Business Structures Flashcards
Question 1
Two years ago, Aadi had set up in business as a sole trader. He invested all of his savings of £10,000 in the business. Recently the business has struggled financially, and a major supplier is owed £18,000. Aadi realises that he will have to sell the business and calculates that if all of its assets were sold, they would realise £8,000. Aadi himself owns a car worth £5,000. He owns a flat which, if sold, will raise £50,000 once the mortgage is paid off. He has no other substantial assets. The business has no other debts.
Which of the following statements best reflects the position of the supplier in relation to the debt?
A. The supplier would only be able to recover £8,000, which is the amount that would be realised from the sale of the assets of the business.
B. The supplier would be able to recover £10,000, as Aadi would be personally liable for the amount that he originally invested in the business.
C. The supplier would be able to recover £13,000 as Aadi would be personally liable for the full amount of the debt and, although he may have to sell his car which will raise an additional £5,000, he could not be forced to sell his home.
D. The supplier would be able to recover the full £18,000 as Aadi is personally liable for the whole of the debt and can be forced to sell any of his assets to pay the balance of £10,000 once the business is sold.
D. The supplier would be able to recover the full £18,000 as Aadi is personally liable for the whole of the debt and can be forced to sell any of his assets to pay the balance of £10,000 once the business is sold.
That is correct. A sole trader has unlimited liability for the debts of the business. If the business fails and cannot pay the full amount of the debt, as here, he will have to meet the debts with his own property, including his home. If he cannot do so he may be declared bankrupt. Here, Aadi seems to have enough assets and can therefore pay the full amount of the debt. Note that the facts state that Aadi has used all of his savings for the business and it appears that his only assets are the car and the flat.
This makes A-C wrong.
Question 2
Assume for the purposes of this question that Aadi set up the business in partnership with Liam. Each of them invested their savings (£5,000 each) in the business. Acting within his authority, Liam entered into a major supply contract, but following some difficult times, the business has been unable to pay the debt, and the supplier is owed £18,000. The partners realise that the assets of the business will have to be sold. Again, the sale would realise £8,000. Aadi has substantial personal assets, including a house and a car. Liam has no substantial assets of his own. The firm has no other debts.
Which of the following statements best reflects the position of the supplier in relation to the debt?
A. The supplier would only be able to recover £4,000 from Aadi personally, as this is the amount of his share of the business.
B. The supplier would be able to recover £5,000 from Aadi, as although he is personally liable for the debt, he is only liable for the amount that he originally invested in the business.
C. The supplier would be able to recover the full £18,000 from Aadi as Aadi is jointly and severally liable for the whole of the debt and he can be forced to sell any of his assets to pay it off.
D. As Liam entered into the contract, he is solely responsible for the debt but as he has no personal assets, the supplier will only be able to recover the £8,000 from the sale of the assets of the business.
C. The supplier would be able to recover the full £18,000 from Aadi as Aadi is jointly and severally liable for the whole of the debt and he can be forced to sell any of his assets to pay it off.
That’s right. The correct answer is C. Partners have unlimited liability and are jointly (and severally) liable for the debts of the business. This means that a creditor can choose to sue any or all of the partners, so he could sue either Aadi or Liam for the whole amount of the debt. On the facts, Liam has no funds, so there would not be much point pursuing him, but the supplier could sue Aadi, who has ‘substantial assets’ for the full £18,000.
As the business appears to have failed and does not have enough money to pay the debt, Aadi will have to pay the balance from the sale of his own property, including his home. This makes A and B wrong. D is wrong as partners are jointly and severally liable, regardless of who concluded the contract.
Question 3
Assume for the purposes of this question that Aadi, Liam and Jess set up a private limited company. Aadi was issued with 10,000 shares and Liam was issued with 5,000 shares. Aadi paid for his shares in full (£10,000) but Liam only paid £2,500, agreeing to pay the balance of £2,500 in two years’ time. Aadi and Liam are the directors of the company together with Jess, who is not a shareholder.
Acting within her authority, Jess entered into a major supply contract, which has turned out to be a very poor deal and following some difficult times, the company has been unable to pay the supplier, who is owed £18,000. The directors realise that the business will have to be sold. Again, the sale would realise £8,000. Both Aadi and Jess have substantial personal assets, including in both cases, a house and a car. Liam has no substantial assets of his own. The company has no other debts.
Which of the following statements best reflects the position of the supplier in relation to the debt?
A. The supplier will be able to recover £8,000 from the sale of the assets of the company and a further £2,500 from Liam, the amount unpaid on his shares.
B. If Liam is unable to pay the £2,500 which he still owes to the company, the supplier will only be able to recover the £8,000 from the sale of the assets of the company.
C. As Jess entered into the contract, the supplier could bring an action against her for the full £18,000.
D. As Aadi is the major shareholder in the company, he will be liable for the full amount of the debt
B. If Liam is unable to pay the £2,500 which he still owes to the company, the supplier will only be able to recover the £8,000 from the sale of the assets of the company.
That’s right. The correct answer is B. As a company is a separate and distinct legal personality, it is liable for its own debts. The shareholders are only liable up to the amount that they have agreed to invest in the company. Only if the shareholder has not paid the full amount that he has agreed to invest, i.e. some of the amount of the shares remains unpaid, can a shareholder be asked to contribute but only up to the unpaid amount on the shares. Liam can therefore be asked to contribute a further £2,500 which will be paid to the company and which could go towards paying the debt, but the supplier cannot directly recover the £2,500 from Liam This makes B correct and A wrong.
This is regardless of whether or not they own a majority of the shares and/or have control of the company (see Salomon v A Salomon & Co Ltd) . If the company fails, as here, the shares become worthless. If a shareholder has paid in full for his shares, then he cannot be asked to pay any more, so D is wrong.
A company has contractual capacity in its own right, so it is irrelevant that Jess concluded the contract. The contract is between the supplier and the company - a director who has entered into a poor deal will not be personally liable either to the creditor or the shareholders, so C is wrong.
Question 4
Assume for the purposes of this question that Aadi set up a private limited company on his own three years ago. Aadi was issued with 10,000 shares, which he paid for in full. Aadi is the sole shareholder and director of the company.
Recently the company has struggled financially. It has an overdraft of £20,000. When the company agreed the overdraft facility with the bank two years ago, the bank asked for a personal guarantee from Aadi for the amount of the overdraft. Aadi signed a written guarantee agreement with the bank, agreeing to be personally liable for all amounts owed to the bank in the event that the company fails to pay. The company is insolvent and has no assets with which to pay its creditors .
Is the following statement TRUE or FALSE?
As Aadi is a shareholder in the company, he will not be liable for the £20,000 owed to the bank.
That’s right. The statement is false.
Generally, it is the company, as a separate legal entity which is responsible for its own debts. The shareholders are protected by the concept of limited liability. In addition, the directors, although they act as the agents of the company in entering into contracts, e.g. as here, an overdraft agreement, are not personally responsible for those debts.
If you have ever rented a property, you may be familiar with guarantees, in that your landlord might have asked your parents to guarantee that they would pay your rent if you fail to do so. In a corporate context, (particularly with smaller companies, where the directors are usually the shareholders), banks and other financial institutions will often ask for a personal guarantee from a director.
The concept of separate legal personality has not been ignored – it is still the company that is liable for the debt, but Aadi has agreed to pay up under a separate agreement if the company defaults. The rule effectively has been circumvented.
Which one of the following law firms is an unincorporated business entity?
- The City firm, Slaughter and May.
- The City firm, Linklaters LLP
- The Leeds based firm, Clarion Solicitors Limited
- The national group of solicitors’ firms, Gateley plc
- The Cambridgeshire based firm, Copleys Solictitors LLP
Option A is the correct answer. Slaughter and May is not a separate legal entity. It is a partnership, an unincorporated business entity. You will note that size is not relevant. Slaughter and May is an international firm with over 100 partners and has never been incorporated as either a limited liability partnership or a company.
The other options are wrong. These all refer to separate legal entities, or ‘legal persons’, which you can tell from their names: Linklaters LLP is a limited liability partnership, Clarion Solicitors Limited is a private limited company, and Gateley plc is a public limited company. The comparatively small Cambridgeshire firm, Copleys Solicitors LLP, with only four members, has been incorporated as a limited liability partnership.
[Note that here we have referred generically to ‘law firms’ and ‘firm’. s.4 of the Partnership Act 1890 provides that the persons who have entered into business in partnership are collectively called a ‘firm’ (The word ‘firm’ describes in the singular what is, in fact, the partners in the plural.). The partners of Slaughter and May can therefore be described as a ‘firm’. The others are not technically ‘firms’ in the strict legal sense but will often be described as such.]
Which of the following statements best explains the concept of limited liability?
1. A validly incorporated company has its own separate legal personality.
2. A validly incorporated company is not liable for its own debts.
3. The shareholders of a validly incorporated company will be liable for the debts of the business but only to the extent of their investment in the company.
4. The directors of a validly incorporated company will not be liable for the debts of the company.
5. A creditor of a validly incorporated company can choose to sue any or all of the shareholders of the company.
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Option C is correct. An incorporated business has its own separate legal personality. As a separate legal person, an incorporated business is responsible for its own debts. If the company fails, the members lose the money which they have invested in the company, but no more. However, limited liability does not mean that shareholders never have to pay anything – they are still liable up to the amount which they have agreed to invest in the company. This is known as limited liability.
Option A is wrong. Legal personality is not the same as limited liability – limited liability is a consequence of separate legal personality.
Option B is wrong. The company itself has unlimited liability for these debts.
Option D is wrong. Unlike shareholders, directors do not have the benefit of limited liability in their role as directors. They are (generally) protected from liability for the acts of the company, e.g. breach of contract, including non-payment of debts. This is because the company itself, not the directors, is liable. This is not the same as limited liability – it is a consequence of the company’s separate legal personality. [Note that there are circumstances where directors may be responsible for the debtsof the business, but these are rare.]
Option E is wrong. Shareholders are not jointly or severally liable for the debts of the company. Option E wrongly attributes the liability of partners in a general partnership to the company structure.
A client, an entrepreneur, is proposing to set up in business working with two friends. The client wants to do so quickly, with the minimum of formality and to minimise any legal costs. The client wants to be responsible for the day to day management decisions of the business himself. The client will invest £100,000 in the business, which will have minimal borrowings. Neither of the two friends are in a position to make an investment in the business, but they have skills and expertise which will be useful in the running of the business.
Which one of the following would be the best option for the client?
- A general partnership
- A limited liability partnership
- A limited partnership
- A sole tradership with employees
- A private limited company
Option D is correct. There are no formalities for setting up as a sole trader, apart from notifying the tax authorities. The client can simply open the doors and start trading. Sole traders are, however, personally liable for all the debts of the business, so the risk is greater, but the facts indicate that there would be minimal borrowing, so the risk is not substantial and the client is an ‘entrepreneur’ so may be more prepared to assume a higher degree of risk.
Option A is not the best answer. A general partnership would be less suitable as, in the absence of a formal partnership agreement (for which it would be advisable to take legal advice), the partners share responsibility for the day-to-day management of the business. Partners have joint and several liability for the debts of the business.
Options B, C and E are not the best options for the client. Setting up either a private limited company, a limited partnership or a limited liability partnership requires a formal registration process.
[Commercial awareness: The facts state that the client is an entrepreneur, and so may be more prepared to assume a higher degree of risk, but should be warned that the enterprise may become riskier in the future, if, e.g. borrowing is required to expand the business.]
A client runs a catering business with his friend. The business has not been incorporated but both the client and the friend invested equal amounts in the business and the two share profits equally. The client signed a long-term supply contract with a limited company which supplies seafood, for the regular purchase of seafood for the business. The terms of the contract were negotiated with the Purchasing Director of the seafood company by the client’s friend.
Which one of the following options most accurately describes who are the parties to the contract?
- The client and the seafood company.
- The client and the Purchasing Director of the seafood company.
- The client, his friend and the seafood company.
- The client, his friend and the Purchasing Director.
- The client’s friend and the seafood company.
Option C is correct. The catering business appears to be run as a partnership, as it meets the definition in s.1 Partnership Act 1890. The two friends are carrying on a business in common with a view to profit. As every partner is an agent of the firm and the other partners for the purpose of the business of the partnership, the client’s purchase of the seafood binds both the client and his friend. Both are therefore liable under the contract. Accordingly, options A and E are wrong.
Options B and D are wrong. The seafood company, as an incorporated body, can enter into contracts on its own behalf, so it is the company itself that is liable under the contract. The Purchasing Director is an agent of the company so is not personally liable.
A client and her brother are accountants practicing in general partnership. Both the client and her brother invested £10,000 when the firm was set up. There are no other partners. The client’s brother gave a businessman tax advice which turned out to be wrong. The firm has admitted negligence and has agreed to settle the dispute and pay the businessman £30,000 to compensate for the loss. The firm does not have sufficient assets to pay the debt.
Will the client be personally liable for the debt?
- Yes, because the client is a general partner with one other, the client will be liable for his half of the debt, £15,000.
- Yes, because the client is a partner in a general partnership, the client will be liable for the full £30,000.
- Yes, because the client invested £10,000 in the firm, the client will be liable for £10,000.
- No, because it was the client’s brother who gave the advice.
- No, because the client will have the benefit of limited liability.
Option B is correct. Partners have unlimited liability for the debts of the partnership and are jointly liable for the full amount of the debt.
Options A and C are wrong. Joint liability does not mean that partners are only liable for half of the debt and, unlike shareholders, their liability is not capped at the amount of their investment in the company.
Option D is wrong as partners are jointly and severally liable, regardless of who concluded the contract.
Option E is wrong. The liability of a partner for the debts of the partnership is unlimited, not limited.
Two friends have set up a private limited company, which is a client of the firm. The friends are both shareholders in the company and have paid in full for their shares in the company. One of the shareholders is also the Managing Director. There is one other director, the Finance Director, who is not a shareholder.
The Managing Director has transferred an item of equipment to the company in exchange for shares.
The Finance Director has entered into a contract with the Sales Manager of a computer company to purchase two laptops, with delivery due in three days and payment in cash within 28 days of delivery.
Which of the following statements best describes the position in relation to these transactions?
- The client company will own the laptops but not the item of equipment.
- The parties to the contract for the purchase of the computers will be the Finance Director and the Sales Manager of the computer company.
- The parties to the contract will be the two shareholders of the client company and the shareholders of the computer company.
- If the computer company fails to deliver the computers, the client company can bring an action for breach of contract in its own name.
- If the client company cannot pay for the computers at the end of the 28 day credit period, the shareholders will be personally liable to pay the full purchase price.
Option D is correct. A company is a legal person in its own right and can therefore do most of the things which a human person can do, including entering into contracts, owning property and, as here, bringing an action for breach of contract in its own name.
Option A is wrong. The item of equipment has been transferred to the company and paid for by the company issuing shares to the Managing Director, so it will own that item and also the computers (which will be paid for in cash).
Options B and C are wrong. As companies can enter into contracts in their own name, the client company and the computer company themselves – not the directors, shareholders or employees – will be the parties to the contract.
Option E is wrong as the company is liable for its own debts. The shareholders have limited liability for the debts of the company, and are not personally liable.
A company makes yoghurts and other dairy products. It has four shareholders who are also the four directors of the company. It has a company secretary. The company is profitable. It has outgrown its existing premises and needs to move to a larger factory. Two of the directors negotiate the purchase of a new large factory on an industrial estate on the edge of the town. The same two directors sign the contract and transfer document on behalf of the company.
Which of the following best reflects whose name(s) will appear on the registered title of the property?
- The names of the two directors who signed the contract and transfer document.
- The names of all the directors.
- The names of one of the directors and the company secretary.
- The names of all the shareholders.
- The name of the company.
Option E is the correct answer. The company is a separate legal person capable of owning all property, including land in its own right.
Options A, B and C are wrong. The directors who signed the documentation are acting as agents of the company in the transaction, and have done so on behalf of the company.
Option D is wrong. The shareholders own shares in the company, which give them certain rights, including a right to a share of the assets of the company when it is wound up, but they do not own its assets (including land) themselves.
