For most people, deciding to trade as a limited company is a conscious choice: one that’s borne out of a passion. Hopefully it’s also a response to strategic planning and professional advice.
Surprisingly, many business owners don’t always give the same consideration as to the most appropriate “trading vehicle” for their business.
Among the many business decisions and choices the founder of a new enterprise must make, choosing which type of trading entity is appropriate is one of the most important.
It’s a decision that can have a considerable impact on the success of the business and on the legal relationships the founder(s) will have with his or her trading partners and stakeholders.
When setting up a new business structure most organisations need only consider the three main alternatives:
- sole trader
- company limited by shares
There are certain misplaced preconceptions about each structure and the protection those who own and run the business have.
Once formed, following its registration and receipt of its Certificate of Incorporation, a limited company is deemed to have a legal personality that is entirely separate and distinct from those who are running and/or own the company.
This point is fundamental when looking at the legal liability and the protection offered to the owners of the business, particularly in respect to the company’s trading debts.
The rules governing a company are set out in the Companies Act 2006 (CA). The CA sets out, amongst other things, the basic duties that a director is expected to observe. These are:
- To act within the powers and in accordance with the company’s constitution (its internal rule book, known as the Articles of Association) and to use those powers only for the purposes for which they were intended
- To promote the success of the company for the benefit of the shareholders as a whole
- To exercise independent judgment when making decisions on behalf of the company
- To exercise a reasonable level of care, skill and diligence
- To avoid conflicts of interest between the director’s personal position and the company’s interests
- Not to accept benefits from third parties
- A director must always declare a personal interest in any proposed transaction or arrangement affecting the company
In my experience, most directors always act in the best interests of the company, since interests of the company are inextricably linked with their own.
However, it is sometimes the most innocuous situations that can cause difficulties. Imagine, for example that the ongoing sales for one particular customer represents a significant proportion of your company’s turnover.
If that customer were to unexpectedly go out of business, leaving you with several months’ worth of unpaid invoices, then the impact on your company could be catastrophic. While you may seek to pursue the debt, if there are little or no assets available to enforce against, your company will be left in the position of being one of many unsecured creditors. The impact this may have on your cash flow and your ability to pay your own creditors would undoubtedly be dire.
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In these circumstances, if you were trading as a sole trader or a partnership, you would be personally liable for the debts of your business.
This could mean that third parties are entitled to pursue you and your personal assets. Conversely, the position with a limited company is different given that the company is deemed to have a legal personality separate from those owning/running it. Accordingly the company itself would be liable for its own trading debts rather than the directors/shareholders.
In this scenario, the benefits of trading as a limited company are clear: your personal assets are sheltered from the debts of the business.
It would also be sensible to check that the business’ trading terms and conditions were appropriately drafted to ensure that the title (ownership) of the goods did not transfer to the customer until their outstanding bills had been settled. In the event of insolvency you may be able to seize your goods and avoid the liquidator selling them on.
Duty of care
When trading as a limited company however directors must always be able to demonstrate that they have discharged their duties under the CA and that they can justify their decision making processes.
Directors are required to exercise ‘reasonable care, skill and diligence’. The test for this is subjective. Ignorance is never an excuse.
In the event of a director not having the appropriate skills to make a reasonable judgment then the court will expect the director to buy in that skill and resource to assist with the decision making. For example, in some cases financial directors are qualified accountants and the court will put a higher burden on the financial decisions they make on behalf of the company.
Directors of limited companies owe a duty of care to manage risk. Directors must consider whether the value of any sale is worth the commercial risk it could potentially pose. A common example of this is relying on a single sale from one customer rather than spreading the risk across several customers. In circumstances where the court may find that a director had not exercised reasonable care you could be personally liable for any debts as a result.
The cornerstone of any business is its trading terms and conditions and other key documents. It is prudent for any business buying or selling goods and/or services to ensure that those documents are regularly reviewed and updated to ensure that they are as protective as reasonably possible in terms of limiting liability. Sound commercial terms make your business competitive in its marketplace as well as protecting those who own and run the business.
Kaye Whitby is a partner in the corporate team at law firm SAS Daniels.
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