Having returned to these updates after taking some leave, I hope you all got a break over the summer. One thought I came back to on the back of a client query, was about when the limited liability that is enjoyed in a company structure could be lost?
This a potential big issue – even people who know very little about the working of limited companies may know that directors and shareholders are not liable for the debts of their companies.
The protection of limited liability has also been one of the key factors in economic growth and commercial activity for limited companies. It has allowed entrepreneurs to both speculate and take risks, many of which they might not have wanted to take if the risk of personal liability existed.
Limited liability is not total, it is subject to exceptions. I will look at 2 areas in brief here: firstly insolvency and distress and secondly other provisions that have more general applicability.
Insolvency/distress situations
If a company is in trouble and may be at risk of insolvency, it is often said that the general common law duties that directors owe, switch from being owed only to the company, and instead become owed to creditors.
Various statutory provisions have been enacted to supplement the general common law duty to consider the interests of creditors, for example:
- Wrongful trading – covering what is often described as “trading insolvently”. If the directors of a company are found to have wrongfully traded, they are not guilty of a criminal offence. The consequences of wrongful trading though are a wholly civil matter and the purpose of the wrongful trading legislation is really to encourage directors to act responsibly as regards the company’s creditors when insolvency is looming. In particular, there should be a point at which the directors should appreciate that the company has no reasonable prospect of avoiding insolvent liquidation.
- Fraudulent trading – Section 213 of the Insolvency Act 1986 contains a specific provision relating to fraud. Where a company goes into liquidation, and it can be shown that the business has been carried out with an intention to defraud creditors or for any fraudulent purpose, then the directors who have been knowingly involved can be made liable to personally contribute to the assets of the company. Of course, where directors commit fraud in a business, they cannot expect the protection of limited liability in respect of their fraud.
- Company Directors Disqualification Act 1986 – this contains the director disqualification scheme. In every insolvency a report on the conduct of the directors will be prepared by the insolvency practitioner and submitted to the government. The government’s Insolvency Service will then determine if it is in the public interest for proceedings to be taken against a director to disqualify that person from thereafter acting as a company director. If in due course, a director is disqualified, a court may also make a compensation order against the director if it considers that the conduct for which the director has been disqualified has caused loss to one or more creditors of the insolvent company. Such a compensation order would render a director personally liable in respect of the liabilities of the company.
- Finance Act 2020 – In 2020 new provisions were introduced to address a concern that insolvency processes were being deliberately abused to avoid tax liabilities. The provisions allow HM Revenue & Customs to issue a ‘Joint Liability Notice’ on an individual in certain circumstances. Directors can now be liable for the unpaid tax of a company where the certain conditions are met.
- Rating (COVID-19) and Directors Disqualification (Dissolved Companies) Bill – this bill addresses concerns that directors may have intentionally used the process of dissolving a company as a means of avoiding any analysis of their own conduct. Currently however, where a company is dissolved without a formal insolvency process, there is no mechanism that allows for scrutiny of the conduct of the directors. The provisions in the Bill would grant to the Secretary of State a power to instigate proceedings against the directors of dissolved companies. That process could then lead to disqualification proceedings or a compensation order under the Company Directors Disqualification Act 1986 as outlined above. Additionally, where the actions of the directors have caused an identifiable loss to the creditors, an order to compensate creditors may be sought and once again that would expose the director to personal liability. This Bill is currently under consideration in Parliament. It is expected to be enacted later during 2021.
Other provisions
These include:
- Breach of duties – as you may know, directors are agents for the company. That relationship means that the directors owe duties to the company. If those duties are breached, then the directors can be called upon to reimburse the company in connection with those breaches. The general duties of directors are now set out in ss171-177 of the Companies Act 2006. The duties include duties to promote the success of the company, to exercise independent judgement and to use reasonable skill, care and diligence. Directors may exercise any powers or discretions that they have only for the benefit of the company. Whereas a result of the actions (or omissions) of the directors, the company suffers prejudice, and where it can be shown that in so acting (or omitting to act) a director has been in breach of a duty, then the director can be made liable to provide recompense to the company personally.
- Unlawful dividends – A company may only pay a dividend if it has sufficient distributable reserves. If, however, the directors permit a dividend to be paid notwithstanding the lack of necessary distributable reserves, that decision will constitute a breach of duty and the directors can be made liable to reimburse the company in respect of the unlawful dividend – whether or not the directors are themselves the recipients of the offending dividends.
- Piercing the corporate veil – as a company is a legal entity distinct from its shareholders. It has rights and liabilities of its own and owns property in its own name. Importantly, this is true regardless of the size of the company and ever since limited liability has formed part of our law, the courts have had to consider in what circumstances limited liability should be lost. This has become known as the common law doctrine of “piercing the corporate veil”. In other words, when is it appropriate to disregard the limited company structure and instead look directly at the individuals behind the company? The courts have always been very reluctant to allow it and indeed it appears from the case law to date that there appears to never have been any instance in which the doctrine has been invoked properly and successfully. However, the courts have however identified:- (i) concealment (where the company disguises the true parties involved): and (ii) evasion (where the individuals behind the company are avoiding an existing legal obligation or restriction by using a corporate structure); as the only two valid grounds for lifting the veil. That will likely mean that veil piercing in the UK will be a very rare thing indeed.
Conclusions
The broad message from the above is that directors should not take the concept of limited liability for granted and should never assume that it is an absolute right. Limited liability is a privilege and can be lost in various scenarios.
The application of these provisions to the particular circumstances of any company is rarely a straightforward exercise. Even the simplest businesses have a degree of complexity about them and for most companies, working out when insolvency can be said to be inevitable and what can then be said to be the appropriate steps that a director should take in connection with that particular business in its unique circumstances at that time, can be extremely difficult. Because of this complexity it can be hard for directors to fully understand the application of the above provisions to their own situation.
Given this, it is essential that directors take appropriate legal advice at the earliest possible point to minimise the risks of personal liability that they may face.
Regards to all
R
