Principle of Separateness

Introduction

Firstly, this paper will examine the case of Salomon v Salomon to determine the exact nature and importance of the Salomon principle of separateness often referred to as the ‘veil of incorporation’. Second, this paper will examine how when limited liability is coupled with the Salomon principle it provides protection to investors over creditors. Third, this paper will examine when the courts are prepared to disregard the Salomon principle to protect creditors and combat fraud or abuse of the corporate form by ‘piercing the corporate veil’.

The Salomon Principle

The doctrine of separate legal personality is the cornerstone of modern company law. It established that an incorporated company is an entity separate from its shareholders and directors but not entirely free from their existence. The case of Salomon v. Salomon & Co Ltd. is universally recognised as authority for the principle that a corporation is a separate legal entity. It created the idea that companies operate behind a metaphoric ‘veil of incorporation’ which separates members from the company and permits the company to be completely independent, with rights and duties distinct from those possessed by its shareholders, directors and employees. The company is deemed an artificial legal person, with independent existence. As Lord Macnaghten put it in Salomon:

‘The company is at law a different person altogether from the subscribers…’

http://www.murdoch.edu.au/elaw/issues/v7n3/puig73a_notes.html – n27The practical need for a separation between a company and its members has never been doubted since the decision in Salomon’s case. The need for the separate corporate entity has been justified on different grounds. Concession theorists, for example, regard corporate personality as a privilege granted by the state ‘thereby underlining the state’s claim to control over the process of incorporation and its subsequent use’. Similarly, the contractarian school argues that ‘[c]orporation law reduces transaction costs by implying in every corporate charter the normal rights on which shareholders could be expected to insist’, such as separate legal status.

In theory, Salomon’s case was a good decision. By establishing that corporations are separate legal entities, Salomon’s case blessed the company with all the necessary attributes with which to become the motivating force of capitalism. However in practice and reality the separation of a legal entity from its members can be problematic. By extending the benefits of incorporation to small private enterprises, Salomon’s case has provided a loophole through which subscribers of a company can evade their legal obligations. Despite its problems, the Salomon principle has stood the test of time and remained in tact to preserve various practical functions for the commercial market. Some of these functions include: perpetual existence, flexibility, financing methods, specialised management and majority rule of the corporation.

Also available to subscribers of an incorporated company is the option of forming a company with ‘limited liability’. Limited liability allows the members of a company to limit their responsibility for a company’s debts. This means the members of an insolvent company do not have to contribute their own personal assets in the liquidation to meet the debts of the company. Liability may be limited to a predetermined sum, payable on winding up, or to the nominal value of the shares held, unless this sum has been paid by the current or a former shareholder. Since most shares are issued fully paid, shareholders have, effectively, no liability for the company’s debts. Limited liability stimulates the economy as a whole, through investment and business activity. It reduces the cost of separation of management and control and reduces the need to monitor control. Limited liability encourages companies to take on the optimal investment and diversification of holdings that may be deemed negative risk taking by an unincorporated trader.

The Difficultly With Limited Liability And The Salomon Principle

Limited liability was very controversial when it was introduced because of its effect of shifting the hazard of business breakdown away from investor(s) to creditor(s) who had to bare the consequences of liquidation. This was perceived to be unfair. The idea behind the controversy is whether limited liability should be available for what is effectively a ‘one-man company’ often used to ‘defraud creditors’. Khan-Freund criticised Salmon as a ‘calamitous decision’ and adhered to the view it is unjust to attribute limited liability to a small company, where there is no business risk or need to encourage outside investment.

The Salomon principle when coupled with the consequential attribute of limited liability provides an ideal vehicle for fraud. It has been argued the Salomon principle is malleable and provides a facility for protecting directors and members against the claims of creditors. The corporate form has been responsible for the development of many different forms of fraudulent activity.

An example of corporate fraud is where subscribers set up a limited liability company that is ‘wafer-thin’ and undercapitalised. The owners then cause the corporation to incur large debts in it’s own name, with little or no prospect of being able to meet these debts. When the creditors seek repayment, the owners argue that they are not liable for the debt because the company as a separate legal person is the debtor.

A second example of corporate fraud is where assets of a corporation are transferred to a new corporation for the purposes of avoiding tax liability. This transfer is often framed in a confusing series of transactions to conceal the real design of the scheme. When funds are traced back to the new ‘vehicle corporate shell’, investigators will find ‘straw men’ have been appointed in the place of original directors. The new asset rich corporation will attempt to dissipate the assets by granting unsecured, interest-free loans by the corporation to the directors or to companies in which they have an interest and the payment of astronomical fees to directors for management services or living expenses.

Today for a small business the Salomon principle coupled with limited liability is an illusory advantage, to some extent because creditors have developed different capacities to protect themselves. Moreover, s. 213, 214 and 215 of the Insolvency Act 1986 impose liability for the debts of a company where its subscribers have been engaged in fraudulent or wrongful trading. Furthermore, negative aspects of the decision in Salomon’s case, have (arguably) been neutralised, through the understanding ‘The courts can and often do draw aside the [corporate] veil. They can, and often do, pull off the mask. They look to see what really lies behind.’ This is a difficult decision to make, because the courts have to decide whether to obey the principle of the separate legal entity or recognise the need for ‘lifting’ or ‘piercing’ the corporate veil.