🪴 Maixnor WU

Limited Liability and Creditors

Nov 04, 20253 min read

Limited Liability

Limited Liability

  • allows for greater diversification of investment
  • allows for asset allocation and fragmentation instead of total commitment to one single venture
  • allows for dealing with riskier ventures responsibly
  • reduces risks of shareholders
  • alternative: micro-loans to companies
    • interest needs to be paid regardless of profits
  • dangerous and beneficial for creditors
    • easier for creditors to assess the value of their claim
      • only need to assess company itself
      • not credit-worthiness of shareholders
    • dangerous if shareholder power comes from single entities
      • parent company in form of a group
      • single shareholder in a small company

Shady Shareholder Tactics

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Creditor Self Help

how do creditors deal with Shareholder Tactics

  • no limited liability
    • Collateral or personal guarantee of shareholders
  • Covenants
  • Accelerated Debt
    • if there is a large change in e.g. leadership the entire liability is due

why is legal restriction still needed?

  • some creditors lack the bargaining power or experience
    • employees (if salary is paid after value creation)
    • suppliers
    • customers paying in advance
  • involuntary creditors
    • companies that receive damages (Tort Law)
  • state (crediting tax and social security money)
    • often a major creditor in insolvencies

Limits of Limited Liability

  • to found a company one needs the starting capital
  • here: capital = equity
  • Share Premium
  • legal capital stays fixed, part of equity
  • criticism as meaningless
    • too little or too high for some lines of business
    • entry barrier for limited liability
    • meaningless information on balance sheet
  • also has upsides
    • proxy for reputability
    • higher initial investment, higher reputability
  • in Austria legal capital is reduced for the first 10 years to 10k
    • questions of importance of 35k

Raising Capital

  • cash considerations
    • simple, cash is cash
  • condiresations in kind
    • hard to pinpoint exact value
    • different valuation strategies
    • no cushion to creditors
    • no proxy for reputability
    • liability for difference in advertised and actual price
    • checked by independent court-appointed expert with AG
  • balance between protecting creditors and flexibility
  • hidden contribution in kind
    • buying a car directly with initial investment from founder instead of supplying his car directly
    • cash payment has to be invested again (twice)

Maintenance of Capital

  • only profits distributed to shareholders
  • if assets - liabilities > reserves → dividends possible
    • non-distributable reserves are mandated by law
  • accounting rules made to protect creditors
    • e.g. value of fixed assets capped at buying price
    • understating the actual business value
  • different account rules sets → different outcomes
    • higher profits under IFRS than under Austrian rules
  • liquidity is not part of balance sheet
    • even if there is a profit in the balance sheet the company may not be able to pay the dividends since the profits are tied up in less liquid assets like real estate
  • hidden or disguised distributions (illegal)
    • parent company pays lower than market value prices to subsidiaries
      • called transactions ‘At Arms Length’
      • e.g. the owners wife is employed despite not working i.e. providing value to the company
    • if reported the money needs to be payed back or compensated otherwise
    • most common with majority shareholders, again discriminating against minority shareholders

Creditor Protection through Insolvency Law

Insolvency

  • Shift from profit maximization to satisfying liabilities to creditors
  • After Liquidation the company ceases to exist
  • Liquidation is often not the best option
    • Creditors foregoing (parts) of the liabilities after a complete restructure of the company to allow further trading is often more advisable
  • If the Liquidation procedure is too expensive (court fees, insolvency administrator, etc) the company is simply deleted from the Business Register and no further action is taken. The creditors loose their entire invenstment

When am I insolvent?

  • not being able to pay the due liabilities
    • second test
  • negative equity in the balance sheet
    • first test (easier)
    • but if the company can still operate normally the company is still not insolvent
    • e.g. real estate prices may be far lower in balance sheet than in reality and this difference can be all the difference

Insolvency Proceedings

  • Managers need to file insolvency
    • Creditors can file insolvency as well
  • Management looses power to represent and lead the company

Route Liquidation

  • After Liquidation the funds are split equally according to their share (everyone gets the same percent of their debts back)
    • Some debts have priority, those of the court and the insolvency case in general are payed first

Route Settlement

  • If a settlement cannot be reached the Route Liquidation is taken
  • If more than 50% of creditors and more than 50% of debt can agree on a settlement to forego the debt then the company may stay operational, but will be restructured by the administrator
    • at least 20% within 2 years need to be payed back, lower is not possible
    • if company agrees to 30% or more within 2 years even managers may stay in power
      • might be dangerous due to inept or conflicting managers

Pecking Order

Who receives money in what order. Only when the higher layer is completely satisfied (repayed) then the next lower layer gets some funds as well. incomplete!

  • Creditors
    • Banks
    • Suppliers
    • Employees
  • Shareholders
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Liability Issues

  • the directors are not liable for the failing company
    • except grossly negligent
    • if grossly negligent → personally liable to creditors
  • if not enough funds for Insolvency Proceedings owners is not permitted to open another company within 3 years
  • Shareholders are covered by Limited Liability, but…
    • hidden distributions may surface → repayment
    • fraudulent dividends have been payed
  • Creditors that cease their collateral shortly before insolvency may have that revoked and the collateral added to the split

Pressures

  • directors experience pressures
  • shareholders pressure to keep going
  • law and social security pressure to file for insolvency
  • difficult if director and shareholder are same person
    • common in small to medium companies

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