Protecting rogue traders or rewarding honest risk takers?

The unintended effect of examinership may force the closure of good firms, writes Bill Hobbs

The unintended consequence of limited liability status, highlighted over 150 years ago remains today – how to prevent the rogue from abusing the privilege of limited liability company status?

When first introduced in Britain the middle of the 19th century limited liability was seen as a “Rogues Charter” contrary to the tradition of the honourable businessman. Originally designed to encourage greater investment by shareholders in publically quoted companies it was extended to cover private companies where sole traders could establish a company and also benefit from limited liability.

While the incorporated limited liability company has significantly contributing to economic growth by providing a model though which investments are made in creating jobs, wealth and economic growth, its contribution to society has been tempered with concerns that unscrupulous dishonest business owners and managers benefit from abusing limited liability status.

In essence the problem is a moral hazard one where “limited liability” perversely gives shareholding owners and managers an incentive to trade recklessly, as they will take all the benefit and do not bear the risk of high failure, save the value of their shareholding. When their shares become valueless, far too many gamble for resurrection and trade into hopeless insolvency. The risk of the business is passed onto those who can least afford it – other small business owners.

The courts have generally acted to protect owner’s limited liability status and failed to protect business creditors. Stripping limited liability protection of owners, called piercing the corporate veil, has been said to be as rare as a lightening strike. However it’s not the job of the courts to fill a legislative vacuum in this area of business morals or behaviours. This is the job of law makers – politicians.

The enterprise model of the limited company is fundamental to the economic and social well-being of a nation. That is until rogues own and trade within its privileges. While laws do exist to deny rogues the protection of limited liability, they are a blunt instrument applied after the damage had been done. And the rogue knows this.

Some maintain small business owners are not really that protected as they are frequently required to sign personal guarantees. Whilst a “personal guarantee” may lessen limited liability, it’s a double edged sword. When powerful creditors, financiers, and bankers demand personal guarantees, then the legitimacy of limited liability is undermined. And this is the rub – what is the proper balance between providing for and rewarding honest risk taking and protecting against rogue trading? Should creditors in a powerful position be allowed to pierce the corporate veil and demand personal guarantees as a matter of course? Is the “personal guarantee” being used to strip bare the protection afforded the honest ethical entrepreneur?

Very often honest business ethic gives way to unscrupulous behaviour as business owners maximise financial leverage, pocketing the profits leaving their businesses financially vulnerable. Frequently these rogues act to distort competition and force honest businesses to collapse. Their suppliers, creditors, financiers, customers and competitors are left with the risk while they take all the benefits. This would not be possible were it not for limited liability status. Many argue the small private limited company is simply the owner’s alter-ego, affording him risk loss insurance privileges.

This is acutely seen with the Phoenix syndrome, when company owners shut down one company and immediately clone a new one to trade free of debts, leaving a trail of economic and social destruction in their wake. Others dodge the liquidation insolvency process which requires liquidators to report to the States corporate enforcement office the ODCE. They cease trading betting their company will be struck off and creditors denied legal redress. Others knowingly trade, betting that company liquidation or examinership will work in their favour.

Some times good intentions have unintended consequences. Introduced in 1990 the company examinership process is designed to rescue viable but troubled companies where they can demonstrate a reasonable chance of survival. Recent court cases have tested “reasonableness” in refusing to grant protection to bail out schemes that could not demonstrate viability. Nonetheless the unintended consequence of allowing a business owner start with a clean slate and others invest in the enterprise, is that legitimate business who are trading their way through difficult times are put at a competitive disadvantage as the recovered company competes at lower costs than its competitor. Some say examinership may allow free riders to buy into viable businesses at low cost and risk to themselves. Indeed examinership may distort competition in certain markets depending on the relative size of competing firms. While the intention may be to rescue viable businesses and preserve jobs, the unintended effect may distort competition, forcing the closure of good firms and consequential loss of jobs.

There are some owners who through no fault of their own get into trouble and others who where reckless and negligent in running their business. Honesty is a cornerstone of business behaviour. If the test of what an honest business person would have done is applied to the examinership process then whether or not rescue is reasonably possible can be tested within the bounds of honourable, ethical and moral business behaviour.

Soon to be enacted, revised and simplified company laws will elevate the status of the small private company, affording it the same status as a human person. But what of consideration of the wider social and economic effect of the unscrupulous owner who would hide behind limited status? Will greater protection be afforded to unsecured creditors against rogue traders? Are the state agencies charged with supervision and oversight preventative measures sufficient? Should consideration of a special statutory insolvency office to liquidate rogue companies with powers to strip away the corporate veil allowing small creditors some possibility of recovering money’s owed from rogue business owners be considered?

Insolvency provisions should not provide safe haven and sanctuary for less than honest behaviour. Nor can they be so onerous as to punish the honest business owner.


This article appeared in the Irish Examiner, Business Section, Monday 22nd February 2010