The principle of limited liability in relation to companies is well established. There are, however, some important exceptions, particularly in relation to directors.

A company is a separate legal entity to those who own it, control it or are employed by it and, generally speaking, those individuals are shielded from the full extent of the company’s liabilities – the shareholders may find that their shares become worthless, and the directors and employees may lose their jobs, but they will not typically be called upon to repay in full the creditors of the company. There are, however, some important exceptions to this rule, particularly in relation to directors.

Some of the more common exceptions of which directors of companies ought to be aware, and how they can avoid falling foul of them, are discussed below.

Breach of duties

Many directors are also shareholders in their company, and may therefore consider the fact that they owe certain duties to the company to be a legal technicality. This approach is incorrect, and relies wholly on the company and the other shareholders acquiescing to any ongoing breaches.

If, following an event of insolvency, the insolvency practitioner (“IP“) appointed to deal with the affairs of the company considers that a director has breached his duties to the company, the IP may seek a court order requiring the director to repay to the company such amount as the Court thinks just. Alternatively, relations between the shareholders may break down, and an alleged breach of duty which was previously considered a technicality, may become a cause of action in its own right. Even if that cause of action is not pursued, it may be a considerable source of leverage in any negotiation exercise.

Fraud

Where a director has made fraudulent misrepresentations, he or she will not be entitled to rely on the separate legal personality of the company. Ordinarily, the burden of proof when alleging fraud is very high. However, in a 2006 decision, the High Court commented that “there is no necessary contradiction between a foolish optimism that something will turn up and dishonesty“. This suggests that in the context of considering whether a director of a company may be personally liable, the courts are willing to apply a lower standard when determining whether they acted dishonestly than when considering an ordinary criminal allegation of fraud.

Wrongful trading

Wrongful trading is a potential offence which arises in the context of an insolvency. An IP may make an application to the Court where he considers that a director may have committed the offence of wrongful trading.

A director will be found liable for wrongful trading where the company has gone into an insolvent liquidation or an insolvent administration and at some time before the commencement of the winding up or administration of the company, the relevant director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into such insolvent liquidation or insolvent administration.

Should the Court make a finding of wrongful trading, it may require the director to make a contribution to the assets of the company. A disqualification order may also be made against the director concerned.

The Court will not require a contribution be made if the director concerned took every step with a view to minimising the potential loss to the company’s creditors as he ought to have taken. This is clearly a high standard and specific to the individual circumstances of the company and director concerned, but shows the importance placed by the English legal system on the rights of creditors of a company. A prudent director will seek professional advice immediately if insolvency becomes a concern, even if it does not appear imminent. Doing so is a key step in demonstrating that due concern was given to the creditors of the company.

Directors should also note that simply resigning from office does not allow them to escape liability for wrongful trading, nor is lack of knowledge of the company’s financial position a defence, as this would indicate that he or she has not complied with the statutory duty of a director to exercise reasonable care, skill and judgement.

Contractual liabilities

A number of common contractual arrangements entered into by company directors can create personal liability. Often lenders to companies will require that the directors personally guarantee the company’s borrowings. Such guarantees will also typically require the grant of security in favour of the lender over the property of the director. Accordingly, directors should seek legal advice before executing any such guarantee, although most lenders will insist that advice is taken.

Many directors who are shareholders will be party to a shareholders’ agreement. This will include a number of obligations, for example not to permit the company to do certain things, which will generally be contained in a list in the agreement. If this is breached, it will give rise to contractual liabilities.

Care should be taken in relation to contracts made around the time of incorporation of the company. A contract purportedly made by the company will be deemed to be made by the person representing the company, if it is made before the company is incorporated. Consequently, that person will be personally liable under that contract. Similarly, where the counterparty is unaware they are dealing with a company, the liability under any contract made with that person will fall on the individual representing the company, which will often be a director.

Conclusion

The concept of limited liability is a key protection afforded to companies and allows individuals to carry on business without much of the risk which they would incur if they did so in their own name. However, the law must balance this with the rights of people doing business with a company, and so places important limits on the application of limited liability.

If you are a director of a company and have any concerns about the impact of potential personal liability, you should seek independent legal advice as a matter of priority.

For further help or advice, please contact Jonathan Oxley.

Please note this information is provided by way of example and may not be complete and is certainly not intended to constitute legal advice. You should take bespoke advice for your circumstances.

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