What is limited liability?
The truth is that companies can and do fail. Official statistics show that about half of new businesses fail within the first three years, while 60% fail within five years.
That’s a lot of failed companies.
If shareholders had to personally repay the debts of those failed businesses, people would be much more reluctant to invest in new companies due to the financial risks. And that would have a devastating impact on the UK economy.
That’s why those who invest in limited companies - the shareholders - receive limited liability. If the company subsequently fails, their losses are restricted to the money they invested in the business (their share capital), and their personal savings and assets are safe.
As an example, let’s say you spend £20,000 of your own money opening and equipping a fish and chip shop. Sadly, you have to close it three years later with £100,000 of debt. However, thanks to limited liability, you only stand to lose the £20,000 you put in. Any remaining debts the company cannot pay will usually be written off when it is liquidated.
The difference between company shareholders and directors
So, thanks to limited liability, when a company incurs debts and becomes insolvent, the shareholders' personal savings or assets, including their properties, are not at risk. However, there are some important exceptions.
To understand these exceptions, it's crucial to distinguish between the roles of shareholders and directors. That’s because a shareholder’s potential liability largely depends on their level of involvement in the company.
Shareholders with no management role
If you operate solely as a shareholder and have no role in the management or operation of the business, your risk is limited to the value of your shareholding. You are not personally liable for the business debts beyond that investment, unless you have signed a personal guarantee for company borrowing.
Shareholders who act as directors
In smaller or owner-managed companies, it's common for shareholders to be involved in running the business. In this case, your exposure to personal liability increases if you also act as a:
- Director (board member) - If you are formally appointed as a company director, you are legally bound by the directors' duties. That includes acting in the creditors' best interests when the company is insolvent. Failure to do so can lead to personal liability issues.
- Shadow director - A shadow director is someone who is not an official director but whose instructions the actual directors often follow. If you influence key decisions without holding a formal position, you can still be held personally liable for breaches of duty.
- De facto director - Even if you’re not formally appointed as a director, if you function as a director or have director-like duties, you still have the same legal responsibilities. And the penalties for breaches include personal liability.
When can shareholders be liable for company debts?
There are several circumstances in which shareholders can become personally liable for the company's debts, particularly when they assume the role of a director.
Personal guarantees
Company shareholders sometimes provide personal guarantees to lenders to secure business loans or credit facilities. The guarantee is a legally enforceable agreement that says the shareholder will repay the loan personally if the company cannot.
Personal guarantees are enforceable regardless of whether the shareholder is also a company director. If the company defaults on the loan, the lender can pursue the shareholder for the outstanding sum.
Unpaid or partly paid shares
In most cases, shareholders pay for their shares in full on issue. However, if you don’t, and the company subsequently fails and enters Liquidation, the liquidator can ask you to pay for the unpaid or partly paid shares for the benefit of the creditors.
Overdrawn director’s loan account
If a shareholder or director takes more money out of the company than they put in, and that money is not in the form of a salary or dividend, you create an overdrawn director’s loan account.
That is not usually a problem when the company is in good financial health, although it can create a tax liability. However, it becomes an issue if the company is insolvent and subsequently enters Liquidation. At that point, the liquidator may ask the shareholder to repay the loan to the company.
Misconduct
Shareholders can become liable for the company’s debts if they also act as a director, shadow director or de facto director and fail to meet their legal responsibilities.
This liability most commonly arises when an insolvent company enters Administration, Creditors’ Voluntary Liquidation, or Compulsory Liquidation, although it can also occur outside insolvency situations.
Examples of shareholder misconduct that can lead to personal liability issues include:
- Continuing to trade and incurring further debts when you know, or ought to know, the company is insolvent
- Selling company assets for less than their true worth to the detriment of the company and its creditors
- Paying dividends when the company does not have sufficient profits to do so
- Engaging in fraudulent business practices with the intent to deceive customers and creditors
How do shareholders become liable for company debts?
The actions that can be taken against shareholders, and who initiates them, depend on the specific reason for the liability.
- Misconduct - When an insolvent company enters Administration or Liquidation, the Insolvency Practitioner must investigate the conduct of the directors (and shareholders acting as directors) in their running of the company.
They will file a Director Conduct Report with the Insolvency Service outlining their findings. The Insolvency Service will then decide whether to investigate further or initiate proceedings, with potential penalties including fines, personal liability for company debts and director disqualification. - Personal guarantees - If you have signed a personal guarantee and the company defaults on the payments, the lender will call in the guarantee and ask you to settle the outstanding amount. And importantly, the lender can enforce the guarantee even if the company has been liquidated.
If you do not or cannot pay what you owe, the lender can pursue you through the courts, putting your assets at risk and potentially leading to bankruptcy. - Overdrawn director’s loan account - If you operate as a director (including shadow and de facto directors) and have an overdrawn loan account, the liquidator can pursue you for repayment. If you do not pay the outstanding balance in full, they can initiate court proceedings that can lead to bankruptcy in extreme cases.
How can shareholders protect themselves from personal liability?
As a shareholder of a UK limited company, there are a few simple steps you can take to protect yourself from personal liability:
- Do not become a formal, shadow or de facto director unless you’re prepared to meet the legal responsibilities
- Avoid signing a personal guarantee
- Pay for your shares in full
- Keep your personal and company finances separate
- Only pay dividends when there are sufficient profits to do so
- Do not engage in fraudulent or unlawful conduct
Seek professional advice when the company is struggling
How can we help?
If your company is struggling and you are worried about becoming personally liable for its debts, please get in touch for a free consultation. We will advise you on how your liability could be affected by an impending insolvency, and explain how we can rescue or liquidate your company while protecting your position.
