Alan Meek: Limited liability – not all it is cracked up to be, Pt II
Alan Meek, partner and head of Morton Fraser’s restructuring and insolvency team, discusses the intricacies of limited liability.
In this two-part article we highlight for directors some of the main ways in which the general protection of limited liability does not apply or can be lost.
Part one of this article discusses those exceptions to the principle of limited liability that arise in insolvency or distress situations. Part two deals with the provisions that have more general applicability.
Breach of duties
Directors are agents for the company. That special relationship means that the directors owe special duties to the company. If those duties are breached, then the directors can be called upon to reimburse the company in connection with those breaches.
The general duties of directors are now set out in ss171-177 of the Companies Act 2006. The duties include duties to promote the success of the company, to exercise independent judgement and to use reasonable skill, care and diligence. Directors may exercise any powers or discretions that they have only for the benefit of the company. Where as a result of the actions (or omissions) of the directors, the company suffers prejudice, and where it can be shown that in so acting (or omitting to act) a director has been in breach of a duty, then the director can be made liable to provide recompense to the company. Accordingly, where a director acts in breach of duties, there can be a personal exposure for that director.
A company may only pay a dividend if it has sufficient distributable reserves. If however the directors permit a dividend to be paid notwithstanding the lack of necessary distributable reserves, that decision will constitute a breach of duty and the directors can be made liable to reimburse the company in respect of the unlawful dividend. And for the avoidance of doubt, that is the case whether or not the directors are themselves the recipients of the offending dividends.
Piercing the corporate veil
A company is a legal entity distinct from its shareholders. It has rights and liabilities of its own and owns property in its own name. Importantly, this is true regardless of the size of the company and the rule applies just as much to a company controlled by one person as it does to one controlled by 20 people. The law allows any person to set up a limited liability company in order to deal with third parties in such a way that their relationship is with the company and not with the individuals behind it. That is the whole idea behind the concept of limited liability - the assets and liabilities belong to the company - not to the directors and the shareholders.
Ever since limited liability has formed part of our law, the courts have had to consider in what circumstances limited liability should be lost. This has become known as the common law doctrine of “piercing the corporate veil”. In other words, when is it appropriate to disregard the limited company structure and instead look directly at the individuals behind the company?
The phrase “piercing the corporate veil”, as the Supreme Court has recently pointed out in Prest v Petrodel Resources Ltd is used to describe a number of different things. However, its proper meaning is only as an exception to the rule outlined above - when is it just and appropriate to disregard the separate legal personality of the company?
The key question is: in what circumstances can the corporate veil can be lifted or “pierced” in order to allow liability to attach to the owners of the company personally? The courts have always been very reluctant to allow it and indeed the Supreme Court commented in Prest that there appears to never have been any instance in which the doctrine has been invoked properly and successfully. It is now accepted that veil piercing can be allowed only where special circumstances exist indicating that the existence of a company is just a façade intended to conceal the true position. To put it another way, the corporate veil can only be pierced when it is necessary to do so to prevent an abuse of the privilege of corporate legal personality.
Accordingly, if it is not necessary to pierce the veil, then a court will refuse to do so. The doctrine can therefore only be invoked in cases which cannot be determined on the basis of other, more conventional, remedies (for example contract, tort, equity, a remedy based on fraud or one arising by statutory exception).
The court has however identified (i) concealment (where the company disguises the true parties involved) and (ii) evasion (where the individuals behind the company are avoiding an existing legal obligation or restriction by using a corporate structure) as the only two valid grounds for lifting the veil. That will likely mean that veil piercing in the UK will be a very rare thing indeed.
So, for directors, the risk of personal liability because of a piercing of the corporate veil may seem remote. However it is clear that in many of the cases where the courts have been asked to pierce the veil, but have refused to do so, that has been because there may have been other remedies available (often a breach of directors duty) and so the director has not escaped scot-free.
The broad message from the above is that directors should not take the concept of limited liability for granted and should never assume that it is an absolute right. Limited liability is a privilege and can be lost in various scenarios. The recent governmental policy initiatives (Finance Act 2020 and the Rating (COVID-19) and Directors Disqualification (Dissolved Companies) Bill referred to in Part one of this article) show that imposing personal liability upon delinquent directors is now very much in the eye of legislators. Directors must always be aware that their acts and omissions in connection with their companies are not to be done in a cavalier fashion but must always be carried out for proper reasons for the benefit of the company, and when the company is at risk of insolvency, for the benefit of creditors.