What is the Corporate Veil & When Are Directors Personally Liable?
If you’re considering the option of piercing the corporate veil to recover a debt from a company director, and making the director personally liable, instead of the business itself, it’s essential to first understand what the corporate veil is and its intended purpose.
When starting or acquiring a business, and then running that business through a company, it’s common to incur various debts and liabilities to ensure its operation and growth.
This aspect is crucial in business as there are numerous initial requirements, such as securing a location, maintaining a steady supply of materials for your products or services, and hiring staff.
For potential business owners, this can be daunting, as they face the challenge of managing these liabilities, which might seem overwhelming.
To foster business development and safeguard the personal interests of business owners and directors, the concept of the corporate veil exists. This legal principle recognises a business as an independent entity, separate from its directors and shareholders.
As a result, the directors are generally not personally liable for the company’s debts or legal issues. This separation is designed to protect the personal lives of directors from professional setbacks, acknowledging that company inherently carries certain risks, some of which might be beyond anyone’s control.
However, under certain circumstances, it is possible to pierce this corporate veil, allowing creditors to hold directors personally responsible for business debts.
This piercing is not a common occurrence and is subject to specific legal criteria, which will be explored in the following sections. It’s a measure taken in exceptional cases, typically when there’s evidence of misconduct or abuse of the corporate structure, ensuring that the shield of limited liability isn’t used unjustly to evade financial responsibilities.
What is limited liability?
Limited liability is a concept where individuals can establish a company without being personally responsible for its debts. This is essentially the “Ltd” part in the “Pty Ltd” of company registration.
Limited liability is a fundamental principle in corporate law that significantly impacts how businesses are formed and operated.
It offers a layer of protection to the individuals behind a company, typically the shareholders or owners, by limiting their financial responsibility to the amount they have invested in the business.
This means their personal assets are generally protected from the company’s liabilities.
When a company is established with limited liability, it becomes a separate legal entity from its owners. This separation is crucial because it means that the company itself is responsible for its debts and obligations, not the individuals who own it.
For instance, if a company goes into liquidation or faces legal actions, the personal assets of its shareholders or owners, such as their homes, cars, or personal savings, are usually not at risk.
Their loss is limited to the amount they invested in the company.
However, this protection is not absolute. There are exceptions where limited liability may not apply.
When are Directors Personally Liable?
There are various instances, occurrences, and scenarios where the corporate veil can be pierced making the director personally liable for the company liabilities, allowing creditors to claim debts from company directors or parent companies, these include:
- Agency: If a subsidiary fails to pay its debts, the parent company can be held liable.
- Fraud: Directors who use the company for fraudulent purposes can be personally liable for its debts.
- Avoiding Legal Obligations: If directors use the corporate structure to evade debts, the court may hold them personally responsible.
- Unfairness/Justice: In cases of unfairness or injustice, such as a subsidiary causing damages it cannot pay, the parent company might be held liable.
These exceptions to the corporate veil are designed to prevent abuse of limited liability and ensure accountability in business operations.
We will explain in more detail below.
Directors Personally Liable – Agency
The first way that we will discuss that you can pierce the corporate veil is in circumstances of agency.
As you are likely aware, some companies invest and split into various branches, or open up companies that they oversee but do not necessarily own. This process is referred to as agency, which is defined as a company that is part of a large corporate structure, where a shareholder or parent company oversee the workings and activities of one or more subsidiaries.
As the subsidiary is a separate company in several ways, you may be owed a debt to one of these types of companies. So, if the smaller company becomes insolvent or does not pay a debt for any other reason, can I collect the debt from the parent company? Yes, you can!
The courts can enforce that a parent company become entirely liable for the liabilities of the subsidiary so that creditors or any other individual that is owed a legal fulfilment by it will have this completed/paid by the parent company.
Directors Personally Liable for Fraud
Another way that the corporate veil can be pierced so that creditors can collect debts from directors is in circumstances of fraud. A director of a company owes certain duties and responsibilities to it which result in penalties if they are breached.
This is to protect businesses, which function as individual “people” by law, and misuse of their position by a director, who have a high extent of power over the workings of a business.
If a director has used the company for which they direct for fraudulent purposes, they have not properly fulfilled their responsibility for the company and misused their position, meaning they can be held personally liable for the business’s liabilities, including its debts.
Fraudulent use of a company also encompasses directors that open businesses simply to take advantage of the corporate veil.
Avoiding Legal Obligations
Another way that the corporate veil can be pierced so that creditors can collect debts from directors is in circumstances of directors looking to avoid legal obligations.
If a director has been found to be using the corporate veil to avoid their legal responsibilities and obligations, the court may decide to remove the corporate veil.
An example of this is if a business owes you a debt. The director, in order to avoid paying you this debt, may choose to move all assets to a separate business and then declare that the company is insolvent, and that owes you the debt and liquidate.
If this can be proven to be the case, the court will likely lift the corporate veil to hold the director personally liable for their behaviour and the debt in question.
Directors Personally Liable if Unfairness/Justice
Another way that the corporate veil can be pierced so that creditors can collect debts from directors is in circumstances of unfairness or injustice. When you pierce the corporate veil on the grounds of unfairness, you are looking to bring about a fair or just result in the matter in the eyes of the law and for all involved.
The principle of “Injustice or Unfairness” in the context of piercing the corporate veil refers to situations where maintaining the separation between a corporation and its shareholders or directors (as distinct legal entities) would lead to clear injustice or unfair treatment of third parties.
This principle is invoked in legal cases where strictly adhering to the corporate entity concept would result in a significant harm or inequity to individuals or entities that are external to the corporation.
In such cases, the courts may decide to pierce the corporate veil, meaning they set aside the usual corporate protections to hold the shareholders or directors personally liable for the company’s actions or debts.
This decision is typically made when the court finds that the corporate structure is being misused in a way that harms third parties and that piercing the veil is necessary to rectify the situation and provide relief to those affected.
This principle is applied cautiously and, on a case-by-case basis, as it involves balancing the fundamental legal recognition of a corporation as a separate entity against the need to prevent misuse of this recognition in ways that cause unjust outcomes.
The aim is to ensure that the corporate form is not used as a shield for improper conduct that results in unfairness or injustice to others.
Other ways Directors are Personally Liable
There are several other ways that the corporate veil can be pierced also, including:
Insolvent trading where directors are obligated to cease trading if their company becomes insolvent, meaning it can no longer meet its financial obligations. This duty is crucial to protect creditors and other stakeholders.
However, if a director neglects this responsibility and the company continues to incur debts while insolvent, they can be held personally liable for these new liabilities. This rule serves as a significant check on directors, ensuring they act responsibly in managing the company’s financial health and safeguarding the interests of creditors.
Phoenix activity, when directors deliberately dissolve a company to evade financial or legal responsibilities, only to restart it under a new guise. Such actions are considered fraudulent and are a direct abuse of the corporate structure.
Directors engaging in Phoenix activity can be personally held accountable for the company’s obligations. This provision is particularly important for creditors who suspect such malpractice, as it allows them to seek redress directly from the directors, bypassing the corporate entity.
Personal guarantees, where a creditor doubts a company’s ability to repay a loan, they might require a personal guarantee from the company’s directors or shareholders. This agreement makes these individuals personally liable if the company defaults on its payments.
Personal guarantees represent a voluntary piercing of the corporate veil, offering creditors a safeguard against the risk of non-payment. It shifts some of the financial responsibility from the corporate entity to the individuals who have a stake in the company, thereby providing an additional layer of security for the creditor.
We will explain these in more detail below.
Directors Personally Liable – Insolvent Trading
One alternative way that the corporate veil can be pierced is if the director has allowed the business to engage in insolvent trading.
As we discussed prior in the article, directors have duties that must be fulfilled in order for their position to be properly performed and for the company they direct for to be protected. One of these duties is that they must prevent the business from trading, or incurring any additional debt or expenses, while insolvent to protect creditors and parties involved in the business.
If the director fails to fulfil this duty, they can be made personally liable for any liabilities, such as debts, that the business has or has incurred since insolvency.
This can be extremely effective in making a director of a company liable for a debt. If the director cannot afford to pay the debts of the business or fulfil any legal requirements told of them, they will face the consequences personally rather than as a business.
Directors Personally Liable – Illegal Phoenix Activity
Another alternative way that the corporate veil can be pierced is if there has been Phoenix activity or illegal activity occurring within the business.
Illegal phoenix activity occurs when the director or directors of a business wind up, liquidate or abandon their role and the company as a whole in order to avoid financial or legal responsibilities.
If you are owed a debt and the business’s directors appear to be committing illegal Phoenix activity, you should investigate and notify the relevant authority. If it is found to be true and the directors have been committing Phoenix activity, they will be held personally liable for the debts and legal requirements of the business.
Directors Personally Liable if given Personal Guarantees
Another alternative way that the corporate veil can be pierced is if there is a personal guarantee in place.
When you agree to incur a loan or other liability to a company, you are loaning to the company itself and not anyone personally involved in it, such as the directors or shareholders. This means that if the business becomes insolvent, the owners, directors, and shareholders will not hold the responsibility to pay the debt; it will be the business’s responsibility, which decreases your likelihood of payment.
This is a risk that you take as a creditor, as businesses will pay their debts back more often than not and it will act as an investment for you, as you are paid interest. If you are unsure about the business’s ability to make payments, however, you may wish to engage in a personal guarantee.
A personal guarantee occurs when one or more parties involved in a business agree to become personally liable if the business defaults on payments. This means that the corporate veil is voluntarily pierced by parties involved in it in order to take out debt!
There are also some legislation which contain clauses which, in effect, pierce the corporate veil and make the directors personally liable.
Under several separate pieces of legislation, different sections can make directors personally liable for different reasons. The pieces of legislation that can make directors liable include (inter alia):
We will explain in more detail below.
Corporations Act 2001
The first act that discusses the personal liability of directors that we will discuss is the Corporations Act 2001. As well as those things already mentioned in this article, a director of a company may be personally liable in the following circumstances:
- Breach of Directors’ Duties: Directors have a duty to act in the best interests of the company, with care and diligence, and to avoid conflicts of interest. Breaching these duties can result in personal liability.
- Insolvent Trading: Directors can be held personally liable for debts incurred by the company if they continue to trade while the company is insolvent.
- Fraudulent Conduct: Engaging in fraudulent activities, such as misrepresentation or embezzlement, can lead to personal liability.
- Breach of Financial Reporting Obligations: Directors must ensure accurate financial reporting. Failure to comply with these obligations can result in personal liability.
- Failure to Comply with Statutory Obligations: Non-compliance with specific statutory obligations under the Corporations Act, such as filing requirements, can lead to personal liability.
- Related Party Transactions: Personal liability may arise from improper related party transactions not in the best interest of the company.
- Failure to Act in Good Faith: Directors must act in good faith in the best interests of the company. Failure to do so can result in personal liability.
- Improper Use of Position or Information: Using their position or information obtained as a director for personal gain or to harm the company can lead to personal liability.
- Failure to Prevent Company Offences: If a company commits an offence (like environmental breaches), directors can be personally liable if they failed to take reasonable steps to prevent it.
- Declarations of Solvency: Making false declarations of solvency in certain situations, such as during a voluntary winding up, can result in personal liability.
- Failure to Maintain Proper Financial Records: Directors are responsible for ensuring that the company maintains accurate financial records. Failure to do so can lead to personal liability.
- Failure to Respond to Liquidator’s Requests: During liquidation, directors must comply with requests from the liquidator. Failure to do so can result in personal liability.
- Failure to Attend Creditors’ Meetings: Directors may be required to attend creditors’ meetings during insolvency proceedings. Non-attendance can lead to personal liability.
- Failure to Assist in Insolvency Proceedings: Directors must assist in insolvency proceedings, and failure to do so can result in personal liability.
- Environmental Offences: Directors can be personally liable for environmental offences committed by the company.
- Work Health and Safety Breaches: Personal liability may arise from breaches of work health and safety laws.
- Tax Liabilities: Directors can be personally liable for certain tax liabilities of the company.
This list is not exhaustive and the specifics of each point can vary based on the circumstances of each case and the specific provisions of the Corporations Act. Directors should always seek legal advice to understand their personal liability under the Act.
Australian Consumer Law
Another piece of Australian law that discusses directors becoming personally liable for the business they direct is Australian Consumer Law or ACL.
It states in section 236 that:
if (a) a person suffers loss or damage because of the conduct of another person and (b) the conduct contravened a provision of Chapter 2 or 3; then the claimant may recover the amount of the loss or damage by action against that other person (or against any person involved in the contravention.
The term “or against any person involved in the contravention” allows those involved in the damage, such as directors, to become personally liable for the damage if their behaviour violates chapter 2 & 3 which bring forward several contraventions relating to misleading and deceptive conduct.
This means that if a director is found to have been misleading or deceptive (or any other contravention under chapters 2 & 3), they can be made personally liable for the damages incurred.
Tax Administration Act 1953
Another piece of Australian legislation that discusses directors becoming personally liable for the business they direct is the Tax Administration Act 1953.
This piece of legislation allows directors of a company to be personally liable for their business’s unpaid superannuation guarantee amounts, PAYG (Pay as You Go) tax, and GST (goods and services tax).
Directors will be issued a notice, referred to as a directors’ penalty notice, that states that they will be made personally liable for this debt, which they must take action upon within 21 days of receiving.
This action may be paying the debt or appointing a liquidator or administrator to wind up the company. If they do not, they will be made liable.
Strategies for Minimising Personal Liability Risks
There are a number of ways that a director can minimise their exposure to personal liability, including:
Directors and Officers Insurance
Directors and Officers (D&O) Insurance serves as a safeguard for directors and officers against personal liability in the event of company difficulties.
This insurance extends its coverage not only to directors but also to employees and non-executive directors. While D&O insurance provides protection against various liabilities not covered under the Deed of Indemnity, it does not extend to instances of illegal activities by directors.
Deed of Indemnity
As a director, securing a Deed of Indemnity, also known as a ‘Deed of Access & Indemnity’ or ‘Deed of Insurance,’ is a proactive step to shield yourself from personal liabilities. This legal agreement between the company and its directors outlines:
- Access to pertinent company documents
- Details regarding Directors and Officers insurance policy
- The extent of directors’ liability protection
However, the protection offered by the Deed of Indemnity has its limitations. It does not cover breaches of directorial duties, fraudulent, dishonest, or criminal actions, nor does it protect against violations of other legal requirements under the Corporations Act 2001 (Cth).
Effective financial management is crucial for directors to avoid the pitfalls of insolvency and the associated personal liabilities. Proactive financial oversight from the outset is key.
While relying on accountants and banks for day-to-day financial management is standard, directors bear the ultimate responsibility for the company’s financial health. To effectively manage finances, consider the following strategies:
- Diligent record-keeping, including financial statements (invoices, cash flow statements, balance sheets), deeds, and meeting minutes
- Managing outstanding accounts
- Monitoring stock levels
- Reducing overhead costs
- Regular assessments of the company’s financial status
- Reviewing and optimising payment methods
While constant monitoring of finances is impractical, maintaining a solid grasp of the company’s financial situation is essential for timely and effective decision-making.
Piercing the Corporate Veil Key Takeaways
The concept of the corporate veil serves as a fundamental principle in corporate law, providing a layer of protection for directors and shareholders by treating the company as a separate legal entity. This separation ensures that the personal assets of those involved in a company are generally shielded from the company’s liabilities.
However, this protection is not absolute and can be pierced under certain circumstances.
Piercing the corporate veil is a legal mechanism that allows creditors to hold directors personally responsible for the company’s debts in specific scenarios. These scenarios include fraudulent activities, insolvent trading, illegal phoenix activity, and situations where directors fail to fulfill their legal and financial obligations.
Additionally, personal guarantees and certain statutory regimes under Australian law, such as the Corporations Act 2001, Australian Consumer Law, and the Tax Administration Act 1953, can also lead to personal liability for directors.
This measure is crucial in maintaining the balance between encouraging entrepreneurship and protecting creditors and the public from potential abuses of the corporate structure. It ensures that the corporate form is not misused to evade financial responsibilities or engage in unethical practices.
Directors must be aware of these liabilities and act responsibly, upholding their duties to the company and its stakeholders.
In conclusion, while the corporate veil offers significant benefits in terms of limited liability and risk-taking in business ventures, it is not an impenetrable shield. Directors must navigate their roles with an understanding of the circumstances under which they could be held personally liable, ensuring that their actions align with legal and ethical standards.
This understanding is essential for the integrity and sustainability of the corporate system, fostering a business environment that is fair, responsible, and accountable.
Piercing the Corporate Veil FAQ
Navigating the complexities of corporate law and understanding the responsibilities and liabilities of directors can be challenging.
To assist in demystifying these topics, we’ve compiled a series of frequently asked questions (FAQs) that delve into the intricacies of directors’ liabilities, the concept of the corporate veil, and the circumstances under which this veil can be pierced.
When can directors be held liable?
Directors can be held liable in situations where they fail to fulfill their legal and fiduciary duties to the company. This includes instances of fraudulent behaviour, gross negligence, breach of duty, engaging in illegal activities, or mismanagement of the company’s affairs. Additionally, directors can be personally liable if they continue to operate a company while it is insolvent, known as insolvent trading, or if they are involved in illegal phoenix activities. The liability also extends to personal guarantees made by directors and specific statutory obligations, such as certain tax liabilities.
Are directors personally liable for unpaid wages?
Directors can be personally liable for unpaid wages under certain circumstances. If a company becomes insolvent and is unable to pay its employees, directors may be held responsible, especially if they were aware of the company’s financial difficulties and failed to take appropriate action. This liability is often enforced through labor laws or specific provisions in corporate legislation, which are designed to protect employees’ rights to fair compensation. However, the specifics can vary depending on the jurisdiction and the exact circumstances of the company’s insolvency.
What taxes are directors personally liable for?
Directors can be personally liable for certain tax obligations of the company, particularly in cases where the company fails to meet its tax liabilities. This often includes Pay As You Go (PAYG) withholding taxes, Goods and Services Tax (GST), and Superannuation Guarantee Charges (SGC) in some jurisdictions. The liability arises when directors fail to ensure that the company meets these tax obligations, and it is especially enforced when the company is insolvent or nearing insolvency. Directors may receive a director’s penalty notice, making them personally liable for these unpaid taxes.
What is an example of breach of directors duties?
An example of a breach of directors’ duties is when a director engages in a conflict of interest without proper disclosure or approval. This could occur if a director makes a decision that benefits them personally at the expense of the company, such as awarding a contract to a business they own or have a significant stake in. Other examples include misusing company assets, divulging confidential company information for personal gain, or making decisions without due care and diligence, leading to financial loss for the company. Such breaches not only violate corporate governance principles but can also lead to legal consequences for the director involved.
What is the corporate veil in business?
The corporate veil in business is a fundamental legal principle that recognises a corporation as an independent legal entity, separate from its shareholders, directors, and officers. This distinction is crucial as it protects these individuals from personal liability for the company’s debts and legal obligations. Essentially, it means that the personal assets of shareholders and directors are shielded from claims against the corporation.
How can the corporate veil be pierced?
Piercing the corporate veil occurs in exceptional circumstances where the separation between the corporation and its owners or directors is disregarded by the court. This can happen if there’s evidence of fraud, abuse of the corporate form, or when the corporation is used to evade legal obligations. Other reasons include situations where maintaining the veil would sanction a fraud or promote injustice. The decision to pierce the veil is typically at the discretion of the court and based on the specifics of each case.
What are the consequences of piercing the corporate veil?
When the corporate veil is pierced, the usual legal separation between the corporation and its individual members (shareholders, directors, or officers) is removed. This means that these individuals can be held personally liable for the company’s debts, liabilities, or for legal judgments against the company. It can lead to personal financial loss, as their assets like homes, bank accounts, and investments become vulnerable to claims against the corporation.
Can fraudulent activities lead to piercing the corporate veil?
Yes, engaging in fraudulent activities is one of the primary reasons for piercing the corporate veil. If a court finds that a corporation was involved in fraudulent transactions or its formation and operation were intended to defraud creditors, customers, or other parties, it may decide to hold the directors or shareholders personally liable. This action is taken to prevent individuals from misusing the corporate structure as a shield for illicit activities.
Is insolvency a reason to pierce the corporate veil?
Insolvency itself is not typically a direct reason to pierce the corporate veil. However, if a company’s insolvency is due to wrongful or fraudulent actions by its directors or if the company continued to incur debts knowing it could not repay them (insolvent trading), the veil can be pierced. This is to ensure that directors cannot hide behind the corporate entity to avoid personal liability for irresponsible or illegal financial practices.
What role does unfairness play in piercing the corporate veil?
Unfairness or injustice can be a significant factor in decisions to pierce the corporate veil. If maintaining the veil would lead to an unjust outcome, such as enabling a company to evade its legal obligations or to perpetrate fraud, courts may decide to hold the individuals behind the company personally liable. This is particularly relevant in cases where the actions of the corporation have caused harm or significant financial loss to others, and piercing the veil is seen as a way to achieve equity and justice.
Are personal guarantees a way to pierce the corporate veil?
Personal guarantees by directors or shareholders do not necessarily pierce the corporate veil but do create a situation where these individuals voluntarily accept personal liability for certain corporate debts. In these cases, even without piercing the veil, creditors can pursue the guarantors personally for these debts, effectively bypassing the usual protections offered by the corporate structure.
How does illegal phoenix activity relate to piercing the corporate veil?
Illegal phoenix activity, where a business is deliberately liquidated to avoid debts and then restarted under a new name, can be grounds for piercing the corporate veil. This activity is considered fraudulent as it abuses the corporate form to evade financial responsibilities. When detected, courts may hold the directors personally liable for the debts of the liquidated company.
Can agency relationships lead to piercing the corporate veil?
In agency relationships, especially in complex corporate structures with parent and subsidiary companies, the veil can be pierced if the parent company exercises excessive control over the subsidiary, or if the subsidiary is merely a façade for the parent’s operations. In such cases, the subsidiary’s liabilities may be attributed to the parent company, especially if the subsidiary lacks the assets or independence to meet its obligations.
What impact does statutory law have on piercing the corporate veil?
Statutory law can play a significant role in piercing the corporate veil. Various legislations, like the Corporations Act or Consumer Law, may contain provisions that hold directors personally liable for specific corporate misconduct, such as insolvent trading or breaches of consumer protection laws. These statutory provisions are designed to prevent misuse of the corporate structure and ensure directors uphold their legal responsibilities.