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Law for Business

Knowhow - guidance - precedents

28 OCT 2015

Did you know … that shareholders’ limited liability derives from the articles of association?

Did you know … that shareholders’ limited liability derives from the articles of association?

There are many reasons why shareholders choose to operate their business through a corporate vehicle, but in most cases their chief motivation is a desire to take advantage of the doctrine of limited liability.

It might be thought that the Companies Act 2006 provides expressly that shareholders enjoy limited liability, but the position is not quite as simple as that, for shareholders are protected by limited liability only if they take the step of ensuring that the company’s articles of association contain appropriate wording to that effect. If, for any reason, the articles are silent on the point, the shareholders are, in fact, fully liable for all the company’s debts in the event that it fails.

What is limited liability?

When limited liability is discussed in relation to companies, what is being referred to is the limited liability of the shareholders, and not the company. In other words, a company is always fully liable for its debts. Thus, if a company enters into a contract under which it is obliged to pay a supplier £500,000, it is liable for the full amount, even if it is what is known as a “limited company” under the Companies Act 2006. The point about limited liability is that the company’s shareholders are not liable to pay off its debts to its creditors in the event that the business fails and the company is wound up.

It should be noted that shareholders’ liability is limited rather than non-existent. Specifically, it is limited to the amount, if any, unpaid on their shares. This means that if a shareholder owns, say, a £20 share in relation to which he has paid the company only £10, he is required to pay the outstanding £10 towards the company’s debts should the company fail. His liability is, in other words, limited to the outstanding £10.

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Where does limited liability come from?

The two pillars of the company law regime are the notion that a company is a legal person in its own right and the doctrine of limited liability. Common sense would suggest that limited liability follows automatically from the company’s separate personality – after all, if a company is distinct from its shareholders, surely they cannot be liable for its debts? – but in fact the default position is that shareholders are fully liable for their company’s debts. According to section 74(1) of the Insolvency Act 1986:

When a company is wound up, every present and past member is liable to contribute to its assets to any amount sufficient for payment of its debts and liabilities …

This sweeping rule is, however, subject to various exceptions. Not only is the liability of past members very substantially circumscribed, but, under section 74(1)(d):

in the case of a company limited by shares, no contribution is required from any member exceeding the amount (if any) unpaid on the shares in respect of which he is liable as a present or past member”.

It will be apparent from this wording that shareholders have limited liability if their company is a “company limited by shares”. What, then, is a “company limited by shares”? The definition of this expression is to be found not in the Insolvency Act 1986, but in the Companies Act 2006, section 3(1) and (2) of which provides as follows:

(1) A company is a ‘limited company’ if the liability of its members is limited by its constitution. It may be limited by shares or limited by guarantee.”
(2) If their liability is limited to the amount, if any, unpaid on the shares held by them, the company is ‘limited by shares’.

Thus, a “company limited by shares” is a company whose constitution – for these purposes, its articles of association – provides that its shareholders’ liability is limited.

In summary, then, if shareholders wish to enjoy the privilege of limited liability, they must ensure that their company is a company limited by shares, and in order to do that they must ensure that its articles limit their liability. The standard wording used in the articles is that contained in article 2 of the model articles for private companies:

The liability of the members is limited to the amount, if any, unpaid on the shares held by them.

Practical implications of the law

If appropriate wording is not included in the articles, the company is known as an “unlimited company”, and the shareholders of an unlimited company which fails are liable under section 74(1) of the Insolvency Act 1986 to make up the shortfall in the amount which it owes to its creditors.

It is vital, therefore, that shareholders ensure that the articles provide for their liability to be limited. Shareholders of a company which adopts the model articles in their entirety, and does not amend them during the course of its life, have nothing to worry about. Problems may arise, however, if a company adopts bespoke articles, either on formation or subsequently. If long-form articles are adopted, there is a risk that the person who is in charge of the drafting will fail to include a provision along the lines of article 2, whether through an oversight or through a failure to appreciate its significance. Similarly, if short-form articles are adopted, the shareholders will need to ensure that the list of provisions of the model articles which are stated to be excluded does not include article 2.

Shareholders who for some reason fail to include the relevant wording in their articles will no doubt complain that it is far too easy to lose the protection of the doctrine of limited liability. The better view, however, is that it is remarkable easy for shareholders who have a basic understanding of company law (or are properly advised) to take advantage of the potentially huge benefits which flow from the doctrine.