The Impact and Abuse of Limited Liability

“When limited liability is cheaply and easily accessible it is likely to be abused”. Critically discuss the above with particular reference to groups of companies. The client would like an answer as to when is there abuse and how do courts deal with it. The answer must include contract/tort victims and parent-subsidiaries. 1750 words

Limited liability is a concept that has developed in tandem with the development of companies themselves. It provides one of the major incentives for traders to incorporate as companies, rather than remain as sole traders or to choose partnerships as the legal corporate vehicle. As the opening quotation suggests, however, where it is both cheap and easily accessible for companies to achieve limited liability, it opens up the potential for abuse. Limited liability itself will be discussed briefly, and its application to companies and groups of companies will be analysed. The potential for abuse of limited liability will be identified, and the courts’ response to cases of abuse will be discussed.

At law, a “company” is an artificial legal ‘person’, which enjoys both rights and obligations distinct and separate from those of its members.^[1] The majority of corporations and businesses are now incorporated as companies under the main company law legislation, the Companies Act 1985 (which is about to be overhauled by the Companies Bill 2006). When a business or corporation incorporates as a company, it will be registered as a certain type of company. For the purposes of this essay, the three main types of companies are those limited by shares; and those limited by guarantee. The majority of companies fall into the former category; that is, are limited by shares. It means that the members of the company, or the shareholders, are liable for the company’s debts in he event of a liquidation. The obvious benefit of a company being limited by shares is that the liability of each individual member for the company’s debts is limited to the value of the member’s shareholding in the company. In other words, if a shareholder has fully paid for any shares he or she owns, and the company goes into liquidation, that shareholder will likely lose the investment, but will not have to supplement this by losing any of their other wealth.

This situation can be contrasted with that of a partnership, in which each partner stands to lose any private wealth that is not invested in the business in the case of liquidation. In other words, there is no limit on the liability of the partners, unless the partnership chooses the business medium of a limited liability partnership which developed to counter this problem, but which is beyond the scope of this essay to discuss. The second type of limited liability company is a company limited by guarantee. Only a few companies opt for this type of limited liability. And they tend to be charitable organisations or other non-trading companies. It means that each member undertakes, or guarantees, to pay a certain amount if the company is put into liquidation. The effect is broadly the same, in that the liability of any particular member is limited to the amount they undertake to pay, although the difference is that unlike with shareholders, this amount will not have been paid at the time of liquidation.

These, then, are the two types of limited liability companies. They can be contrasted with unlimited companies which, although permissible under the Companies Act 1985, are rare. This is because, as the name suggests, the liability of the members is unlimited, so, as with a partnership, in the event of liquidation, the members may find themselves having to contribute the whole of their private wealth to off-set the company’s debts. The concept of limited liability, then, can be seen as an effective means of encouraging investment in companies, as it allows the investor, or member, control over how much of their personal wealth they are prepared to put in, and of course risk losing. How, then, can this concept be abused?

A concept that is inherently linked to that of limited liability, and which was mentioned briefly above, is that of a company being a separate legal person. It is described as a ‘body corporate’, and has rights and obligations distinct from those of its members and officers. This concept was established and illustrated in the seminal case of Salomon v A. Salomon and Co Ltd (1897). What does this mean in effect? As a separate and distinct legal entity, a company is able to own its own property; it is liable for its debts and obligations; it can sue its debtors and be sued by its creditors; and it has ‘perpetual succession’, meaning that the company survives the death or retirement of any of its members. Once again, the members’ liabilities are separate and distinct from those of the company itself, and are limited to the value of their shareholding or guarantee. The common law, however, reveals certain instances of the courts, albeit reluctantly, overlooked the legal fact that a company is a separate legal person. This is described as ‘lifting the veil of incorporation’, and reveals one of the courts’ major responses to perceived abuse of limited liability. The occasions where this is done are rare, however, and the judicial reluctance to do so were revealed in the case of Adams v Cape Industries (1990).

The courts will be more willing to lift the veil of incorporation where the proprietors of a company have attempted to use the company to avoid a personal legal obligation. In the case of Jones v Lipman (1962), a company director had contracted with the plaintiff to sell him some land. In an attempt to avoid a subsequent order for specific performance, the director then conveyed the land to a company before completing the transaction. Specific performance orders are unobtainable once third party rights have been acquired, so the move was a deliberate attempt to avoid such an order. The court, however, made an order against both the vendor and the company to which he had conveyed the land, which he also owned and controlled. The case provides an example of someone abusing the concept of limited liability, and also the court’s willingness to counter this.

Abuse of limited liability is, of course, most likely to occur in instances of company insolvency, which is when the members and officers of a company will be seeking to limit their liability as far as possible. The National Audit Office has pursued a concerted approach to tackling abuse of limited liability, as is revealed in a 1999 article entitled ‘Director disqualification – the National Audit Office follows up’.^[2] The article discusses the power to disqualify directors where it is revealed that such abuse has occurred.

It is not just the common law, however, that has shown itself willing, on rare occasions, to look beyond the fact that a company is legally a separate person responsible for its own obligations, where there is a perception of abuse of limited liability. Statutory law also departs from the general principle on occasion. This is most notable in section 213 of the Insolvency Act 1986, which is concerned with fraudulent trading. This provides that any person who is or was knowingly a party to a company’s fraudulent trading with intent to defraud others, may be liable to pay the company’s debts. This can be seen to overrule the concept of limited liability in the instance of individuals using the ‘veil of incorporation’ for fraudulent purposes. This, of course, makes legal sense, although the limited effectiveness of this provision is due to the high burden of proof for establishing fraudulent activity. Similarly, section 214 of the same Act allows for company directors’ personal liability for the debts of the company where wrongful trading can be established. This occurs in cases of insolvency where it is considered that the company directors have failed to take the appropriate steps to protect the company’s creditors.

The impact of limited liability, and the abuse of this, on groups of companies is most evident in the area of accounting practices. Accounting rules for groups of companies are more onerous than for individual companies, and must reflect any intra-group transactions and trades. Such transactions are often entered into for the purposes of reducing the group’s tax liabilities by moving assets or balances around the group. There is, then, considerable scope for abuse in this area, and the more onerous accounting rules for groups of companies reflect this. Under section 227 of the Companies Act 1985, companies that are members of a group must produce group accounts that reflect that the financial transactions of the subsidiary companies are actually activities of the holding or parent company. Furthermore, tax legislation often imposes liabilities on the shareholders, because of the fact that they benefit from the transactions of the company. This again reflects the fact that the abuse of limited liability is envisaged, and countered by statute.

The concept of limited liability is a crucial one to the very existence of companies. It provides an incentive for individuals to invest personal wealth in a company (which requires this wealth to operate), knowing that they have full control over how much they invest and thus risk losing. It is remarkably easy to incorporate as a company within England and Wales, and the vast majority of businesses do so. There is, however, potential for abuse of the concept of limited liability, usually in order to make personal gain while shifting the risk onto the company. The courts, as well as Parliament, have been called upon to counter this and with considerable reluctance, they have shown themselves, on occasion, willing to do so.

BIBLIOGRAPHY

Statutes

Companies Act 1985

Insolvency Act 1986

Cases

Adams v Cape Industries [1990] Ch 433

Jones v Lipman [1962] 1 WLR 832

Salomon v A. Salomon and Co Ltd [1897] AC 22

Secondary source

Davies, P. (2002) Introduction to Company Law (Oxford: OUP)

Blumberg, P. (1993) The Multinational Challenge to Corporation Law (Oxford: OUP)

Hicks, A. (1999) ‘Director disqualification – the National Audit Office follows up’, Tolley’s IL & P, 15, 4, 112

Rutledge, T. (2006) ‘Limited Liability (Or Not)’, South Dakota L Rev 51 (3), pp 417-449

Slorach, J.S. and Ellis, J. (2005) Business Law (Oxford: OUP)

Footnotes

^[1] See, for example, Slorach, J.S. and Ellis, J. (2005) Business Law (Oxford: OUP), p39

^[2] Hicks, A. (1999) ‘Director disqualification – the National Audit Office follows up’, Tolley’s IL & P, 15, 4, 112