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Brief Counsel

Limited liability - "the greatest single invention of modern times"

25 February 2013

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This Brief Counsel also appeared as an article in www.nbr.co.nz on 22 February 2013

Limited liability has been described as "the greatest single invention of modern times" - a bold claim obviously but, in our view, defensible. 

We provide a refresher on what the concept entails, how it is buried deep within the DNA of Western style capitalism, why it is important to the New Zealand economy and why it must not be compromised.

What is limited liability?

The doctrine of limited liability simply says that “shareholders are not liable for the obligations of the corporation, beyond their capital investment”.1  Limited liability means that a person who pays $100 for shares risks that $100, but no more. Similarly, a person who buys a bond for $100, or sells goods to the company for $100 on credit, risks $100, but no more. 

No one risks more than he or she invests.  When a business fails, the shareholders are the ones to have their investment wiped out first, but each investor has a guaranteed maximum on the loss he or she must bear.

Why it is important

It was not always this way.  Collective financial endeavours were historically carried on via partnerships.  If they failed, the partners were personally liable for all the venture’s debts and obligations.  When a poor investment means losing not merely the money you put in, but everything else you own as well, you will be pretty cautious about investing – and reluctant to invest at all without direct oversight and control over the venture. 

Limited liability solves this problem.  It encourages and enables invention, risk and, most obviously, investment.  It is the reason markets exist and can diversify.  It is the reason that firms can raise capital at a low cost. 

Investors can have diversified portfolios and invest in riskier ventures, without having any management control, because they know that they risk no more than their investment.  Those requiring capital for new ventures can therefore attract the investment they need without having to give up (too much) control.  

The roles of directors and shareholders

Recent calls for the law to be changed so that directors cannot “hide” behind limited liability misinterpret both the purpose of limited liability and the nature of the director's role.

Limited liability does not operate to protect directors; it operates to protect shareholders.  The apparent confusion over this may stem from the fact that, for many small companies in New Zealand, the shareholders and the directors are the same husband and wife couple. 

However, directors and shareholders have very distinct roles and powers, which should not be conflated.  Directors are the managers, not the muscle, behind the company.  Power ultimately rests with the shareholders.  The shareholders own the business.  Shareholders appoint directors to manage the company, and generally choose people with experience and expertise.  Just as quickly, shareholders can remove the directors, modify or revoke the company’s constitution, or place the company into liquidation.2

Directors already personally accountable

The bigger problem with the argument that the limited liability provisions should be amended to hold directors more accountable for a company’s failure is that directors are already personally liable for their actions when managing the affairs of the company. 

It is the directors who are in the firing line after a company fails, if they have acted inappropriately. They can be personally liable if they have acted in bad faith, had a conflict of interest, acted recklessly or negligently, misled investors, or traded while insolvent. 

Where a company is insolvent, or is close to becoming insolvent, the directors have duties not just to the shareholders of the company, but to take into account the interests of the creditors as a whole.  Directors will be personally liable if a court decides that they have allowed the business to be run in a manner likely to create a substantial risk of serious loss to company creditors (including employees or contractors). 

There may be a risk of over-exposure

There is widespread concern among corporate governance experts, including the Institute of Directors, major corporate law firms, BusinessNZ and INFINZ, that the Companies and Limited Partnerships Amendment Bill as currently drafted over-exposes directors to liability.

It does this by seeking to criminalise behaviour which is not motivated by dishonesty, thereby failing to strike an appropriate balance between achieving regulatory compliance and encouraging legitimate risk-taking which is essential to wealth creation and employment. 

An increased exposure to potential criminal liability – or even a criminal trial in which you are acquitted (Feltex, anyone?) – may have a chilling effect on directors’ preparedness to serve and to take business risks, which is the whole point of corporate law.  (Those who do not think that this is a real risk should spend more time in New Zealand boardrooms, or with those who do.)

Fortunately, the select committee has acknowledged this issue and has asked officials to redraft the relevant section in the Bill for presentation to the House via a Supplementary Order Paper.  We await the SOP with interest.

In summary

  • Limited liability does not protect directors, it protects shareholders.
  • Limited liability for shareholders is one of the greatest facilitators of the modern market economy.
  • Directors are already held personally liable for their actions and omissions in office, including reckless trading, which fall below the expected standards of honesty and competence.

Our thanks to Beth Murphy for writing this Brief Counsel. For further information, please contact the lawyers featured.

Footnotes

  1. (Phillip Blumberg, Blumberg on Corporate Groups at 3-5).
  2. Note that, if the constitution of a company permits, the directors can also receive to put a company into liquidation, or to apply to the court for such orders, but again - as the shareholders control the constitution - they must grant the directors that power. Constitutions rarely include such a provision.

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