The Company Is at Law, a Different Person Altogether

– RESEARCH PAPER-

“The company is at law, a different person altogether from its members. The company is not, in law, the agent of the subscribers or trustees for them.”

Introduction:

In this paper, we discuss what it means when a company is said to be a separate legal entity from its members and shareholders and is treated as an ‘artificial’ human being in law. We shall take a look at how this law came into being and define it properly, look at its benefits and ways in which it can be exploited, how the court may choose to circumvent this law in special cases and round off with a look at famous cases involving this law

Upon incorporation, the law states, a new and separate artificial entity comes into existence. At law, a corporation is a distinct person with its own personality separate from and independent of the persons who formed it, who invest money in it, and who direct and manage its operations. It follows that the rights and duties of a corporation are not the rights and duties of its directors or members who are, most of the time, obscured by a corporate veil surrounding the company.

The company, being a legal entity independent of its members, can enter into contracts and own property in its own right, can sue and be sued and also taxed in its own name. The principle of corporate entity was established in the case of Salomon v A. Salomon, now referred to as the ‘Salomon’ principle. [1]

(The facts of this case will be dealt with, in much more details in the next section.)

The House of Lords affirmed this principle, and stated that the company was also not to be regarded as an agent of the owner, as the company is at law a different person altogether from the subscribers to the memorandum and the company is not in law the agent of the subscribers or a trustee for them. [2]

Salomon v. A Salomon & Co Ltd: [3]

Mr Aron Salomon was a leather boot and shoe manufacturer. He had a wife, a daughter and five sons. Four of the sons worked with him. The sons wanted to be partners, so he turned the business into a limited company. The wife and five eldest children became subscribers and two eldest sons also directors. Mr Salomon took 20,001 of the company’s 20,007 shares.

The price fixed by the contract was £39,000, which was “extravagent” and not “anything that can be called a business like or reasonable estimate of value.” Transfer of the business happened on June 1, 1892. Purchase money for the business was paid, totalling £20,000, to Mr Salomon. £10,000 was paid in debentures to Mr Salomon as well.

But soon after Mr Salomon incorporated his business, there was economic trouble. A series of strikes in the shoe industry led the government, Salomon’s main customer, to split its contracts between more firms. His warehouse was full of unsold stock. He and his wife lent the company money. He cancelled his debentures. But the company needed more money, and they sought £5000 from a Mr Edmund Broderip. They gave him a debenture, the loan with 10% interest and secured by a floating charge. But the business still failed, and they could not keep up with the interest payments. In October 1893 Mr Broderip sued to enforce his security. The company was put into liquidation. Mr Broderip was paid but other unsecured creditors were not.

The liquidator met Broderip’s claim with a counter claim, joining Salomon as a defendant, that the debentures were invalid for being issued as fraud. The liquidator claimed all the money back that was transferred when the company was started: rescission of the agreement for the business transfer itself, cancellation of the debentures and repayment of the balance of the purchase money.

Verdicts:

High Court

In the first case, Broderip v Salomon [1893], Vaughan Williams J said Mr Broderip’s claim was valid. It was undisputed that the 20,000 were fully paid up. He said the company had a right of indemnity against Mr Salomon. He said the signatories of the memorandum were mere dummies, the company was just Mr Salomon in another form, an alias, his agent. Therefore it was entitled to indemnity from the principal. The liquidator amended the counter claim, and an award was made for indemnity.

Court of Appeal

The Court of Appeal [1895] confirmed Vaughan Williams J’s decision against Mr Salomon, though on the grounds that Mr. Salomon had abused the privileges of incorporation and limited liability, which Parliament had intended only to confer on “independent bona fide shareholders, who had a mind and will of their own and were not mere puppets”. Lindley LJ (an expert on partnership law) held that the company was a trustee for Mr Salomon, and as such was bound to indemnify the company’s debts. Lopes LJ and Kay LJ variously described the company as a myth and a fiction and said 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.

House of Lords

The House of Lords unanimously overturned this decision, rejecting the arguments from agency and fraud. They held that there was nothing in the Act about whether the subscribers should be independent of the majority shareholder. 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.

Lord Macnaghten asked what was wrong with Mr. Salomon taking advantage of the provisions set out in the statute, as he was perfectly legitimately entitled to do. It was not the function of judges to read limitations into a statute on the basis of their own personal view.

The House held:

“Either the limited company was a legal entity or it was not. If it were, the business belonged to it and not to Mr Salomon. If it was not, there was no person and no thing to be an agent [of] at all; and it is impossible to say at the same time that there is a company and there is not.

“The company is at law a different person altogether from the [shareholders] …; 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 received the profits, the company is not in law the agent of the or trustee for them. Nor are the, as members, liable in any shape or form, except to the extent and in the manner provided for by the Act.”

The effects of veil of incorporation:

The principle established in Salomon’s case has been applied in a variety of other situations:

Ownership of property. Macaura v. Northern Assurance Co Ltd (1925) [4]

Employment. Lee v. Lee’s Air Farming (1961) [5]

Landlord and tenant.

Fiduciary duties. The fiduciary duty which a directors owes to a company is not, in ordinary circumstances, owed to its members. The members, even where they exercise practical control over the directors whom they have appointed to office, owe no duty to the company. A good example of this is Multinational Gas and Petrochemical Co v. Multinational Gas and Petrochemical Services Ltd (1983).

Piercing the Corporate Veil: [6]

Separate legal personality often has unintended consequences, particularly in relation to smaller, family companies. In B v. B [1978], it was held that a discovery order obtained by a wife against her husband was not effective against the husband’s company as it was not named in the order and was separate and distinct from him. And in Macaura v. Northern Assurance Co Ltd [7] , a claim under an insurance policy failed where the insured had transferred timber from his name into the name of a company wholly owned by him, and it was subsequently destroyed in a fire; as the property now belonged to the company and not to him, he no longer had an “insurable interest” in it and his claim failed.

However, separate legal personality does allow corporate groups a great deal of flexibility in relation to tax planning, and also enables multinational companies to manage the liability of their overseas operations. For instance in Adams v. Cape Industries plc [7] it was held that victims of asbestos poisoning at the hands of an American subsidiary could not [8] sue the English parent in tort. There are certain specific situations where courts are generally prepared to “pierce the corporate veil”, to look directly at, and impose liability directly on the individuals behind the company. The most commonly cited examples are:

Where the company is a mere façade, used to enable members to evade legal or contractual obligations or restrictions binding on them personally.

Where the company is effectively just the agent of its members or controllers.

Where a representative of the company has taken some personal responsibility for a statement or action.

Where the company is engaged in fraud or other criminal wrongdoing.

Where the natural interpretation of a contract or statute is as a reference to the corporate group and not the individual company.

Where permitted by statute (for example, many jurisdictions provide for shareholder liability where a company breaches environmental protection laws).

In many jurisdictions, where a company continues to trade despite inevitable bankruptcy, the directors can be forced to account for trading losses personally.

Famous cases:

Minton v. Cavaney, (1961) [9]

Mr. Minton’s daughter drowned in the public swimming pool owned by Mr. Cavaney. Then-Associate Justice Roger J. Traynor (later Chief Justice) of the Supreme Court of California held: “The equitable owners of a corporation, for example, are personally liable . . . when they provide inadequate capitalization and actively participate in the conduct of corporate affairs.”

The “single economic unit” theory was rejected by the CA in Adams v Cape Industries, [10] where it was held that cases where the rule in Salomon had been circumvented were merely instances where they didn’t know what to do. The view expressed during Creasey v Breachwood that English law “definitely” recognised the principle that the corporate veil could be lifted was described as a heresy in Ord v Bellhaven, and these doubts were bought up again in Trustor v Smallbone: the corporate veil cannot be lifted merely because justice requires it. Despite the rejection of the “justice of the case” test, it is observed from judicial reasoning in veil piercing cases Zthat the courts employ “equitable discretion” guided by general principles such as male fides to test whether the corporate structure has been used as a mere device.

The cases of Jones v Lipman, where a company was used as a “façade” to defraud the creditors of the defendant and Gilford Motor Co Ltd v Horne, where an injunction was granted against a trader setting up a business which was merely as a vehicle allowing him to circumvent a covenant in restraint of trade are often said to create a “fraud” exception to the separate corporate personality. Similarly, in Gencor v Dalby [2000], the tentative suggestion was made that the corporate veil was being lifted where the company was the “alter ego” of the defendant.

Berkey v. Third Avenue Railway Co [11]

Minnie Berkey had an accident on a tram line operated by the Forty-second Street, etc., Railway Company. She suffered personal injury. The Third Avenue Railway Co owned it, along with another two corporations with street railways on different routes. Third Avenue not only owned nearly all the stock, the board of directors and executive officers were also nearly the same. Ms Berkey sued the parent, Third Avenue Railway Co, to compensate her for personal injury.

However, it was contrary to New York law at the time for one street railway company to assign its franchise to another without the Railway Commission’s approval. So it was argued that a transfer in any liabilities from one to the other was an illegal contract, and therefore transfer of tort liability for Ms Berkey’s personal injury was also illegal.

Paul v. Virginia (1869) [12] , was a historic case in corporate law in which the United States Supreme Court held that a corporation is not a citizen within the meaning of the Privileges and Immunities Clause.

Walkovszky v. Carlton, [13] is a leading decision on the conditions under which Courts may pierce the corporate veil. A cab company had shielded themselves from liability by incorporating each cab as its own corporation. The New York Court of Appeals refused to pierce the veil on account of undercapitalization alone.

Adams v Cape Industries plc [1990] [14] , is the leading UK company law case on separate legal personality and limited liability of shareholders. The case also addressed long-standing issues under the English conflict of laws as to when a company would be resident in a foreign jurisdiction such that the English courts would recognize the foreign court’s jurisdiction over the company.

DHN Food Distributors Ltd v Tower Hamlets London Borough Council [1976 [15] ] is a UK company law case, where on the basis that a company should be compensated for loss of its business under a compulsory acquisition order, a group was recognized as a single economic entity. It stands as a liberal example of when UK courts may lift the veil of incorporation of a company.

Conclusion:

The question of whether the negative aspects of the decision in Salomon’s case outweigh the good ones is best left unanswered for it is far too broad. One is inclined towards the view that the principle of separate legal entity established in Salomon’s case has been instrumental in the development of modern capitalism and the immense social and economic wealth which it has generated. The House of Lords extended the principle so far as to cover small private enterprises. This move has had several negative consequences over time. However, it is also true that these have been largely neutralized by joint legislative and judicial action.

As far as lifting the veil of incorporation is concerned, the development has been essentially haphazard and irrational. Although result is usually that justice is done, the lack of policy produces inconsistency and uncertainty.

It can be argued that when this law came into being, it had many loop-holes and people, over time, have tried to exploit those. However, various amendments have taken place over the years, and now, it would appear then that the overall balance is positive and that the decision of the House of Lords in Salomon v Salomon & Co Ltd was a good decision.