Shareholders´ responsibilities for their company‘s obligations
Lithuanian legislation provides that both public and private limited liability companies (both referred to as “a company” in the text) are limited liability legal entities. This means that in principle a company is not liable for the obligations of its participants (shareholders, members of the Board or Supervisory Board), whereas they in turn, are not responsible for the company’s obligations. This kind of separation of assets is beneficial for the development of company’s activities, businesses and investment as well as expansion of credit relations.
Nevertheless, the Civil Code of the Republic of Lithuania (“the Civil Code”) has established the legal doctrine known as “piercing of corporate veil” which implies that under certain conditions a company’s members may be held liable for the company’s obligations. In most cases we would be dealing with a shareholder’s responsibility for a company’s obligations, whereas the case-law concerning liability of other members of the company is rather sparse; therefore in this article the attention will be paid to a shareholder’s responsibility for a company’s obligations.
Paragraph 3 of Article 2.50 of the Civil Code provides, that “where a legal person fails to perform his obligations due to acts in bad faith of a member of the legal person, the member of a legal person shall, in a subsidiary manner, be liable for the obligations of a legal person by his property”.
In order for this legal provision to be applicable, existence all of the following circumstances must be established:
- legal entity’s inability to fulfill its obligations;
- causality between the inability of the legal entity to fulfill its obligation and the actions of the legal entity’s member;
- bad faith in the actions that have caused the inability to fulfill the obligation.
Criteria of fairness of the actions
The first two of the criteria are much easier to prove compared to bad faith of a member of a legal person. Evaluation of fairness of a member’s actions should be based on subjective criteria (e.g. the shareholder consciously aimed to make the fulfillment of the obligation impossible for selfish reasons) as well as on the objective ones (e.g. how would a reasonable person have acted in good faith in such a situation). Therefore, shareholders taking decisions which could affect the company’s opportunities to fulfill its obligations against third parties should consider not only their own intentions and interests, but also whether these decisions are fair in respect of the third parties.
It should be noted that under paragraph 2 of Article 2.50 of the Civil Code a member of a legal person shall be liable for the obligations of the legal person also in additional cases provided by the incorporation documents (Articles of Association) of a legal person.
Although the legislation does not specify which of the shareholder’s actions should be considered to be made in bad faith, the case-law gives certain criteria that should be evaluated in determining whether these actions were in good faith. The actions should be considered as made in bad faith when:
1. the shareholder fails to ensure compliance with the legislative requirements governing the company’s activity (giving direct orders to other company members, improperly processing company’s financial records, not keeping shareholder’s personal and company’s assets separate, a decision to pay dividends not being in compliance with the legislative requirements, failing to initiate bankruptcy proceedings when the circumstances stated in Law on Enterprise Bankruptcy exist, taking a decision to sell the company’s property below its market value, reducing the company’s assets before initiating bankruptcy, etc.);
2. the shareholder fails in taking actions which would be expected from a diligent shareholder or takes actions which compromise the company’s financial position (chooses inadequate company’s capital, makes agreements between the shareholder and the company which are not favourable to the latter, etc.);
3. the company is set up in order to avoid the shareholder’s responsibility (i.e. the shareholder’s actions make the company’s creditor believe that he is concluding an agreement with the shareholder, while he is actually concluding the agreement with the company);
4. the shareholder fails to fulfill his direct obligations under the laws (when the company’s equity capital falls below ½ of the of the amount of the authorised capital and shareholders fail to restore company’s equity capital by their own account, reduce the authorised capital or transform or liquidate the company, etc.).
Shareholder‘s influence on company’s activity
It is worth noting, that when dealing with the question of a shareholder’s responsibility it is important to consider his role and actual possibility to influence the company’s activity, i.e. the shareholder must have a possibility of implementing control and decisive influence on the company (e.g. being the only or major shareholder, managing a subsidiary company, etc.).
Responsibility of the members of the Board and Supervisory Board
As it was already mentioned, not only the shareholders are responsible for the company’s obligations, but also the members of the (management) Board and the Supervisory Board. The responsibility of these members of the company is related to the responsibility of the company’s manager as being based on the same provisions. Basically, dealing with the issue of responsibility of these members, it must be proven, that the company has become unable to fulfill its obligations due to illegal actions of these individuals.
In case of the Board, it will usually imply that the Board members have not properly implemented their duties specified by law and Articles of Association (made the decision on unprofitable sale of company’s assets, undertook the obligations contrary to the activity of the company or for covering unreasonable payments, etc.).
Illegal actions of Supervisory Board members may reveal negligent fulfillment of duties by its members: insufficient control over the activity of the Board, not analyzing or analyzing insufficiently the company’s financial situation, use of funds, bookkeeping, financial accounting or other company’s documents, taking no measures to repeal illegal resolutions of the Board, etc.
It is important to note that the responsibility of a member of a legal person is subsidiary (secondary): he will be held liable for non-fulfillment of an obligation only in case of failure of the legal person itself to do so. Furthermore, the company’s liquidation does not affect the liability of a member, i.e. the company’s bankruptcy is not to extinguish its member’s liability.
Minimizing the responsibility of the company’s members
There are some practical recommendations on how it would be possible to minimize the responsibility of the company’s members (shareholders in particular):
- avoiding participation in the company’s day-to-day activities;
- avoiding participation in the management activities, assuming the functions of the company’s manager;
- having clear company’s operating procedures established, including internal regulations determining the type and scope of responsibility of the company’s managing bodies;
- avoiding intermingling of personal property with the corporate one (i.e. avoiding reciprocal loans, common projects, etc.).
Although the institute of responsibility of legal person’s member for the company’s obligations is a sufficiently new phenomenon in the Lithuanian legal system, it is increasingly common that the creditors failing to recover their debts from a company direct their claims against members of the company, shareholders in particular.