Limited liability and corporate personality

Question 1

Limited Liability

Answer 1

There is a distinction between two groups of trading structures: those (sole traders and partnership) where there is no distinction between the assets of the owners and the business when faced with claims from creditors, and those (private and public limited companies) where the assets of the owners and the business are entirely separate, thereby protecting the personal assets of the owners from the claims of the company’s creditors. Another way of expressing this is that, in the first category, the liability of the owners in ‘unlimited’ whereas, in the second category, it is ‘limited’. The availability of ‘limited liability’ is one of the most important incentives to set up company.

Question 2

Key statute: Insolvency Act 1986, Section 74(2)(d)

Answer 2

In the case of a company limited by shares, no contribution is required from any member exceeding the amount (if any) unpaid on the shares in respect of which he is liable as a present or past member.

Question 3

Limited liability contd

Answer 3

This means that the only money for which the shareholders may be pursued is any amount which remains unpaid on any shares which have been bought ‘partly paid’. Therefore, under normal circumstances, even if the company’s debts run to millions of pounds the shareholders cannot be asked to pay more.
In a company limited by guarantee, the amount which members must pay is the sum which they agreed (or ‘guaranteed’ to pay) when the company was incorporated.

Question 4

The incentive of limited liability

Answer 4

For those wishing to invest in companies, the assurance that their liability will be limited is a powerful incentive as it means that entrepreneurs can form companies safe in the knowledge that, if the company fails, their personal assets will be safe. This can be contrasted with the sole trader or member of a partnership, who may find themselves declared bankrupt as creditors pursue claims against them.

Question 5

Limited liability - note that..

Answer 5

Although limited liability protects the owners of companies, it does little to help the company’s creditors and customers who, ultimately, bear the losses when the company fails. By contrast, the owners can, effectively, walk away from the debts and then set up a similar company, sometimes from the same premises. Such ‘phoenix companies’ have a clear potential for fraud and there are concerns that it is too easy for incompetent or dishonest business owners to misuse limited liability.

Question 6

Corporate personality

Answer 6

The concept of limited liability requires a distinction to be made between the assets of the individual shareholder and the assets of the company itself. For the company to be able to own its assets it must have a legal capacity separate from its owners. This is known as corporate personality.

Question 7

Corporate personality - Key definition

Answer 7

The separate legal status of a registered company which provides it with an identity which is separate from that of its members, shareholders and employees.

Question 8

Salomon v Salomon & Co Ltd - Facts

Answer 8

Salomon had for many years made boots and shoes as a sole trader before deciding to register the business as a limited company. The vast majority of the shares were held by Salomon and one share each held by six other members of his family. He then sold his business to the company. This was paid for by the company paying cash to Salomon and his family and by secured debenture (i.e. a debt) of £10,000 to Salomon personally. When the company failed, the liquidators argued that the debenture (which would take priority over the other debts) was invalid as Salomon and the company were effectively one and the same and so the debenture represented a debt to himself, which was impossible in law.

Question 9

Salomon v Salomon & Co Ltd - Legal principle

Answer 9

Held: the House of Lords held that the debenture still took priority over the other debts of the company as it was a separate legal entity, completely distinct from its members. Therefore, it could owe money to its members and, accordingly, the debenture in favour of Salomon was valid. Lord Herschell: ‘It is to be observed that both courts treated the company as a legal entity distinct from Salomon and the then members who composed it, and, therefore, as a validly constituted corporation.

Question 10

Corporate personality - Tip

Answer 10

Salomon remains the single most important decision in company law. As such, you must be able to explain both the facts and the significance of the case.

By the third time the case was heard, the debenture had been transferred to a third party: however, this was held to be irrelevant. The third party was equally entitled to the security conferred by the debenture.

Question 11

Effects of corporate personality

Answer 11

Although limited liability is the most important consequence of corporate personality, there are others:

1. The company can sue and be sued in its own right.
2. The company can be a party to contracts (e.g. to buy and sell goods and to employ staff).
3. The company can continue to function after the death of a shareholder.

Question 12

Macaura v Northern Assurance Co [1925] AC 619 (HL) -

Facts

Answer 12

Macaura sold all of the timber on his estate to a company. He owned almost all of the shares in the company. He insured the timber in his own name but, when the timber was destroyed in a fire, the insurance company refused to pay him, claiming that the timber belonged, not to him, but to the company.

Question 13

Macaura v Northern Assurance Co - Legal principle

Answer 13

Held: the House of Lords held that the insurance company was correct. The policy would only be valid if the timber belonged to Macaura. However, as it belonged to the company, only the company could insure it. Lord Sumner: ‘It is clear that the appellant had no insurable interest in the timber described. It was not his. It belonged to the company’.

Question 14

Lee v Lee’s Air Farming Ltd [1961] AC 12 (PC) - Facts

Answer 14

Lee owned all but one of the company’s shares and was a director. He was killed in a work-related accident but the company’s insurers refused to pay compensation as they claimed he could not be an employee of the company. As he owned so much of the company this would amount to him making a contract with himself.

Question 15

Lee v Lee’s Air Farming Ltd - Legal principles

Answer 15

Held: the House of Lords held that, on the basis of Salomon, there was nothing to prevent the company (as a separate legal entity) from employing Lee. Therefore, his estate was entitled to compensation. Viscount Simonds: ‘The company and the deceased were separate legal entities’.

Question 16

The ‘veil of incorporation’

Answer 16

The law recognises a separation between the assets of the company and those of the members. The barrier between the two has become known as the veil of incorporation.

Question 17

Lifting the veil

Answer 17

There are a number of instances where the courts are prepared to ignore the veil of incorporation and hold members personally liable for the debts of the company. Such exceptions to the general principle in Salomon are known as ‘lifting the veil’ and can be found in both statute and common law. There are, however, two common features to all of the recognised exceptions:

1. They are designed to prevent the protection of limited liability being abused to perpetrate fraud or other wrongdoing.
2. They will only apply to members of the company who actually created the situation (i.e. directors).

Question 18

Statutory exceptions - Fraudulent trading

Answer 18

One obvious example of conduct which might lead the court to ignore the veil of incorporation is where the company has been created or managed in order to commit fraud.

Question 19

Statutory exceptions - Fraudulent trading - Key Statute

Answer 19

INSOLVENCY ACT 1986, SECTION 213
If in the course of the winding up of a company it appears that any business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person, or any fraudulent purpose … The court, on the application of the liquidator may declare that any persons who were knowingly parties to the carrying on of the business in the manner above-mentioned are to be liable to make such contributions (if any) to the company’s assets as the court thinks proper.

Question 20

Statutory exceptions - Fraudulent trading

Answer 20

The fact that the law will not allow companies and limited liability to be used to commit fraud is unsurprising but it should be noted that fraud is often difficult to prove and required evidence of real dishonesty.

Question 21

Statutory exceptions - Fraudulent trading - Key Case

Answer 21

RE PATRICK LYON LTD [1933] All ER Rep 590 (Ch)
Facts - A director of the company carried on the business and delayed liquidation of the company for six months after the issue of certain debentures to himself in order to deprive the unsecured creditors of the company of the right to challenge the debentures under section 266 of the Companies Act 1929.
Legal Principle - Held: Maugham J: ‘I will express the opinion that the words “defraud” and “fraudulent purpose”, where they appear in the section in question, are words which connote actual dishonesty involving, according to current notions of fair trading among commercial men, real moral blame’.
(Note the above decision concerned the earlier comparable provisions under the Companies Act 1929.)

Question 22

Statutory exceptions - Wrongful trading - Key statute

Answer 22

INSOLVENCY ACT 1986, SECTION 214.

(1) If in the course of the winding up of a company it appears that subsection (2) of this section applies . . . the court, on the application of the liquidator, may declare that that person is to be liable to make such contribution (if any) to the company’s assets as the court thinks proper.
(2) This subsection applies in relation to a person if -
(a) the company has gone into insolvent liquidation,
(b) at some time before the commencement of the winding up of the company, that person knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, and
(c) that person was a director of the company at that time.

Question 23

Statutory exceptions - Wrongful trading - Key Case

Answer 23

RE PRODUCE MARKETING CONSORTIUM LTD [1989] BCLC 520 (Ch)
Facts - The directors of a fruit importing company had continued to trade, despite their company being technically insolvent, in the hope of ‘turning the corner’. Their intentions had been honest but they had ignored warnings from the company’s auditors concerning the company’s financial position.
Legal principle - Held: the directors would be forced to contribute to the company’s debts. Knox J: ‘This was a case of failure to appreciate what should have been clear rather than a deliberate course of wrongdoing . . . [however] the fact that there was no fraudulent intent is not of itself a reason for fixing the amount at a nominal or low figure’.

Question 24

Common law exceptions - ‘Sham’ or ‘facade’ companies

Answer 24

The courts have been prepared to lift the veil of incorporation where it is deemed that the company has been used as a ‘sham’ or ‘facade’ to hide another, dishonest purpose.

Question 25

Common law exceptions - ‘Sham’ or ‘facade’ companies - Key Case

Answer 25

GILFORD MOTOR CO LTD V HORNE [1933] Ch 935 (CA)
Facts - The defendant was formerly managing director of the claimant company and was subject to a covenant not to approach clients of the company after his employment had ended. After leaving the company, he incorporated a company with his wife and used the company to approach the customers of his former employers.
Legal principle - Held: the defendant had set up the company, not as a genuine business, but rather as a ‘sham’ or ‘facade’ to hide his intention to break the covenant with his former employers. This was an abuse of corporate personality. Farwell J: ‘I am quite satisfied that this company was formed as a device, a stratagem, in order to mask the effective carrying on of a business of Mr EB Horne’.

Question 26

Common law exceptions - ‘Sham’ or ‘facade’ companies - Key Case

Answer 26

JONES V LIPMAN [1962] 1 All ER 442 (Ch)
Facts - The defendant agreed to sell a plot of land to the claimant but, before completion, he transferred the land to a company of which he and a partner were sole shareholders and directors. He claimed to be unable to complete the original sale on the basis that he no longer owned the land as it belonged to the company as a result of the transfer.
Legal principle - Held: the company was a ‘sham’ or ‘facade’ to prevent having to honour the agreement to transfer the land. Russell J: ‘The defendant company is the creature of the first defendant, a device and a sham, a mask which he holds before his face in an attempt to avoid recognition by the eye of equity’.