Have you ever found yourself in situation where the product you thought you had turns out to be something quite different? Maybe it was ‘conservative’ investment product that turns out to include ‘collateralised debt obligations’ (CDOs), or mobile call plan that has fewer free minutes than you had been banking on.
Some company directors and shareholders are now finding themselves in similar situation with their so-called ‘limited liability’ companies. They are discovering too late that their company structure has not provided them with the protection they thought it would.
Given the current economic climate and string of recent cases, most directors are very conscious of the risk that they might be held personally liable if they allow their companies to carry on trading while the company is insolvent (so-called ‘reckless trading’). As result, directors are generally very cautious when their companies get into financial difficulty, and they won’t wait too long before pulling the plug by either putting the company into voluntary liquidation or ceasing trading and waiting for the creditors to appoint liquidator.
As director who takes this sensible approach, you may think to yourself that it’s under control – you have limited liability company, your other business assets are safe in separate companies, and you have complied with your responsibilities to creditors.
But do you really have the protection you think you have?
What many directors and shareholders do not fully appreciate is that liquidator isn’t just interested in reckless trading or other breaches of key directors’ duties, but that they will closely examine the extent of the company’s compliance with the technical and mundane procedures set out in the Companies Act, to see whether any amounts can be clawed back from directors, shareholders, or related companies.
The following scenarios might find you within the liquidator’s crosshairs and where the protection of limited liability is unavailable. Fortunately, in most cases, there are simple steps you can take to protect yourself, and your assets, to ensure your company structure is strong enough to withstand the liquidator’s challenge.
Payments to shareholders
Liquidators will closely examine any dividends or other payments made to shareholders.
Shareholders can be required to repay dividends if the company did not meet the ‘solvency test’ immediately after the dividend was declared or paid. Furthermore, if the directors did not follow the correct procedure when declaring the dividend or did not have reasonable grounds to believe the solvency test would be satisfied, then the directors will be personally required to repay to the company much of the dividend that is unable to be recovered from shareholders.
Whether or not company meets the solvency test is not always clear – the value of the company’s assets must exceed the value of its liabilities, and the company must also be able to pay its debts as they fall due. Just because company is cash-flow positive and profitable does not necessarily mean it meets the solvency test. The risk of failing the solvency test is often higher with under-capitalised trading subsidiaries that are funded through bank and/or shareholder loans, and/or where key assets are leased from other group companies.
The solution is straightforward, but easy to overlook. Directors should ensure that the company will meet both limbs of the solvency test immediately after declaring or paying any dividend.
Liquidators will not only look at clawing back historic dividend payments. They will also examine any repayments of loans to directors or shareholders. liquidator can ‘set aside’ these repayments and require them to be returned if they were ‘preferential’, for instance if they enabled the recipient to receive more toward payment of debt than it would have received in liquidation. This can be real risk where company is part of wider group that moves cash around according to where it is needed, since the transfers of cash will normally either be loan advances or repayments and the repayments will be at risk of being set aside as preferential payments by liquidator.
The solution to this issue is to ensure from the outset that inter-company or shareholder loans are secured by security interests, since repayments to secured creditors are generally not liable to be set aside as preferential payments in the same way as payments to unsecured creditors.
Payments to directors
In addition to closely examining payments to shareholders, liquidators will also scrutinise payments made and benefits provided to directors. These can be clawed back if the authorisation procedures in the Companies Act were not followed precisely, unless the director can positively prove that the payment or benefit was fair to the company (which can be difficult).
The Companies Act provides that company should only pay remuneration or provide other benefits to director if the board is satisfied that doing so is fair to the company. The board must certify their opinion in writing setting out the grounds for their opinion. Furthermore, details of the payment or benefit made to the director must be entered in the company’s interest register.
Once again, the solution is simple – ensure that you comply with the procedures set out in the Act, and make sure any director remuneration or benefits are fair to all parties.
Record keeping and performance monitoring
Finally, directors should ensure that adequate records are maintained by the company, and must closely monitor the performance of the company and its management at all times.
The directors of company commit an offence if they fail to ensure the company keeps adequate records – possible consequence of which is that the directors can be personally liable for all the debts of the company. In addition to keeping records, director’s general duties under the Companies Act require them to have proper systems in place to monitor the company’s management and financial performance, such as business plan, budget, and an ongoing review of profit and expenditure in relation to that budget.
As long as you take careful steps to ensure that the company keeps proper records, has proper systems and controls and complies with the various procedural requirements of the Companies Act, you will be able to take advantage of the company’s limited liability status. And, although protection from the liquidator and creditors is important, it’s not the only benefit of structuring your affairs in this way. The value of your business will be enhanced because potential investors or purchasers will gain confidence from the existence of proper systems and controls and accurate and complete records.
If you don’t follow this advice, you may find your limited liability company is something quite different.
Rodney Craig is partner and Campbell Featherstone solicitor at Kensington Swan, both specialising in the corporate and commercial area.
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