Liability of Debt

Debt is a necessary part of maintaining good financial health for many businesses and individuals. But debt also puts the borrower in a position of accepting liability for the borrowed money. The liability of debt, including who is responsible for paying it back and under what circumstances, involves many areas of law and is important or both lenders and borrowers to understand in order to make fiscally responsible decisions.

Loan Agreements

Liability of debt falls under legal regulations based on the type of debt as well as the loan agreements lenders and borrowers sign. These agreements define the liability for debt and include terms, such as how long the borrower has to pay back the debt, what the rate of interest will be and under what conditions the lender can take possession of any property the borrower puts up at collateral. Loan agreements are subject to contract law, which means neither party can attempt to defraud the other without risking the validity of the loan agreement.

Limiting Liability

Several types of business structures offer limited liability for a business's owners. Corporations and LLCs, or limited liability companies, have legal protection that shields the owners' personal assets and keeps them separate from business debt. This allows owners to take risks on behalf of the business without risking their personal finances. Business structures also prevent personal debt from affecting a business' standing.

Piercing the Corporate Veil

In some cases, a court may hold a business owner personally liable even if there is a limited liability arrangement. This process is known as piercing the corporate veil and it can only occur when the owner is directly involved in fraud or other illegal activity that causes a business to incur debts or to be unable to pay off legitimate debts. In these cases, the owners may be liable for business debts and their assets, including property and investments, may be seized to repay the business' lenders.

Bankruptcy

When an individual or business files for bankruptcy, the issue of debt liability determines how the court discharges debt and what it means for the borrower. Upon filing for bankruptcy a borrower receives a stay, which means lenders can't take legal action against the borrower regardless of liability. Bankruptcy courts must honor the correct order of repayment based on the borrower's liabilities; for example, the first lenders to be repaid are those with secured debts backed by property the borrower still owns, while unsecured debts have a lower order of liability and are paid back later, if at all.