds, if the company has a large deemed trust obligation, this can erode the security of the financial institution--and subject the principal to more exposure on the guarantee. Guarantors should therefore make every effort to ensure that government source deductions and other remittances are paid on time.

Unfortunately, since government remittances are based on a self-assessment system, too often these are not paid when an organization faces financial challenges. For these reasons, it's important that directors conduct proper due diligence to ensure that government obligations are paid on a timely basis. This is especially true for directors who may not be involved in the company's daily operations. You must take special care to monitor these obligations--especially if the company is experiencing turbulent financial times.

Personal assets

As mentioned, both company assets and the personal assets of directors and officers are at risk. Only a few personal assets are exempt from seizure by a creditor. These vary somewhat from one jurisdiction to another. In Ontario, for example, exempt assets include:

* $5,000 of personal possessions (such as clothing, jewellery, sports equipment, etc.);

* $5,000 of motor vehicles;

* $10,000 of household furnishings;

* $10,000 of tools of the trade (equipment used to earn a living); and

* certain types of RRSPs.

In some provinces, the cash surrender value (CSV) of certain types of life insurance is protected from seizure by trustees or creditors as well. The thinking behind this is that these policies are intended to protect the welfare of others who are dependant on the policy owner. Generally speaking, the CSV would be exempt if the beneficiary of the policy is a spouse or someone in direct lineage, such as a parent, grandparent, child or grandchild of the insured.

Similarly, only certain RRSPs are protected from creditors. In Ontario, for example, this applies to RRSPs with a life insurance component held with an insurance company.

The more personal assets you have, obviously the more you risk losing. Thus, many entrepreneurs hold few or no assets in their name because prior to embarking on their business venture, they transfer certain assets to other family members.

You can accomplish this by transferring funds or property to a spouse or another family member by sale or mist transaction. Should you decide to do so through a trust vehicle, the arrangement must be properly documented and the funds or property administered by a trustee.

There are many other risk-reduction strategies that you might want to consider to minimize liability in the event of business failure. But if you start with these basic four--before financial stresses arise--then you can forget about the impact of failure on yourself and your loved ones and focus on succeeding; which is, after all, what owning a business is all about.

Brian Pritchard ( is a senior vice-president of BDO Dunwoody Limited.
COPYRIGHT 2003 Society of Management Accountants of Canada
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2003 Gale, Cengage Learning. All rights reserved.

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Title Annotation:management trends
Author:Pritchard, Brian
Publication:CMA Management
Geographic Code:1CANA
Date:Oct 1, 2003
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