Article by Suzanne Jones, a solicitor at law firm Howard Kennedy.
The first thing you need to think about is the legal structure of your business. A sole trader has unlimited liability, which means the individual is responsible for all of the business debts. A normal partnership works in the same way, and each partner has unlimited liability.
However, it is entirely possible for sole traders and partners to establish limited liability business trading structures. In the case of a limited liability partnership and a limited liability company, it is the corporate vehicle itself that bears liability for debt; the liability of the partners or contributories is limited to whatever they have invested in the vehicle.
But it isn’t quite that simple. For one thing, it has become more common in recent years for lenders to require company directors of small and medium-sized enterprises to offer personal guarantees (PGs) or a charge on personal property to secure the borrowings. Many directors offer such guarantees and charges without giving it a second thought, as they are naturally extremely optimistic about their new venture and do not expect these to be called upon. While most PGs limit the amount and the time, some are very widely drawn and offer the director no limitation on the amount that can be demanded and the time in which the demand can be made.
Where there are a number of directors giving personal guarantees, joint and several liability may arise, which enables the lender to claim the full balance from the signatories as a group (not necessarily on a proportional basis) or from each of them individually, or from just one signatory who has sufficient assets to satisfy the debt, without taking action against the others.
The other instance in which directors will not be protected by a limited company structure is in the case of wrongful trading. That’s why it’s imperative to be aware of the financial position of the company at all times. As a director, you should seek specialist professional advice immediately if the company cannot meet its debts as they fall due or if the company’s liabilities exceed its assets.
Fraudulent trading will also expose a director to personal liability, in any situation where there is fraud involved, whether or not the company is insolvent. A director could also be at risk of personal liability in any situation where a director’s conduct may be called into question and a misfeasance claim is brought.
There are other ways in which company directors can minimise or eliminate the risk that they will become personally liable in the event of company failure:
In the capacity of a company director:
• Keep accounting records up to date and plan for financial needs. The earlier financial difficulties are recognised, the more options are available.
• Maintain good corporate housekeeping: minute trading decisions and provide justification, which can deflect later criticism.
• PGs and charges on personal property should only be given as a last resort. If PGs have to be given, do your best to limit the scope.
• If borrowing is obtained from family and friends, ensure each person receives independent advice if security is granted and ensure it is properly documented; do not borrow from them more than they can afford to lose.
• Do not continue to place personal funds into the company if there is no realistic prospect of its survival.
As an individual:
• Communicate with creditors and negotiate time to pay arrangements.
• It may be possible to negotiate with a lender to carry any debt across into a new venture, and it may not be necessary to discharge the PG immediately.
• If the company is insolvent, or potentially insolvent seek advice immediately.
When a director’s company has been liquidated and the director sets up a new venture, it is imperative that the same name or a name which is similar to the liquidated company is not used. Otherwise the director could become personally liable for the debts of the new company.
If it is the intention of the company director to carry on as a director of another company, it is important to do everything possible to avoid bankruptcy, as a bankrupt is prohibited from holding the office of a director. Any misconduct of a director or of an individual could result in further restrictions being imposed. Company directors should take action now to avoid potential problems in the future.