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Creditors’ right to payment of debt and limited liability feature of a company limited by shares

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Creditors’ right to payment of debt and limited liability feature of a company limited by shares
Richard Nunekpeku is a lawyer at E.L Agbemava Law Office

The START Column :

A company limited by shares construct produces an entity bestowed with legal personality, limited liability, transferability of shares, delegated management and investor ownership according to Reinier Kraakman.

Globally, these distinct features backed by legislation and practice have become common features of such companies – and similarly, the Companies Act, 2019 (Act 992) recognises these features.

An incorporated company limited by shares enjoys the privilege of limited liability – creating a corporate shield and protecting shareholders against personal liabilities for the debts of the company. Whilst there is growing advocacy for companies to offer more social value for this continuing privilege, its rationale remains to incentivise risk-takers (entrepreneurs) to invest in businesses and promote economic growth, innovation, create employment among others.

A company limited by shares depends on various funding sources for its operations – equity (capital) contribution of shareholders and debt financing – credit extended by shareholders and 3rd parties either as a loan or in the ordinary course of business of the company. Largely, debt financing constitutes a significant portion of companies’ funding mix – by so doing, creating liabilities (creditors) with claims of payment on a company.

A creditor’s right to payment of debt could be hindered by the limited liability feature of a company. Therefore, it is important to understand the scope of the concept of limited liability as it pertains to debt payment by a company limited by shares.

In this article, whilst discussing the concept of limited liability and the creditors’ right to payment, I will offer some recommendations on creditors’ due diligence as a means of averting the ultimate termination of the right to the payment due to the benefit of a limited liability concept.

Liabilities (debts) of a company limited by shares

A company limited by shares operates just like any other form of business. In the pursuit of its objects and purpose, it incurs liabilities (debts) – short and long-term. Its liability portfolio could comprise debts from multiple sources and classifications.

Debts arising from contractual relationships could be secured or unsecured. Where a debt repayment is backed by security for repayment like mortgage, debentures (either floating or fixed) among others, the charge over the assets or properties of the company makes such debts secured – guaranteeing a right to dispose of the related asset(s) in times of default or priority during insolvency proceedings. On the other hand, debts without any security constitute unsecured debts – usually made of debts arising from the contract for the sale of goods, provision of service, payment of employees’ remunerations, payment obligations by the operation of law in the forms of taxes, pensions, etc.

Either as secured or unsecured liability, directors and managers retain greater control over the amount, payment terms, debt management etc. and can exercise due care and skills not to overburden the company and run it into insolvency.

Also, a company could be liable in tort. Liabilities in tort arise from proven claims of negligence resulting in the award of damages (the company becoming judgment debtor) or levy of fines and must be honoured either planned or not. This category of liability creates an undeterminable (in comparison to contract) debt with the potential to outweigh the values of the assets and capital of a company depending on the value of claims.

Regardless of the type of debt, once a company becomes liable, it has the responsibility to (and must) honour them in full when they become due.

The limited liability feature

With statutory backing, an incorporated company limited by shares is one with limited liability. The concept implies that, generally, a company cannot pay or be liable for the payment of its debts (liabilities) in values more than the values of its assets and capital contribution of its shareholders at all times – even during insolvency proceedings.

A company’s ultimate payment responsibility is less or equal to its assets and capital values.

This feature creates a corporate shield or veil insulating shareholders from liabilities beyond their capital contributions and the assets of the company. Shareholders in any claim for payment of liabilities may only lose their capital contributed, entitlements to future dividends (profits) and return of assets of the company, nothing more.

However, this scared feature and privilege conferred on companies by law and practice sometimes become an incentive for overzealous investment decisions resulting in excessive risk-taking and lack of due care by directors and shareholders.

In such circumstances, where directors and shareholders incur liabilities acting in good faith, the law permits them to walk away with no personal liabilities. Nonetheless, liabilities incurred as a result of fraud, and other illegal considerations may result in lifting the veil and placing personal liabilities on shareholders and directors beyond the values of assets and capital contributions of a company – operating as an exception to the limited liability feature of companies.

The Companies Act, 2019 (Act 992) and case law – Ghanaian and Common Law over the years support the use of the lifting of the veil in an attempt to realise the full values of liabilities by creditors. The common practice of the demand for personal guarantees by directors and shareholders in securing debt financing arrangements such as bank loans may also operate as an exception to the limited liability feature of companies.

Creditors’ right to the payment of debt

There is no dispute about a creditor’s entitlement to payment of debts – just as a company is entitled to the benefits of debts, creditors are equally entitled to the payment of debts when they fall due. Debts either by contract – secured or unsecured or tort must be honoured in full by companies.

When a company regularly pay its debts, there is no need to rely on the benefits of its limited liability feature or justify the same. A company will only seek to rely on the limited liability feature when it is unable to pay its debts on demand or during insolvency proceedings.

At this stage, a creditor’s concern becomes whether the debt owed can fully be realised or not. Legislative interventions have resulted in providing priority status for some category of debts over others in the repayment efforts by companies during such times. Payment of debts either as priority or others (although regularly incurred) beyond the assets and capital values of a company may not be honoured due to the benefits of the limited liability feature – providing a ceiling for liability payment and limiting a creditor’s right to payment of debt.

Unless the circumstances of liabilities justify the lifting of the veil, a creditor’s right to payment of debt terminates when the limited liability feature of a company limited by shares is invoked.

The creditors’ due diligence

A creditor by contract has the liberty to choose his/her/its debtor unlike the one in tort who cannot predetermine his/her/its tortfeasor. Therefore, creditors by contract must endeavour to undertake some due diligence on the companies they extent credits.

Any due diligence should not be limited to only the form of company registration but must include the understanding of the debt portfolio of the company – value, type of debts, etc, its operational liquidity position, previous debt records and payment terms, management competence and corporate governance structure, market opportunities for growth, industry regulations, etc.

Good due diligence will offer the advantages of understanding the extent of current encumbrances on the assets of a company, its ability to pay debts when they fall due among others.  Ultimately, it prevents the loss of a creditor’s right to payment of debts when the company is unable to pay debts and relies on the limited liability feature.

Conclusion

The operations of a company cannot only be financed by the capital contribution of its shareholders. Therefore, debt financing is imperative for any company’s sustainable operations.

Whilst it is desirable that all debts (liabilities) incurred by companies must be honoured in full when they fall due, the financial circumstances of some companies make it difficult for the realisation of this business expectation.

Creditors may be able to recover their debts depending on the incorporated form of a company beyond its assets and capital contribution. Where a company is registered as a company limited by shares, it is bestowed with a limited liability feature that shields the shareholders from personal liabilities except as permitted by law.

Creditors must endeavour to work with the understanding of the effects of the limited liability feature of a company limited by shares and undertake some due diligence before granting credit(s) to such companies to avert the ultimate loss of credits (debts).

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