When a company cannot meet its liabilities and obligations to its creditors it is said to be insolvent. When a company is insolvent, and its creditors cannot be paid, the company may be wound up either voluntarily or involuntarily. In the case of a voluntary winding up, the directors of the company may appoint a liquidator to wind up the affairs of the company. In the case of an involuntary winding up, the court may appoint a liquidator to wind up the affairs of the company.
The level of exposure and risks that director and/or shareholders face when an insolvent company is wound up depends on the type of company in question. In general, directors and/or shareholders are not personally liable for the debts of the company, but there are instances where the corporate veil may be lifted to hold them liable for the company’s debts.
The Companies Act, 2015 (hereinafter the “Act”) and the Insolvency Act, 2015 govern the winding up of companies. Section 582 (2) (b) of the Act provides that on the winding up of a company, the company’s assets are to be applied in satisfaction of its liabilities, and any surplus is to be distributed among the members of the company according to their rights and interests in the company.
Companies that can be wound up include private companies, public companies and companies limited by guarantee. Further, private companies have limited or unlimited liabilities on their shareholders that they shall be personally liable to meet when the company is being wound up. We shall focus on the exposure that directors and/or shareholders have when shareholders have their liability limited to the number of shares they subscribe to, to wit a Limited Liability Company (hereinafter “LLC”). Shareholders’ personal assets are not at risk in the event of the company’s insolvency, and they are only liable up to the amount of their investment in the company.
Liability in Limited Liability Company
The liability of shareholders in an insolvent limited liability company being wound up is limited to the amount unpaid on their shares. Directors and/or shareholders are typically protected from personal liability for the debts of the company. However, there are certain circumstances in which they may be held personally liable that we shall discuss below.
Worthy to note is that Directors or shareholders who have provided personal guarantees for loans or debts of the company may be held personally liable for such debts in the event of the company’s insolvency.
Overview of Director and/or Shareholder Exposure in Limited Liability Company
The principle of limited liability is based on the legal fiction that a company is a separate legal entity from its shareholders. This therefore means that the liability of the shareholders is limited to the amount of their shareholding.
To hold directors and/or shareholders personally liable, you must pierce the blanket of protection, the veil of incorporation, accorded to them in the distinction of their person and the company as separate legal entities. This is called, lifting/piercing the veil of incorporation and it may happen when the directors and/or shareholders have breached their fiduciary duties to the company or if they have engaged in fraudulent or wrongful trading with intent of defrauding the company’s creditors.
Further, during liquidation, if the liquidator of a company determines that a person who was a director or officer of the company has misapplied or retained, or become accountable for, any money or other property of the company, or has been guilty of any misfeasance or breach of trust in relation to the company, the liquidator may bring proceedings against that person to recover the money or property, or to seek compensation or damages.
Lifting the Veil of Incorporation
The corporate veil refers to the legal separation between a company and its directors and/or shareholders. In general, directors and shareholders are not personally liable for the debts of the company, as long as the company is properly incorporated, and the directors and/or shareholders have acted within their authority. However, in certain circumstances, courts can lift the corporate veil and look behind the company’s separate legal personality to the actions of its directors and/or shareholders. These instances include:
- When a company is used as a “mere façade” or sham to conceal illegal activities or fraud. A sham company is one that has been created for an improper purpose, such as to avoid taxes or to defraud creditors. An example is when shareholders and/or directors transfer properties of the company in order to avoid a court order. Courts will look at the company as a “mere façade” and the defendants as the true owner of the property.
- When directors and/or shareholders have abused their powers or breached their fiduciary duties. Directors owe several duties to the company, including a duty to act in good faith, a duty to act for proper purposes, and a duty to act with reasonable care and skill. Courts will then hold them personally liable for losses incurred by the company as a result of their breach of the fiduciary duty they owe the company.
- When directors continue to trade with knowledge that the company is insolvent, they will be held personally liable for any losses incurred by the company’s creditors. Directors have a duty to prevent the company from trading while insolvent, and if they breach this duty, they may be held personally liable for the debts of the company.
- Where a company is used to evade an existing legal obligation or to conceal the true ownership of assets. Courts don’t hesitate to order that shares held by such a company in other companies transferred or sold to pay creditors.
- The courts may lift the veil of incorporation as well where the company is being used as an agent of the directors or shareholders. In these cases, the court may disregard the separate legal personality of the company and hold the directors or shareholders liable for the debts of the company.
Are shares held in other Companies in any Risk?
The shares that directors and/or shareholders hold in their personal capacity in other companies are not at risk when the corporate veil is lifted, unless the directors and/or shareholders have given personal guarantees for the debts of those companies, or their assets are not enough to fulfil their level of liability when the veil of incorporation is lifted. This is because each company is a separate legal entity, and the actions of the directors and/or shareholders in one company do not affect their liability in another company.
In conclusion, the liability of directors and/or shareholders of a limited liability company in the event of an insolvent winding up is significant. The Companies Act provides for the liabilities of directors, and the courts may lift the veil of incorporation to hold directors and/or shareholders liable for the debts of the company as discussed above. It is essential that directors and/or shareholders adhere to their obligations and ensure that they contribute to the assets of the company in case of an insolvent winding up.
By Otieno R.
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