Liabilities for Parent Companies and Shareholders

Johan, Jonathan, Jason and James are the shareholders and directors of Ehlers Ltd, the parent company of wholly owned subsidiaries JBB Ltd, JD Ltd and JS Ltd. Ehlers Ltd had divided its business into three between the subsidiaries specifically to minimise its liability for tax and tortious actions. JBB Ltd buys and mixes chemicals for use in blasting in the mining industry, JD Ltd transports the chemicals and JS Ltd markets the mixed chemicals. All the profits of the subsidiaries flow back to Ehlers Ltd. An accident occurs while JD Ltd is transporting hazardous chemical along the motorway. Fifteen people are badly burned and noxious fumes are released into the air near a town.

Additionally, chemicals leak into a major river contaminating the water downstream for hundreds of miles. The projected damages and fines payable by JD Ltd come to millions of pounds. JD Ltd is capitalized only to the extent it needed to transport chemicals in the two trucks it owns. It has some liability insurance but only to the amount of £1 million. After a few months JD Ltd is in insolvent liquidation. In the meantime, Ehlers Ltd has set up another wholly owned subsidiary to carry out the group’s transport needs.

Discuss whether the parent company and/or its members could be liable for the action of JD Ltd. When you have done that critically evaluate the legal outcome.

ANSWER

Introduction

This paper offers a discussion as to the legal position and potential liability of Ehlers Ltd and its members in regards to the liabilities of JD Ltd consequent to the accident detailed in the facts set out above. It is appropriate at the outset to advise that the situation under review generates issues relating to the law concerning the effects of the recognition of the corporation as a separate legal entity^[1] distinct from its members and controllers which manifests itself in practice as the so-called “corporate veil”. Relevant case law is considered and applied to the facts in deriving conclusions and firm advice on liability. This outcome is critically evaluated in a closing commentary.

The separate legal persona of JD Ltd

It is submitted that it is a general principle of company law that JD Ltd is considered as a separate legal entity with a legal personality that encompasses rights and liabilities independent of its members and the outside world by virtue of foundation authority such as Salomon v Salomon & Co Ltd (1897)^[2]. In Salomon Lord Halsbury handed down the following seminal ruling:

‘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.’

The Salomon principle of the separate corporate persona is very well entrenched in English company law^[3] and has been endorsed and applied in a veritable constellation of cases in a wide variety of contexts, including inter alia: Macaura v Northern Assurance Co Ltd (1925)^[4] and Lee v Lee’s Air Farming Ltd (1961)^[5].

It is submitted that this authority indicates that the liabilities generated by JD Ltd as a consequence of the accident involving the transportation of hazardous chemicals will be confined at law to JD Ltd exclusively and independently and not extrapolated to its members (once the value of their shareholding has been exhausted in discharging JD Ltd’s debts) or to any other party. It is submitted that this is clearly the result that the parent company and its controllers had in mind when they established the parent/subsidiary company network of relationships in the facilitation of their commercial endeavour.

That said, it is submitted that it is important to consider the fact that a branch of law has been developed to deal with what the courts deem to be abuses of the separate legal entity principle as established in Salomon^[6]. This branch of company law, which sees expression in both statute and case precedent, dictates that an independent legal persona may be investigated in certain cases so as to lift the “corporate veil”^[7] and possibly expose the membership or controllers of a company to scrutiny and liability for the company’s debts.

It should be noted that one situation in which the courts have in the past been prepared to lift a corporate veil is in the case of a group of companies which are connected by a parent-subsidiary network. This is the case in relation to JD Ltd and its relationship with Ehlers Ltd and its other subsidiaries, therefore it is necessary to examine the relevant law to determine whether there is a risk that the corporate veil around JD Ltd could be lifted on the facts before us. This would potentially have the effect of exposing Ehlers Ltd and its subsidiaries to liability for those debts that JD Ltd has been unable to meet as a consequence of the accident under discussion. The applicable law is discussed in the following section.

JD Ltd’s corporate veil: could it be lifted?

It is a general principle of company law that the Salomon principle may be ignored (or temporarily set aside) in cases where the principle is deemed to be abused for the purposes of fraud or malpractice. Authority such as Gilford Motor Co v Horne [1933]^[8] testifies to this. There is also authority to suggest that the courts may be moved to lift a corporate veil in circumstances where it is deemed appropriate to extend the rights and liabilities of a subsidiary to a parent or holding company. Such cases include: Smith, Stone & Knight Ltd v Birmingham Corporation (1939)^[9] and DHN Food Distributors v Tower Hamlets London Borough Council (1976)^[10].

The DHN Food Distributors case prompted the Court of Appeal and Master of the Rolls Lord Denning to rule that a group of companies should be treated as a “single economic entity” so as to extend the rights and liabilities of a subsidiary to its holding company. If this case was to be followed in relation to JD Ltd’s situation, then Ehlers Ltd could be exposed to full liability for the debts left undischarged by JD Ltd after its insolvent liquidation.

However, it is considered that this outcome is unlikely, given the trend of subsequent case law. The House of Lords moved quite quickly after the DHN decision to clarify the true state of the law and buttress the integrity of the principle of separate corporate personality in the case Woolfson v Strathclyde Regional Council (1978)^[11], which prompted a finding that the corporate veil would not be lifted in the context of a group of companies and that the Salomon rule would be upheld. The courts remained reluctant to lift the veil on a group of companies in order to impose liability for the debts of a subsidiary on its holding company in Multinational Gas & Petrochemical Co v Multinational Gas & Petrochemical Services Ltd (1983)^[12]. In this case a subsidiary generated debts as the consequence of alleged breaches of duty but it was held that because the company was not deemed a ‘sham’ the corporate veil would be preserved and the effect of this was that its parent companies could not be sued.

Thereafter, Adams v Cape Industries plc (1990)^[13] served to address the confusion that had arisen among lawyers uncertain about the conflict between DHN and Woolfson. In Adams, Slade LJ cited Bank of Tokyo v Karoon (1986)^[14] and ruled:

“Counsel suggested beguilingly that it would be technical for us to distinguish between parent company and subsidiary company in this context; economically, he said, they were one. But we are concerned not with economics, but with law. The distinction between the two is, in law, fundamental and cannot be bridged.”

This represented a definitive statement of the law and protected corporate groups against the lifting of their corporate veils. As a consequence of the Adams line of authority it is likely that Ehlers Ltd will be insulated against liability for JD Ltd’s debts.

Conclusions

The Adams v Cape restatement of the policy of maintaining the corporate veil in the context of company groups was confirmed in the more recent case of Trustor AB v Smallbone and Others (2001)^[15]. Moreover, the Companies Act 2006^[16], which engineered root and branch reform, modernisation and consolidation of company law presented the ideal opportunity for change to the law on this specific point but the doctrine was left entirely untrammelled by the new legislation. In conclusion it is submitted that Ehlers Ltd and its surviving subsidiaries will be insulated from liability for the debts of JD Ltd by the operation of the Salomon principle and its manifestation in the form of the corporate veil, which will, as the authorities considered indicate, be left undisturbed by the courts.

A critical evaluation of the likely legal outcome

It is asserted that the likely outcome to this case is in conformity with established legal principle, but nevertheless it is arguably unsatisfactory. In his article “Multinationals and the Antiquities of Company Law”^[17], the eminent commentator Lord Wedderburn put the problem eloquently:

“How can poor old Salomon cope with Multinational Gas?… the reality today is not the company. It is the corporate group… It is surely time for statute to break corporate veils and make parent corporations, in stated circumstances, liable for some at least of the debts and liabilities of the subsidiaries”

There is commonsense and moral force in Wedderburn’s argument, which was put some twenty four years ago but which is of even more relevance today. In 2008 in many cases it is corporate groups that do business as a single economic entity in practice and it is curious that holding companies are still being protected from the debts generated by the very same subsidiaries that the holding company relies on to generate its profits. The situation can only be justified on the basis of economic pragmatism and a desire to encourage entrepreneurial activity and wealth generation through the protection of the rights of the corporate form. Ehlers Ltd is currently protected by this policy, but the question of whether it still should be is difficult to answer.

THE END

EXACT WORD COUNT : 1559

Not including question text or footnotes.

BIBLIOGRAPHY

Case law as footnoted to standard citation

Dine J., Company Law, 5th ed, (2005) Palgrave Macmillan

Freedman J., “Small Businesses and the Corporate Form: Burden or Privilege?” The Modern Law Review, Vol. 57, No. 4 (Jul., 1994), pp. 555-584

Kahn-Freund O., “Some Reflections on Company Law Reform” (1944), 7 Modern Law Review 54

Sealy L. and Worthington S., Cases and Materials in Company Law, (2007) Oxford University Press

Wedderburn, Multinationals and the Antiquities of Company Law, (1984) Modern Law Review 87.

1

Footnotes

^[1] See Sealy L. and Worthington S., Cases and Materials in Company Law, (2007) Oxford University Press, p39 et seq.

^[2] (1897) AC 22.

^[3] See for comment: Freedman J., “Small Businesses and the Corporate Form: Burden or Privilege?” The Modern Law Review, Vol. 57, No. 4 (Jul., 1994), pp. 555-584.

^[4] (1925) AC 619.

^[5] (1961) AC 12 (PC).

^[6] See for a critique: Kahn-Freund O., “Some Reflections on Company Law Reform” (1944), 7 Modern Law Review 54.

^[7] See Sealy L. and Worthington S., Cases and Materials in Company Law, (2007) Oxford University Press, p51 et seq.

^[8] [1933] Ch 935.

^[9] (1939) 4 All ER 116.

^[10] [1976] 3 All ER 462.

^[11] [1978] SLT 159, HC.

^[12] (1983) 2 All ER 563.

^[13] (1990) Ch 433.

^[14] (1986) 3 All ER 468.

^[15] [2001] 1 W.L.R. 1177.

^[16] See: http://www.opsi.gov.uk/ACTS/acts2006/ukpga_20060046_en.pdf.

^[17] Wedderburn, Multinationals and the Antiquities of Company Law, (1984) Modern Law Review 87.