Limited liability is real, but it is not unconditional. Here are the four routes by which company debts become personal, and what protects you from each.
Limited liability is one of the most useful ideas in commercial law, and one of the most misunderstood. It is real: a company is a separate legal person, and its debts are its own. But it is not unconditional, and the conditions bite hardest in exactly the circumstances where directors are least able to think clearly.
There are four routes by which company debts become personal. It is worth knowing all four.
1. Personal guarantees
This is the most common and the least interesting legally. If you signed a guarantee (to a bank, a landlord, a trade supplier, an invoice financier), you promised to pay if the company did not. When the company fails, that promise is called in.
Directors are frequently surprised by how many they have signed, and by how routine the signing felt at the time. If a business is under pressure, a sensible early step is simply to establish which guarantees exist and what they cover. We help people manage the consequences of these under managing personal financial distress.
2. Wrongful trading
This is the one that worries directors most, and the one most often misunderstood.
Wrongful trading arises where a director continued to trade after the point at which they knew, or ought to have concluded, that there was no reasonable prospect of the company avoiding insolvent liquidation. If that is established, the court may order the director to contribute personally to the company’s assets.
Two points matter enormously here.
It is judged on what a reasonably diligent person would have concluded, not on what you actually believed. Optimism is not a defence.
The measure is the increase in the deficiency to creditors from the point at which you should have stopped. This is why delay is expensive in a very literal sense: every month of continued trading while insolvent potentially adds to the sum a director could be asked to contribute.
The defence is that you took every step with a view to minimising the potential loss to creditors. Taking professional advice, documenting the decisions and acting on them is the single most effective thing a director can do, both because it usually improves the outcome, and because it is the evidence that you behaved properly.
3. Misfeasance
A broader category: breach of duty by a director in relation to the company’s property or affairs. It covers things like paying yourself in preference to creditors, taking company assets at less than value, or failing to keep proper accounting records.
Books and records deserve a specific mention. Where records are missing or inadequate, an office holder cannot establish what happened, and directors frequently find that the resulting inference is drawn against them. Keeping the records in order is unglamorous protection, but it is protection.
4. Challengeable transactions
Certain transactions entered into before an insolvency can be unwound, and can carry personal consequences:
- Transactions at an undervalue: gifts, or sales for significantly less than the asset was worth.
- Preferences: putting one creditor (often a director, or a creditor whose debt the director has guaranteed) in a better position than they would otherwise have been in.
- Transactions defrauding creditors: arrangements whose purpose was to put assets beyond creditors’ reach.
The point directors miss is that these are assessed with hindsight, by someone whose statutory job is to look for them. A payment that felt fair and obvious at the time can look very different when set out in a report two years later. See investigations.
What actually protects you
Not much of what directors think protects them does. Resigning does not undo what happened while you were in office. Nor does the company being struck off, since it can be restored.
What does help:
- Recognising the moment. Know the two insolvency tests and apply them honestly.
- Taking advice early, and in writing. It widens the options and evidences your conduct.
- Documenting decisions. Board minutes recording what was known, what was considered and why a course was chosen are worth a great deal later.
- Keeping records straight. Including through the difficult period, which is precisely when record-keeping tends to slip.
- Acting on the advice. Advice taken and ignored is worse than no advice at all.
If you are worried about your position
That worry is usually a signal worth acting on rather than sitting with. A conversation with a licensed insolvency practitioner is free, confidential, and does not commit you to anything. Get in touch.
This article is general guidance and is not a substitute for advice on your specific circumstances. Please see our disclaimer.