When limited liability won't save you from a lawsuit (and how to avoid being sued)

When Robert went into business with David, he thought he could trust him to make it a success. If things went bad, then Robert could always rely on the limited liability status of the joint venture company to ensure his personal assets were not at stake. So when Robert received a claim against him for the company's debts, he nearly had a heart attack. What started out as a bad investment was quickly turning into a personal nightmare.

Why the investment went wrong

Robert was approached by David two years ago with a revolutionary new product which David said would take the country by storm. Very soon, David had Robert intrigued by this new product, but there was one small problem: David didn't have sufficient capital to take the product to market. That's where Robert came in. David wanted Robert to invest in the company and in return he would give him a 50% shareholding and directorship.

The problem for Robert was that he didn't know anything about the industry. Neither did he have much time to contribute to the running of the company. David assured Robert that this was not a problem because David had all the expertise and would run the company for them both. They both joked when David said that Robert would be a sleeping director.

Robert slept his way into problems

Robert became a sleeping director in every sense of the word as David was left in sole charge of the day to day running of the company. Every 4-6 weeks, Robert would call David and they would talk over the phone about how the business was performing. David gave constant reassurances to Robert that all was well and that Robert's profits would be rolling in soon. Very soon, the capital was used up and David came to Robert to ask for his signature on some loan documentation. The loan didn't require any personal guarantees from Robert so he was happy to sign.After a year had passed, Robert became curious to see when the company would start making a profit. David told him that it was only a matter of time and that they were nearing a breakthrough.

The breakthrough never came

Six months later the company went into liquidation owing its creditors $250,000. Robert was gutted that he had lost his initial $50,000 investment into the company. David had taken out a mortgage on his home to raise his initial investment into the company and when the company went into liquidation he starting defaulting on his mortgage repayments and shortly afterwards went bankrupt.

Robert was fortunate, so he thought, because he had savings and whilst he couldn't afford to lose $50,000, it wasn't the end of the world. However, being sued for $250,000 eventually caused his bankruptcy too.

Why Robert got sued for the company's debts

Robert was sued for the company's debts because it was alleged that he had allowed the business to be carried out in such a way as to create a substantial risk of serious loss to creditors. 

Robert couldn't understand the allegation because he believed that by setting up a limited liability company he was shielded from the company's creditors. However, his lawyer explained to him that the notion of limited liability applied to his shareholding, but as a director, he owed various duties to the company and ultimately the creditors of the company. He had failed in those duties so therefore the liquidator of the company (on behalf of the creditors) decided to sue him - of course David was equally liable, but being a bankrupt had no money and was not worth suing.

Where Robert went wrong 

When you hear the term "corporate governance" you immediately think of big business. But small business owners are just as exposed to the risks of poor corporate governance as directors in large multinational companies.    

Robert's mistake was that he let David run the company without any checks or measures in place to ensure that he was doing so prudently. He relied upon David's assurances without asking for any evidence to back up what he was saying. What Robert was being told was in stark contrast to what actually was happening.
As a director, Robert was a guardian of the company and the creditors. He allowed the company to trade recklessly by not asking the right questions. His ignorance of what was really going on was no defence.

The moral of the story

So the moral of the story is: if anyone asks you to be a sleeping director, think twice. There is no such thing as a sleeping director, and if you sleep you not only risk your own investment into the business but could become liable for the businesses debts.


Print this pageEmail to a friendUse this article in your newsletter/magazine