It is widely understood that company directors enjoy limited liability from the debts of a limited company. This provides reassurance and encourages business people across the UK to invest time and money into new commercial ventures. In practice, however, there are limited circumstances in which a director may be liable for some of the debts of a company, e.g. if a director’s loan account becomes overdrawn or a director has signed a personal guarantee. In this article, we will explain the general principles of director liability and when a company director can be held liable for the debts of a company in the UK.
Understanding limited liability
According to the Companies Act 2006 (the Act), the personal financial liability of a director of a limited company is limited by shares or guarantee. The Act states:
“A company is a “limited company” if the liability of its members is limited by its constitution. It may be limited by shares or limited by guarantee.
(2)If their liability is limited to the amount, if any, unpaid on the shares held by them, the company is “limited by shares”.
(3)If their liability is limited to such amount as the members undertake to contribute to the assets of the company in the event of its being wound up, the company is “limited by guarantee”.
Most companies in the UK are limited by shares. Under this arrangement, directors are only liable up to the ‘nominal’ value of their shares in the company. The nominal value is the value of the shares when first issued by the company (typically £1). A company limited by guarantee is different. Under this arrangement, a company does not have any shares or shareholders; rather, it is owned by guarantors who agree to pay a fixed sum if the company gets into debt. This means that a director of a company limited by guarantee is only liable for the amount of their personal guarantee.
What is a Personal Guarantee?
While a director is not normally responsible for the debts of their company due to the benefit of limited liability, entering into a Personal Guarantee effectively limits the amount of protection available to the amount stated in the guarantee.
Newly established companies that are not backed up by shareholders are often required by lenders to have a Personal Guarantee. A Personal Guarantee is a legally binding contract which states that the guarantor (e.g. a director) will take on the contractual obligations and liabilities of the business to creditors if needed. As such, if the company cannot satisfy its contractual obligations and cannot pay its bills, the guarantor can be called upon to discharge the liability on behalf of the company.
A Personal Guarantee gives banks and other potential lenders the assurance that if the company becomes insolvent, they can get their money back and allows new companies to borrow despite not having a solid credit rating.
A Personal Guarantee does not automatically end when a director leaves the company. This will only normally be the case if the creditor agrees in writing to release the director from the guarantee.
Director’s duties
While company directors are protected from personal liability, they are still expected to act in the best interests of the company as required by the Act.
Directors have a legal duty to:
- Exercise independent judgement
- Exercise reasonable care, skill and diligence
- Avoid conflicts of interest
- Not accept benefits from third parties, and
- Declare any interests in transactions or arrangements.
It is important to understand that a breach of these duties by a director can lead to personal liability.
Civil liability
In addition to the duties contained in the Act, directors have common law duties that must be adhered to in the running of their company. These common law duties existed before the instruction of the Act and evolved over time through case law, and include:
- The duty to act with care and skill, and
- Fiduciary duties – these include the duty of directors to:
- Always act in good faith and in the best interests of the company
- Avoid a situation of conflict with the company
- Never compete with the company
- Not make a secret profit
- Exercise their powers for a proper purpose and not allow discretion to be fettered
- Take proper care of the company’s assets and
- Use the powers granted to them for the purposes for which they were conferred
For example, if a director decides to enter into a contract for personal gain, they may be held personally liable for any debts that arise in accordance with common law.
What are the exceptions to director limited liability?
Despite the protection offered to directors of limited companies, it is important to understand that this is not absolute. There are a number of exceptions, which mean that limited directors can be held personally liable for their company’s debts.
The main exceptions to limited liability for directors are as follows:
Breaching director and common law duties
If a director is found to have breached any of the duties outlined above, and this results in debts being incurred by the company, they may be held personally liable for any amount owing. This includes cases of fraud, dishonesty, wrongful trading, misfeasance, and failure to exercise reasonable care. For example, if a director is found to have acted negligently, recklessly, or fraudulently in the running of their company, and this causes the company to incur debt, they may be personally liable for the money owed.
Another important area for consideration is insolvency law. If a limited company becomes insolvent (i.e. it does not have enough money to pay its debts) and a director is found not to have adhered to their legal duties by prioritising the interests of shareholders rather than creditors, they may be held liable for the debts of the company. In this case, they may also face prosecution and disqualification from being a company director.
Directors may also be held accountable for wrongful or fraudulent trading if they continue to trade if they knew (or ought to have known) that the company had no reasonable prospect of avoiding insolvency.
Personal guarantees
Directors who provide personal guarantees (i.e. as in the case of a company limited by guarantee) will be personally liable for any company debts up to the amount of that guarantee. So, while this does offer some protection because there is no unlimited liability, the extent of any personal debt liability is typically more than for a company limited by shares.
Overdrawn director’s loan accounts
Many directors do not understand that a company’s director’s loan is a company asset. A director’s loan account (DLA) allows a company director to take money from their business, but this is not treated in the same way as a salary, dividend, or business expense. Any money taken from the DLA must be clearly recorded. If the DLA account becomes overdrawn at any point, the director may be liable to return the amount borrowed to the account, especially if the company has become insolvent.
Unlawful distributions
Directors who authorise the payment of dividends while the company is insolvent may be personally liable to repay those amounts.
What are the implications for a company director if personally liable?
If a director is held personally liable for the debts of their company for any of the reasons set out above, the chances are that they will need to cover the amount owed by the company. Being asked to pay a considerable amount of money to cover the debts of a limited company can come as an enormous financial shock to any company director, especially if personal savings have been used up to keep the company going. In this case, it may be necessary to seek the advice of an accountant or an insolvency practitioner as soon as possible. Depending on the circumstances, they may recommend entering into an Individual Voluntary Arrangement (IVA), debt management plan, filing for bankruptcy, or another arrangement to resolve the matter.
Final words
It is essential to recognise that the principle of limited liability generally shields directors from personal liability for company debts, but not always. Directors of limited companies in the UK have significant legal duties that, if not adhered to, can expose them to personal liability for the debts of their company. Understanding the circumstances under which directors can be held personally liable is key to avoiding such a scenario. By adhering to the statutory duties of a director, exercising due diligence, and acting in the best interests of the company, directors can prevent themselves from ever being held personally liable.
Above all else, remember that limited liability is not absolute, and directors must operate well within the limits of the law to avoid personal liability, criminal prosecution, and a damaged reputation.
The best way to avoid any such situation is to work with a trusted company accountant who can advise you when making important financial decisions and ensure that you keep within the rules.
