Limited Liability in a Company - Essay Example

 Limited Liability An ordinary reference to a company is understood to a limited liability company. Limited liability is one of the fundamental principles of modern corporate law1. The attribute of limited liability earns its support from the fact that when a company is not managed by its shareholders, then ‘shareholders’ limited liability for torts is a privilege shielding them from liability2.’ Limited liability companies are so called because the liability of each shareholder for the company’s debts and other liabilities are limited to the amount that remained unpaid on his shares.3 Companies Act 2006 has accredited the limited liability feature to both public and private companies. The word limited indicates that the liability of members in respect of company’s debts and other liabilities is limited to amount contributed or undertaken by the member to contribute in respect of share capital of the company. Limited liability protects shareholders against any financial loss exceeding the investment4. It has been termed as the greatest single discovery of modern times, even more than steam and electricity.5 As per Ross Grantham and Charles Rickett6 there are certain economic justifications to such restriction of liabilities of member of a limited body corporate. The limited liability reduces the shareholders’ responsibility to monitor corporate managers because the financial consequences of company failure on shareholders are limited. Corporate managers work efficiently for profit maximization because limited liability induces free share transferability that would force shareholders to withdraw funds from unprofitable ventures. Directors who run the company can take risky decisions as well as they aware that shareholders have nothing at stake.7 That is why Tony Orhnial8 states that limited liability ‘is not related to company structure but to the business’s economic risks, and is instrumental to the encouragement of entrepreneurial risk bearing and innovative attitude’. The principle of creating a limited liability company is that debts in case of failures cannot be carried back to founders9. Limited liability works as an extra non- taxable incentive for investments besides dividends and capital gains on transfers of shares that are taxable. Moreover the attribute of ‘limited liability is quite significant when work locale, machinery, chemicals, or even artwork are potentially hazardous’10 Limited liability has helped to develop public share market.11 The primary objective of limited liability is to encourage investment by the public in risk taking enterprises by insulating the investing public from debts of the enterprise.12Limited liability encourages public trading in shares and it facilitates diversification.13 To understand the rationale of limited liability it is important to understand the concept of unlimited liability. ‘Unlimited liability’ condition of membership of a company may require its shareholders or members to contribute unlimited amount to meet the debts and other liabilities of the company. Members can be called upon to satisfy personally the whole of company’s liabilities to its creditors.14 That is to say the liability of each member extends to the whole amount of the debts and liabilities of the company, which is not so in case of limited liability. A member of an unlimited company is more or less in same position as a partner in general partnership. That is why when a shareholder bears the brunt of all of portion of liability of the company, the shareholder becomes entitled to contribution towards those liabilities from other shareholders as well. It is not necessary for an unlimited company to have a share capital. However, ‘a member resigns or terminates his, her or its membership only if the memorandum or articles so provide and in accordance with the conditions set out therein.’15 Unlimited companies have been granted the privilege of not filing the accounts with the registrar of companies provided they are not in banking or insurance business; as well as during the accounting period they were not construed as limited companies on application of certain provisions of companies act, 2006.16 An unlimited company is not the same as an unincorporated company, though in both cases the liability of members is unlimited. The difference between the two is that unlimited corporation is a ‘legal person’ whereas in an unincorporated association only individual members have rights and duties as the association as such have no legal status. A limited company is also different from limited liability partnership (LLP). In LLP a partner can act as an agent of the other partners. Each limited partner’s acts and omissions are binding on other partners, but such partner is responsible for partnership liabilities only up to contributed assets. But a limited liability corporation can only be compared with a general partnership ‘for which the liability of general partners is restricted’17 A limited liability partnership have two types of partners, partners with limited liabilities, and at least one of them with unlimited liability; whereas members of limited liability corporation can have all members with limited liability. Section 3 of Companies Act, 2006 seeks distinction of limited liability of its members constitutionally with reference to shareholding or guarantee undertaken by them. ‘It may be limited by shares or limited by guarantee’18 Company is a legal person and treated as separate entity from shareholders. Limited liability feature of the company has separated the personal assets and liabilities of shareholder from that of the company. A sort of corporate veil has been drawn between shareholder and the company. The veil is almost impermeable and cannot be pierced except in rare circumstances.19 Limited liability feature is related only to liabilities of the company and not to the personal liabilities of shareholders. On the same footings shareholders of a limited corporation are not directly responsible to creditors of the company. ‘So in that sense limited liability means zero liability’20, but the shareholders may be indirectly liable. Having a separate legal status company has its own rights. It can sue for torts committed against it and can also commit torts.21 It has constitutional rights.22 It can be said to have mens rea.23 It seems that shareholders’ limited liability for torts is a privilege conferred by Government and never created by contract.24 Limited liability shifts the risk from shareholders to creditors, whether they are voluntary or contract creditors and involuntary or tort creditors.25 Contract creditors like banks are aware of limitations of recovery created by limited liability feature of the companies. Therefore they take extra precautions and seek collateral securities for charge high interest for unsecured credit facilities. Many a times the limited liability is misused by company management say by fraudulent trading or wrongful trading. Fraudulent trading means the company carries on business with intent to defraud its creditors or 3rd party creditors or for any fraudulent purposes.26 Trading is considered wrongful when a director knowingly permits the company to continue doing like that say before commencement of winding up proceedings. The court can declare such director under the Insolvency Act, 1986 personally liable to the contribution to company enabling the company to make payment to such creditors.27 If the business is legal the premise of limited liability works well, and in risky ventures it is not fair for shareholders to gain all awards by misusing the privilege of limited liability. In such situations the courts will disregard the corporate form and ‘pierce the corporate veil’ of limited liability.28 Most people argue that limited liability promotes risk taking abilities among creditors of the company. But that is not correct. It that would have been the case then one might expect to observe an undersupply of those products and services produced or delivered by organizations that are forbidden by law to operate through limited liability vehicle.29 The basic arguments in favor of limited liability are economic one. It appears that corporate limited liability will continue to exist in its present form because of the economic incentive it accommodates, provided it does not protect those individuals who are truly culpable for the losses of others.30 References Read More