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Corporate shield and personal liability

IPA Insolvency Practitioner newsletter, June 2023

Contents

An article prepared by Keith Tully, Partner at Begbies Traynor Group plc and personal debt adviser at Scotland Debt Solutions.

Incorporation places a protective financial ‘shield’ around directors and shareholders, assigning liability for business debts to the company. This legal separation makes the limited company structure an attractive proposition for business owners.

The corporate shield safeguards directors’ assets from third party claims should the business fail, the principle being that as long as the business is run with care and integrity, the risk of personal liability is avoided. 

The only liability taken on by shareholders, therefore, is the amount they have invested as individuals. But what does the concept of the corporate shield rely upon? What must directors do to ensure they meet the requirements of UK company law?

What are director duties in the corporate structure?

To enjoy the privilege of operating behind a corporate shield, directors take on responsibilities and duties to creditors, shareholders and the company. These obligations should guide their decision-making processes and actions when running the business.

It must be noted that these duties also apply to officers of the company who act as directors but who are not officially registered as such with Companies House. Briefly, the concepts of acting ethically, and with integrity and transparency, permeate through the duties and obligations of company directors.

These are their main duties:

  • Act within their powers
  • Promote the success of the company
  • Exercise independent judgement
  • Exercise reasonable care, skill and diligence
  • Avoid conflicts of interest
  • Not accept benefits from third parties
  • Declare interests in transactions or arrangements

Two key areas that can lead to personal liability for directors are conflicts of interest and the lack of transparency:

Conflicts of interest

A central issue concerning the ‘corporate shield’ is the transparency of actions and transactions so that no conflicts of interest occur. If a conflict is known, it must be declared and officially recorded, and then sanctioned by the board of directors where appropriate.

Transparency and integrity

An unbiased approach to company affairs and awareness of how they impact stakeholders is a key director duty. This ensures that no preferences are given to particular parties, and that transparent operational practices are in place.

So what lies behind the corporate shield?

Looking behind the veil of incorporation

Since 2015 liquidators and administrators have been able to apply to the courts for compensation orders, in addition to disqualification orders, where misfeasance and other breaches of duty are apparent.

The law protects those who suffer financial loss at the hands of unscrupulous directors, but also directors who have acted negligently or wrongfully, however unintentionally. If a compensation order is granted by the court, the director must provide financial recompense to the company and/or the creditors affected.

An example of this is where one creditor is paid in preference to others. This might typically occur during the time leading up to insolvency, and contribute to the company’s severe financial distress or be the sole cause of the insolvent event.

Change of director priorities

Creditors must be treated equitably, and if the business becomes insolvent, director duties change so that creditor interests are prioritised over those of the company. Business creditors can also bring civil claims against directors, either individually or as a group.

This has increased the risk of the corporate veil being removed, and places directors’ personal financial assets at greater risk. An office-holder can pursue a director through the courts for payment to the point where bankruptcy may be the only option.

Company directors, insolvency, and personal liability

When considering the corporate shield and personal liability, we need to view the company in an environment of financial distress, insolvency, and the likelihood of liquidation. One problem is that it can be difficult to appreciate the threat of personal liability when a business is on an upward trajectory and experiencing significant growth.

As it takes very little negative commercial impact to reverse that prosperity, the threat of business failure is always on the horizon. A key customer loss, a downturn in the market or a failure to collect debts efficiently can all rapidly jeopardise financial well-being and result in the Insolvency Service or company creditors ‘lifting’ the protective veil of incorporation.

So considering directors and insolvency, what are some of the circumstances that can result in personal liability for company directors?

Wrongful trading

Trading whilst insolvent risks increasing creditor losses even if trade continues with the best of intentions. A key director duty when their company is insolvent is to stop trading immediately and seek assistance from a licensed insolvency practitioner.

If this does not happen, any such additional losses suffered by creditors could result in personal liability for one or more directors. Crucially, if further breaches of duty are uncovered, they may become personally liable for more than the additional losses.

Misfeasance

Claims for misfeasance commonly involve the misappropriation of funds, or antecedent transactions such as the preferential payments mentioned above. It can also include the transfer of property or sale at an undervalue, and the misappropriation of cash sums.

Unlawful dividend payments

The corporate shield can be removed if dividend payments are made illegally. Dividends should only be paid where sufficient distributable profits are available, so a financially distressed company that cannot pay its creditors should not issue dividends to shareholders.

Overdrawn Director’s Loan Account (DLA)

Personal liability can result from the improper use of a director’s loan account and a subsequent claim from the officeholder. An unpaid director’s loan is a business asset and in an insolvency situation is required to boost payments to unsecured creditors.

Personal guarantees

Personal guarantees for company borrowing will be called in if the business collapses, leaving directors jointly and severally liable for full repayment of the borrowing, or the pre-agreed sum detailed in the guarantee.

Protection for directors, but also creditors

Although the corporate shield protects directors’ financial assets and provides legal separation, it is a fundamental necessity to be able to remove that protection where fraudulent or negligent activity is apparent.

Directors should seek professional advice on matters of personal liability to understand the serious implications when the corporate shield is removed, as both civil and criminal action can result depending on the severity of the case.


Please note that guest content does not necessarily represent the views of the IPA.

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