Corporate Secretarial: Using A Front Company As Risk Management Tool
In our earlier posts, we had written about the type of business structures in Malaysia and also discussed about the company’s legal personality which is separate from its shareholders. In this post, we are going to focus on the corporate manoeuvre of using the principle of company’s separate legal personality (See Types of business structures in Malaysia) to manage corporate risk.
A company in an active trade will always face the unavoidable risk of failure in its business ventures. However, any seasoned businessmen will tell you this, just because the risk is unavoidable does not mean it cannot be managed.
Be that as it may, it is unfortunate that some novice entrepreneurs take the position that the failure of a company’s business ventures will not affect them much since their liability is only in respect of their shares (usually limited by shares) and because of the separate legal personality concept, they will not be liable for the company’s debt.
Such thinking is not entirely wrong. However, it must be noted that if the company become insolvent due to its inability to pay debts, all of the company’s asset will be used to repay its debt to the creditors.
On the surface, the abovementioned circumstances seem pretty normal. In fact, some may even argue that is how it is supposed to be.
However, consider this hypothetical situation. Company A have assets worth RM 10 million. It then conducts a business trade with a projected cost of RM 2 million. When the business venture fails, the company suffers unexpected liabilities such as lawsuits, interests on debts etc worth (as an example) RM 1 million. In addition to the cost of RM 2 million, the company also have to bear the cost for the unexpected liabilities for RM 1 million.
If Company A does not manage the corporate risk, it will only take Company A few similar business ventures to bring it down. When Company A becomes insolvent because of the failed business ventures, it has to use its assets to repay all of its liabilities.
In such case, the shareholders of Company A will have to start all over again and contribute tens of millions to start another company with similar financial standing with Company A before the failure business ventures.
Managing Business Risks
One of the methods to manage such risk is by incorporating a front company. With the help of a corporate secretary in Johor Bahru, big corporation will usually incorporate a front company as a special purpose vehicle to conduct its business venture. When a company owned or is a shareholder of another company, the former is then known as a holding company e.g. Company A incorporate Company B and holds 100% shares of Company B. Company A is the holding company whereas Company B is the subsidiary company.
While a front company may not be able to reduce the risk of failure in any business venture, it is able to mitigate the devastating effect of a failed business venture. This is because the concept of separate legal personality still applies. This means, unless the exception to the principle of separate legal personality applies (e.g. fraud), Company A cannot be made liable for Company B’s debt. So, how does Company B mitigates the devastating effect of the business venture? Here’s how.
Consider the earlier hypothetical situation. Instead of conducting the business trade with projected cost of RM 2 million by itself, Company A incorporates Company B with RM 2 million as its capital and have Company B conducted the business venture.
When the business venture failed and Company B incur unexpected liabilities mentioned earlier, Company B can apply for dissolution. In such event, all of Company B’s assets will be used to repay its creditors. Company B’s cannot claim from Company A if Company B’s assets is insufficient to repay the debts.
Therefore, instead of losing more than it should, Company A only lose out RM 2 million and this all become possible just by incorporating company in Johor Bahru.
However, it must be noted that the explanation of the abovementioned corporate manoeuvre has been simplified. In practice, such corporate manoeuvre is usually executed under professional corporate secretarial advice.
Risk of failure is part and parcel of business world. Opportunities for gain also entail the risk for loss. In order to thrive in such environment, one must be smart to manage the risk, at the same time satisfy statutory compliance. They who failed to manage the business risk in corporate practice are destined to fail since the most important traits needed to survive in the business world is the capability to overcome and withstand financial challenges.