One of the advantages of trading as a limited company (as opposed to a sole proprietor) is that, generally, company liabilities stay with the company. The protection from personal liability is, however, not absolute. It’s therefore important that company directors clearly understand where it applies and where it doesn’t.
The basics of company liability vs personal liability
In a nutshell, a company’s directors can only be held personally liable for company liabilities if one of the following applies.
They have given a personal guarantee.
They can be shown to have acted in bad faith.
The first point is obvious. The second may seem to have no relevance to most company directors. Technically, this may be true. Practically, however, it can actually be very risky to assume that your good faith will be taken as read. This applies under any circumstances but it has particular relevance for any form of insolvency.
If a company goes insolvent, creditors will get as much as the company can afford to give them. That may be nothing at all. The less a creditor gets, the more it benefits them to look for evidence of directors acting in bad faith.
If a creditor can prove this, they can at least potentially make a company director personally liable for the company’s debt. Even if they only have a marginal case, the threat of court action can be enough to force company directors to negotiate when otherwise they would have walked away.
This means all company directors should take care to protect themselves from being accused of any deliberate wrongdoing. In particular, they should take care to protect themselves from accusations of failing to protect creditors\’ interests when insolvency is possible and from accusations of trading while insolvent.
A director’s role in an insolvency situation
Again, in a nutshell, a company should be able to fulfil both its obligations to its shareholders and its obligations to its creditors.
If, however, there are reasonable grounds to believe that the company cannot fulfil its obligations to both groups, then the company should give priority to its creditors. The greater the conflict between the two obligations, the more the company should give priority to its creditors.
For example, it’s absolutely fine for a company to pay shareholders dividends as long as it can also pay its creditors. If, however, the company has any doubts about its ability to pay its creditors, then it should rein in the dividends. If necessary, it should cancel them completely.
In general, if a company has any reasonable grounds to believe that it is at any risk of insolvency, its directors must keep the needs (and rights) of creditors front and centre in all decisions.
Managing a company through a challenging financial situation
Fundamentally, the best practices for managing a company through a challenging financial situation are much the same as the best practices at any other time. They just have potentially higher stakes in the sense that any successful challenges to them could lead to a company’s directors being held personally responsible for its debts.
The first key rule to remember is to record the decision-making process behind every action. Be sure to reference any evidence used in making that decision. Ideally, store a copy of it with the notes on how the decision was reached. If that’s not possible, record exactly what it is and where it can be found. In some cases, you can split the difference and record a summary of the evidence with a note of where the full evidence can be found.
The second key rule to remember is to call in an insolvency practitioner as soon as there is even a hint that insolvency may be on the cards. It is literally an insolvency practitioner’s job either to save a company or to wind it up in a legal way while protecting the directors as much as possible.
