Business and organisational characteristics - Limited liabil...

Learning Outcomes

This article outlines the concept of limited liability and its significance for different business structures tested in the SQE1 assessment. It explains the principle of separate legal personality established in Salomon v A Salomon & Co Ltd, contrasts it with unlimited liability for sole traders and partners, and highlights how incorporation reallocates risk between owners and creditors. It examines the rare circumstances in which the corporate veil may be pierced, focusing on the Prest v Petrodel concealment and evasion principles and their strict application in modern case law. The article also covers how limited liability operates in companies and LLPs during insolvency, including the impact of wrongful trading, fraudulent trading, and the two-year clawback regime for LLP members. In addition, it details partner liability in ordinary partnerships, including joint and several liability, liability for existing and future debts, the legal effect of retirement and admission of new partners, and the doctrine of holding out. Throughout, the emphasis is on recognising how these rules are presented in SQE1-style multiple-choice questions and on distinguishing clearly between corporate, LLP, and partnership liability.

SQE1 Syllabus

For SQE1, you are required to understand the practical implications of limited liability for various business types. You may need to advise clients on the suitability of structures offering limited liability or identify the consequences for shareholders and members if a business fails, with a focus on the following syllabus points:

• The core principle of limited liability and how it contrasts with unlimited liability.
• The concept of separate legal personality as established in Salomon v A Salomon & Co Ltd.
• The application of limited liability in private limited companies, public limited companies, and LLPs.
• The exceptional circumstances under which the corporate veil might be pierced, based on the principles in Prest v Petrodel.
• The key advantages and disadvantages of operating a business with limited liability.
• How partner liability works in ordinary partnerships, including joint and several liability, incoming and outgoing partner liability (ss 9 and 17 Partnership Act 1890), notice on retirement (s 36 PA 1890), and holding out (s 14 PA 1890).
• The insolvency-related exceptions to limited liability for directors and LLP members (fraudulent trading under s 213 Insolvency Act 1986; wrongful trading under s 214 IA 1986; and the two-year clawback regime for LLP members).
• The practical impact of corporate transparency and filing obligations as the trade-off for the protection of limited liability.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. A shareholder owns 100 £1 shares in TechStart Ltd, all fully paid. If TechStart Ltd becomes insolvent owing £50,000 to creditors, what is the shareholder's maximum liability to the company's creditors?
   1. £100
   2. £50,000
   3. £0
   4. An amount determined by the liquidator based on the company's debts.
2. Which legal principle established that a company is a legal entity separate from its owners and managers?
   1. The principle of limited liability.
   2. The doctrine of ultra vires.
   3. The principle of separate legal personality.
   4. The rule against piercing the corporate veil.
3. In which of the following business structures do the owners typically have unlimited personal liability for business debts? (Select all that apply)
   1. Private Limited Company (Ltd)
   2. Sole Trader
   3. Limited Liability Partnership (LLP)
   4. Ordinary Partnership
4. Under the 'evasion principle' established in Prest v Petrodel Resources Ltd, when might a court pierce the corporate veil?
   1. Whenever it is in the interests of justice to do so.
   2. If a company cannot pay its debts.
   3. If a person interposes a company to deliberately evade an existing legal obligation.
   4. If a director acts negligently.

Introduction

A fundamental concept in business law is the extent to which the owners of a business are personally responsible for its debts. This article explores limited liability, a key feature of incorporated businesses like companies and Limited Liability Partnerships (LLPs), contrasting it with the unlimited liability faced by sole traders and partners in ordinary partnerships. Understanding limited liability, and the related concept of separate legal personality, is essential for advising clients on choosing the appropriate business structure and understanding the potential risks and protections involved.

Limited liability does more than shield personal assets. It shapes how businesses raise finance, how risk is allocated, and what governance and transparency obligations apply. Companies and LLPs can grant floating charges over a changing pool of assets, which often improves access to bank finance compared to sole traders and ordinary partnerships. The benefit of limited liability and the ability to raise capital in more flexible ways attract stricter filing, disclosure, and governance requirements, including the keeping of statutory registers, annual accounts and reports, and confirmation statements. These transparency obligations are the price paid for the protection of incorporation and are central to creditor due diligence.

Separate Legal Personality and the Salomon Principle

The basis of limited liability for companies lies in the principle of separate legal personality. This means that, upon incorporation, a company becomes a legal entity in its own right, distinct from the individuals who own (shareholders/members) and manage (directors) it.

Key Term: Separate Legal Personality
The legal status of an incorporated entity (like a company or LLP) as being distinct from its owners and managers. It can own property, enter contracts, sue, and be sued in its own name.

This principle was famously established in the House of Lords case of Salomon v A Salomon & Co Ltd [1897] AC 22. Mr Salomon transferred his sole trader business to a limited company he formed, taking shares and a secured debenture (a loan secured against the company's assets) as payment. His family members held nominal shares. When the company failed, the liquidator argued Mr Salomon should be personally liable for the company's debts, claiming the company was just his agent or a sham. The House of Lords rejected this, holding that the company was validly formed and legally distinct from Mr Salomon. Its debts were its own, not his. The Salomon principle confirms that incorporation creates a 'veil' between the company and its members, shielding the members from the company's liabilities.

Salomon does more than confirm the company’s separate personality. It clarifies that a company is not the agent of its shareholders, even where one person holds a controlling stake and runs the business day to day. A one-person company is valid and will not be treated as the owner’s alter ego merely because control is concentrated. By confirming that ownership of shares does not, by itself, give rise to agency or trusteeship, Salomon enables incorporation to be used legitimately to manage risk.

Separate personality brings other practical consequences:

• The company can hold legal title to property and contract in its own name. This avoids constant retitling when ownership of shares changes and supports perpetual succession, allowing the business to continue despite changes in membership.
• Directors, acting within authority and subject to statutory rules such as Companies Act 2006 s 40 (protection of third parties dealing with the company), bind the company. Agents who contract for the company generally drop out of the transaction; liability is the company’s, not the agent’s.
• Each company in a group is a separate legal person. The fact that companies operate as a group does not merge their personalities. Cases such as Adams v Cape Industries plc illustrate that, absent statute, the courts will treat group companies as distinct legal entities and will not automatically regard them as a single economic unit. Liability can still arise for a parent on conventional principles—for example, a parent may assume a duty of care to employees of its subsidiary (as discussed in Chandler v Cape plc)—but this does not involve disregarding the subsidiary’s separate personality.

Limited Liability Explained

Limited liability directly flows from separate legal personality. Because the company is responsible for its own debts, the liability of its members is limited.

Key Term: Limited Liability
A legal protection for the owners (shareholders/members) of certain business structures (companies limited by shares or guarantee, LLPs) where their responsibility for the business's debts is restricted to a specific amount, typically the nominal value of their shares or their guarantee.

Companies Limited by Shares

For a company limited by shares (the most common type of company), the liability of each shareholder is limited to the amount, if any, remaining unpaid on their shares (s 74(2)(d) Insolvency Act 1986 (IA 1986)). If the shares are fully paid, shareholders owe nothing more to the company’s creditors if the company is wound up. If shares are partly paid, the shareholder can be called upon to contribute up to the unpaid balance when the company enters liquidation.

This simple rule supports a wide market in shares. Investors can quantify the maximum financial exposure from holding shares. It is also why under-capitalised companies may pose risks to creditors and why lenders often seek personal guarantees from controlling shareholders or directors: limited liability restricts recourse to the company’s assets, so creditors sometimes require additional personal undertakings outside the corporate structure.

Worked Example 1.1

Anisha subscribed for 500 £1 ordinary shares in Innovate Ltd when it was formed. She paid 50p per share (£250 total) on allotment. Innovate Ltd is now being wound up with significant debts. What is Anisha's maximum potential liability?

Answer:
Anisha's liability is limited to the amount unpaid on her shares. She has paid 50p per share, leaving 50p per share unpaid. Her maximum liability is 500 shares x £0.50 = £250. If she had fully paid for her shares, she would have no further liability.

Worked Example 1.2

Bola holds 2,000 £1 shares in BuildCo Ltd. 1,500 are fully paid; 500 are partly paid with 25p outstanding per share. BuildCo enters insolvent liquidation owing significant sums. What contribution can the liquidator seek from Bola as a member?

Answer:
The liquidator can only call for the unpaid element on the partly paid shares. Bola can be required to pay 500 x £0.25 = £125. No contribution is due in respect of fully paid shares.

Companies Limited by Guarantee

For a company limited by guarantee (often used for non-profits), members guarantee to contribute a certain amount (often nominal, e.g., £1) towards the company's debts if it is wound up while they are a member or within one year after they cease to be a member (s 74(3) IA 1986). The guarantee is not called while the company is solvent or operating; it crystallises in winding up. Although private companies limited by guarantee are less central to typical SQE content, understanding the concept reinforces how limited liability is defined by the constitution and statute rather than by investor behaviour.

Limited Liability Partnerships (LLPs)

LLPs, formed under the Limited Liability Partnerships Act 2000 (LLPA 2000), also have separate legal personality (s 1(2) LLPA 2000) and offer limited liability to their members (s 1(4) LLPA 2000). Members are not generally personally liable for the LLP's debts; the LLP itself is liable. LLPs sit closer to companies than to ordinary partnerships in many respects: they are incorporated by registering with the Registrar of Companies, they have filing obligations (including annual accounts and confirmation statements), and many provisions of company and insolvency law apply to them.

When an LLP becomes insolvent, the company liquidation regime under the IA 1986 applies to both the LLP and its members. Members may face personal liability in specific circumstances:

• Fraudulent trading (s 213 IA 1986) if they are party to carrying on the business with intent to defraud creditors or for any fraudulent purpose.
• Wrongful trading (s 214 IA 1986) if they knew or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation and failed to take every step to minimise potential loss to creditors.
• Clawback of withdrawals: where a member withdrew property (e.g., profit shares or loan repayments) within two years before insolvent liquidation and knew or had reasonable ground to believe the LLP was or would be unable to pay its debts as a result, the court may order them to contribute back to the assets.

Designated members have administrative responsibilities (similar to company directors in many respects), including filing documents and maintaining statutory records. LLPs can own property in their own name and can grant fixed and floating charges, which, like companies, can improve access to secured finance.

Worked Example 1.3

Cara is a member of ProServices LLP. In the 18 months before ProServices enters insolvent liquidation, Cara withdrew significant profit shares at times when she knew the LLP was struggling to meet liabilities as they fell due. The liquidator seeks a contribution from Cara. Is that possible?

Answer:
Yes. Under the Insolvency Act 1986 clawback regime as applied to LLPs, a court can order a member to contribute to the LLP’s assets if, within two years before insolvent liquidation, the member withdrew property and knew or had reasonable ground to believe the LLP was unable to pay its debts or would become unable to pay its debts as a result. The liquidator may also consider claims for wrongful or fraudulent trading depending on conduct.

Unlimited Liability

In contrast, unincorporated businesses do not have separate legal personality. The business and the owner(s) are legally the same entity.

Key Term: Unlimited Liability
The status of business owners (sole traders, partners in an ordinary partnership) where they are personally responsible for all the debts and liabilities of the business. Their personal assets are at risk if the business fails.

Sole Traders

A sole trader is the business. There is no legal distinction. Therefore, the sole trader has unlimited personal liability for all business debts. Personal assets (house, car, savings) can be used to satisfy business creditors, and the sole trader can face bankruptcy if debts cannot be met. Sole traders face fewer formation and regulatory costs and enjoy privacy, but they lack the asset-shielding protection of incorporation and cannot issue shares to raise equity finance.

Ordinary Partnerships

Partners in an ordinary partnership (governed by the Partnership Act 1890) are jointly liable for the firm’s debts incurred while they are partners (s 9 PA 1890) and jointly and severally liable for the partnership’s liabilities arising from wrongful acts or omissions and misapplication of third party property committed by a partner in the ordinary course of business (ss 10–12 PA 1890). Joint and several liability means creditors can pursue any one partner for the full amount of a partnership debt, or pursue all partners collectively. Each partner is an agent of the firm (s 5 PA 1890) and can bind the firm in contracts within authority; apparent authority can also bind the firm when a third party reasonably believes the partner has authority.

Key features relevant to liability:

• Incoming partners are not liable for debts incurred before they joined (s 17(1) PA 1890).
• Retiring partners remain liable for debts incurred during their time as partner unless released by creditors (s 17(2)–(3) PA 1890). To avoid liability for future debts, retiring partners must ensure proper notice is given: actual notice to those who have previously dealt with the firm and public notice (e.g., via the London Gazette) to those who have not (s 36 PA 1890).
• Holding out (s 14 PA 1890) can impose liability on someone who represents or knowingly allows themselves to be represented as a partner, where a creditor extends credit on the faith of that representation.

Default internal rules under PA 1890 (unless varied by a partnership agreement) include equal sharing of profits and losses, no entitlement to remuneration, and unanimity for admitting new partners and changing the nature of the business. These internal rules do not reduce exposure to third-party claims; they only govern the allocation of liability among partners inter se.

Worked Example 1.4

Leah retires from an ordinary partnership on 30 June. The firm writes to all existing suppliers to notify the retirement on 1 July and publishes a notice in the London Gazette the same day. In September, the firm enters a contract with a new supplier and later defaults. Is Leah liable for that debt?

Answer:
No, provided the s 36 PA 1890 notice requirements were satisfied. Existing suppliers received actual notice, and the Gazette notice constitutes public notice to others. Leah remains liable for debts incurred while she was a partner, but not for new debts incurred after retirement if appropriate notice was given and she is not liable through holding out.

Worked Example 1.5

Omar left a partnership last year but never updated the firm’s website or headed paper, which continue to list him as a partner. A new supplier checked the website, believed Omar remained a partner, and extended significant credit. Can the supplier claim against Omar?

Answer:
Possibly. Under s 14 PA 1890 (holding out), if Omar allowed himself to be represented as a partner and the supplier relied on that representation when extending credit, Omar can be liable for the firm’s debt despite having retired.

Advantages and Disadvantages of Limited Liability

Advantages

• Risk reduction: Protects personal assets of shareholders/members, encouraging investment and entrepreneurship.
• Investment: Makes investing in businesses less risky, enabling capital raising. In companies, investors can subscribe for shares knowing any call on insolvency is limited to unpaid share capital.
• Business growth: Enables companies and LLPs to undertake larger, potentially riskier projects necessary for growth.
• Facilitates share trading: Limited liability makes shares more attractive and easier to trade, as buyers know their maximum potential loss.
• Financing flexibility: Companies and LLPs can grant floating charges over pools of assets, often improving access to credit compared to unincorporated businesses.
• Perpetual succession: The entity’s life is not tied to the life or involvement of specific owners; transfer of shares or membership changes do not end the entity.

Disadvantages

• Creditor risk: Creditors bear more risk as their recourse is limited to the entity’s assets. This can lead to higher borrowing costs or requirements for personal guarantees and security.
• Moral hazard: Owners/managers might take excessive risks knowing their personal assets are protected. Statutory regimes (e.g., wrongful trading and fraudulent trading) temper this risk by imposing personal consequences in insolvency.
• Formalities and costs: Maintaining limited liability status requires compliance with corporate governance, filing, and disclosure rules, adding administrative burden and cost compared to unincorporated structures. Public disclosure of key information (e.g., annual accounts, registers of members and people with significant control) aids creditor and investor scrutiny but reduces privacy.
• Abuse potential: The corporate structure can potentially be used to evade obligations, although mechanisms like ‘piercing the veil’ exist to counter this in rare cases. More commonly, conventional legal principles and statutory remedies address misuse without disregarding separate personality.

Corporate transparency is central to the system. As the ability to shield members from liability increases creditor risk, Parliament requires disclosure of financial and governance information to support informed decision-making by those dealing with companies and LLPs. This includes annual accounts, confirmation statements, and registers such as the register of people with significant control (PSC), all of which contribute to market scrutiny and accountability.

Piercing the Corporate Veil

While the Salomon principle establishes a strong 'veil' of incorporation, courts possess a very limited power to disregard the separate legal personality and hold members/directors personally liable. This is known as piercing the corporate veil.

Key Term: Piercing the Corporate Veil
An exceptional legal doctrine where a court disregards the separate legal personality of a company to impose liability directly on its members or directors.

The circumstances where the veil can be pierced are extremely narrow, as clarified by the Supreme Court in Prest v Petrodel Resources Ltd [2013] UKSC 34. Lord Sumption identified two principles:

1. Concealment principle: Looking behind the company structure to discover the true facts it conceals. This does not involve piercing the veil; it is an exercise in fact-finding that may reveal agency or trust relationships or other bases for liability.
2. Evasion principle: This is the only true basis for piercing the veil. It applies where a person is under an existing legal obligation, liability, or restriction and deliberately interposes a company under their control specifically to evade or frustrate that obligation. Piercing the veil is a remedy of last resort, used only if other conventional remedies are inadequate.

Prest narrowed earlier, more expansive suggestions that courts might treat a group as a single economic unit or pierce the veil to achieve justice. Post-Prest, courts prefer orthodox routes to liability:

• Agency: Where a company acts as an agent for an owner on the facts.
• Trusts: Where assets are held on trust for an individual.
• Tort: Imposing duties of care on parents or controllers (e.g., Chandler v Cape plc) without disregarding corporate personality.
• Statute: Director and member liability under insolvency legislation (wrongful trading, fraudulent trading), disqualification, or criminal offences.

Group structures remain separate by default. Adams v Cape Industries plc illustrates judicial reluctance to merge personalities within corporate groups. Occasional references to single economic unit treatment (e.g., DHN Food Distributors Ltd v Tower Hamlets) have been doubted and limited.

Worked Example 1.6

David owes £100,000 to Clara under a personal contract. To avoid paying, David transfers all his personal assets into a newly formed company, David Holdings Ltd, of which he is the sole director and shareholder. Can Clara ask the court to pierce the corporate veil of David Holdings Ltd to enforce the debt against the assets held by the company?

Answer:
Possibly. This scenario appears to fit the evasion principle from Prest. David had an existing legal obligation (the debt to Clara) and deliberately interposed a company under his control (David Holdings Ltd) to evade enforcement of that obligation by shielding his assets. If Clara has no other effective remedy, a court might pierce the veil to allow her access to the assets transferred to the company.

Worked Example 1.7

A parent company, P plc, oversees detailed health and safety policies for its subsidiary, S Ltd, whose workers suffer asbestos-related injury. Can claimants recover against P plc by piercing the veil?

Answer:
Not by veil piercing on these facts. The likely analysis is that P plc may owe a duty of care if, applying conventional tort principles, it assumed responsibility and it was fair, just and reasonable to impose a duty (as in Chandler v Cape plc). Any liability arises without disregarding S Ltd’s separate personality.

Exam Warning

For SQE1, remember that piercing the corporate veil is highly exceptional. The Salomon principle of separate legal personality is the default and dominant rule. Focus on understanding that principle and the very limited scope of the Prest evasion principle. Do not assume the veil will be pierced simply because it seems ‘fair’ or because a company is insolvent. Statutory routes to director and LLP member liability in insolvency (e.g., wrongful trading under s 214 IA 1986 and fraudulent trading under s 213 IA 1986) are distinct from common law veil piercing.

Revision Tip

Clearly distinguish between limited liability and separate legal personality in your revision. Separate legal personality (the company or LLP as a distinct entity) is the basis upon which limited liability (the owners’ restricted financial exposure) is built for companies and LLPs. Understanding Salomon is key to comprehending separate personality. Know the conventional methods for imposing liability without piercing the veil (agency, trusts, statutory exceptions, and tort duties) and be able to identify when each applies.

Summary Table: Liability Comparison

Key Point Checklist

This article has covered the following key knowledge points:

• Limited liability restricts an owner's financial responsibility for business debts to their investment (e.g., unpaid shares) or a specified guarantee amount.
• It derives from the principle of separate legal personality, where an incorporated business (company/LLP) is legally distinct from its owners (Salomon v Salomon).
• Sole traders and partners in ordinary partnerships face unlimited personal liability for business debts; partners are jointly liable for debts (s 9 PA 1890) and jointly and severally liable for certain liabilities (ss 10–12 PA 1890).
• Incoming partners are not liable for pre-admission debts (s 17(1) PA 1890); retiring partners remain liable for debts incurred during their tenure but can avoid future liability with proper notice (s 36 PA 1890). Holding out (s 14 PA 1890) can impose liability on a person represented as a partner.
• LLP members generally have limited liability, similar to company shareholders, but may be liable under insolvency legislation for wrongful trading, fraudulent trading, and clawback of withdrawals.
• Piercing the corporate veil is an exceptional remedy, applicable only under the strict evasion principle outlined in Prest v Petrodel. Courts more commonly impose liability via conventional principles (agency, trusts, tort duties) or statute.
• Limited liability encourages investment and growth but increases creditor risk and requires adherence to corporate formalities and transparency (e.g., accounts, confirmation statements, PSC registers).
• In companies limited by shares, calls in liquidation are limited to unpaid amounts on shares (s 74 IA 1986); members holding fully paid shares owe nothing further.

Key Terms and Concepts

• Separate Legal Personality
• Limited Liability
• Unlimited Liability
• Piercing the Corporate Veil