Business and organisational characteristics - Limited liability

Learning Outcomes

This article outlines the concept of limited liability and its significance for different business structures relevant to the SQE1 assessment. It explains the principle of separate legal personality established in Salomon v A Salomon & Co Ltd and the contrast with unlimited liability. You will learn about the rare circumstances where the corporate veil may be pierced, referencing the Prest v Petrodel criteria. By understanding these concepts, you will be equipped to apply the relevant legal principles to SQE1-style multiple-choice questions concerning business structures and their liability implications.

SQE1 Syllabus

For SQE1, you need 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.

As you work through this article, focus on:

• 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.

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.

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.

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)).

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.

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).

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 generally not personally liable for the LLP's debts, although exceptions exist, for instance, relating to personal negligence or under clawback provisions in insolvency.

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.

Ordinary Partnerships

Partners in an ordinary partnership (governed by the Partnership Act 1890) are jointly and severally liable for the firm's debts incurred while they are partners (ss 9, 17 PA 1890). This means creditors can pursue any one partner for the full amount of a partnership debt, or pursue all partners collectively. Like sole traders, partners face unlimited personal liability.

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.
• Business Growth: Enables companies 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.

Disadvantages

• Creditor Risk: Creditors bear more risk as their recourse is limited to the company's assets. This can lead to higher borrowing costs or requirements for personal guarantees.
• Moral Hazard: Owners/managers might take excessive risks knowing their personal assets are protected.
• 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.
• 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.

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.
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.

Worked Example 1.2

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.

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 liability in insolvency (e.g., wrongful trading under s 214 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 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.

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).
• 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.
• LLP members generally have limited liability, similar to company shareholders.
• Piercing the corporate veil is an exceptional remedy, applicable only under the strict 'evasion principle' outlined in Prest v Petrodel.
• Limited liability encourages investment but increases creditor risk and requires adherence to corporate formalities.

Key Terms and Concepts

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