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As a shareholder in a company, you may be familiar with the principle of limited liability: you are only liable for the value of your share capital in the company. However, this benefit of limited liability is not absolute. There are certain circumstances where the law can find you personally liable (responsible) for your company’s debts. This article will explain the law surrounding limited liability and consider it from a practical perspective.
The Corporate Veil
The corporate veil is an analogy to describe the relationship between a company’s shareholders and the company itself. The general rule is that there is a veil between the company and its shareholders. This veil acts as a barrier between the company and its creditors. If the company cannot meet its debts, in most cases, the law does not permit any of its creditors to “pierce the veil” and pursue the shareholders individually.
However, there are certain exceptions. Where certain circumstances arise, the law disregards the principle of limited liability and allows a company’s creditors to claim against the shareholders personally. The law refers to this exception as “piercing the corporate veil”.
Piercing the Corporate Veil
Certain circumstances may entitle a creditor to pursue a company’s shareholders for the company’s debt. The thread that ties these circumstances together is where one or more shareholders use the company as a vehicle to engage in improper conduct.
Three essential elements must be in place for the law to pierce the veil.
1. Company Must Be in Control of Another Person
The law must identify an individual that exercised some control over the company.
In practice, this is usually quite clear. The company is typically small and owned by one or more shareholders that also act as directors. In such a capacity, they then exercise their control over the company to undertake improper action.
Notably, the law will also identify non-shareholders as having control over the company, such as:
- non-shareholding directors;
- unofficial directors (commonly called shadow directors); and
- other creditors.
2. Company Must Be a Party to the Alleged Misconduct
The company itself must be a party to the misconduct. Otherwise, a court would not need to entertain arguments for other parties not relevant to the dispute.
3. Individuals Controlling the Company Intentionally Use the Company as a Shield
To compel a court to pierce the corporate veil, claimants against the company must convince the court that the individuals controlling the company intended to exploit the company. Specifically, they used the benefit of limited liability with the intent to engage in misconduct.
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Practical Considerations
The following section explores three hypothetical scenarios that would likely permit a creditor or other aggrieved party to pierce the corporate veil.
| Using a company to conceal facts about a transaction |
Jim creates a company called NaughtyCo and transfers the title to the family home, which is solely in his name. Jim knows his marriage is about to end and transfers the home to try and avoid his wife gaining any interest in it when they divorce. His wife wants to assert an interest in the home, but the company legally owns it. |
| Using a company to avoid a personal contractual obligation |
Elaine worked as a director for a consulting company. As part of her employment contract, she agreed not to compete against her employer for six months. Elaine later leaves with the intent to take a client with her. She incorporates a company called SubversionCo and enters into a contract with the client. The client wants to enforce the non-compete agreement, but technically, Elaine is not a party to a contract in breach of the non-compete. |
| Using a company to engage in a fraudulent transaction |
Collin has a company called PoorlyManagedCo. It has had a bad series of years and is in danger of falling behind on payments. Instead of seeking advice, Collin lies to lenders and creditors to try and get as much cash as possible, which he uses to pay himself an unreasonable salary. PoorlyManagedCo’s creditors want their money back, but the company has no cash left. |
Alternatives to Piercing the Veil
Most misconduct involving a company tends to arise under a similar set of circumstances. Usually, a smaller company will be owned by shareholders also acting as directors, who enter into various transactions that create obligations they know the company cannot meet. Specifically, they authorise the company to take on more debt than it can afford, as in the third example above.
Where this occurs, in nearly all cases, such conduct falls under various offences related to unlawful trading and insolvency. Since the individuals engaged in misconduct through the company are directors, the law holds them accountable as directors (rather than shareholders).
As a result, the law declares the directors are personally liable and that the creditors can claim against them personally. However, this is not because the law permitted the creditors to pierce the corporate veil. In other words, this is a different legal mechanism but practically has the same effect.
Key Takeaways
The principle of limited liability states that a company’s owners are not liable for its debts. Consequently, a company’s creditors cannot pursue the shareholders if the company cannot meet an obligation or pay a debt. However, the law makes an exception to the principle of limited liability. This is when shareholders use the company to engage in some misconduct with the intent to exploit the benefit of limited liability. Where this is the case, the law will disapply the protection of limited liability. Practically, most company misconduct is treated as separate offences, which means the law can achieve the same effect without having to pierce the corporate veil.
If you need help understanding your liability as a company shareholder or director, our experienced corporate lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today at 0808 196 8584 or visit our membership page.
Frequently Asked Questions
No. In some circumstances, the law can hold shareholders personally liable for their company’s debts. Generally, the law will not permit a shareholder to benefit from limited liability where the shareholder has used the company to engage in unlawful or improper misconduct.
The corporate veil refers to a barrier between the company’s liability and the liability of the company’s owners. If a court finds a shareholder responsible for the company’s debts, they will pierce the veil. That is, the shareholder will no longer benefit from limited liability.
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