Separate Legal Entity and Limited Liability Differences

This research was carried to investigate the difference between separate legal entity and limited liability. Which Professor Kahn-Freund described as a calamitous decision in Salomon V Salomon & Co case meaning that the decision taken by the courts was bound to happen, so that the doctrine of separate legal entity comes about to help in future judgments as the judicial precedent. It elaborates more on the factors that brings about incorporation, the good points and the bad points which about with incorporation and to find ways in which the law can be fixed in order to improve the process of incorporation. Separate legal entity: this means that a company is separate and distinct from its members. A company is defined to be an artificial person; the best definition of separate legal entity can be best described in the case of Sunrise Sdn Bhd v First Profile (M) Sdn Bhd & Anor (1996) whereby there was no dispute of who the identity controller of the company was. Unlimited liability is whereby a company cannot lose more than the amount invested. The members are not personally liable for the debts and obligations of the company.

FACTORS THAT INSTIGATE INCORPORATION

There are many factors that influence incorporation. The state of incorporation is the process by which a business receives a state charter allowing it to be corporation. That is the formation of the company. This is when a business entity takes a step to be separated from its members and owners. This form of distinction is called separate legal entity. This in law is defined as a company being different from its owners, this means that a company is an artificial person who can sue or be sued in their own name. This means that if a company needs to get involved in any kind of legal action, it is free to do so as it is on its own. When a company is being sued the company is on its own as a legal artificial person, the members belongings are not at risk of being taken away when the action is taken against the company. For a company to come into existence it should first have enough capital, this is to make sure that company will continue running in the foreseeable future. There seem to be no problem with a company starting with capital minimum as £10 but this does not secure the company’s future. The creditors must be assured that they would get paid. This also implies that a company is formed with the view that it would not dissolve. This is governed by the insolvency act which governs issues related to things like bankruptcy. Before a company is incorporated it has to know if it is going to be a public or a private company. Then after it has to know how it is going to raise its capital. Since public companies are listed at the stock exchange and are opened to the public for them to invest and raise capital for the company while private companies allot shares to members within the company itself. Incorporation can also be brought about by the fact that is that the company will be experiencing limited liability. Limited liability means that the members and owners are not personally liable for the losses and liabilities of the business. Limited liability concept protects the members against creditors running after them personally. Like it is mentioned earlier the business is by itself.

But every country has its own way of incorporation. The registrar of companies in the UK also known as the Companies House is the one responsible for registering companies in the UK. In June 2010 alone the statistics from the registrar of companies (Companies House) showed that there were 32, 150 new companies incorporated. The weekly registrations were between 6000 and 7000, this really showing that the number of incorporations grow weekly. To incorporate a limited company in the UK the following requirements need to be fulfilled or met first. The Company should bring a document called the Form IN01, which contains the intended situation to the Registered Office, the details of the approved secretary and directors, the details of the subscribers and if they are limited by shares, the details of the share capital. The second document that is needed by the Companies House the

Memorandum of Association which contains the names and signatures of the members that wish to form a company a commitment by shareholders to have at least one share each. The Articles of Association which gives the details of the company’s internal affairs, how the business is run and its liability. The company then can only come into existence when there have been issued with the certificate incorporation for private companies and the certificate of incorporation and certificate of commencement of trade for public companies. Certificate of incorporation0 is evidence that the registration requirements have been met and also it serves as evidence to date of incorporation.

FOOTNOTES

Birth certificate

When a company becomes incorporated it forms a legal entity by itself. Once the company is incorporated it has the ability to accumulate debts, hire employees, own its property and sell goods. The following are the favored points and adverse points of incorporation in UK.

THE ADVANTAGES OF INCORPORATION

The doctrine of separate legal entity is the main reason why companies are being incorporated. Separate legal entity means that a company really exists, can sue or be sued in its own name, holds its own property and is liable of the debts it incurred. This concept allows limited liability to shareholders because the debts incurred are for the company not the shareholders in the company. This concept can be clearly illustrated in the case of Salomon V Salomon & Co whereby Mr. Salomon carried on a business as a leather merchant. In 1892 he formed the company Salomon & Co Ltd. Mr. Salomon, his wife and five of his children held one share each in the company. The members of the family held the shares for Mr. Salomon because the Companies Acts required at that time that there be seven shareholders. Mr. Salomon was also the managing director of the company. The newly incorporated company purchased the sole trading leather business. The leather business was valued by Mr. Salomon at £39,000. This was not an attempt at a fair valuation; rather it represented Mr. Salomon’s confidence in the continued success of the business. The price was paid in £10,000 worth of debentures giving a charge over all the company’s assets (this means the debt is secured over the company’s assets and Mr. Salomon could, if he is not repaid his debt, take the company’s assets and sell them to get his money back), plus £20,000 in £1 shares and £9,000 cash. Mr. Salomon also at this point paid off all the sole trading business creditors in full. Mr. Salomon thus held 20,001 shares in the company, with his family holding the six remaining shares. He was also, because of the debenture, a secured creditor. However, things did not go well for the leather business and within a year Mr. Salomon had to sell his debenture to save the business. This did not have the desired effect and the company was placed in insolvent liquidation that is it had too little money to pay its debts and a liquidator was appointed. The liquidator alleged that the company was but a sham and a mere ‘alias’ or agent for Mr. Salomon and that Mr. Salomon was therefore personally liable for the debts of the company. The Court of Appeal agreed, finding that the shareholders had to be a bona fide association who intended to go into business and not just hold shares to comply with the Companies Acts. But the House of Lords disagreed with Court of Appeal and found out that the fact that some of the shareholders were only holding shares as a technicality was irrelevant; the registration procedure could be used by an individual to carry on what was in effect a one-man business. A company formed in compliance with the regulations of the Companies Acts is a separate person and not the agent or trustee of its controller. As a result, the debts of the company were its own and not those of the members. The members’ liability was limited to the amount prescribed in the Companies Act that is the amount they invested1. By far it was said that the decision taken by the House of Lords was good because it was going to help to judge the similar events in the future.

FOOTNOTES

The decision showed that the use of debentures rather than shares was made in order to protect the investors

This concept stresses out the point of a company being distinct and different from its members. The owner can also be an employee and can be entitled to health and life insurance2.

The other advantage of incorporation is the fact that members will be enjoying the concept of limited liability meaning that shareholders and members of the company are not personally liable for the debts and obligations of the company. The creditors of the company cannot run after the shareholders for the debts incurred by the company instead they go after the company itself; this secures the personal property and belongings of the shareholders. The case above of Salomon V Salomon & Co also illustrates

this concept of limited liability because the courts also held that Salomon was like any other creditor to the company formed. The person has fully paid for their shares; they cannot be forced to pay debts incurred by the company. The case of Macaura V Northern Assurance Co ltd & others shows the concepts of separate legal entity and limited liability. In this case Macaura was a sole proprietor and owned a timber firm, and bought and registered it in his own name not the firm’s name; the timber was later destroyed in fire. He wanted to claim with the insurance but he could not as the destroyed goods were in his name not of the firm, the courts held that3.

Another advantage of incorporation is that there is perpetual succession of the company. This means that the company will continue to exist in the future unless otherwise the shareholders wish to dissolve it. This is another good reason why companies are incorporated. Incorporation takes place because the ownership and controlling of the business are totally different. This means that shareholders form a company and they own it and then from there they select a board of directors who will be in charge with the day-to-day running of the business. There is also a free transferability of interest and shares. Shares of corporations are freely transferable, because as a separate entity, the existence of a corporation is not dependent upon whom the owners or investors are at any one time. A corporation continues to exist as a separate entity, and is not terminated or dissolved even when shareholders die or sell their shares. Shares of corporations are freely transferable unless shareholders have “buy-sell” agreements limiting when and to whom shares may be sold or transferred. Also, securities laws may restrict the transferability of shares. The case of Re Noel Tedman Holdings illustrates the advantage of perpetual existence and also the transferability of shares and interest. This is when there was a death of both directors and shareholders to the company4.

FOOTNOTES

2. Lee V Lee’s Air Farming

3. Shows the distinction of the company and its members and also the members are only liable for their own personal debts.

4. The shares were transferred to the beneficiary who was the infant baby.

THE DISADVANTAGES OF INCORPORATION

Below are the disadvantages of incorporation;

Identification; an incorporated company needs to keep accurate and timely records. They are needed for external publishing of financial reports yearly. This makes companies to be regulated by the state, federal and local government. Thus making the company to reveal its losses and profits to the government, if the business is at loss it will easily show and exposing the company spoiling its name and reputation. Moreover corporations are forced to undergo double taxation. Companies are charged tax on their earning as a company firstly and then secondly they are charged when a shareholder get paid. This tax they pay is corporation tax which can be helpful or harmful depending on the nature of business you are running. There is a lot of paper work that needs to be done before a company could be incorporated. Reports are needed to filed and be readily placed for external checking, for the board of directors, and shareholders. There are misconceptions associated with incorporation, that because someone is a shareholder they can freely use the company’s money for their own use. This is not allowed because the company will be the one bearing the consequences of running shortage in finances. Also the misconception should be linked to the case of Salomon V Salomon & Co, be in that case Mr. Salomon did what he did in order to save the company from liquidation. Since corporations have a perpetual existence, states provide a mechanism for dissolving a corporation and liquidating its assets. Dissolution does not happen automatically. A corporation can be dissolved voluntarily or involuntarily. A corporation’s officers and directors are charged with responsibility for dissolving the corporation, including gathering corporate assets, paying creditors and outstanding claims, and distributing the remaining assets to shareholders.

The concept of separate may bring problems like members not being careful and not taking good care of the company because they just know they have nothing attaching them to the company and they do not face any loss in the situation that is they do not bear any personal loss. The concept of limited liability can also be a disadvantage due to the above mentioned carelessness, just because the creditors would not run after the shareholders personally and because everything is done in the company’s name, the parties concerned with the company can sue the company in the name of the company not in the name of the shareholders. The shareholders may also face risk of not having to be trusted by the creditors and may suffer loss in the reputation of the company. Because in this concept of legal entity the company is said to an artificial legal person, it needs people to operate it and these people may later use it for criminal and fraudulent acts hiding behind the company’s name 5. But if there are suspicions of acts like this the courts may lift the veil of corporation to see what is going on6.

FOOTNOTES

5. Atlas Maritime Co SA v Avalon Maritime Ltd

6. Court disregards the existence of the corporation because the owners failed to keep one or more corporate

Professor Kahn-Freund’s theory

Professor Kahn-Freund describes the decision taken by the courts in Salomon’s calamitous because he thought the decision was not adequately justified in the principle and policy7. And also because back then the courts were trying to act in the best interest of the shareholders, to protect them, but the question that Professor Kahn-Freund was asking was what were they being protected from? He felt that the courts instead acted in the interest of the creditors. The courts took the decision they took to try to avoid things like forming a company with less capital this would prevent it from coming into liquidation in the near future like what happened in the case of Salomon V Salomon & Co. Professor Kahn-Freund that this was bound to happen because in the case of Salomon the shareholders were his family, cost of incorporation was too much and also the had minimum capital for their business8. The decision was made to conform to the law one person company, to save the corporate controller from personal liability and to secure the creditor’s point of view in the case of Salomon. He thought limited liability was originally invented for companies to raise capital and the small businesses took it wrongly. He made a suggestion that rather than changing legal outcomes of the formation of the company, one should make it expensive and more difficult and by so doing reducing the number of companies being formed.

FOOTNOTE

7. The courts failed to protect shareholders and this affected the whole business life.

8. The courts wanted to introduce minimum amount of capital for all companies and abolish private companies.

IMPROVEMENT OF THE LAW

The legacy of Salomon in Salomon V Salomon & Co still lives today. But even though the courts did a great by introducing it there are some points by which the law should be improved so that it favors everyone and also is fair to everyone. The changes have been made to company law because companies do business differently and it is not like in that time of Salomon.

There have been improvements in law in the past few years. The law was improved in 2006 and the provisions came into practice in 2008, there have been major taken to improve and make it easier for people to run a private company, as it is shown above that it was difficult to run a private company in the past as shareholders were not protected and the courts would always decide in favor of creditors. The improvements that are needed to be made are not making it a requirement for a company to have a secretary because some companies are big but small meaning that they would not need a secretary. This is a better approach and a think small first approach. Shareholders are allowed to engage in long term investments this they are suppose to it a culture. Private companies should be assisted financially like any other company. The directors’ duties to be set out on statutory statement including a new duty to promote the success of the company. A wide range of measures to be innovated in consultation with the shareholders and is made to modernize and simplify company law. The company should also provide improved rights for both the investors and shareholders. These improvements are according to the UK law.

CONCLUSION

To sum up I can say that separate legal entity is a good concept because it is not all the shareholders who are active in the running of the business, they work hand in with the directors they appointed. Because if something goes wrong in the business it does not affect them personally, the company is on its own. But the concept of limited liability may encourage wrongful act in the company because everything is done in the company’s name, nothing is attaching the shareholders to the company. I can say that separate legal entity and limited liability are equally important in the smooth sailing of the company. And also companies should take note of the above mentioned improvements in law.