By Mike Smith
One of the biggest benefits of incorporating a business and becoming a private limited company (Ltd) is the protection it provides the directors and shareholders from the company’s debts. Having ‘limited liability’ allows shareholders to invest in businesses safely in the knowledge that if things were to go wrong, all they stand to lose is the value of their initial investment. And importantly, their personal finances and assets would be safe.
However, the situation is not always so clear-cut. There are a number of different scenarios which could lead to a company director/shareholder being made liable for a proportion of the company’s debts. It’s a good idea to be aware of those different situations to avoid what could be a nasty shock.
When the director of an insolvent company engages in wrongful trading
If a company is struggling and ultimately fails then the directors of the limited company will not normally be held liable for the debts of the company. However, in certain circumstances, the courts can deem one or more directors liable for the company’s debts while it undergoes a formal insolvency procedure.
When a business becomes insolvent, i.e. it cannot afford to pay its debts when they become due, the directors have a statutory duty to act in the best interests of the company’s creditors. For example, directors of insolvent companies must not:
- Continue paying shareholder dividends while the company is insolvent;
- Continue trading with no intention of repaying creditors;
- Attempting to repay debts through fraudulent means such as dishonest transactions that cannot be fulfilled;
- Selling assets for less than their market value;
- Repaying some creditors but not others.
The liquidator of an insolvent company must investigate the actions of the directors in the time leading up to the insolvency. If they find a director has been involved in any of these examples of wrongful trading then they can ask for an order from the courts to make the director personally liable to contribute to the company’s assets.
For that reason, directors of insolvent companies should seek professional advice from a turnaround practitioner or insolvency practitioner immediately. The advice they receive will help them meet their fundamental duty to act in the interests of the creditors as a whole and demonstrate they have done everything in their power to ensure repayments are made.
When the director has signed a personal guarantee
When attempting to secure finance, sometimes banks, landlords and even suppliers will ask the directors of a limited company to provide a personal guarantee. That means that if the company cannot afford to repay a loan or meet the terms of a lease then the director will be responsible for the repayments personally.
In some circumstances, banks and building societies will instead ask that a director uses their home or other personal assets as security. If the business defaults on the loan then those personal assets can be repossessed by the lender.
Overdrawn directors’ loan accounts
If a company is performing well then the most tax efficient way to take money out of the company is for the directors to pay themselves a small salary and withdraw dividends from profits. However, a director can also withdraw money from a company in a form that isn’t a dividend or a salary. That is called a director’s loan. When a director takes more money out of the company than they put in then that creates an overdrawn loan account.
An overdrawn loan account in itself isn’t necessarily a problem as long as records are kept of the amounts owed to the company and they are settled within nine months of the financial year-end. The problem comes when the company starts to struggle financially.
When a company becomes insolvent, the liquidators who are appointed to release whatever value they can from the business for the benefit of the company’s creditors will view the overdrawn director’s loan account as an asset they can pursue. The director will then be liable to repay the loan amount from their personal finances for the benefit of the creditors.
Partly paid shares
The protection provided by limited liability caps the personal liability of company directors to the amount they have agreed to pay for their initial shareholding. However, directors do not always pay the full value of their shares upfront. If directors hold shares which are not fully paid up then any outstanding amount will have to be paid on the administration or insolvent liquidation of the company.