One of the primary concerns of individuals looking to start their own limited company is the level of financial protection they have if their business becomes insolvent. Simply put, what do they stand to lose? Whilst the limited company model provides a strong level of financial protection, there are specific circumstances when a director can become liable. In this article, we explore these scenarios.
Limited liability in a limited company
The main benefit of a limited company is the limited liability that it provides its shareholders – the owners of the company.
If a company encounters financial difficulties and can’t pay its debts, the shareholders are only liable to pay for the unpaid nominal value of the shares that they hold. This is except in very rare instances where the ‘corporate veil’ is lifted and shareholders can take full liability.
The financial protection that the limited company structure boasts, on the whole, extends to the company directors – these being the people who oversee the day-to-day running of the business.
However, referring to a directors’ protection as ‘limited liability’ isn’t entirely correct, as directors do not hold shares. So, there is no shareholding in place to set a limit on the level of liability. As such, limited liability is a concept very much associated with shareholders (when a shareholder is also a director, the two ‘roles’ must be treated separately).
Nonetheless, as agents working on behalf of a company, directors – in most cases – are typically shielded from personal loss.
Scenarios when a director is liable for company debt
Some acts would make a company director liable for an appropriate amount of debt. Typically, but not always, this happens during periods of financial difficulty, such as insolvency and liquidation.
Here are some examples of when a director can become liable:
1. Fraudulent activity has taken place
Let’s start with the most obvious example of wrongdoing on a director’s part. If a company director intentionally misleads a fellow director, shareholder, customer, or investor (including a loan provider, such as a bank), their behaviour could be categorised as fraudulent.
As you would expect, any fraudulent activity carried out by a director – as well as being a criminal offence (which obviously comes with its own punishments) – can result in the director becoming personally liable.
2. The director’s loan account is overdrawn
A company director can lend money to the business and likewise, borrow money from the business. The director’s loan account (DLA) is the method by which this money is tracked.
If the business owes the director money, the DLA is in credit (it is, after all, the director’s loan account, not the company’s loan account). On the other hand, if the director owes the business money, the DLA is overdrawn.
In the case of the latter, when a business faces insolvency, the money that the director owes is defined as an asset of the company. In this situation, the director would need to repay what they owe, to allow the company’s creditors to be repaid.
This begs the question, what happens if the company enters insolvency whilst owing a director? The good news – for the director – is that they do become a creditor and so should be paid back. The bad news is that as a director, they are immediately placed at the bottom of the repayment list.
3. A personal guarantee has been given
Banks, suppliers, and other organisations that are in the business of extending credit are familiar with the challenges of retrieving money from a company once it has become insolvent. Because of this, they will often not provide a loan or other line of credit until a shareholder or director of the company has provided a personal guarantee.
This, of course, makes the individual vulnerable to liability if the company itself cannot cover the debt that is owed.
4. A director has instigated wrongful trading
When a company enters into insolvency, the director’s focus must deviate from general director responsibilities and instead, shift to minimising the loss of the company’s creditors.
A director who continues to allow their company to trade, even though an insolvent liquidation or insolvent administration is inevitable, is partaking in wrongful trading. This can make said director personally liable.
Of course, there is a fine line here. A director may continue to trade in good faith, believing that the financial difficulties of the company can be overcome – perhaps it is a cash flow issue, or there is the expectation that further funding is going to be obtained shortly.
Because of this, directors trading amidst financial difficulties should be able to explain their reasoning at all times. In this situation, it would be advisable to seek professional assistance.
5. A transaction at an undervalue has occurred
When a company encounters financial difficulties, it’s understandable if company directors wish to sell an asset below its true value to ensure a quick sale. The problem here is that if the company becomes insolvent, the company’s creditors will be deprived of what they are owed.
Such an act would qualify as an antecedent transaction, and could result in a director becoming liable if the asset’s genuine value cannot be recovered. If a company is insolvent, we recommend seeking professional advice before any items are sold or given away.
6. A preference payment has been made
Another example of an antecedent transaction, a preference payment is when a director of an insolvent company arranges payment to a specific creditor or set of creditors, whilst neglecting others. This often comes about because of a sense of loyalty to a particular supplier, or when money is owed to a friend or family member.
Again, if a company is insolvent, we recommend seeking professional advice before carrying out any transactions.
7. An illicit dividend payment has been rewarded
Dividends are the method by which shareholders are rewarded for their investment in the company. They can be approved by company directors as and when they are seen fit. This can be done regularly, such as annually, or on an ad-hoc basis.
However, dividend payments are a form of profit distribution, so should only rewarded when profits are available. Directors found to be generating dividends when profits aren’t available (for example, when a company is insolvent – in which case this would be considered an antecedent transaction) can make themselves personally liable.
8. Accurate accounting records have not been kept
As set out in the Companies Act 2006, ‘every company must keep adequate accounting records’. If directors fail to meet this requirement, and as a result, cannot distinguish between business finances and personal finances, they can take on debt and ultimately become liable.
This is one of the many reasons why directors should ensure that they have a dedicated business bank account for their company, and consider hiring an accountant.
So there you have it
Those are some of the scenarios when a company director can become liable for a company’s debt. Despite what we have covered in this article, it’s important to recognise that the examples highlighted come about because of either neglect on the director’s part, or a misunderstanding of their duties and responsibilities.
Provided that you run your business in good faith and compliantly, you will be able to benefit from the financial protection that the limited company structure provides.
If you are concerned about being able to meet the requirements for running a company correctly, we can help through our Full Company Secretary Service, available for £149.99 per year – whereby our team of company experts can help you operate your limited company in the correct, legal manner.
Thanks for reading. Please leave a comment if you have any questions.
