*LET ENTREPRENEURS BEWARE!!
UNDERSTANDING LEGAL ATTRIBUTES OF BUSINESS
VEHICLES. THE IMPORTANCE FOR MALAYSIAN SMES
ENTREPRENEURS.
Zuhairah Ariff Abd Ghadas (Dr.)
Assistant Professor
Ahmad Ibrahim Kulliyah of Laws
International Islamic University Malaysia
Abstract
In all business, there will always be business risks faced by entrepreneurs, be it calculated
or uncalculated risks. Other than finding the right investments or business, it is also
important for businessmen to know the means to minimize liability in the business. In
such a matter, the choice of business vehicle is vital. At present, the Malaysian market
place offered sole proprietorships, partnerships and companies structure as options of
business vehicles. With the expansion of business structures, particularly in the
developed country and the inherent effect of globalization, local entrepreneurs need to be
ready for the possibilities and opportunities of practicing new business vehicles. This
paper discusses legal framework of present business vehicles that are available for
Malaysian entrepreneurs; focusing on limitation of liability. This paper also intends to
highlight development of business vehicles which are relevant and important for
Malaysian SMEs entrepreneurs.
Keywords: Business Vehicles, Limited Liability, Entrepreneurs.
Introduction
In Malaysia, the SMEs are grouped into three categories: Micro, Small, or Medium.
These groupings are decided based on either :1
•
the numbers of people a business employs OR
•
the total sales or revenue generated by a business in a year
I. Based on the number of full-time employees:
Primary Agriculture
Manufacturing
Services
Sector
(including Agro-Based)
(including ICT**)
& MRS*
Micro
Less than 5 employees
Less than 5 employees
Small
Between 5
employees
&
19 Between
5
employees
&
50 Between 5
employees
&
19
Medium
Between 20
employees
&
50 Between 51
employees
&
150 Between 20
employees
&
50
Less than 5 employees
II. Based on annual sales turnover:
Primary Agriculture
Manufacturing
Services
Sector
(including Agro-Based)
(including ICT**)
& MRS*
Micro
Less than RM200,000
Less than RM250,000
Small
Between RM200,000 & Between RM250,000 & Between RM200,000 &
less than RM1 million
less than RM10 million
less than RM1 million
Medium
Between RM1 million Between RM10 million & Between RM1 million
& RM5 million
RM25 million
& RM5 million
Less than RM200,000
The role of Small and Medium Enterprises (SMEs) in the Malaysian economy is
undoubtedly important. It assumes a significant role in the country’s industrialization
program as it represents the largest percentage of establishments at 99.2 per cent. In terms
of its' economic contribution, SMEs contributes 32 per cent to Gross Domestic Products,
56.4 per cent to total work force and 19 per cent to total exports.2 Based on Census on
Establishments and Enterprise 2005, there are a total of 552,849 companies in
operations.3 Out of this, a total of 548,307 or 99.2 per cent were defined as Small and
Medium Enterprises (SMEs).4
1
Retrieved from http://www.smidec.gov.my/, March 2008..
Statistics, retrieved from http://www.smidec.gov.my/, March 2008.
3
Ibid.
4
Ibid.
2
Acknowledging the significance of SMEs as main contributors to our economy, it is
important to prepare the existing and future entrepreneurs with good business planning
and one of the ways to do this is by exposing them to the right business vehicles.
This paper will discuss option of business vehicles which are presently available for the
Malaysian SMEs entrepreneurs and how they cater to limit the entrepreneurs’ liability in
business. This paper also intends to highlight the development of business vehicles in
relation to limited liability and to propose for additional option of business vehicles to be
introduced to our SMEs entrepreneurs.
Business vehicles
Carrying out trade in any countries all over the world would require certain medium to
deliver business to the market. These medium are generally known as business entity or
business vehicles or business organization. According to Ronald Coarse (1937)5, all
business organizations represent an attempt to avoid certain costs associated with doing
business. Each is meant to facilitate the contribution of specific resources, investment
capital, knowledge and relationships towards a venture which will is profitable to all
contributors.
To select a business vehicle which is most suitable to them, the entrepreneurs should
consider few important aspects:6
1.
Cost: Cost not only refers to the cost of creating the business entity, but also the
cost of maintaining it.
2.
Maintenance: This refers to how much work needs to be done in maintaining the
business. Some entities do not require maintenance once they have been
established. Others require serious record-keeping effort in order to comply with
state regulations.
3.
Tax Liability: Some business entities will save money on the income taxes by
passing the income directly to the owner. This way, the owner avoids his money
being taxed twice (once when paid to the company and once when paid to the
owner through a paycheck or dividend.)
4.
Legal Liability: Some business entities protect their owners from personal
liability against legal claims in the due course of the business.
5.
Ownership: Different entities have different rules as regards to ownership. This
is important to think about if there is a plan of going public.
In the Malaysian market place, the option for business vehicles are merely confined to
the traditional structure, namely, sole proprietorships, partnerships and companies
structure.
A sole proprietorship refers to one man business whilst a partnerships structure connotes
a business which comprises two or more business partners with a view to share the profit.
Both sole proprietorships and partnerships are unincorporated business association.
Another business vehicle which is available in the market place is the company structure.
A company can be registered as a private or public company and either with a limited or
unlimited liability. A limited company, either by shares or guarantee is particularly
5
6
Ronald Harry Coase, The Nature of Firm (1937)
Retrieved from http://www.nolo.com/article.cfm/, March 2007
famous to entrepreneurs as it provides maximum limited liability whereby members are
only liable up to the amount of the unpaid shares or guarantee. The company being a
separate legal person has to bear its own liability and cannot make the members liable for
more than their contribution to the capital, As long as the members had fully paid up their
shares or guarantee to the company, they cannot be made further liable for debts of the
business. Another pulling factor, which attracts entrepreneurs to opt for this vehicle, is
the tax incentives offered by the Government, which are not available to other business
vehicles.
Legal attributes
All business organizations represent an attempt to avoid certain risks associated with
doing business. They are also introduced to facilitate the contribution of specific
resources whether in the form of investment capital, knowledge or relationships.7 For
example, in limited liability companies, the fact that they have separate legal entity
entitled the members to limit liability in business whilst in sole proprietorships and
general partnerships, they can not provide limited liability as they have no legal entity.
However, despite the disadvantages of unlimited liability, both sole proprietorships and
partnerships structure offer flexibility in internal regulation and less formalities in
registration whilst the companies structure are heavily regulated and requires formalities
in incorporation.
Another legal attributes of business vehicles which is important is transferability of
interest as it indicate the flexibility of the internal management. In the non legal entity
structure such as partnerships and sole proprietorship, the transferability of interest
generally depend upon the owner’s/ partners’ agreement. Whilst in the company
structure, transferability of interest is subject to the company Article of Association.
This paper focus mainly on the attribute of limited liability as it is one o
Liabilities in Business .
From the legal perspective, there are two type of liability which may arise in business:
(a)
Internal liability
(b)
External liability
Internal Liability
The contractual liability may arise internally, between the partners or members inter-se of
a firm or company, respectively. In a partnership firm, the relations of partners are
heavily regulated by the partnership agreement. As such partners are bound by the
contractual principles between themselves and may take action against one another if
there is a breach of the partnership agreement.
A firm of partnership may also take action against the partners and vice versa for breach
of the partnership agreement as there is an agency between the firm and the partners. The
firm constitutes as the Principal and therefore liable for any contract entered by the
partners on its behalf whilst partners are agent to the firm and therefore liable for any
breach of fiduciary duties to the firm.
Nonetheless, the partners are given the freedom to decide measures to regulate their
internal matters. As such in limiting risks for certain liabilities, the partners can construed
7
Business Organization. Retrieved from http://en.wikipedia.org/wiki/Business_entity , March 2008.
the partnership agreement in the best form possible, for example, by restricting some or
all partners from involving in certain transaction and including an express term which
clearly define the maximum limit of transactions in which the partners can enter.
For members in a company, the memorandum of association and article of association
constitute as contract between each other and also between the members with the
company.8 The members have contractual rights to enforce terms of the MA and AA
against the members inter se or against the company. As the internal regulation9 of a
company is not as flexible as in a partnerships, the internal disputes between members
inter-se or between the members with the company may have to be brought to court
unless there is an express arbitration clause in the MA or AA which requires the internal
matters to be amicably settled by arbitrator before the case can be brought to the court.
For sole proprietorship, there is no issue of internal liability as the business is owned by
one man who is only subjected and liable to himself or herself.
External Liability
This liability generally relates to the third parties. In the company’s structure, with the
separate legal entity distinct from its members, liabilities of the business shall be borne
by the company.10 The third parties can not take legal action against members of the
company for debts of the business. In fact, upon winding up of the company, payments of
the debts are made according to priority of creditors.
In sole proprietorships, the owner will be personally liable for all the creditors claims
made against the business as the enterprise and the owner is not distinct from each other.
In a partnership, the third party’s rights against the firm lie in the principle of agency. As
long as the partners entered into the transaction ( with a third party ) within their
‘authority’, the firm will be liable for the transaction as the principal. The outsiders are
entitled to assume that an agency exists between the individual partners and that what one
partner does or says automatically imposes obligations on all others.11 In Re
Agriculturists Insurance Co., James L.J explained the application of agency rule in
partnership: 12
“As between the partners and the outside world, (whatever may be the private
arrangements between them), each partner is the unlimited agent of every other in every
matter connected with the partnership business, and not being in its nature beyond the
scope of the partnership. A partner who may not have a farthing of capital left may take
money or assets of the partnership to the value of millions, may bind the partnerships by
contracts of any amount, may give the partnership acceptances for any amount, and may
even involve his innocent partners in unlimited amounts for fraud which he has craftily
concealed from them.”
8
Hickman v Kent [1915] 1 Ch 881, Rayfield v Hands [1960] Ch 1
Alteration of the article of association must be properly done subject to the Companies Act. Refer to
section 31 of Companies Act 1965.
10
Salomon v A Salomon & Co.Ltd [1897]AC 22
11
Stephen Graw, An Outline of the Law of Partnership, The Law Book Company Ltd, 1994 at 52.
12
[1870] LR 5 Ch.App.725 at 733.
9
A partner who creates a contractual responsibility for his firm subjects it to a single joint
obligation binding all the partners, including him. Consequently, a partner who has
contracted on behalf of his firm is jointly liable with his co-partners and has no separate
individual responsibility.13
Limited Liability
The concept of limited liability was introduced two hundred years ago in order to enable
the large scale investment necessary for the Industrial Revolution to take place.14 With
the severance of investment in the business from the management of that business there
was considered to be a need for the protection of the investors, who were often
individuals with a relatively small amount of capital, from the possible fraudulent actions
of the managers of the business.15 This paved the way for the attraction of many more
investors, thereby enabling the growth in size of the business enterprises, with those
investors secure in the knowledge that they were protected from any loss greater than the
sum they had invested in the enterprise. Thus for relatively small levels of risk they were
able to expect potentially great rewards and thereby escape from some of the
consequences of the actions of the enterprise. In short, limited liability encourages
entrepreneurial risk-taking, which encourages economic growth.
Limited liability is normally justified by its economic benefits, which include:16
(a) the decreased cost to shareholders of monitoring the actions of managers;
(b) the increased incentive to managers to act efficiently and in the interests of
shareholders by promoting the free transfer of shares;
(c) the increased efficiency of securities markets since share trading does not
depend on an evaluation of the wealth of individual shareholders, only the
company itself;
(d) its encouragement to shareholders to hold diverse share portfolios, thereby
permitting companies to raise capital at lower costs because of the
shareholders’ reduced risks; and
(e) the facilitation of optimal investment decisions by managers by pursuing
projects with positive net present values rather than being concerned with the risk to
shareholders that such projects may bring.
From the legal perspective, limited liability of business enterprises is conceived from the
principle of separate legal entity. For example, in a company structure, limited liability
flows from the fact that the companies are vested with a distinct legal personality by law
when properly incorporated, and as such, the debts of the incorporated entity are distinct
from the personal assets of the entrepreneur. In other words, the personal estate of the
13
Ex p Wilson (1842) 3 Mont D & De G 57; Ex p Buckley (1845) 14 M & W 469.
David Crowther, Limited Liability = Limited Risk = Limited Accountability. Retrieved from
http://www.le.ac.uk/ulmc/research/crowther.pdf, February 2008.
15
Ibid
16
Easterbrook and Fischel The Economic Structure of Corporate Law, Harvard University Press, 1991, pp.
41–4. Summarized in Ford’s Principles of Corporations Law at [4.160]).
14
entrepreneur cannot be attached or utilized by creditors of the incorporated entity, in
order to settle amounts owing by the incorporated entity to such creditors. This is perhaps
one of the greatest advantages of an incorporated entity.
Business Vehicles and Limited Liability
(a) Sole Proprietorship
In a sole proprietorship, the business is generally run and own by a single person who
will have to bear all liabilities of the business. Despite the sole debt bearer element, the
merits of setting up sole proprietorship is that all profits goes to the owner and the
decision making power is vested solely in him/herself. It is a well known fact that one of
the reasons why people set up business is to be their “own boss”, then sole proprietorship
is a good choice of business vehicle as the business is owned by him/herself without any
intervention from any other person. For the small and cottage businesses, sole
proprietorship is normally the most opted vehicles, particularly due the small-scale
business, minimum business risk and small return of profit. The advantages of this
business vehicle are its simplicity, less formalities and minimum restrictions whilst its
main disadvantages are unlimited liability and possible difficulty in raising capital.
Limitation of liability in sole proprietorship is only available through management of the
business risks by the owner him/herself whereby the extent of business liabilities will
depend upon the owner own resolve to take up any business risk. If the entrepreneur is
willing to bear big debts for a bigger return then he/she must be ready to accept bigger
liability or larger business debt. The best method to limit liability in this business
structure is to know more about the business venture/s so that both the calculated and
non-calculated risk can be foreseen and evaluated. Another method in limiting liability in
sole proprietorship is to acquire good managerial skill so that the business risks can be
minimize through good management of business.17
(b) Partnerships
Another business vehicle, which is common in Malysia is the partnerships structure. In
this type of business vehicle, the business normally comprised of two or more business
partners who pooled their resources in a business with a view to share the profit. A
partnership as a business vehicle is easy to organize because it has internal flexibilities
and combines skills and financial strengths of more than one person. The main
disadvantage of partnership structure is the unlimited liability faced by each partner.
In a partnership structure, partners cannot limit their liability in business in whatever
circumstances. This is why partnerships structure is link to the doctrine of unlimited
liability. Partners are “equally” liable for the business liabilities even though he /she were
ignorant on certain or all transactions of the firm. The partners are collectively liable for
debts and liabilities of the firm as long as they hold the position of a partner in the firm.
In fact, the liabilities are extended to the estate of a deceased partner provided that the
firm incurs the debts during his/her lifetime as a partner.18
17
For example minimizing the operational cost and an efficient delegation of work may reduce some of the
unavoidable business debts.
18
Bagel v Miller [1903] 2 KB 212
The extent of unlimited liability of partners in partnership also covers up to their personal
assets. This means, when the partnership’s assets are not sufficient to pay the business
debts, partners will be personally liable to settle debts of the firm. As such, personal
property of partners can be seized to settle the business debts when the firm’s fund is
insufficient. This is why it is common for a formal partnership agreement being drawn up
either by the partners or by legal counsel, which outlines the responsibilities of each
partner, conditions of termination and means of resolving intra-partner disputes. By
construing the partnership agreement in the best form possible the partners might be able
to put a ceiling limit on the amount of transactions in which the partners can enter or
terms which caution each other from entering into transactions that have high business
risks.
In most of the developed countries, the partnership structure has undergone a rapid
development, from general partnerships to limited partnership and limited liability
partnerships.
(c ) Companies
The most popular business vehicle in the market place is the companies’ structure. A
limited company, either by shares or guarantee is particularly famous to entrepreneurs as
it provides maximum limited liability whereby members are only liable up to the amount
of the unpaid shares or guarantee. The company being a separate legal person has to bear
its own liability and cannot make the members liable for more than their contribution to
the capital, As long as the members had fully paid up their shares or guarantee to the
company, they cannot be made further liable for debts of the business.
Development of Business Vehicles
The development of business vehicles in relation to limited liability is very obvious in
partnerships structure amidst the criticism of the unlimited liability principle and double
application of agency rule. From merely the traditional form (general partnerships), the
structure has been expanded to include limited partnerships and limited liability
partnerships (LLP).
A limited partnership differs from a general partnership in the role and responsibilities of
the partners. Limited partnerships comprise of the general and limited partner.19 The
general partner controls the limited partnership's day-to-day operations and is personally
liable for business debts.20 Limited partners on the other hand, have minimal control over
daily business decisions or operations and in return, they are not personally liable for
business debts or claims.21
Another fascinating structure which is said to be an extension of partnership structure is
limited liability partnerships (LLP).22 However, to conclude that the LLP is a partnership
19
Terence Prime and Gary Scanlan, The Law of Partnership, (Butterworths, London, 1995) at p 342.
For example under the Limited Partnership Act (UK) 1907; s4 (2), Labuan Offshore Limited
Partnerships Act 1977; s 9(1).
21
Limited Partnership Act (UK) 1907; s 6(1). In Labuan Offshore Limited Partnerships Act 1977; s 11
provides the rights which limited partners have which did not include right in management.
20
22
For UK LLP, see http://www.companieshouse.gov.uk/infoAndGuide/llp.shtml for detail information on
LLP.
structure is not very accurate as it is actually a hybrid creature of a company and a
partnership. It has a separate legal entity and therefore enjoys most of the attributes of a
company such as limited liability, right to own property and right to take legal action.
The external obligations of LLP are also similar to requirements applicable to companies
such as audit and disclosure requirements. However, as regards to its internal regulation,
LLP has the flexibility of a partnership, as the members are given the right to decide
through the members’ agreement.
Despite the similarities in the external and internal regulations, there are two types of
LLP. The first type of LLP has the status of a partnership whilst the second type of LLP
has the status of a body corporate. Examples of the first type of LLP are United States
LLP23 and the UK’s offshore LLP24 whilst examples of the second type of LLP are the
Singapore LLP25 the UK LLP26.
For the company structure, the development in relation to limited liability can be said to
be oblivion as it is an inherit attributes of a company structure. However, in the United
States of America (USA), a country where the business vehicles went through a vigorous
expansion, other than the common form, the company structure has been extended to
include S-Corporations and limited liability companies (LLC). Both structures have the
status of a body corporate but different tax status. For the S corporation, it has similar
attributes, external responsibilities and internal regulations of a company but the
members have the option to pay income taxes similar to sole proprietor or a partner.27
The LLC structure is generally similar to the LLP whereby it combines the best attributes
of a partnership and a corporation. It has the status of a body corporate which entitled the
members the limited liability protection and can choose either to be tax either as a
company or as an individual.
Proposals
In today’s business world, small, medium and big companies play significant roles in the
economy. With consumers and clients becoming more demanding and aware of their
rights, legal actions are unpredictable. One the mechanisms to minimize the business risk
are by choosing the correct business vehicle, which provides limited liability. At present,
the option of business vehicles, which are available in Malaysia, are merely confined to
the traditional business vehicles, namely, sole proprietorships, partnerships and
companies. Among these three options, only companies’ structure is able to provide
limited liability to the members. For sole proprietorships and partnerships, the
entrepreneurs are subjected to unlimited liability in business which exposes them to
maximum business risks.
It is highly proposed that option of business vehicles, which provide limited liability for
the local entrepreneurs are expanded to include limited partnerships, LLP and LLCs. For
the small and cottage entrepreneurs, the limited partnership or the LLPs structure are seen
23
See Chapter 614 Uniform Partnership Act. Limited Liability Partnerships.
For example, the Jersey LLP. See Jersey Limited Liability Partnerships Law 1997.
25
See Singapore Limited Liability Partnerships Act 2005; s 4(1)
26
Limited Liability Partnerships Act (UK) 2000; s.1 (3).
27
. Retrieved from http://www.nolo.com/article.cfm/, March 2008.
.
24
to be more suitable as both requires less formalities in formation and operation.
Furthermore with the internal flexibilities of management, the entrepreneurs can manage
the business on their own or with small number of partners but still enjoy limited liability.
As for medium and big scale entrepreneurs, who can afford both the cost and operational
cost of a company, LLCs might be a good option if the business or the owners can gain
better advantage to be tax for as individual rather than as a company. A good tax
planning is another mechanism to increase profits margin in business other than limiting
the business risks.
It is observed that the main impetus behind any change in the market place is the
entrepreneurs themselves as the main actor and actresses. As such, in proposing for
expansion of business vehicles in Malaysia, the entrepreneurs must play the main role by
addressing the importance and needs for the changes to the relevant agencies,
organizations and ministries. Having a strong business support groups or association is
vital as collective action is always better than an individual or personal action.
Increasing knowledge in all aspects of business including development in other countries
particularly the developed countries with strong economy will obviously assist the local
entrepreneurs in addressing the proposal to the government on the needs for a change or
expansion in the local market place.
Finally and most importantly, the Malaysian government, through respective agencies
and ministries must open and ready to facilitate and improve the condition of the local
entrepreneurs. One of the ways is to enact new regulations and laws which allows
expansion of business vehicles from the traditional structure to the new ones, particularly
those which provide limited liability and able to minimize business risk. It is in the
writer’s opinion that by providing business vehicles, which minimize business risks,
more people, with or without big capital, will be attracted to participate in the business
and become entrepreneurs. It is strongly felt that the Malaysian government should start
to look into ways and means to introduce these new and developed business vehicles not
only to expand the local economy but also as a preparation for the consequence of
globalization.