The legal separation between a company and its directors is a key element of the limited company business structure. It safeguards directors from personal liability, but not in all cases.
There are some instances when liability for business debts moves away from the company and to its directors. Known as removing the ‘veil of incorporation,’ this can have serious consequences for directors on a personal and financial level, writes Paul Williamson, a veteran business transfer agent at Selling My Business.
What does limited company liability mean for a director?
If a business fails, the directors are only liable to repay creditors to the extent of their investment in the company. Sole traders, in comparison, have no such security and are personally liable for all of their business debts in all outcomes.
Incorporation is an attractive business structure, therefore, which offers valuable protection for directors’ finances. A key issue is whether directors are aware of the fine line between company and personal liability for business debts, and fully understand the implications.
When is a company liable for business debts?
In good financial times, a company pays its own liabilities, and in many cases, responsibility for business debts remains with the company even when it fails. This is the crux of the limited company structure, which often leads to unsecured debts being written off due to a lack of funds in liquidation.
Certain caveats apply in the case of insolvent businesses, however, or businesses where fraudulent activity becomes apparent. This means that companies are not always responsible for their debts, and directors can be exposed to personal financial jeopardy.
These limitations are there to protect company creditors and other stakeholders, as well as the public at large. Clearly, directors could find themselves financially destabilised under certain circumstances, by becoming personally liable for their business debts.
So when might this happen and what are the potential consequences for directors?
When can directors be held personally liable for business debts?
Personal guarantees
If a company fails and cannot afford to repay borrowing with a personal guarantee attached, the lender will demand payment from the director(s) under the guarantee. Lenders can pursue them through the courts if necessary.
Overdrawn Director’s Loan Account (DLA)
When a director withdraws more money from the business than they have invested, the director’s loan account becomes overdrawn. This is a common situation that typically creates no issues unless the company enters insolvency when the director must repay the loan straight away.
Providing personal guarantees and running an overdrawn director’s loan account can lead to financial liability for directors, but misconduct and negligent behaviour are also major factors in personal liability cases.
For example:
Wrongful trading
If company directors continue trading after the business has entered insolvency, and they worsen creditors’ financial position, they may become liable for the additional financial losses suffered.
Illegal dividends
When a dividend is paid there must be sufficient distributable profits held within the company to cover the payment. An illegal dividend is not financially supported by the business and that may contribute to the company’s decline.
Preferential payments
When one creditor is paid in preference to others – perhaps a director knows their company is in financial distress and repays a loan that has a personal guarantee – it is a preferential payment, as other creditors have not been treated equally.
Transactions at undervalue
If company assets are sold at a price below their market value, often with the intent to remove them from the administration or liquidation process, it is called a transaction at undervalue and may be reversed by the officeholder.
Taking a high salary
When a director takes an excessively high salary, it may contribute to the company’s financial distress and ultimately cause an additional financial loss for creditors. The director will be legally obliged to return the funds to the company.
What are the consequences of personal liability for directors?
Potential bankruptcy
As directors can be taken to court for the money they owe their company, they could be forced into bankruptcy if unable to pay. This may result in the loss of their home and other significant personal assets.
Director disqualification
Directors can be disqualified for up to 15 years in addition to being held personally responsible for business debts. This means they cannot act as directors during this time or be involved in the formation or management of any company.
Limited company vs director liability
In many cases, a limited company is wholly responsible for business debts if it enters insolvency and has to be liquidated. With this fine line between company and director liability, however, directors need to be aware of how personal guarantees and overdrawn directors’ loan accounts could affect them.
Understanding the change in priorities as directors of an insolvent company is also key. So, rather than acting in the best interests of the company, they would prioritise creditor interests to prevent further financial loss.
