Did Company Law Benefit From the Decision of the House of Lords?

Introduction

It is hard to exaggerate the significance of the case Salomon v. Salomon & Co Ltd [1897] [1] in terms of its contribution to the conceptualisation and development of UK [2] company law. At law, a company is deemed to have a separate legal existence and persona from that of its members and directors. This legal fiction is fundamental to the operation of company law and its effects are both far reaching and profound.. Much of our understanding of the separate corporate personality flows from the jurisprudence set down in Salomon, indeed the notion of the distinct corporate persona is often referred to as the “Salomon principle” in modern literature [3] and the Salomon case is typically treated reverentially by academics, practitioners and the judiciary alike. [4]

The facts of the Salomon case are as follows. Mr Salomon ran a successful shoe repair business in the capacity of a sole trader for some thirty years before forming a registered company for the purpose of incorporating his business in 1892. The shares in the company were divided between Salomon and members of his family but all the shares were held on trust for Salomon himself. Salomon transferred his business to the new company for £9000 in cash, £20,000 in £1 shares and a £10,000 debenture owed to Salomon. Within months of formation the new company ran into financial and trading difficulties and was wound up. At the point of liquidation the company had around £6000 worth of assets but owed £7000 to unsecured trade creditors. Given that the debenture issued to Salomon took precedence for repayment over the unsecured trade debt Salomon was permitted to recover the remaining assets himself and the unsecured creditors were left with nothing. The unsecured creditors were unhappy about this result and took the matter to court, arguing that the security given by the debenture was invalid given that the new company was, to all intents and purposes, merely “Mr Salomon in another form”. The primary issue in the ensuing case was whether the liability of the company should be regarded as Mr. Salomon’s or as solely belonging to the company.

Reversing the decision of the Court of Appeal it was ultimately held by the House of Lords that the debts of the company were its own and that they could not be imputed to its members or officers. Lord Halsbury remarked:

‘Once the company is legally incorporated it must be treated like any other independent person with rights and liabilities appropriate to itself, and… the motives of those who took part in the promotion of the company are absolutely irrelevant in discussing what those rights and liabilities are.’

Lord Macnaughten added as follows:

‘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 precisely 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.’

It was thus found that “the company has a legal existence separate from that of its members” and this distinct legal persona allowed Mr Salomon both to avoid personal liability for the company’s trading debts and to stand aside from the company to enforce the debenture that had been issued to him by the company.. The Salomon case therefore permitted the application of the doctrine of the separate corporate persona in the context of “one-man companies”.. [5]

Over the years that followed the Salomon principle became known as the “veil of incorporation” in certain contexts. This phrase describes the fact that the ownership and management of a corporation are distinguished, and the fact that the members of the company are separated from the trading relationships entered into by the company in the outside world. Indeed the phrase is appropriate because, functioning very much like a veil, the membership of the company is revealed but cannot be touched by third parties.

The Consequences of the Doctrine of the Separate Corporate Persona

Many effects and consequences flow from the fact that the company is a separate legal persona from its membership at law. For example, the modern corporate structure was in large part created with a view to providing entrepreneurs with a less risky means of pursuing commercial ideas and projects. The concept of limited liability, which dictates that shareholders are only liable for the debts of a company to the value of their shareholding, is absolutely crucial to the justification of the corporate vehicle as a means of doing business and without the existence of a separate corporate persona it simply could not exist. In simple terms, the company, as a separate person, is liable for its own debts just as any other person in society is. [6]

Another important consequence is that of perpetual succession. Given that the company exists in its own right, changes in its membership, which are likely to be commonplace in the context of any company of substance, will not affect its existence as an entity.. Members may transfer their shares, become bankrupt, be declared insane or die, but this will not affect the company. [7]

The separate corporate persona also affords the company contractual capacity in its own right and can sue or be sued in its own name. In addition, the doctrine allows business property to be owned by the company itself. The members of the company have ownership of their shares only, not the individual assets of the company.

This can have some interesting practical consequences. In Macaura v Northern Assurance Co.(1925) [8] the plaintiff had owned a timber estate outright, before forming a one-man company and transferring the estate to it. Unfortunately he continued to insure the estate in his own name. Later the timber estate was destroyed by a fire. When Macaura attempted to claim for the loss his insurer refused to pay out under the policy. Thereafter the matter went to court and it was held that Macaura no longer had a personal insurable interest in the property given that it was now owned by the company. The fact that the company was wholly owned and controlled by Macaura did not mean that he could insure the timber estate that the company now owned. It was an expensive mistake: the policy should have been in the company name.

It is important to note that the Salomon principle has also had beneficial effects. In the case Lee v Lee’s Air Farming Ltd [1960] [9] the appellant’s late husband was the governing director and controlling shareholder of the respondent company. He was also employed by the company as the chief pilot.. The deceased took all decisions about contracts for aerial top dressing, prices and the use of the plane. In the course of such an operation the plane stalled, crashed and he was killed. When the widow sought compensation under the New Zealand Worker’s Compensation Act 1922 the question was whether the deceased was a “worker”.

In his judgment, Lord Morris confidently distinguished between the legal persona of the deceased and the company itself; and found no difficulty in the concept of the deceased in the capacity of the company issuing orders to himself in his capacity as a “worker”. The Salomon principle was therefore applied to derive a ruling in the widow’s favour. Lee v Lee’s Air Farming Ltd was discussed and applied in regards to its treatment of the Salomon principle in the Scottish case William Pettigrew v Tilbury Douglas Construction Ltd (2004) [10] heard in the Outer House of the Court of Session.

In Buff v Kelson [1952] [11] it was held that a company should not be considered a trustee of its property for the shareholders even in circumstances where the directors have been appointed trustees of some or all of the shares. Furthermore, confirming the older authorities, in the case Tunstall v Steigman [1962] [12] the fact that one individual held all or virtually all of the share capital was not sufficient reason to ignoring the separate personality of a company.

The so-called rule in Foss v Harbottle (1843) [13] is also pertinent in this context. This rule stipulates that where the company sustains a loss or injury it is for the company (by means of majority action) to take steps to remedy the wrong. The corollary of this is that an individual minority member cannot take action on his or her own behalf to right the wrong suffered by the company. The problem with this manifestation of the Salomon principle is clear. Companies are governed on the basis of Majority Rule. Most company decisions are taken on the strength of a simple majority by way of an ordinary resolution. The effect of this is that shareholders commanding an effective majority of the company’s shares can behave, to a great extent, just as see fit, without reference to or due consideration of the interests of minority shareholders.

In light of this rule the group that can most easily cause loss to the company, is also only the group that can act in the company’s name to secure a remedy for that loss. This was the situation in Foss v Harbottle itself, where a minority was denied the opportunity to sue wrongdoing directors on behalf of the wronged company. Obviously this is unsatisfactory, but company law has been adapted to deal with the problem, first by the establishment of exceptions to the rule in Foss v Harbottle allowing what are known as ‘derivative actions’, and second by the creation of purpose built statutory mechanisms designed to remedy wrongs and protect minority interests. Section 459 of the Companies Act 1985 [14] , now to be found in section 994 of the Companies Act 2006 [15] provides for the protection of members against unfair prejudice for example. This mechanism has been widely utilised over the years and it is interpreted and applied both contextually and purposively by the judiciary. Strict rulings have been laid down confirming the courts’ determination to deal assiduously with this problem created indirectly by the implications of the Salomon principle.. It is therefore clear that the law has proved itself flexible and responsive enough to address this arguably damaging implication of the Salomon v Salomon & Co Ltd ruling.

Lifting the Corporate Veil

As has been discussed, the Salomon principle has been described as introducing a so-called “corporate veil”. This phrase refers to the separation between the ownership and control of the company and between the officers and owners of the company and the outside world. The general rule and the typical stance of the court, is that the corporate veil should be preserved and that the Salomon principle should be respected. In practice this means that, generally speaking, the law operates to insulate directors and shareholders from the liabilities accumulated by the company in the outside world. Even in circumstances where one shareholder controls all, or virtually all, the shares in a company the Salomon principle will serve to uphold the legal personality of the company and the “veil of incorporation” will not be lifted so as to attribute the rights or liabilities of a company to that individual.

This basic principle established in Salomon in regards to single companies has been extended to apply to groups of companies by a comparatively recent decision of the Court of Appeal in Adams v Cape Industries plc (1990) [16] . In Adams, the Court of Appeal ruled that, as a matter of first legal principle, it was not justified in piercing the corporate veil of a defendant company, which was a member of a large corporate group, merely on the grounds that the corporate structure had been engineered so as to ensure that legal liabilities in respect to particular future activities of the group would be imposed on another member of the group rather than on the defendant company itself. In simple terms, the Court of Appeal dismissed the argument that the corporate veil should be pierced purely because a group of companies functioned as a single economic entity. Inter alia, in the case of Stocznia Gdanska SA v Latvian Shipping Co and others [2000] [17] it was argued that to find a parent company liable for inducement merely on the grounds of the fact that it controlled a subsidiary would be to unfairly deny the parent of the protection in Salomon v Salomon & Co Ltd. The Court agreed. The simple fact of control did not justify the Court in reaching the conclusion that the directors of the subsidiary performed like automatons and treated requests as if they were instructions to be carried out without question. The subsidiary was a separate legal entity and to make another presumption would mean that the principles underpinning the separate incorporation of the subsidiary would have to be ignored. In the final analysis the Salomon principle was upheld: the subsidiary was deemed to be a separate legal entity distinct from its ultimate parent.

All that said, there are certain situations in which the courts of Scotland and England have proved themselves prepared to lift the veil of incorporation, that is to say, to ignore, disregard or set aside the separate legal personality of a company. This appears to conflict with the grand, sweeping statements of Lord Halsbury and Lord Macnaughten featured above, who failed to add caveats for fraud and abuse in their explanation of the law, but clearly, in pragmatic terms, exceptions to Salomon are essential. In particular, the courts will not allow the Salomon principle and the corporate form it underpins to be exploited for the purposes of fraud or dishonestly for the manifest purpose of denying a claimant the ability to exercise the full range of his legal rights. The courts will also refuse to allow the Salomon principle to be employed as a mere device or sham to evade a contractual or other legal obligation or as a façade to conceal a true set of facts.

In the case Gilford Motor Co v Horne [1933] [18] Horne was a car salesman, who entered into a contract (in fact a restrictive covenant) with his employer which stated that he was not permitted to solicit his employer’s customers for a period of time after leaving his employ. On leaving his employment with Gilford Motor Co Horne proceeded to set up a company which then almost immediately approached his former customers. Horne argued that first that it was the separate person of the company itself that was approaching the customers, not him; and second, that if there was wrongdoing, it should be the company that was liable for it and not him. The courts held that the company was sham, an alias of Horne, and granted an injunction against the company as well as him in person. The company’s corporate existence was not denied by the court, but the company’s corporate veil was indeed pierced to identify Horne’s personal culpability for the breach of the restrictive covenant he had entered into.

The courts have also proved themselves predisposed to lift corporate veils and thus disregard the Salomon principle in times of national emergency or where some crisis dictates that such a course of action is desirable. It may for example be expedient to lift a corporate veil in times of war to prevent trade with the enemy. In Daimler v Continental Tyre & Rubber Co [1916] [19] the Continental Tyre Co attempted to enforce a debt owed to it by Daimler. It was found that the membership of Continental Tyre was comprised of German nationals and the UK was at war with Germany at the time. As a consequence the House of Lords (reversing the Court of Appeal decision) refused to sanction the enforcement of the debt. In so doing the House of Lords refused to recognise that Continental Tyre was an entity which was separate from its membership. It is submitted that this ground for disregarding the Salomon principle is inevitably limited in application to narrow circumstances, but it nonetheless demonstrates a clear judicial departure from the concept of the separate corporate persona. That said however, it is submitted that this does not weaken the Salomon principle in terms of its general application. Expedient flexibility is far, far better than a rigid dogmatic stance. If anything these stated exceptions to Salomon strengthen the underlying concept and rationale for the rule.

Many other attempts have been made to persuade the Scottish and English courts that the list of circumstances permitting the lifting of the corporate veil should be lengthened.. A clear attempt of this nature was made in Trustor AB v Smallbone and Others (2001) [20] ; however, whilst holding that the corporate veil could be pierced on the grounds that one of the recognised exceptions had been established, the Court upheld the strict approach adopted in previous cases by refusing to acknowledge any further exceptions to the basic principles. In Trustor itself the court did however find itself to pierce the corporate veil on the familiar ground of fraud. In the case a director paid company money to a sham company he had created purely for the purposes of perpetrating the fraud and this was justification enough.

Trustor AB v Smallbone and Others seems to suggest that contemporary courts will not tolerate any further erosion of Salomon’s fundamental principle that a company must be treated as a legal entity with a separate legal personality, quite distinct from that of its members. Alongside cases such as North West Holdings v Backhouse (2001) [21] , Trustor confirms that lifting a corporate veil should only be permitted in those time-honoured and narrowly construed and carefully justified cases discussed above.

There have been cogent and influential judicial attempts to extend the concept of lifting the corporate veil hostile to the principle set down in Salomon v Salomon & Co Ltd. Before the seminal decision of Adams v Cape Industries Ltd was handed down the law was for a while muddied by two opposing decisions, the first of which suggested that the Salomon principle could be overlooked merely in the interests of justice while the second indicated that it was a sovereign principle worthy of respect and application in almost every case.

The first ruling was handed down in DHN Food Distributors v Tower Hamlets London Borough Council. [22] Here a company’s trading premises where compulsorily acquired. The premises at issue were owned by a wholly owned subsidiary of the company that brought the action and the local authority invoked the Salomon principle to assert that the business of the owner had not been affected. The Court of Appeal, which was led by Lord Denning, one of the most the famous Master of the Rolls of the twentieth century, found unanimously that it was entitled to look at the realities behind the situation and therefore to pierce the corporate veil. As a result, the parent company, although not actually the owner, was indeed allowed to recover for loss of trade of the subsidiary. Lord Denning stated that there was evidence of a general trend in the law to disregard the Salomon principle and the fiction of the separate legal entities of various companies within a corporate group, and to apply the law collectively to the economic entity of the entire group.

It is submitted that Lord Denning was a towering figure of the law of the 1960s and 1970s. Choosing to remain as Master of the Rolls in the Court of Appeal, rather than accept promotion to the House of Lords, he felt he could exercise a greater influence over the development of the law as leader of the busy lower court rather than become an ordinary Law Lord in the upper House. He was well known for his disregard for long established legal principle in circumstances where he believed that the principle in question was frustrating natural justice in a particular case. Instead of mechanically applying fundamental principles of English law Lord Denning was famous for finding ways to circumnavigate them or except himself from them where he considered such was in the interests of justice. It is argued that Lord Denning could recognise the importance of the Salomon principle but that he found unfairness in its slavish application.

The decision in a Scottish case soon challenged DHN Food Distributors. This was the 1978 ruling of the House of Lords in the case Woolfson v Strathclyde Regional Council [23] . This was a case very similar to DHN Food Distributors, involving the compulsory acquisition of trading premises by a local authority and a claim for the loss of business by the parent trading company. Clearly, and in particular given the ruling in DHN Food Distributors, the fact that the company did not own the premises itself and was therefore technically excluded by the Salomon principle, did not dissuade it from its appeal.

The House of Lords held that Woolfson could be distinguished from DHN Food Distributors by virtue of the fact that the company owning the property was only partially, rather than wholly, owned by the claimant company. Furthermore, the decision in DHN Food Distributors was held by the House of Lords to have been incorrectly decided. Lord Keith stated that the Court of Appeal in DHN Food Distributors had failed to apply the guiding principle that there is justification to pierce the corporate veil only where fraud or other specific circumstances are proved.

It is submitted that, although Woolfson was a decision of the House of Lords, it was uncertain for a while as to whether the case established a binding precedent for English courts given its Scottish provenance. The judicial supporters of Lord Denning’s approach in the Court of Appeal failed to follow Woolfson in subsequent cases in which it was again held, that the court should pierce the corporate veil whenever justice so requires. [24] However, the black letter lawyers reasserted their dominance by unequivocally supporting the Salomon line in Adams several years later, which was decided after Denning’s retirement when his influence on the law had considerably reduced.

Analytical Commentary

United Kingdom company law under went root and branch consolidation in 2006 with the passing of the Companies Act 2006 [25] , some twenty one years after the last grand consolidation of the Companies Act 1985 [26] . The 2006 Act has the distinction of being the longest Act ever passed by the Westminster Parliament, comprising some 1,300 sections and 15 schedules. However, addressing as it does almost every aspect of English and Scottish company law it is significant to note that Salomon principle and most of its implications have remained essentially unaffected by this massive overhaul of the legal regime. So fundamental to the overarching superstructure of company law is the decision of the House of Lords in Salomon v. Salomon & Co Ltd [1897] and its implications that it is hard to conceive of a way in which it could be amended or materially fettered without drastically changing the nature and rationale of UK company law..

Where the Salomon principle has been found to cause problems, for example in cases of abuse of the corporate veil or abuse of majority control and Foss v Harbottle situations, the law has shown itself to be responsive and flexible enough to evolve to establish new principles to deal with the problems. These include new common law precedents and effective statutory mechanisms such as section 459 of the Companies Act 1985, which is now to be found in section 994 of the Companies Act 2006.

The legal principle illustrated by the ruling in Salomon v. Salomon & Co Ltd has been variously portrayed as a necessary evil and a pragmatic response to the needs of commerce. That said, although the Salomon principle and its consequences have been vigorously criticised over the years in numerous contexts and situations it must be acknowledged that, generally speaking, the corporate vehicle that the principle has empowered has proved a runaway success. UK companies have proliferated and grown from strength to strength over the last century vast amounts of wealth have been generated and the great majority of workers in this country owe their careers to a greater or lesser extent, to the corporate form enshrined by the Salomon principle.

It should be noted that the Salomon principle has not had enjoyed unblemished application.. Cases such as DHN Food Distributors demonstrate that factions of the judiciary have over the years been prepared to treat the principle with suspicion and avoid it with impunity. However, the bud of DHN was swiftly crushed in later cases such as the Scottish case of Woolfson and the leading judgment of Adams v Cape Industries, which returned the authority of the Salomon principle with unequivocal force.

It is certainly true that some of the implications of Salomon have proved damaging some of the time. However, it is submitted that the socio-economic and commercial benefits generated as a consequence of the Salomon principle hugely outweigh the largely unavoidable (in conceptual terms) negative effects that it has had. In summation, while it is difficult to envisage exactly what the Law Lords in Salomon v Salomon & Co Ltd had in mind when they handed down their seminal rulings in the case, it is doubtful that they would have been tempted to alter or temper much of their rulings in substance, even with the benefit of the hindsight that a commentary written in 2007 permits. Perhaps the only way in which their Lordships would adjust their rulings if they were given a chance to do so would be add that the principle of the separate corporate persona would remain subject to bona fide behaviour on the part of the creators and operators of the company and be qualified by manifest evidence of fraud, malpractice or deceptive intent. To say as Lord Halsbury did that human motives are “absolutely irrelevant” in discussing a company’s rights and liabilities is clearly not the case, because fraud is generally accepted as a appropriate and reasonable justification for lifting the corporate veil today.

That said however, the existence of a list of situations in which the courts have proved themselves willing to disregard the Salomon principle and dislodge the corporate veil of a company does not invalidate the principle itself. Such a list merely indicates that the law must remain flexible enough to cater for extremes of circumstance and motive. Exceptions to a rule do not weaken or undermine the rule. Rather they may, if properly justified and ordered, strengthen the fundamental reasons that lie behind the principle and enhance the efficacy and pragmatism of the law. It is submitted that this is the case with regards to the law’s accommodation of the Salomon principle: it is treated with reverence and respect, but not with slavish and blinkered adherence. So it is that the exceptions to the Salomon principle actually serve to justify its continued observance in general terms.

The Salomon principle is a rock on which much of twentieth and twenty first century commerce and entrepreneurship has been founded, we do not live in a perfect world and human nature being what it is Salomon has clearly been employed by some as a tool for mischief, but without question the ruling has proved overwhelmingly beneficial, both for UK company law and the society it serves. Indeed, the doctrine of the separate corporate persona is not merely beneficial to company law, it is the cornerstone on which the law rests.

THE END

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