Forming a company – what is the meaning of ‘limited liability’?

In the UK, there are four main types of limited liability companies: Private limited companies limited by shares, private limited companies limited by guarantee, private unlimited companies, and public limited companies.

What is the meaning of ‘limited liability’?

The question is, in what sense do any shareholders and directors have limited liability should things go wrong in one of these types of business structures?

What does limited liability mean in reality, and in what circumstances might a director still be found liable?

In a nutshell, limited liability means that any debts incurred by a company remain the company’s debt or liability and do not carry over to the company’s directors or shareholders.

The director’s assets are also protected if something goes wrong.

In other words, under current UK law, the company is treated as a legal entity or ‘person’ separate from the directors and shareholders.

That said, sometimes the courts can and do act on behalf of creditors and will hold directors liable for company debts.

So, it is perhaps more accurate to say that directors have limited financial responsibility when it comes to paying off company debts, if not a free pass.

We’ll look at some instances where personal liability for company debts might arise later.

How liability applies

In a private company limited by shares, liability is limited to any amount due for unpaid shares. No additional liability applies once shareholders or directors have paid for their shares.

In companies limited by guarantee, members are bound by the terms of a memorandum created at the company’s formation to pay debts up to a fixed sum only.

For a private unlimited company, the members’ liability is unlimited; in a public limited company, liability is limited to the value of any unpaid shares by each member.

In general partnerships, which require two partners to be registered, the partners are responsible for ALL debts.

Sole traders also have unlimited liability and are treated as the same legal entity as the business.

With limited liability partnerships (introduced in the UK in 2000), liability will depend on the type of partner in the business.

In what circumstances might a director still be found liable?

If a company is declared insolvent because debts are greater than assets, the directors still have a statutory duty to act in the best interests of any creditors.

They have to be able to demonstrate that they have done everything possible within their control so that creditors are repaid from the company’s resources.

This means they cannot do anything that would make the company’s financial situation worse by incurring even more debt.

Nor can directors favour one particular creditor or supplier over another.

If a director is deemed to have failed in their statutory duties in any regard, they could be disqualified from acting as a director of a limited company again, as well as face personal liabilities.

Some examples of inappropriate actions

Creditors may seek to claim personal liabilities against a director in some of the following instances:

• If a director continues paying dividends to shareholders after the company has been declared insolvent.
• Breaching the terms of a personal agreement with an individual or lender.
• Using company funds for what are non-business activities – an offence known as misfeasance.
• Attempting by fraudulent means to raise funds to pay off creditors. This includes trying to obtain finance from a lender by providing misleading information.
• Accepting payment for goods or services whilst knowing the goods or services can’t be delivered.
• Selling or otherwise disposing of company assets at below the market value.
• Creating an overdrawn loan account or overpaying oneself from the company.

Potential consequences for directors

In the event of a company’s insolvency, the insolvency practitioner (such as a liquidator or administrator) will investigate the directors’ actions to ensure they have acted in the best interests of the company’s creditors.

If they find evidence of wrongful conduct or misfeasance, a report will be submitted to the Insolvency Service, an executive agency of the Department for Business and Trade, which may carry out further investigations and take enforcement action where appropriate.

They have the power to disqualify a company director for up to 15 years, and any member with an overdrawn directors’ loan must pay the money back.