It is not unusual for companies, particularly newer, capital-constrained ones, to accept loans from, or make repayments to directors (or their associates). This might be for working capital, bridging shortfalls, or to enable new business initiatives. However, director-related loans carry unique risk: in a liquidation, a liquidator may seek to claw back some or all those payments under the Corporations Act 2001 (Cth) (the Corporations Act), even where the company was solvent at the time the loan or repayment was made.
The New South Wales Court of Appeal’s decision in Changela v Dracoma Pty Ltd (fondly known as ‘the Chickpea Case’) offers comfort for directors and companies alike. It confirms that not every repayment to a director is suspect, and courts will consider the commercial realities of the transaction rather than relying on hindsight.
The story behind the chickpeas
A small export company borrowed money from its directors to fund the purchase of a chickpea crop. A few months later, while solvent, trading normally, and with no outstanding creditors, it repaid those loans in full.
When the company later failed, the liquidator sought to claw back those repayments as “unreasonable director-related transactions” under section 588FDA of the Corporations Act.
The Court of Appeal disagreed. It found the repayments were made to discharge genuine debts, at a time when the company was solvent, and in circumstances where no one else was disadvantaged. The payments were not ‘unreasonable’ merely because the company later went under.
Why the Court allowed the repayments
The repayments were upheld for a straightforward, logical reason: the surrounding circumstances demonstrated they were neither improper nor detrimental to creditors. The detailed reasoning of the Courts decision includes:
- The company was solvent at the time: There was no evidence of unpaid creditors or financial distress.
- The repayments discharged genuine debts: Real loans had been made by the directors and were being repaid.
- There was no preferential treatment: The directors weren’t being repaid ahead of other creditors.
- The repayments were commercially ordinary: The loans and their repayment were consistent with how the business had historically operated.
- Hindsight is not the test: The Court focused on what was reasonable at the time, not how things looked after failure.
These factors led the Court to conclude that a reasonable person in the company’s circumstances would have entered those transactions, and that section 588FDA wasn’t designed to penalise sensible, good-faith transactions between solvent parties.
Why this matters
Section 588FDA allows a liquidator to claw back payments to directors if a reasonable person in the company’s circumstances would not have made them. Unlike most voidable transaction provisions, it does not require insolvency, meaning even healthy companies can be caught out if the transaction looks self-serving or lacks proper documentation.
That’s why director loans and repayments demand careful thought and good governance, even in stable financial conditions.
What makes a loan ‘safe’?
What distinguishes a safe loan from a risky one often comes down to the quality of the company’s paperwork, processes, and governance. Taking these simple precautionary steps can save a lot of headaches down the track:
- Have a written loan agreement: Outline the purpose, amount, repayment terms, and whether the loan is secured or subordinated.
- Record the board’s reasoning: Include commercial rationale and a note on solvency.
- Keep evidence of solvency: Maintain records of cash-flow forecasts, management accounts, and solvency certificates.
- Treat directors like any other creditor: Avoid repaying insiders ahead of trade creditors.
- Seek advice early: External legal or accounting input strengthens the record.
Contact one of our experienced lawyers today on 1300 654 590 or email us for tailored advice and assistance in drafting a comprehensive loan agreement.
What the chickpea case doesn’t change
The Court’s decision is not a free pass. It doesn’t protect every repayment to a director. If the company is insolvent, if repayments prejudice other creditors, or if the documentation is unclear, a liquidator can still challenge them.
What Changela v Dracoma does clarify is that reasonableness must be assessed at the time of the transaction. When repayments are genuine, transparent, and commercially justified, they are more likely to withstand later scrutiny.
Conclusion
Director loans aren’t inherently risky, so long as they are executed correctly. What matters is the commercial justification and the supporting paper trail. Documentation is your best defence: courts look favourably on companies that can demonstrate careful decision-making, transparency, and solvency at the time of repayment.
Hindsight doesn’t equal guilt, and directors shouldn’t be punished for making reasonable commercial decisions that later appear unwise because of unforeseen events. However, before proceeding with any loan or repayment, directors should ask key questions about the company’s financial position, the potential impact on creditors, whether the transaction is structured at arm’s length, and whether the reasoning is supported by proper advice. Transparency builds trust, and clear communication and thorough minutes protect both the company and its directors.
In short, preparation pays off and every director loan or repayment should be made on the assumption that it might one day be reviewed and should be able to withstand that scrutiny.
Final word
Director loans can be a lifeline for many businesses. The Chickpea Case offers reassurance that genuine, well-documented transactions won’t automatically be clawed back.
If your company is considering a loan to or repayment from a director, it’s worth taking the time to get the structure and records right. The investment in good governance now may save you from an expensive dispute later and help you keep your own ‘peas of mind.’
How we can help
Director loans and shareholder funding don’t need to be a source of risk, provided they’re handled correctly. Our team regularly assists family businesses and SMEs to:
- Put in place or review clear director loan agreements.
- Prepare board minutes and solvency declarations.
- Assess governance risks under sections 588FDA and 588FE.
- Strengthen your internal approval processes and governance frameworks.
If you’re uncertain whether your company’s director loans are adequately documented or compliant. Contact one of our experienced lawyers today on 1300 654 590 or email us for tailored legal advice.
