Basic Company Law Principles

To help directors understand what standard of performance is required of them to avoid becoming liable for the debts of their company it is important to understand a few basic company law principles.

The concept of a company having a separate legal personality to its shareholders was established in the case of Salomon v Salomon [1897] AC 22.

Lord McNaughten “The Company is at law a different person altogether from the subscribers to the Memorandum and although it may be that after incorporation the business is precisely the same as it was before, and the same persons are managers, and the same hands receive the profits, the Company is not at law the agent of the subscribers or a trustee for them. Nor are the subscribers as members liable, in any shape or form, except to the extent and in the manner provided in the Act ”.

The consequences of this decision and of companies having separate legal personality are that a company can own property in its own name, be sued in its own name and incur debts in its own name. As a result the shareholders of a company are not liable to the company's creditors in respect of the company's obligations. The company's obligations are separate and distinct from those of its shareholders. Therefore the shareholders are said to have limited liability. This means that if the company is wound up the shareholders can only be liable for the amount unpaid on the share capital they have subscribed for.

The danger with this concept is that separate legal personality can become an effective way for the people who control a company to engage in risky business activities or to avoid the payment of debts by hiding behind the cloak of the company's separate legal personality.

One of the ways the courts have tried to combat this is by establishing the concept of director's duties. The basic principle is that because the people who control a company are its directors, the directors owe a fiduciary duty to the company. This is an analogous concept to the principle of a trustee owing a duty of care to a trust he is a trustee of. Therefore in conceptualising what standard of care is required a director should imagine that the Company is a trust fund, he is a trustee and the shareholders are the beneficiaries.

The basic duties established by the courts are:

(a) Directors must exercise their powers in good faith and in the interests of the company as a whole;

(b) Directors are not allowed to make an undisclosed personal profit from their position as directors, and must account for any profit which they secretly derive from their position; and

(c) Directors are obliged to carry out their functions with due skill, care and diligence.

In certain circumstances a director can become liable to account to the Company for any loss the Company incurs on foot of his breach of duty. This principle applies not just to people who are formally appointed as directors but also to Shadow Directors. A Shadow Director is someone in accordance with whose instructions the Company is accustomed to acting. In recent years the concept of director's duties has been extended to provide that in circumstances where a company is insolvent the directors owe a fiduciary duty to the Company's creditors. There may also be circumstances in which the directors owe a duty to the Company's employees and shareholders but these areas of law have not yet been fully developed.

The legal definition of insolvency is the ability to pay debts as they full due. Accountants may have more sophisticated tests for insolvency but for the purposes of company law this is the definition which applies. In making this assessment the contingent liabilities of the Company e.g. guarantees, indemnities, overdrafts are generally not included.

Relevant Statutory Provisions

The above Common Law principles have been codified and extended by the legislature in the Companies Acts, 1963-2006. The purpose of these provisions is to hold to punish and hold to account directors who have not acted prudently.

A list of some of the key provisions is set out below.

• Section 297A of the Companies Act, 1963 – reckless trading;
• Section 137 of the Companies Act, 1990 – Criminal liability for fraudulent trading;
• Section 138 of the Companies Act, 1990 – Civil liability for fraudulent or reckless trading;
• Section 140 of the Companies Act, 1990 – Power to make a contribution order;
• Sections 149 – 158 of the Companies Act, 1990 – Restriction of directors of insolvent companies;
• Sections 159 – 169 of the Companies Act, 1990 – Disqualification of directors;
• Section 203 of the Companies Act, 1990 – Power to impose penalties on officers where proper books of account are not kept;
• Section 204 of the Companies Act, 1990 – Imposition of personal liability on officers where proper books of account are not kept;
• Part 4 of the Company Law Enforcement Act 2001 – Restriction and Disqualification of directors; and
• Part 5 of the Company Law Enforcement Act 2001 – Powers of Director of Corporate Law Enforcement which apply to insolvent companies and companies which are winding up.

Conclusion

It is important for the directors of a Company to establish what level of risk the company should take in its normal trading activities. In making this decision it is important that they understand what type of risk taking is legislated against by the Companies Acts 1963-1990, and in what circumstances the directors may become personally liable for the debts of the Company if they take the wrong risks.

Where a Company is trading while insolvent it is essential that the directors get proper financial and legal advice in relation to every decision they take which results in the Company incurring further liabilities. They also need to record the minutes of all board meetings. These board minutes should provide evidence that the directors are taking due care and applying proper skill and diligence in discharging their duties.

Please note that this paper is intended to provide an overview of this complex area and is not a substitute for obtaining proper legal advice.

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