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It is a fundamental principle of English company law and modern commerce that a limited company is a separate and distinct entity from its shareholders and directors. A company will normally be treated as solely responsible for the debts it incurs and the obligations which it enters into, notwithstanding that it requires individuals (generally the directors of the company) to act as its agents and enter into arrangements on its behalf.
However, the principle outlined above will not be applied without exception. This note highlights some of the main ways in which directors may find themselves personally liable for the debts and obligations of their company. It doesn’t focus on conduct close to or amounting to fraud, but rather the types of issues which are likely to be most relevant to directors who are acting in the normal course of business.
Liabilities under contract
- Personal guarantees and other security
Often, particularly with smaller private companies, directors will be required to personally guarantee, or otherwise secure, obligations of the company such as bank overdrafts or leases.
- Underlying shareholders’ agreements
There may also be other contractual arrangements relating to the company, such as shareholders' agreements, in which directors have explicitly entered into obligations to contribute to the assets of the company or grant security for the company's debts and obligations.
- Partly paid shares
The liability of shareholders to contribute to the assets of the company is limited to the amount which they have agreed to subscribe for their shares. Directors who also hold shares which are not fully paid up will be required to pay up outstanding amounts on their shares if called to do so, and should certainly expect this to occur on an administration or insolvent liquidation.
- Pre-incorporation arrangements
Unless any other specific arrangements are made, a contract made before a company is incorporated will be deemed, notwithstanding that it purports to be entered into by a company, to be made by the person acting for the company (with consequent personal liability).
- Counterparty unaware they are dealing with a company
Company law operates on the basis that when directors act on behalf of a company they do so as agents. Accordingly, as agents they will not generally incur any personal rights or obligations to the counterparty. There is a real risk however of a contract being binding on a director in their personal capacity if the director does not make those with whom they are dealing aware that they are acting on behalf of their company, rather than in their individual capacity.
As a practical measure, it is important for directors to make sure that stationery, business cards and emails do not give the impression that they are acting as an individual, rather than on behalf of their company. It is also important to immediately correct any attempt by another party to make the director individually liable for the company’s contractual liabilities. In McKenzie O’Brien Butcher v Smith ((2009) ChD 7/10/2009), a meat supplier, concerned about a company’s finances, deliberately decided to invoice the director personally rather than the company. In that case the director became personally liable for the outstanding balance on the invoices.
- Breach of warranty of authority
Directors need to take care to ensure that when dealing with third parties they do not exceed any limits on their authority to bind the company. In the normal course one would not expect a third party dealing with a director who exceeded their actual authority to have a claim directly against that director as an individual. However, any arrangements entered into could still be binding on the company which might then seek redress against the relevant director.
Directors of a company owe various duties to their company, including general duties such as the duty to act in a way considered to be ‘good faith’ and most likely to promote the success of the company for the benefit of its members as a whole; specifically duties such as not accepting benefits from third parties. These duties were codified in the Companies Act 2006.
If these duties are breached then various consequences can arise for directors including an award of damages or compensation, restoration of a company's property, or a requirement to account for profits. Subject to the provisions of the 2006 Act, breaches of duty can generally be ratified by shareholder resolution.
The relevant duties are all owed to the company and so a feeling may arise in some companies that breaches of duty are basically a legal technicality. This is grounded in the idea that if a director or group of directors control a board and hold a majority of the shares in a company, they will be able to control the right of the company to enforce those duties and accordingly there is no risk of liability arising in practice.
However, this is incorrect both legally and commercially. Developments such as the company entering administration or insolvent liquidation, a share sale to a new third party owner or even persons previously acting in concert falling out, can result in a change in those who can direct the enforcement of rights vested in the company.
It may also be possible for minority shareholders to apply to court to bring a derivative claim in the name of the company.
Liability in tort
It is possible for directors to have joint tortious liability alongside their company. The circumstances in which this may occur are difficult to define precisely. The courts have tried to strike a balance between the legal principles that (i) an incorporated company is separate and distinct from its shareholders, directors and officers, and (ii) everyone should be liable for their tortious acts.
The case of Williams and another v Natural Life Health Foods Ltd ( 2 All ER 577) considered whether a company director would be personally liable for a negligent misrepresentation. The House of Lords held that, in accordance with normal tortious principles, a director would only be liable if he assumed personal liability for a representation and the other party could reasonably rely on that assumption of responsibility. On the facts of the case the relevant director had not effectively assumed personal liability.
It does seem reasonably clear that a director is very unlikely to attract any liability in tort for simply carrying out his constitutional role in governance of the company, for example by attending and voting at board meetings.
Equally however, where an element of fraud is involved, a director who has made fraudulent misrepresentations will not be able to raise the limited liability and separate legal personality of the company as a defence.
Though the focus is not on liability arising from fraudulent conduct, what constitutes fraud in the context of a tortious claim may in fact involve a smaller degree of wrongdoing than one might imagine. In the High Court decision in Contex Drouzhba Ltd v Wiseman and another ( EWHC 2708), Irwin J commented:
"In my view, there is no necessary contradiction between a foolish optimism that something will turn up and dishonesty. Specifically, it is perfectly possible for a businessman to practice deceit in order to keep his business alive, in the unreasonable hope that things will come right in the end".
The key representation which was found to be 'fraudulent' in that case was the director agreeing to pay for goods ordered within 30 days after shipment, when the defendant knew that his company would be unable to pay for those goods at all (let alone within the stated time period).
Insolvency Act 1986 – wrongful trading
Under section 214 of the Insolvency Act 1986, where a company is being wound up the liquidator may apply for a court order that a previous director of the company can be required to make a contribution to the company's assets. There are various conditions which need to be satisfied for such a liability to arise, but the crucial point is that at some point before the winding up of the company began, the relevant director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation.
There is of course no offence of trading whilst insolvent under English company law. A prudent, responsible director will not generally be subject to any liability under this provision solely because they have been a director of a company which has gone into administration or insolvent liquidation. Equally however, no element of genuine wrongdoing is required for liability to arise – directors who ignore the company’s situation, bury their head in the sand and continue to trade once the point of no return has been reached could find themselves liable under this section.
Whilst the principle of separate legal personality is still the cornerstone of English company law, there are numerous ways in which even directors who are not guilty of genuine wrongdoing may end up being personally liable, directly or indirectly, for the debts and other obligations of the company.