Principles of Incorporating a Company

This paper aims to explore the principles of incorporating a company and the dilemma faced by individuals with businesses. This will typically be done by weighing the arguments in favour of and against incorporation whilst looking at the structure of incorporation with emphasis on the United Kingdom (UK). The UK and London in particular is a vital key location for trade and finance in the world. Company Law in the United Kingdom continues to evolve however, in comparison America and China it emerges as one of the most adaptive and sophisticated. Given the scope of my essay, the UK is my jurisdiction of choice as it has an advanced enforceable legal and regulatory structure for corporate governance and financial reporting Great Britain, has more than 2 million limited companies currently registered and more than 300,000 new companies are incorporated each year [1] .The Companies Act 2006 (CA 2006) is the primary source of legislation on company law in the UK. It is also one of the largest ever to be enacted in the country. However, there are additional legislation affecting companies that can be found in the Companies (Audit, investigations and Community Enterprise) Act 2004, Financial Services and Markets Act 2000, Insolvency Act 2000, and the Enterprise Act 2002. Based on an exhaustive review of the arguments in favour of and against incorporation, it can be deduced that for a business to expand and grow without the individual’s fear of personal liability, the company will need to be incorporated. However, it is imperative to note that no business form will shield the individual from personal negligence. There are various forms of business organisations operating in any given economy. The business structure in use can be defined by the legal framework under which it operates. Therefore, the rules applied to these entities are different. Some of the types of business forms include Partnerships, Sole Proprietorships, Corporations, etc. Other forms may include entities set up not to make a profit but sometimes for the benefit of the community. My paper will focus on the incorporated business entity limited by shares.

Incorporation is when a business decision is made to form a new legal entity which is recognised by law to either undertake a not for profit business or for profit business. In the UK, S.7 of the C A 2006 [2] states a company is formed under this Act by one or more persons subscribing their names to a memorandum of association and complying with the requirements of this Act as to registration. Section 8 of the CA 2006 requires a memorandum of association stating the subscribers wish to form a company under this Act. They agree to become members of the company and, in the case of a company that is to have a share capital, to take at least one share each [3] .As part of registration, the company is required to provide Articles of Association unless model articles apply by virtue of s.20 of the Act [4] .

To incorporate a company in the UK, the company will need to submit an application with the requisite documents to the Registrar of Companies at the Companies House. If the Registrar is satisfied that the requirements under the Act have been met, then he shall register the documents delivered [5] . A Certificate of Incorporation is issued to the company with a unique number and the Registrar’s official seal. This Certificate must state among other things the date of incorporation, whether it is a limited or unlimited company, and if it is limited whether it is limited by shares or limited by guarantee and whether it is a private or a public company.

The corporate entity status of the company means it can sue and be sued. It can own property and function as a separate entity from its owners. This concept is the fundamental principle underlying company law in the UK, USA China and many other jurisdictions. The main Act applicable in the UK does not allow a company to be incorporated in which members are totally free from liability. The fictitious nature of the Incorporated Company means that it will still need human beings to make decisions and implement it on its behalf. Decisions on its behalf are made by the appointed board of directors or the shareholders at a general meeting. Officers and employees also act on behalf of the company. An example of a Corporation is Santander UK PLC, which is a financial services company in the UK. Although there are hybrid types of incorporation the main types include a Private Company limited by shares, this is where a company is normally set up for profit making and has a share capital. The CA 2006 S 3(2) states If the liability of shareholders is limited to the amount, if any, unpaid on the shares held by them, the company is “limited by shares” [6]

. A private company as its name implies cannot offer its shares to the general public. The next form of incorporation is a Private Company limited by guarantee. This form of incorporation will have no share capital. Under the Companies Act, a company cannot be limited by guarantee if it has a share capital. This form of incorporation will normally be used for charitable organisations or quasi-charitable societies. These organisations provide services for the benefit of the community. Another form of incorporation is a Private unlimited company. As the name implies, the liability of its members is unlimited. The unlimited nature of this form of incorporation enables them to disclose less financial information than a limited liability company. Last but not the least is a Public limited company. This form of incorporation is also limited by shares. It may be referred to as the opposite of a private company limited by shares. This is because it has a share capital and limits the liability of its members to the amount unpaid on their shares. The shares held in such companies can be traded in the capital market in line with listing rules. To understand the problems faced by the individual businesses contemplating incorporation, we would need to look at the merits and demerits of incorporation whilst aligning this with the nature of business activities the company undertakes. A significant factor will be the vision and ideals of its current owner or owners’ not losing sight of any specialist requirements in the industry. The main argument in favour of incorporation is the corporation set up is able to protect its shareholders from incurring personal liability in the event of business insolvency. The fictitious entity set up is a legal person separate and distinct from its members. The incorporated company is capable of allowing the shareholders who form the company to have limited liability. Some businesses will not operate or exist without this Limited Liability status. Without the Corporate entity Status, it will be impractical to expect every person or shareholder in a big, risky company to be engaged in the actual running of the company. This allows the operational duties to be delegated to the directors who in turn sub delegate to subordinates or employees. In the case of a corporation with share capital, the liability of shareholders is limited to the amount if any, owed on their allocated shares A sole trader’s personal assets including cars houses boats etc can be seized and sold to help pay off any outstanding debts in the event of the company collapsing. However, as a shareholder in the company your personal assets cannot be seized unless you have given a personal guarantee. This enables the company to be managed more efficiently without the fear of personal liability. However, the activities of the business should be legal [7] and the terms of the C A 2006 adhered to prior to insolvency. In the land mark UK Company law case Salomon v A Salomon & Co Ltd [8] the house held “that the company is at law a different person altogether from the subscribers to the memorandum; and, though it may be that after incorporation the business is the same as it was before, and the same persons are managers, and the same hands receive the profits, the company is not in law the agent of the subscribers or trustee for them, nor are the subscribers as members liable, in any shape or form, except to the extent and in the manner provided by the act”. Another advantage of the legal entity status is that value can be given to this fictitious entity which can be sold in the future as an asset. Secondly, it can be argued that incorporating a business provides the company access to capital needed to expand and develop the company. In these current economic times where banks are not so keen to lend, incorporating will enable the business to raise funds through the alternative capital market. This is particularly crucial for the survival of any multinational organisation. The incorporated company can raise debt or equity capital by issuing shares to the general public, in return for the capital invested by shareholders. Looking at incorporated companies such as General Motors or Barclays Bank Ltd it can be said that, for a modern company to expand its business activities beyond the borders of its home country it will seriously need to consider incorporating. For example, an incorporated company from country A can issue securities in the country B where it is intending to make an acquisition. This will give it the needed foreign exchange capital required to acquire the new company. However, the company will need to adhere to the listing rules in county B. For instance, foreign companies wishing to penetrate the American Market can start by issuing securities to “Qualified Institutional Buyers” subject to Rule 144A Securities Act of 1933. Incorporation also makes the issue and transfer of shares easy and straightforward. However under chapter 3 Sec 561 of the CA 2006, existing shareholders rights are protected under the “Existing shareholders right of pre-emption”. This provision protects existing shareholders rights from being diluted by the company directors’ issuing shares to new investors. You could argue that this protects unsophisticated investors using the capital market to invest in companies. Unlike the Sole Trader, employees of the Limited Company are able to acquire shares. Another merit of incorporation is that the funds obtained by an Initial Public Offering will not need to be serviced like a loan. The Corporation does not have to worry about paying this money back. Related to raising capital is a bank’s ability to create what is referred to as a floating charge on assets of the company. This form of loan is where the collateral security for the loan is shifted from one underlying asset to the other. Lenders will not usually agree to these loans unless the lender is able place the charge over certain of the company’s assets. In order to achieve this, the business will need to be incorporated with the entity owning the assets/property. As an alternative, Banks are also more likely to lend if the lender can place a fixed charge in respect of the loan. Incorporating a business, allows for continuity of not only the business name but also the business itself. In the event of the death or retirement the Sole Trader’s business ceases, to exist. In the case of a Partnership especially a specialist’s partnership, when one of the partners dies it is normally difficult to find someone with the same or similar intellectual ability to replace the deceased partner. However, an incorporated company continues to exist if a shareholder or director dies. Incorporation allows directors, shareholders and employees to be easily replaced. Therefore, it suffices to say that the easiest way to ensure continuity of the business by an individual setting up any form of business is to become incorporated. In the case of a company limited by shares whose main object is to make a profit for shareholders, incorporating will most likely attract the much needed business. Ultimately this will in the long run lead to much needed profit. Most companies and individuals will rather deal with incorporated business than a sole trader. For example, the financial sector, individuals are more likely to deposits their funds with incorporated banks like Barclays Bank PLC and Santander UK PLC. This is because they find incorporated companies to be more secure than companies that are not incorporated. In addition to the above, a business owner would like to incorporate his company for taxation purposes. The UK like many other countries including Canada offer tax advantages to Private Limited Companies. These advantages derive from the Private Limited Companies (PLC) being able to determine the distribution percentages of salary and dividend at the end of the year. Although tax rates are continually changing in the UK corporation tax rates are usually lower than income tax rates. When a company becomes incorporated the owner becomes a shareholder. As a share holder, dividends received will be taxed but usually at a lower rate. It has also been argued that distributing shares among members of the family will help reduce the tax burden. The transfer and change of ownership can be done smoothly without affecting the operation of the business. In the case of sole trader, to transfer ownership means to sell the whole company and transfer control to a different person. However, a corporation will transfer ownership through the sale of shares. Current management and employees are not affected by the change of ownership unless a decision is made by new management not to have the existing employees. There are potentially no interruptions in the daily administration of the company resulting from management changes. The company name will also be protected especially in cases where the brand/company name is essential to the success of the business. Incorporating a business may enable its owners to become anonymous. When a company decides to incorporate, the owner/s can decide to use a different name altogether from the existing company name. However, to enable an individual who is contemplating incorporation to make a decision, we will also need to consider the arguments against incorporation. The Companies Act 2006 requires that an incorporated company discloses financial information about the company to the public regularly. This involves publishing company accounts and director’s reports. A sole trader, on the other hand is not required to publish any information about the activities of the company. Subsequently their financial affairs can be kept confidential. All registered companies are required under the CA 2006 to file annual disclosure reports with the Companies House. This disclosure can range from the simple disclosing of the company’s name to the disclosure of in depth financial records of the company. Directors of the company are also required to prepare and submit an annual report including an audited account. However under Section 415A of the CA Act 2006 some registered companies are eligible for small companies’ exemption when it comes to the Directors report. It is worth noting that any director who approves false information in the report could be indicted and imprisoned. The breach of some of the regulations by directors can result in civil or even criminal liability. On the contrary, a Sole Trader is not required to file regular reports with the Companies house thereby making it possible for all business sensitive information to be kept within the company. The initial cost of incorporating a company, might be high a sole trader. Apart from the fact that drafting of the Articles of association mentioned earlier in this paper may involve fees, the company will need to pay money to the Registrar of Companies before the company can be incorporated. Depending on the form of incorporation being contemplated, the company will need to engage the services of specialists such as lawyers and accountants to advice on issues including taxation. The newly incorporated company will continually engage the services of specialists at considerable cost when it comes to submitting annual reports and audited accounts. This statutory requirement places an immense burden on incorporated companies. For a company to raise funds through the capital market, it is required to make an application to the relevant authority. In the UK, this application should be made in line with s.75 of the FSMA 2000 to the regulator (FSA) [9] .

For a company to be listed in the UK it will not only need to comply with UK listing rules but also incur cost in the form of application, vetting, sponsor and annual fees. The company will be compelled to provide a full and timely disclosure of all relevant information about its operations to enable investors to make an informed decision. To protect investors from deceptive companies, the FSA is authorized to impose special conditions on any listing application. The FSA under Sec 75 of the FSMA 2000 can also refuse a listing application if considers that granting it would be detrimental to the interests of investors [10] . Failure to comply correctly with these rules or the provision of inadequate information could lead to punitive actions against the company and its directors in Fraud, Misrepresentation or Market abuse by the regulator s.91 of FSMA [11] . For example the Financial Services Authority (FSA) fined Pace Micro Technology plc (Pace) 450,000 for breaches of the Listing Rules in January and February 2002 [12] . This action resulted mainly from Pace’s failure to ensure that its Interim Announcement on 8 January 2002 included all material information. This action resulted mainly from Pace’s failure to ensure that its Interim Announcement on 8 January 2002 included all material information. A registered UK company has to have, and maintain a registered office as part of the incorporation. [13] In the case of a small company, this could add to the cost of operation. Some people have argued that there could be double taxation when a Sole Trader for instance becomes incorporated. This is because, after incorporation the Sole Trader will be potentially be taxed on the Salary drawn and taxed on the dividends received. Incorporating means the finances of the company are entirely different from personal finances. A Sole Trader has the opportunity of covering personal debt with company funds and vice versa. After reviewing the arguments in favour of and against incorporation, there is a clear indication that the arguments in favour of incorporation outweighs those against. Subsequently, incorporating is the way forward for a modern company which wants to remain established. However, the individual cannot base their decision only on the advantages discussed above. As indicated earlier, consideration will need to be given to the aims and objectives of the company. If a company is designed to be a one man small business operated from home as opposed to a risky capital intensive business then, an alternative business form like a Sole Trader will be suitable. Alternatively an individual considering a risky venture or a capital-intensive company such as an oil company involving exploration, then it makes economic sense incorporating to limit your personal liability. Subsequently, the business form should be taken into account along with the needs of the establishment.

Serious consideration will need to be given to how the business structure may be affected by the legal form of incorporation being contemplated. For example, a company limited by guarantee (without share capital) cannot in pay dividends consequently doing so will contravene s.62 3(b) of the CA 2006 [14] . It is also crucial to align the business with the relevant Business/Company Law and Regulations governing the incorporated company in the place of incorporation. It is worth choosing the right geographical location for the incorporation of the business. All other things being equal some places of incorporation may offer certain benefits for the kind of business the individual is intending to set up. The individual will also need to weigh the tradeoff between the protection of his assets and limitation of his personal liability. Consideration will also need to be given to employment or independent contractor agreements if the company is going to have more than employee. In the case of a company limited by shares, it is vital for the individual to consider the amount of shares that will be issued to other shareholders in determining ownership percentages. The courts will normally not decide a case by setting aside the corporate entity status of the incorporated company. The courts will normally not decide a case by setting aside the corporate entity status of the incorporated company. This was emphasized in the case of Macaura v Northern Assurance Co Ltd, where the court held that neither a shareholder nor a simple creditor of a company has any insurable interest in any particular asset of the company. The owner of a timber estate sold the whole of the timber thereon to a timber company in consideration of fully paid up shares in the company. Subsequently he took out policies in his own name on the timber with several insurance companies against fire. After a greater part of the timber was destroyed by fire, the insurance company declined the claim by Mr Macaura. This was on the basis that the timber belonged to the corporate legal entity which is the company and not Mr Macaura… The case finally ended up in the House of Lords the House declining the claim on the basis that the timber belonged to the company and not the shareholder or the creditor. Even though the appellant was the sole shareholder and was also owed money by the company as a creditor. It is clear that the court was reluctant to disregard the incorporated entity status so as to infer a relationship between Mr Macaura and the company.

However in conclusion, it is essential to acknowledge that no business form will shield the individual from personal negligence or fraudulent activities. Section 213 (2) of the Insolvency Act of 1986 [15] confirms that “the court, on the application of the liquidator may declare that any persons who were knowingly trying to defraud creditors whilst managing the business will be liable to make such contributions (if any) to the company’s assets as the court thinks proper. In addition, there are documented cases where the courts have set aside the corporate legal entity status of the company. This is referred to as Piercing or Lifting the “Veil of Incorporation”. Although it is difficult to state the circumstances within which the courts will lift the veil, in Re Bugle Press Ltd [16] , it was held, the minority shareholder had shown that there were special circumstances why the court should, in the exercise of the discretion conferred by section 209 of the Companies Act of 1948 [17] , “order otherwise” than to sanction the expropriation of the minority holding. Although the transferee company was in law distinct from its only two shareholders, in substance it was the same as the majority shareholding in the transferor company. In such circumstances, unless good reasons in the interest of the company were shown making expropriation of the minority interest desirable, the court should “order otherwise”. In this case the court went behind the corporate entity status to uncover underlying individual intentions. In the more recent case of Trustor AB v Smallbone (No 2) [18] the defendant a managing director transferred huge sums of money to another company which he controlled. The court held that in such instances where a company had been used as a device to conceal the facts…it would be appropriate to pierce the corporate veil.

Finally the decision of whether to incorporate or not to incorporate will depend primarily on the factors discussed above. However, in an ever changing society like ours, an individual will need to evaluate the objectives of the business with respect to the relevant legal framework. The advancement of technology has made it seemingly easier than before to incorporate a business. However, existing and ever changing Statutory Regulations aims to provide certainty, predictability and enforceability in instances where rules governing incorporation are breached by persons managing the corporate entity.

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