The separate personality of a company
A company is an entity that is distinct from its owners – the shareholders – as well as from its directors, creditors and employees. It has a separate legal personality with its own rights and obligations. A company continues to exist even if its shareholders and/or directors change. This is a fundamental concept of company law, since there is always an extra entity to take into account: the company.
Directors, in general, owe their duties to the company, not to the shareholders. Shareholders usually have rights against the company, rather than against the directors, and third parties with whom the company does business contract with the company, even though they negotiate with the directors.
Limited liability
Limited liability does not mean that the company’s liability is limited; it means that the shareholders’ liability (i.e. shareholders’ responsibility for the company’s debts) is limited. The creditors to whom the company owes money can assert their rights in full against the company but if the company has insufficient funds to meet its liabilities the company’s creditors cannot then pursue their claims against the shareholders.
If their company goes into an insolvency procedure (such as liquidation or administration), the shareholders will be liable to lose the money that they have invested in the company by subscribing for its shares but that is the extent of their liability.
Limited companies as popular commercial vehicles
Limited liability is the quality that has caused companies to become such useful commercial tools. The personal assets of shareholders are distinguished from the assets of the company. The concept of limited liability is fundamental to:
1. passive investment: the shareholders can invest in a company following an assessment of the risks of losing that investment, knowing that the rest of their personal assets is safe and without having to take an active role in management;
2. why many entrepreneurs seek to conduct business through the medium of a limited liability company; and
3. why groups of companies have developed: riskier business divisions can be conducted through separate companies within the group without the less risky companies becoming vulnerable to creditors of the riskier companies.
Section 74 Insolvency Act 1986 enshrines the concept of limited liability, confirming that the shareholders of a limited company are, generally speaking, not liable to contribute towards the debts of the company following it going into
liquidation expect to the extent they owe money for the purchase of their shares.
Limits to the doctrine of limited liability
Note that it is possible to incorporate unlimited companies and also that there are limits on the doctrine of limited liability, both commercially and legally. In certain, much debated, situations the court can ‘pierce the corporate veil’ in the interests of justice, for example if the company is considered a façade.
There are however many devices which creditors can employ to try to improve their position. This is usually by contractual means. Properly entered into, these contracts are effective and enforceable: for example a creditor can require a guarantee from the shareholder(s) of a company, which will then circumvent the limited liability of the shareholder(s). The use of these strategies comes down to commercial factors: the bargaining power of the parties and the ingenuity of their advisors.
It is only possible to grasp why these devices are needed if you can appreciate the underlying fundamental concepts of limited liability of shareholders and the separate legal personality of a company.