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Limited Liability – what could possibly go wrong?

April 03, 2014
by Stephen Kimbell
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The creation of limited liability companies in the Victorian era may be considered one of the most important innovations of the late industrial revolution period.  

Limited liability means that, in the case of insolvency, shareholders are under no obligation to the company or its creditors beyond their obligations on the par value of their shares. It combines the concept of separate legal personality with a membership able to invest with their liability limited.

Initially designed for public corporations and larger public utilities projects where there is separation between management and investment, the investor knows that the most he can lose is what he has put in and, unlike in an unlimited partnership, the identity of other shareholders/partners and their wealth is irrelevant.

So, what could possibly go wrong?

The limitation of liability shifts risk from shareholders to creditors. Shareholders will reap all the benefits, but, aside from their initial investment, will bear no risk.  Large lenders can secure their position with charges over assets and guarantees from directors; small creditors will not have that bargaining power. Thus limited liability moves risk from superior lenders to small trade creditors. The thinking of those at the helm may be more reckless as the risks are not theirs.

Fraudulent trading provisions were introduced in 1929 but their use, due to strict standards or proof, meant these were rarely used. In 1986 the wrongful trading provision of the Insolvency Act came in – the burden of proof is lower than for fraudulent trading enabling directors who traded on after they “knew or ought to have concluded that there was no reasonable prospect that the Company would have gone into liquidation” to be pursued to make good their losses.

Clearly there is a problem determining the precise point when they “should” have stopped; the costs of pursuit are high; and it is only capable of being pursued after the damage has been done. One by-product of a successful wrongful trading action is the prospect of automatic director disqualification.

In most corporate insolvency cases an insolvency practitioner (IP) is required to report on the conduct of directors within six months of appointment. The number of adverse conduct returns submitted by IP which resulted in directors being disqualified fell from 45% in 2002-3 to 20% in 2009-10. Over the two four year periods 2002-6 and 2006-10 this was a fall from 37% to 25%. At no time during this period did the percentage increase.

This woeful decline is subject to review and efforts are now being made to better protect the public from the worst offenders. It is the serious and serial offenders we need stopped, not simply the low hanging fruit and easy kills whose disqualification satisfy a Whitehall target setter seeking to reassure us that our public interest is being well served.

About the Author
Stephen Kimbell is a specialist in business strategy and deal doing. He is an investor, an entrepreneur and an experienced non-executive director. During his many years in the corporate finance world, as a lawyer, a company director and as an academic, Stephen has helped numerous companies achieve success.
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