The Rationale behind Limited Liability

Brief : 215801

Delivery Deadline : 14/01/08

Title: A) What is limited liability and what is its rationale? (750 words)

(b) What is meant by the statutory contract, and what is its importance for company law? (750 words)

ANSWER

Introduction

This paper considers two important aspects of company law. Part A discusses the concept of limited liability and its rationale in law and business. Part B analyses the so-called “statutory contract”, its effect on the relationship between the company, its members and outsiders (non-shareholders) and its importance in the context of the overarching company law. Relevant authority is cited and discussed and pertinent conclusions are drawn on the basis of the analysis provided.

A) Limited Liability

The often-used phrase “limited liability company” is slightly misleading. It is very important to note that the concept of “limited liability” refers to the members of the company and not to the company itself. Companies are always liable without limit for their own debts and liabilities, whatever their designation.

The designation “limited” or “unlimited” relates exclusively and specifically to the company’s membership. Limited liability means that the liability of the members of the company in question is limited to the extent of their shareholding in the company^[1]. Once this is paid a member in a limited liability company has fully discharged his or her liability and cannot be called upon for further amounts. Section 3 of the Companies Act 2006^[2] provides the following:

“(1) A company is a “limited company” if the liability of its members is limited by its constitution. It may be limited by shares or limited by guarantee.

(2) If their liability is limited to the amount, if any, unpaid on the shares held by them, the company is “limited by shares”.

(3) If their liability is limited to such amount as the members undertake to

contribute to the assets of the company in the event of its being wound up, the

company is “limited by guarantee”.”

If a company is formed without limit on the liability of its members then the company is classified as an unlimited company (see section 3(4) Companies Act 2006).

The existence of the principle of limited liability is made possible by the law’s recognition of separate and independent personality of the company. Without legal acknowledgement of the distinct persona of the corporation, limited liability would make no sense because there would be no one to shoulder the liabilities of the company over and above those accounted for by the combined value of the members’ shareholdings. The case that underpins the separate legal personality of the corporation, and thus also underpins the concept of limited liability itself, is the very well known Salomon v. Salomon & Co Ltd [1897]^[3]. The significance of this case as the cornerstone of modern company law is difficult to exaggerate^[4]. Without the Salomon principle, company’s would be very different legal constructs and incorporation would be a far less attractive prospect.

This brings us neatly to the rationale for limited liability. It can be argued that the concept of limited liability is an absolutely invaluable tool for wealth generation and the encouragement of entrepreneurial activity. In order to make a profit and thus create wealth and jobs for the benefit of society it is necessary to invest money and take financial risks. A world without the protection and guarantee of limited liability would be a very intimidating one indeed. If everyone engaged in a commercial endeavour was held liable to the full extent of their capital each and every time they invested in a business, commercial activity would be massively restricted. It is easy to see why. If when an individual considers investing in a business he knows his entire savings and even his house and personal property is “on the line” if the venture fails he is far less likely to go ahead and invest in the project. Limited liability encourages considered and measured financial risk-taking, because a prospective investor knows that only the value of his chosen investment (i.e. his shareholding in the business) is at stake.

Therefore, the rule of limited liability encourages entrepreneurial activity and investment in wealth generation. An investor may well be prepared to risk £10,000 on a promising venture, but is far less likely to risk his entire assets and even the roof over his head. The Salomon principle, as discussed and applied in a vast number of different legal contexts^[5] (see inter alia: Macaura v Northern Assurance Co. (1925)^[6]), recognises the company as a separate legal person, independently liable for its own debts just as all other individuals in society are. As a consequence of Salomon, investors can rely upon the mechanism of limited liability without fear of being subject to a company’s entire debts, which might well prove overwhelming.

It is the availability of limited liability that most clearly distinguishes the corporate form from that of the traditional partnership. It is also limited liability that constitutes the greatest single advantage of incorporation over the partnership and sole trader forms of commercial activity in practice. The historical justification for the creation of the limited liability principle was the encouragement and facilitation of entrepreneurial activity and that justification remains intact and compelling today.

Part A: 754 words

B) The Statutory Contract

By way of introduction, in the context of company law the “statutory contract” is a term used to describe the relationship between the company and its members (or shareholders). This relationship is structured on the basis of a company’s constitutional documents, which include the memorandum of association and articles of association. As will be discussed, there are a large number of cases on the statutory contract and until recently the Companies Act 1985 set out the applicable legal matrix. It is important to note that the Companies Act 2006^[7] has now altered the law relevant to the statutory contract.

Section 33 of the 2006 Act specifies the effect of a company’s constitution as follows:

“(1) The provisions of a company’s constitution bind the company and its members to the same extent as if there were covenants on the part of the company and of each member to observe those provisions.”

It is useful to contrast this new formulation against the form of words set down in the 1985 Companies Act, where section 14 provided as follows:

“Subject to the provisions of this Act, the memorandum and articles, when registered, bind the company and its members to the same extent as if they respectively had been signed and sealed by each member, and contained covenants on the part of each member to observe all the provisions of the memorandum and of the articles.”

It is submitted that the two versions are substantively similar and that the law on the statutory contract has not been varied in any significant fashion by the 2006 Act. The new version has been streamlined and simplified, but it is argued that it does not alter the existing principles (as expounded in previously decided case law) in material terms.^[8] The terms of the provision have therefore been updated and clarified and made specifically applicable to a company’s articles only, however, that aside, the case law on the old statutory formulation continue to be relevant.

In Oakbank Oil Co v Crum (1882)^[9], Lord Selbourne LC described the contractual effect of the articles as follows:

“Each party must be taken to have made himself acquainted with the terms of the written contract contained in the articles of association… He must also in law be taken to have understood the terms of the contract according to their proper meaning… and that being so he must take the consequences whatever they may be, of the contract which he had made.”

It is submitted that the primary legal effect of the statutory contract today is that the articles will be deemed to constitute a binding contract between the company and every individual member. This means that each member is legally bound to the company to comply with the terms laid down in the articles in his capacity as a member and the company, in return, is bound to each individual member in their capacity as a shareholder.

Cases that clearly illustrate this mutual and reciprocal obligation include Hickman v Kent or Romney Marsh Sheepbreeders’ Association (1915)^[10], where a member was required to abide by the statutory contract and Wood v Odessa Waterworks Co (1889)^[11], where the company was obliged to pay a dividend as prescribed by the articles. In Wood Stirling J remarked:

“the articles of association constitute a contract not merely between the shareholders and the company, but between each individual shareholder and every other.”

Alongside this primary legal effect it is important to note the boundaries of the statutory contract. It is long-established law (left intact by the 2006 Act) that the articles do not foster a contract that extends to impose obligations on or provide rights for outsiders or non-members. In addition, the statutory contract does not support rights applicable to members when acting in a capacity other than that of a member of the company. ‘Outsider rights’ are therefore unenforceable under the statutory contact. A case in point is Eley v Positive Government Security Assurance Co (1876)^[12]. In Eley, company articles specifically provided that the plaintiff member would be engaged as the solicitor of the company. The plaintiff was however dismissed from his post and sued for breach of the term of the statutory contract as described. It was held by the court that the action failed because the articles were not capable of founding a binding contract between the company and a member in a capacity other than that of membership, e.g. as a solicitor. The member’s interest as a solicitor was thus deemed to be merely an outside interest in the terms of the statutory contract and therefore unenforceable.

This therefore is what is meant by the “statutory contract”. Its importance lies in the legally enforceable relationship it establishes between the company and its members, and in the fact that the obligations and rights it gives rise to are binding in the capacity of company membership.

Part B: 813 words

THE END

WORD COUNT INCLUDING TEXT OF A & B ANSWERS ONLY : 1567

Question text, footnotes and bibliography not included

BIBLIOGRAPHY

Case law as footnoted to standard citation

Companies Act 2006: http://www.opsi.gov.uk/ACTS/acts2006/pdf/ukpga_20060046_en.pdf

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

DTI, Companies Act 2006: A summary of what it means for private companies, February 2007: http://www.dti.gov.uk/files/file37956.pdf.

Grantham R. and Rickett C. (eds.), Corporate Personality in the Twentieth Century, (1998) Hart Publishing

Hannigan B., Company Law, (2003) Oxford University Press

Hicks A. and Goo S.H., Cases & Materials on Company Law, 5th ed, (2004) Oxford University Press.

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

1

Footnotes

^[1] Or to the extent of their guarantee in a smaller number of cases.

^[2] For full text see: http://www.opsi.gov.uk/ACTS/acts2006/pdf/ukpga_20060046_en.pdf

^[3] (1897) AC 22.

^[4] For analysis see: Hicks A. and Goo S.H., Cases & Materials on Company Law, 5th ed, (2004) Oxford University Press.

^[5] For insightful comment see: Grantham R. and Rickett C. (eds.), Corporate Personality in the Twentieth Century, (1998) Hart Publishing.

^[6] (1925) AC 619.

^[7] For full text see: http://www.opsi.gov.uk/ACTS/acts2006/pdf/ukpga_20060046_en.pdf

^[8] Interestingly under the 2006 Act the company memorandum is now merely treated as a formal document recording the position at the point of registration, and only the articles of association will now be treated as the continuing constitutional document of the company. This does not constitute a significant reform in practice in light of the fact that it has always been the company’s articles of association that supply the great majority of terms litigated on.

^[9] (1882) 8 App Cas 65.

^[10] [1915] 1 Ch 881.

^[11] (1889) 42 Ch D 636.

^[12] (1876) 1 Ex D 88.