In a Recent Review of UK Company Law

There was no merit in imposing a more integrated regime on groups of companies which would take away flexibility and strike at the limited liability basis of company law.

“That there was no evidence of abuse of corporate status by parent companies”.

Through a critical analysis of the corporate group structure assess the validity of this statement. In so doing pay particular attention to the relationship of a parent company to its subsidiary and of any potential liability a parent might have for the acts of its subsidiary.

Relation ship: double theory, agency theory

GENERAL OBJECTIVE:

The assignment will find out benefits of UK laws on companies in terms of companies’ limited liability and flexibility and will discuss related cases thus evaluate to whom potential liabilities belongs considering parent-subsidiary relationship in the light of double and agency theory.

SPECIFIC OBJECTIVES:

To be acquainted with company, groups of companies, parent company including its subsidiary.

To know legal entity of the company.

To be familiar with limited liability of the company.

To know parent-subsidiary relation ship in the light of double and agency theory including limited liability.

To recognize why the parent companies incur subsidiary company or companies.

The assignment will analyse impact of UK laws with more integrated regime within the parent-subsidiary context.

It will evaluate to whom potential liabilities belongs in terms parent-subsidiary relationship.

COMPANY AND DOUBLE THEORY:

Ron Harris stated that Grant theory and separate personality theory together known as double theory for business companies in Britain. Grant theory prevailed there through out the eighteenth and early nineteenth centuries. The Companies Act of 1862 was referred throughout the opinions of the Lords and creating business companies having separate personality was recognised in the judgement of Salomon v Salomon Co Ltd case in 1897. [1]

COMPANY AND AGENCY THEORY:

Under general principles of agency, a person either company or human may, act as a principal and can appoint another as an agent, to work for him. Agent may also be either human or corporate. The agent then deals with others named third parties. The consequence of the agency relationship is that the principal can be held liable for the acts of his agent, and the third party may seek redress directly against the principle.

Kendall Roth and Sharon O’Donnell opined that agency theory is relevant to situations that have a principal-agent structure. The headquarters- foreign subsidiary is considered such a structure as headquarters delegates work and responsibilities to the foreign subsidiary. As the principal, the headquarters cannot effectively make all the decisions in the Multinational Company (MNC) since it does not possess and must, therefore, depend on the unique knowledge of subsidiaries. At the same time, the headquarters cannot hand over all decision-rights to the subsidiaries since the local interests of subsidiaries may not always be aligned with those of the headquarters or the MNC as a whole. [2]

COMPANY AND ITS LEGAL ENTITY:

According to article by Farrar, John ‘a corporation is a legal concept which, through the conferment of separate legal personality, provides legal recognition of bodies of persons as distinctive holders of rights under a collective name, having distinct legal consequences.’ In 1897 Salomon v Salomon & Co – the HL case firstly confirms this principle of separate legal personality in UK. That has been followed by US and other country subsequently. [3]

Adolf A. and Berle, Jr. stated that classically, a corporation was conceived as an artificial person, coming into existence through creation by a sovereign power. Its primary business advantage of course is insulation of individual shareholders composing the corporation from liability for the debts of the corporate enterprise. [4]

Katsuhito Iwai written that ‘corporate realism’ believes that the corporation is a full-fledged organizational entity whose legal personality is no more than an external expression of its real personality in the society. The ‘fiction theory’ stated that the corporation is a separate and distinct social entity and its legal personality is a mere fiction approved by the state or formed by law. [5]

Charles Wild and Stuart Weinstein outlined two distinguishing features of a corporation such as: 1)It is an artificial legal entity and not a natural person -which in certain circumstances may prevent it from making a successful claim for the harm inflicted upon it. 2) It has perpetual succession, i.e., its existence is maintained by the constant succession of new persons who replace those who die or in some other way removed. [6]

Alan Dignam & his colleague found that corporate personality refers to the fact that, as far as the law is concerned, a company really exists that means a company can sue and be sued in its own name, hold its own property and essentially be liable for its own debts. It has allowed limited liability for shareholders as the debts belong to the legal entity of the company and not to the shareholders in that company. [7]

CORE FEATURES OF NOW A DAY’S COMPANIES:

Henry Hansmann and Reinier Kraakman found that there are five core features of now a day’s companies and those are (1) full legal personality, including well-defined authority to bind the firm to contract and to bond those contracts with assets that are the property of the firm as distinct from the firm’s owners, (2) limited liability for owners and managers, (3) shared ownership by investors of capital, (4) delegated management under a board structure, and (5) transferable shares. [8]

EVOLUTION OF THE CONCEPT OF SEPARATE LEGAL PERSONALITY:

Before 1897 corporations were mainly charitable. In 1905, John P Davis wrote that corporations have changed from divisions of society to associations of individuals. The early theory of incorporation was predicated on the idea of privilege to be granted on certain terms. With the modern company registration system from the UK Companies Act 1844 and its Australian counterparts, the corporation was based on contract. This reflected increasing autonomy with regard to corporate constitutions. The way in which corporate personality and limited liability link together is best expressed by examining the key case of Salomon v Salomon & Co.3,7

THE HISTORICAL CASE OF SALOMON V SALOMON & CO. LTD:

Mr. Salmon was a successful business man of manufacturing leather boots and decided to incorporate his business as a Limited Liability Company. He had given its name ‘ Salomon & Co. Ltd’. The shareholders were Mr. Saloman himself, his wife, daughter and four sons comprising seven persons and met the requirement for incorporation. Mr. Salomon became the managing director and his two sons appointed as directors. Mr. Salomon sold his business to the new corporation ‘Salomon & Co. Ltd’ for £39,000. The price was paid in £10,000 worth of debentures giving a charge over all the company’s assets, plus £20,000 in £1 shares and £9,000 cash. Mr Salomon paid off all the sole trading business creditors in full. Thus he held 20,001 shares in the company, with his family holding the six remaining shares. Because of the debenture Mr. Salomon was a secured creditor.

However, business was not running well and within a year Mr Salomon had to sell his debenture to save the business. This did not bring the desired effect and the company was placed in insolvent liquidation and it had too little money to pay its debts.

A liquidator was appointed by the court and he alleged that the company was but a fraud and a mere agent for Mr. Salomon for this reason Mr. Salomon was therefore personally liable for the debts of the company.

The Court of Appeal also ruled against Mr. Salomon on the ground that Mr. Salomon had abused the privileges of incorporation and limited liability. The lord justices of appeal variously described the company as a myth and a fiction, and undoubtedly opined that the incorporation of the business by Mr. Salomon had been a mere scheme to enable him to carry on as before but with limited liability.

Later on The House of Lords unanimously overturned the decision of The Court of Appeal, rejecting the arguments from agency and fraud. They held that there was nothing in the Act about whether the shareholders should be independent of the majority shareholders. The company was duly constituted in law and it was not the function of judges to read into the statute limitations they themselves considered expedient. The 1862 Act created limited liability companies as legal persons separate and distinct from the shareholders. [9] , 3,7

Discussion:

It was a good decision at general level since Salomon’s case is universally recognized as authority for the principle that a corporation is a separate legal entity. Judgment of Salomon’s case gave the companies with all the necessary qualities with which the companies become the powerhouse of capitalism. Later on it is found that investors become more interested to invest money in establishing corporation avoiding unlimited liability once they had. Thus it brought a revolution in business through out the world till date. And the principle of separate entity with limited liability contributed to individual’s and country’s prosperity. Thus corporation as a separate legal entity founded modern corporate law. However there exists no statistically significant misuse of corporate structures till date following the doctrine of Salomon case.

It is also found that by extending the benefits of incorporation to small private enterprises those promoted fraud and the evasion of legal obligations. There are many arguments that subsidiary companies became flexible in its existence with the parent company if they follow Salomon’s doctrine. There may have unfair means, abuse of money and power in this context but that might not be statistically significant and it needs further research to know and evaluate frauds including unfair means.

ENGLISH COMPANY LAW stated that the doctrine of separate corporate entity has some interesting consequences. Only the company and not individual members can sue to redress a wrong done to it.’ [10]

PARENT COMPANY:

Section 736. of Company Act 1985 (c.6) of UK stated that (1) A company is a “subsidiary” of another company. The act stated that a parent company has following core features: It (a) holds a majority of the voting rights in it, or (b) has the right to appoint or remove a majority of its board of directors. [11]

According to Vassya P, Parent Company is –

(1) one, which has a majority of the shareholders’ or members’ voting rights;

(2) a company entitled to appoint or remove a majority of the members of the administrative, management or supervisory body of the subsidiary who is though a separate entity and is at the same time a shareholder of parent company;

(3) continuing as a company, which can exercise a dominant influence over the subsidiary of which it is a shareholder, pursuant to a contract between the two or to its memorandum or articles of association, where allowed by the national law of the subsidiary (option modified to address the German reality);

(4) a company, shareholder in another company, who has exclusively appointed the directors for the current and preceding financial years;

(5) a company, which controls another company (no need to be a shareholder) by means of control agreement a country could provide more detailed clauses for such control agreement, as is the situation in Germany. [12]

SUBSIDIARY CORPORATION:

According to Vassya P, and UK Company Act 1985 (c.6)11 we can state a subsidiary corporation or company is one in which parent company has possession of all or at least a majority of the shares. Vassya P, also stated that in most of the legislations it is supposed that the parent company uses control over the subsidiary.

GROUPS OF COMPANIES:

Vassya P, stated that the groups of companies means “one or more controlled enterprises together with a third enterprise able to exert control over them.” The European Company Statute also recognizes the groups of companies, but unfortunately could not give its definition.

THEOROTICAL PPERSPECTIVE ON HEAD-OFFICE-DRIVEN PROCESS OF SUBSIDIARY COMPANY:

JULIAN B,and NEIL H, stated that as the overseas subsidiaries grew in size and developed their own unique resources it became apparent to many researchers that corporate headquarters was no longer the sole source of competitive advantage for the MNC.

Two theoretical perspectives shed light on the head-office-driven process of subsidiary evolution: (1) the product life cycle (PLC) model (Veron, 1966) and (2) the internationalization process (Johanson & Vahlne,1977). Both worked on the assumption that subsidiary is an instrument of the multinational corporations (MMC) and it acts solely with regard to head-office-determined imperatives. [13]

PARENT AND SUBSIDIARY COMPANY RELATIONSHIP:

Eric J. Gouvin commented that the idea of parent and subsidiary as separate corporate entities is a concept that has worked well in some situations for a long time. We must remind ourselves, however, that the idea of the corporation as a “person” and the idea of related corporations as “parent and child” are mere metaphors. Unlike real children, corporate subsidiaries usually do what the parent requests. The author urged that the law to face the reality of corporate life, relieve subsidiary directors from the charade of independence, and impose the duties that independent directors of subsidiaries should have borne directly on the parent corporation. [14]

JULIAN B . and his colleagues, found following significant relationships in a multinational corporation.

(a) internal subsidiary resources in combination with initiative have a strong positive impact on the subsidiary’s contributory role; (b) subsidiary initiative is strongly associated with the leadership and entrepreneurial culture in the subsidiary; and (c) contributory role is strongly associated with subsidiary autonomy and a low level of local competition. [15]

CONTROL AND OWNERSHIP LEVEL:

In 2006,Vernimmen, P and others stated that the level of control measures the strength of direct and indirect dependence that exists between the parent company and subsidiary, joint venture or associates. This level reflects the percentage of voting rights held by the parent company in these companies. While the ownership level is used to calculate the parent company‘s claims on its subsidiaries, joint adventures or associates. It reflects the proportion of their capital held directly and indirectly by the parent company. [16]

WHY DOES PARENT COMPANY CREATE SUBSIDIARYCOMPANY:

William O. Douglas and his colleagues stated that the reasons for the use of this structure are manifold:

There is increased facility in financing;

Parent company desires to escape the difficulties in business;

It wants to avoid of complications involved in the purchase of physical assets;

It wants to avoid taxation;

Parent company likes to escape from cumbersome management structure;

Parent company found that existing limited liability has appeared to recede. [17]

EXAMPLES OF PARENT COMPANY’S ABUSE:

Waldemar Braul and Paul Wilson found that environmental liability is increasingly an international concern. This is especially evident in judicial decisions holding parent corporations liable for environmental damages caused by their foreign subsidiaries. They gave several examples:

In 1978, the Amoco Cadiz tanker grounded on the coast of France and spilled its cargo of crude oil, damaging the marine environment. In the sue court found the negligence of the subsidiaries was assigned directly to American parent Standard Oil Company. The Court found Standard Oil liable in tort for its negligent supervision of its subsidiaries.

2. THE US BHOPAL DECISION – In 1986, the Government of India and victims of the 1984 factory explosion in Bhopal, India sued New York-based Union Carbide Corporation in the U.S. Federal Court. The factory was owned by Union Carbide India Ltd. whose majority shareholder was the Union Carbide Corporation. The New York Court declined jurisdiction to hear this tort claim, stating that “the Indian legal system is in a far better position than the American Courts to determine the cause of the tragic event and thereby fix liability.”

3. Like the US Bhopal Decision, the same happened in The English Cape Asbestos Decision. [18] , 27, 7

Discussion

The parent companies knew that the activities of the subsidiaries were responsible to cause damage to environment and lives. But it is jurisdiction that escapes liability for the parent company!

Limited Liability (LLB), SHAREHOLDERS, PARENT AND SUBSIDIARY COMPNIES:

– limited liability is the logical consequence of the existence of a separate personality.

– the members of the company are only liable for the amount unpaid on their shares and not for the debts of the company.

– limited liability minimises the risk for investors and is said to encourage investment.

– it allows managers to take greater risk in the knowledge that the shareholders will not lose everything.

A company may still be formed today without limited liability as a registered unlimited company in UK under the Company Act 2006 under s.3(4).7 Limited liability has utmost importance in its use for the corporate shareholders. And both Anglo-American corporation law and corporation law of the civil system acknowledged it.

According to most authors including Phillip I. Blumberg, it can be noted that

1. Limited liability’s doctrine protects

investors in the enterprise from the liabilities of the enterprise.

the parent and its subsidiaries.

2. Limited liability for the enterprise is equally applicable for each of its successive tiers.

3. Corporate groups enjoy the same benefits of limited liability as the common law.

4. Limited liability doctrine helped today’s multinational corporations to organize in the form of a parent corporation with dozens or even hundreds of subsidiary corporations.

5. Limited liability facilitated companies to conduct most of the world’s business explicitly.

6. Limited liability permits to achieve layers of insulation for the parent corporation from liability for the obligations of its numerous subsidiaries.

And it is found that substantial industrial development acknowledged to limited liability on shareholders of the corporate both in England and in the United States under their own legal systems around 1855 and 1825 respectively.

REEXAMINATION OF LIMITED LIABILITY CONCEPT AND PARENT-SUBSIDIARY RELATIONSHIP:

Phillip I. Blumberg, also stated that

– if limited liability has been carried carelessly beyond the original objective of insulating the ultimate investor from the debts of the enterprise has come into view as an issue of major importance that need re-examination of ‘limited liability’ in relation to world wide environmental and other disasters.

-the most burning worldwide concerns with the insulation of multinational parent corporations from liability for the acts of their subsidiaries relate to torts of a magnitude and widespread impact unimaginable a few years ago:

1. oil spills in the English Channel affecting miles of coastline,

2. the disaster in Bhopal.

This combination of multinational corporate groups and complex torts is one of the vital factors making the re-examination of the application of limited liability to corporate groups.

UK LEGISLATION AND CORPORATE RELATIONSHIP:

As corporate affairs became more complex and group structures emerged a number of provisions were introduced by UK legislation to control companies through revision of Company Acts. For example:

-s.399 CA 2006 provides that parent companies have a duty to produce group accounts

-s.409 CA 2006 also requires the parent to provide details of the shares it holds in the subsidiaries and the subsidiaries’ names and country of activity.

-s.993 CA 2006 which is used for criminal offence of fraudulent trading

-ss.213–215 Insolvency Act 1986 which contain the most important statutory veil lifting provisions. [19] ,7

LIFTING VEIL OF CORPORATE PERSONALITY AND UK LEGISLATION IN SUMMARY:

Richard Squire stated that in certain situations the court will ignore the separate identity of the company. The cases where this will happen have never been properly defined and the principles used to justify lifting the veil have been applied inconsistently. It is summarised below:

a) When cases find paramount public interest e.g., Daimler Co. v Continental Tyre Co Ltd [1916] 2 AC 307 (alien enemy), Re FG (Films) Ltd [1953] 1 All ER 615 (economic policy) etc.

b) When there is evasion of legal obligations e.g., Gilford Motor Co v Horne [1933] Ch. 935 (restrictive covenant), Jones v Lipman [1962] 1 All ER 442 (specific performance), Hilton v Plustitle Ltd [1989] 1 WLR 149 (avoidance), Adams v Cape Industries [1990] 2 WLR 657 (business planning),etc.

c) When there is abuse of legal procedure e.g., Re Bugle Press [1961] Ch. 270 – a case involving Companies Act 1985, ss. 428-30.

d) When company acting as agent for its members e.g., Smith, Stone & Knight Ltd v Birmingham Corporation [1939] 4 All ER 116 (criteria for determining agency)

e) When company acting as trustee for its members e.g., Trebanog Working Men’s Club v Macdonald [1940] 1 KB 576 etc.

f )In case of groups of companies where much business activities whether domestic or multinational is carried out via a group structures where the parent company is the owner of the subsidiaries. Law treat parent and subsidiary as legally distinct such as when company acting as trustee for its members as found in DHN Foods v Tower LBC [1976] 1 WLR 852 (Denning’s radicalism – single economic entity permits disregard of legal niceties) requires veil lifting.

Insolvency Act 1986 – Fraudulent and wrongful trading (ss.213 and 214).

The typical large business corporation divides itself into a multitude of subsidiaries and if the group of companies stays solvent the shareholders benefit from the lower interest rates on the guaranteed debts. And if the group of companies faces insolvent, the triggering of the guarantees makes no difference to the shareholders – because their equity stakes in the guarantor entities are wiped out anyway. Then veil lifting is required. It is required when the following situations arise in a group of companies.

– employer within a group of associated companies employing a number of people for purposes of employment law.

– some one doing market misbehaviour creating a market competition .

– at common law or in equity where some fraud, dishonesty, or improper purpose is found to exist.

– where principles of agency are said to apply.

Hence where there exists an enterprise entity which may embrace one or more separate legal entity companies within a group and there arise circumstances signifying that a particular corporate form is being used within a group of companies in some improper ways. And this wrong doing has close links within the context of the parent subsidiary relationship and the corporate group structure. [20]

Judges have lifted the corporate veil in a great number of cases when the case satisfy the court with following six considerations and lack of one or more consideration will not allow veil lifting. The considerations are:

Were the profits treated as those of the parent company?

Were the persons conducting the business of the subsidiary appointed by the parent company?

Was the parent company the “head and brains” of the trading venture?

Did the parent company govern the adventure?

Were the profits made by the subsidiary company made by the skill and direction of the parent company?

Was the parent company in effective and constant control of the subsidiary?

Another criterion is whether the subsidiary company is undercapitalised for the carrying on of an independent existence. [21]

SMITH, STONE & KNIGHT LTD V BIRMINGHAM CORPORATION [1939]

Facts:

Smith, Stone and Knight Ltd (SSK) owned some land, as a subsidiary company of Birmingham Waste Co Ltd (BWC). BIRMINGHAM CORPORATION (BC) issued a compulsory purchase order on this land. Any company which owned the land would be paid for it, and would reasonably compensate any owner for the business they ran on the land. Since the subsidiary company (SSK) of (BWC) did not possess the land, Birmingham Corporation (BC) claimed that SSK was entitled to no compensation.

Held:

The courts held that the subsidiary company was an agent and BC must pay compensation. In Smith, Stone and Knight Ltd case Atkinson J, lifted the veil to enable a subsidiary company operating business on land owned by the holding company to claim compensation on the ground of agency. [22]

It is certain that six requirements21 must be established before the Salomon principle could be disregarded to support the finding that a subsidiary carried on a business as agent for its holding company.

The court lifted the veil of incorporation to find out the ownership of the waste paper business and the ownership of the land, which the waste paper business was operated. The court found out Smith, Stone& Knight Ltd, a holding company did not transfer ownership of waste paper business and land to Birmingham Corp. Therefore, the waste paper business was still the business of parent co & it was operated by the subsidiary as agent of the parent co. [23] , [24]

Discussion:

-Judges treated a group of associated companies as a single economic entity.

-Judges did not find evasion of legal obligation.

-Often the courts ignore the veil of incorporation when the corporate form is being used to evade a legal obligation.

– Judgement and six criteria strictly followed in subsequent cases as for example Jones v Lipman [1962] case was considered no veil lifting.21

– the subsidiary company worked as an agent an agent of the parent company, therefore compensation was payable.

-whether the doctrine of Piercing the corporate veil should be adopted or not has use, is also debatable in view of strict requirement of disclosure in the accounts.

Comment:

It is stated at the sl1, that the profits of the subsidiary company must be included as the profit of Holding company. But as subsidiary is a separate juristic person and what it has earned cannot be the earnings of other entity even though it may be the cent percent holding company.

Regarding Sl.2,3 and 4 are commercial decisions and all the holding companies do take this kind of interests in the subsidiaries companies.

Regarding sl.5.: It is true that the major decisions subsidiary company are taken whether formally or informally by the holding company as it is the major stake holder and there is nothing wrong with this sort of practice. Regarding Sl.6:  Appointment of the directors of subsidiary company is always with the Holding company. [25]

DHN FOOD DISTRIBUTORS LTD V TOWER HAMLETS LONDON BOROUGH COUNCIL [1976] 1 WLR 852 (permits disregard of legal niceties):

Facts:

In 1963 at Bow in the east end of London there was a firm of grocery and provision

merchants. But the firm and its property were not in a single ownership.

It was owned by three companies.<