Many franchisees (and franchisors) set up their franchise business trading through a limited liability company or occasionally a limited liability partnership, rather than as a sole trader.
Many franchisees (and franchisors) set up their franchise business trading through a limited liability company or occasionally a limited liability partnership, rather than as a sole trader. The main reason for doing so is to limit the liability of the franchise entity to the assets of the company as the company will be seen as a separate legal entity from its directors and shareholders who can shield themselves behind the corporate veil.
In general, this is true and a good business strategy for minimising personal risk, however it is not an absolute protection. Directors of limited companies can (in certain circumstances) be personally liable for the company’s conduct or their own actions in relation to the company, particularly where they fail to comply with their duties as a director of the company. This area of personal liability is often overlooked.
What are the director’s duties?
Directors have clear statutory duties which they must fulfil and these are set out in the Companies Act 2006 (CA 2006). These include:
- To promote the success of the company by acting in the way he or she considers, in good faith, would most likely to promote the success of the company for the benefit of its members as a whole;
- To act within the powers of the company (i.e. in accordance with the company’s constitution, including the articles of association);
- To exercise independent judgment;
- To exercise reasonable skill, care and diligence, taking into account the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company and the general knowledge, skill and experience that the director actually has;
- To declare interests in any proposed or existing transactions or arrangements with the company (e.g. where a company is proposing to enter into a customer or supply contract with another company and a director is a director of both companies);
- Not to accept benefits from third parties which is given either because he or she is a director or because he or she does (or does not do) anything as a director (for example, lavish and excessive corporate hospitality);
- To avoid conflicts of interest (e.g. where the director of a company is also a director of a competitor company).
Directors also have a range of other specific duties under other legislation and common law, such as duties of confidentiality to the company and relating to health and safety, anti-bribery/corruption, competition law and the environment.
When can a director be personally liable?
If a director is found to have breached any of the duties listed above then he/she can be personally liable and the corporate veil of the company can potentially be pierced. A breach of duty will have to be established but depending on the circumstances the director can be liable to the company’s shareholders, his/her fellow directors or even criminally liable. In this current difficult economic climate one of the clear risk areas to look out for is wrongful trading.
Wrongful trading is where a director allowed the company to continue trading when he/she knew, or ought to have known, that there was no reasonable prospect of the company avoiding an insolvent liquidation and they failed to take every step a reasonably diligent person could be expected to take to minimise loss to creditors. Here a director may be personally liable to the company (or, in an insolvency situation, the liquidator) and can be ordered to contribute personally to the assets of the company.
Wrongful trading is separate from fraudulent trading, which is where, in an insolvency situation, a director can be personally liable where he or she was a knowing party to the carrying on of a business within intent to defraud creditors, or for any fraudulent purpose.
The consequences of breaching director’s duties can be severe
Where a director is found to have been “unfit” in the conduct of a company (particularly in an insolvency situation) that director can be disqualified from acting as a director of another company for a period of between 2 and 15 years. The UK Competition and Markets Authority has powers to disqualify directors where there have been breaches of competition law and has used these powers in recent cases. For example, in 2018 two directors of estate agent companies involved in a price fixing cartel were disqualified from acting as a director of any company for periods between three and three and a half years. This can have disastrous consequences, especially where the individual is a director of a number of companies within a franchised network.
In addition a director may be personally liable for criminal penalties under the Insolvency Act 1986 which allows directors to be prosecuted in certain circumstances, for example if directors engage in fraud in anticipation of winding-up, or make false representations to creditors.
Liability under the franchise agreement
Most corporate franchise agreements require a personal guarantee from the directors, which in itself side steps the limited liability protection of the company vis a vis the franchisor. This means that a franchisee wishing to acquire the right and franchise to trade through a company is still personally liable for the failure by the franchisee company to perform its obligations under the franchise agreement or to pay sums when due. The justification for this is that franchisees must have a personal commitment to the franchise and without this could simply place the franchisee company into liquidation and walk away thereby avoiding liability to the franchisor.
In addition, many franchise agreements also require directors of franchisee companies to remain a director at all times. Therefore, if a director acted in such a way as to be disqualified as a director this could be a breach of the franchise agreement, which could potentially entitle the franchisor to terminate. Franchise agreements also often permit the franchisor to terminate where the franchisee company’s directors are convicted of criminal offences or, behave in such a way that could bring the franchisor’s reputation into disrepute.
Strategies for mitigating risks and safeguard the position of directors
Directors of franchisee companies (and franchisors) should consider the following practical steps to mitigate the risks set out above and protect their position:
- Putting in place training programmes and providing guidance notes to ensure that directors know what their duties are;
- Ensuring that board meetings happen regularly and are attended wherever reasonably possible.
- Each director should also make themselves aware of the day to day business of the board of directors – including functions which have not been specifically delegated to him or her;
- Making reasonable enquiries into the nature of any documents they are asked to sign and any business to be transacted at a board meeting so as to ensure that they can make an informed decision in deciding how to vote;
- Where a director has the ability to delegate, ensuring that any delegate is competent and trustworthy and ensure the director remains informed as to the activities which the delegate is carrying out;
- Ensuring that all formalities are observed, in particular that all meetings are properly minuted and all transactions properly documented;
- Where a director objects to a course of action which is nevertheless approved by the majority of directors, he or she should note their objection in writing to the board of directors and try to ensure that such objection is noted in the minutes of the relevant board meeting;
- Seeking relevant legal and other professional advice, particularly where there is a concern that insolvency may be an issue (to avoid committing offences such as wrongful trading). The closer the company gets to financial difficulties the more important it is for the board to be seen to have taken suitable independent advice.