The Concept Company Ownership

Introduction:

The concept company ownership is a complex, powerful and controversial idea. It is impossible to imagine current economic life without webs of controlled or related corporations. In this perspective, it is not really surprising that the concept of limited liability with all its opportunities raises questions about justice and fairness in a modern economy. Company law is still experiencing an evolutionary development that once started at a very simple point with the introduction of the separate legal entity concept accompanied by limited liability for shareholders. However, these simple tools are used to generate legal constructions of incredible complexity and potential. Groups consisting of more than three vertical layers of separate companies, each single layer inevitably connected with the barrier of limited liability, are by no means a shortage. Corporate groups may consist of the same tools, but they are by far more than the mere sum of its parts. In this coursework I will examines the relationship between a parent and subsidiary company in respect of the corporate entity rule with particular regard to case law, Company Act 2006 and Insolvency Act 1986.

Theories Of The Company:

Probably the most important legal feature of a body corporate is its dual nature as both an association of its member and a person separate from its members. Various attempts have been made to describe what a company is. In terms of English law, is that “an entity can be incorporated with separate personality in England and Wales only by or on the authority of the crown or parliament.” The original models of the company were underpinned by “fiction” or “concession” theories of the company. These theories saw the company as a separate entity, but with the state legitimately entitled to restrict its functions since the company’s very existence was derived from a state concession or privilege. This view was willingly supported when each company was formed by charter or by specific Act of Parliament. Now, however, companies can be set up unilaterally and with almost unlimited objects. It follows that this particular model, and its associated justification for state intervention, is no longer persuasive. Any effort to argue the contrary–for example, to suggest that a modified version of the concession theory justifies certain modern forms of state intervention, such as the disqualification of directors under the Company Directors Disqualification Act 1986–cannot be sustained. Increasingly scholars now stress the social importance and institutional nature of the company and conceive of the company in “communitarian” terms where the interests of all groups must be respected.

Basic Structure Of Group Liability Law

The usual concept of limited liability basically means that company’s debts or responsibilities, in particular when it has gone into insolvency, should not affect its directors’ and shareholders’ personal assets. The company creditors are not, thus, entitled to target them for recovering the debts owed by the company,   though even in the earliest cases this did not prevent the courts from holding directors liable as quasi-trustees for managing their corporation negligently. This, and development of limitation of liability by share or guarantee, has created a highly flexible method of conducting business of almost unlimited scope and scale. The system offers substantial protection to creditor, member, employee and director, while maintaining a form that is subject to the control of the law to a remarkable degree. The true value of the system can be seen in cases where there is attempted abuse of limited liability or company law, or where injustice would follow too strict an application of the principle. The courts are fairly willing to lift the “veil of incorporation” in appropriate cases and certain situations illustrate this well.

The Panorama Of The Parent-Subsidiary Relationship

Parent companies normally allow the reduction of risk for the owners and can allow the ownership and control of a number of different companies. A parent company is given considerable freedom to act in a detrimental manner towards its subsidiaries. The parent’s detrimental conduct per se will not give rise to any cause of action whereby the parent’s conduct affects its right to claim in a subsidiary’s liquidation. Indeed, beyond the remedies associated with fraud, maintenance of capital and wrongful and fraudulent trading, because of the doctrine of separate personality a subsidiary’s creditors have no recourse against a parent or other group company. A parent company may use a subsidiary outside these relatively discrete boundaries ‘with an eye single to its own interests’.

A parent acts in two capacities towards a subsidiary. First, the parent is a shareholder. The law construes a parent’s actions in this limited dimension. Second, a parent is a controller. The law in England fails adequately to attribute any responsibility to a parent in this role. Reform proposals to date have been conspicuously deficient. The notions of wrongful trading and the ‘shadow director’ were a useful yet minimalist reform that was never intended to alter radically the parent-subsidiary relationship. The recommendations of the Cork Report concerning the potential for abuse of the parent-subsidiary relationship and intercompany indebtedness have fallen on deaf legislative ears. This is not surprising as, legally, there are considerable barriers to reform. It is evident that in England the legislative regime permits no freedom for the modification of the debtor-creditor relationship due to the strict order of priority rules and the statutory force given to the pari passu rule of distribution. Second, the potential for detriment suffered by a subsidiary at the hands of a parent is not recognised. This occurs because the role a parent serves as the controller of a subsidiary’s enterprise is not recognized. Third, persistence on the legal concept that companies in a group are atomistic, each distinct, with its own distinct creditors, has a long history.

Power is used in a group of companies to ensure that each member complies with the wishes of the controller–usually the parent. The way parental control works can be separated into the legal and the ‘factual’ forms. A parent’s legal right of voting control enables it to control the content of a subsidiary’s articles of association and the constitution of the board of directors. A parent also exercises ‘extra-legal’ or ‘factual’ control over the subsidiary dictating the directors’ choices by exerting pressure or influence. The conventional legal view of the parent-subsidiary relationship in England treats the parent as no more than a shareholder. Shareholders are not liable to anyone except to the extent and manner provided in the Companies Act 1985. A company exists for the benefit of the shareholders, who, provided they acted intra vires and in good faith, can manage its affairs as they wish. Shareholders can lawfully take risks if they wish that no prudent man would take. Just as an individual can act like a fool so too can a company. The shareholders owe no duty to those who do business with the company. This is a risk creditors must assess for themselves. It follows that a parent, even as the majority shareholder in a subsidiary, is not liable to creditors. While a parent can manipulate a subsidiary’s directors, the total ability to control a subsidiary provides neither a modicum of accountability nor any direct duty between the parent and the subsidiary.

A parent shareholder is not held responsible for its use of control. Any duty to a subsidiary is owed directly by its own directors. As a fiduciary, a director’s duty is to exercise that degree of care to the subsidiary as a reasonable man might be expected to take in the same circumstances on his own behalf. Decisions by a parent that are adopted by a director may be in neglect of his duty. The director is effectively immune from any action on the part of a subsidiary against delinquent directors prior to insolvency. Typically, the parent will ratify the director’s actions, making them the actions of the subsidiary. Further, no duty arises between parent and subsidiary because a parent has coercive power over a director in terms of dismissal as an employee or removal from office. A rare breach of duty may occur when the parent’s actions override the director’s obligations to the subsidiary. Here it can be said that the parent has ‘interfered’ with the affairs of the subsidiary by precluding compliance by the subsidiary’s directors with their duties. The ‘interference’ must have sufficient causality to give rise to a duty of care. As such, the director’s actions must be directly influenced by the parent. It is not clear what ‘ interference’ actually is; however, it is not any of the following: the parent’s failure to provide adequate group accounting to a subsidiary; a parent’s use of a subsidiary’s surplus funds for its own benefit; a parent’s failure to conduct adequate internal audits of its subsidiary; and the total control of the subsidiary by the parent. The possibility of a duty arising between parent and subsidiary becomes even more remote if the subsidiary has independent directors that are not accustomed to acting on the instructions or directions of the parent.

Rationally, if a corporation is pursuing a course that accords within the spirit of the law then close association between the parent and subsidiary should not deprive companies of legitimate privileges. The desire to limit liability using a subsidiary is not a fraud. Mere control of the subsidiary by a parent is not a badge of impropriety provided the influence of the parent either directly or via its directors is intra vires and in good faith. The problem is that the potential for abuse is very real, which law should control. Contrary to this reality, form triumphs over substance once again–‘given the command which a parent has in practice over the affairs of the subsidiary, it is absurd and unreal to allow the commercial realities to be disregarded’. The present situation in the law lies in stark disregard of the recommendations of the Cork Report:

“It is unsatisfactory and offensive to the ordinary canons of commercial morality that a parent should allow its wholly owned subsidiary to fail, or that a company should be permitted by other companies in the same group, and particularly by its ultimate parent, to take commercial advantage from its membership of the group, without there being incurred by those other companies any countervailing obligations.”

The lack of any duty between a parent and subsidiary means that there is no minimum standard of conduct. Consequently, a parent can exercise an abusive attitude towards a subsidiary which has been strongly criticised. The possibility of abusive control and the power to manipulate credit means that a parent will make an effort to gain advantage over other creditors in the event of liquidation.

The Company–A Separate Legal Entity:

In examining the first part of the question which concerns the extent to which attitudes of the parent company have changed, Salomon v A. Salomon and Co Ltd has to be considered. The fact of the case is well known. Aron Salomon, for many years carried on business, on his own account, as a leather merchant and wholesale boot manufacturer. With the design of transferring his business to a joint stock company, which was to consist exclusively of himself and members of his own family, he, on July 20, 1892, entered into a preliminary agreement with one Adolph Anholt, as trustee for the future company, settling the terms upon which the transfer was to be made by him, one of its conditions being that part payment might be made to him in debentures of the company. A memorandum of association was then executed by the appellant, his wife, a daughter, and four sons, each of them subscribing for one share, in which the leading object for which the company was formed was stated to be the adoption and carrying into effect, with such modifications (if any) as might be agreed on, of the provisional agreement of July 20. The memorandum was registered on July 28, 1892; and the effect of registration, if otherwise valid, was to incorporate the company, under the name of “Aron Salomon and Company, Limited,” with liability limited by shares, and having a nominal capital of 40,000l., divided into 40,000 shares of 1l. each. The business was sold to the company for over £39,000. Part of the purchase price was used by Mr Salmon to subscribe for £20,000 further £1 shares in the company, but £10,000 of the purchase price was not paid by the company, which instead issued Mr. Salmon with a series of debentures for £10,000 and give him a floating charge on its assets as security for the debt. Unfortunately the company’s business failed and went into liquidation. The company’s liquidator wanted somehow to ignore the fact that Mr Salomon now had only limited liability to that company instead of the unlimited liability he had had when he conducted the business as a sole trader.

It was held that the proceedings were not contrary to the true intent and meaning of the Companies Act 1862; that the company was duly formed and registered and was not the mere “alias” or agent of or trustee for the vendor; that he was not liable to indemnify the company against the creditors’ claims; that there was no fraud upon creditors or shareholders; and that the company (or the liquidator suing in the name of the company) was not entitled to rescission of the contract for purchase. The HL’ decision in Salmon had established as basic principal that a company, even if it is a “one-man company” such as Saloman, cannot be a mere alias or an agent of the principal shareholder. This would mean that whatever the economic realities, the law begins with the principle of the company realities, the law begins with the principle of the company being a separate legal entity. This judgment “opened up the new vistas to company lawyers and the world of commerce”. This decision has been criticised. The company’s property is the property of the company as a separate person not the members.

Corporate Groups And Control By Holding Companies:

The leading case is Smith Stone & Knight v Birmingham Corporation , where the court reviewed the question of a holding company’s entitlement to disturbance compensation for property occupied in the name of, and for the purposes of, a subsidiary. The judgments advocate tests to ascertain the reality of who traded there: was it a truly independent subsidiary or a mere corporate shadow of the holding company? The court looked behind the veil and saw clearly that the subsidiary had little existence beyond paper and parent company should succeed in obtaining compensation.

There are some reported cases in which an English court decided to pierce the corporate veil on the ground that a company was being used as a “sham” were decided only two years after the House of Lords’ rendered judgment in Salomon. Of these two cases, the more authoritative was that of Apthorpe v Peter Schoenhofen Brewing Co, decided by the CA and Firestone Tyre and Rubber Co v Llewllin. The facts of this case centred around a provision in the laws of the American State of Illinois that forbade foreign companies from holding property within the boundaries of the State. An English company, wishing to establish a beer brewing business within Illinois, attempted to evade the effect of this prohibition by purchasing all except three of the shares in an existing Illinois brewing company, the three remaining shares being held by members of the acquired American company. In addition to this arrangement, the English parent company entered into a formal agreement with the members of the American company, in which it contracted for full rights of ultimate direction and control, both generally and as regards any particular incidental matters, over the subsidiary’s business. It was agreed, however, that the day-to-day operation of the business was to continue within the hands of the members of the American company who remained based in Illinois

In what circumstances Court will pierce the corporate veil? Where the reason of the holding company in forming or operating a subsidiary company is to commit a fraud, the corporate veil will be lifted. The complexity is to identify what precisely may make a company a “mere facade”. The motive/intention is viewed objectively, to be inferred from the circumstances and evidence of the case. However, it will not be a fraudulent abuse of corporate principles to manipulate the corporate structure of a group of companies so as to ensure that legal liability (if any) falls on a particular member of the group. Indeed, to hold otherwise would be to seriously disturb the very foundations of the Salomon principle. In recent years there has been a tendency to disregard separate legal personality whenever it was considered convenient to do so, particularly when the realities in the opinion of the court justified it. But in CA decision of Adams, we find a different attitude where there was a greater reluctance to depart from the corporate attitude where there was greater reluctance to depart from the corporate separate legal entity principle.

The fact was that Cape Industries plc (Cape) presided over a group of companies involved in mining asbestos in South Africa and marketing it in, among other places, the United States. Asbestos, mined by a South African subsidiary ultimately owned by Cape, was sold to a factory in Owentown. Capasco Ltd (Capasco), an English company, and North American Asbestos Corporation (NAAC), a company incorporated in Illinois, were marketing companies controlled by Cape; the former marketed the asbestos worldwide whereas the latter confined its activities to the United States. In 1978 NAAC was put into liquidation. To carry out Cape’s marketing activities in the United States a Liechtenstein corporation, Associated Mineral Corporation (AMC), and a new Illinois corporation, Continental Productions Corporation (CPC) were formed. The shares in AMC were held on behalf of a subsidiary of Cape and the shares in CPC were held by the ex-president of NAAC. In 1974 employees and ex-employees of Owentown factory commenced an action (the Tyler 1 action) in the United States Federal District Court at Texas (the Tyler court) against, inter alia, Cape and Capasco claiming damages for personal injuries arising from exposure to the asbestos dust. Cape and Capasco protested against the jurisdiction of the court and repeated these protests when they filed with the court defences as to the merits of the claims. These actions were settled in 1977 and a judgment was entered against Cape and Capasco. A second action (the Tyler 2 action) was commenced against, inter alia, Cape and Capasco in the same court as the Tyler 1 action but neither Cape nor Capasco entered an appearance. A default order was made against Cape and Capasco which the plaintiffs sought to enforce in the present proceedings. Scott J dismissed the actions of the plaintiffs and the plaintiffs appealed on two grounds (a) “the single economic ground” (b) the corporate veil and the agency argument.

The Single Economic Ground

It was argued that while the fundamental principle was that each company in a group of companies is a separate legal entity, the court could, in the appropriate circumstances, ignore the distinction between them and treat them as one.

Agency Argument

The Court of Appeal held that, unsurprisingly, the veil of incorporation could in essence be pierced when there was an express agency agreement between, for example, parent and subsidiary. However in the absence of such agreement there is no presumption of one.

In Adams v Cape Industries which sought to distinguish the varying degrees of overall control. There the exercise of control located in the organ of the parent company was over the corporate financial affairs of the subsidiary, this, it was found, was ‘no more and no less than one would expect to find in a group of companies such as the Cape group’. There clearly has to be something more. Scott J in the lower court believed this ‘ something more’ to be a control over the actual ‘ commercial activities’ of a company, only then, in exercising a direction over routine operational decision making, did it acquire the status of being a power associated with an organ of the company controlled.

The nature of what Scott J termed, ‘routine parent subsidiary group relationships’ was further examined by the Court of Appeal. It had been argued in the lower court that all major policy decisions of the various subsidiaries in the group, were taken by the parent, but the Court of Appeal, observed that “it is of the very nature of a parent subsidiary relationship that the parent company is in a position, if it wishes, to exercise overall control over the general policy of the subsidiary” and that this alone was insufficient to question the authenticity of an individual corporate act within the group. The Appeal Court did appear to accept however, Scott J’s first instance distinction between the control employed over corporate strategic decision making and the control over the commercial activities of a company. The court found that the relevant influence being exercised at the time within the Cape group, was of a routine strategic kind, and therefore not significant for present purposes. The court went on further to reaffirm Lord Keith’s famous judgment in Woolfson v Strathclyde Regional Council where when referring to DHN v Tower Hamlets, he said, ‘ it is appropriate to pierce the corporate veil only where special circumstances exist indicating that it is a mere “ facade” concealing the true facts’ . If this is subjected to Staughten LJ’s distinction in The Coral Rose between ‘lifting’ and ‘piercing’, then the Woolfson decision is distinguishable. In speaking of a ‘piercing’ of the veil where a façade is said to exist, it identifies those instances where an abuse of the corporate form has taken place. Some wrongdoing having occurred, it would constitute something beyond a lifting of the veil in order to determine the character in which corporate acts are carried out.

This recognition of the differing nature and types of control being exercised between companies is not new; it is a theme running through many of the earlier judgments. Fletcher Moulton in Gramophone Typewriter v Stanley spoke of the difference between shareholder control and management control. In this case, yet again a dispute concerning the liability of an English company to pay income tax on the profits of a foreign subsidiary, an English company had, at a point in time following its acquisition of a controlling stake in a German subsidiary, come into full ownership of the shares of that subsidiary. On the basis of this fact, the Commissioners of Inland Revenue argued that the business of the wholly-owned German subsidiary was, for all intents and purposes, the business of the English parent, and that the English company should therefore be taxed upon the profits accruing from its subsidiary’s operations in addition to its own. The CA unanimously rejected this argument. In support of this decision, Lord Cozens-Hardy stressed the significance of the fact that:

“ [t]he German company was not at first, and there is no evidence that it has ever become, a sham company or a mere cloak for the English company” .

Lord Buckley, likewise, claimed that legal recognition of the unity of the two companies hinged upon the unfound contingency that:

“ the German company [was] a fiction, a sham, a simulacrum, and that in reality the English company, and not the German company, is carrying on the business”

Such a distinction was implicit in Atkinson J’s often criticised six criteria in Smith Stone & Knight v Birmingham Corporation ; also in Harold Holdsworth v Caddies Lord Morton expressed the view that each company in a group is in law a separate entity carrying on its own business, however, through the nature of the management control being exercised, they could be regarded as constituting a new single entity. Lord Reid, in the same case, spoke of looking at ‘ the facts and realities of the situation’ . These cases clearly show a degree of control over the acts of a company where it is of a type associated with an organ of that company; it is distinguishable from shareholder control, even that unique shareholder control found to exist in wholly owned parent subsidiary group relationships.

In illustrating the legal process of ‘lifting’ as opposed to ‘of piercing’ the veil, any assessment of control will involve a finding of fact requiring consideration of the actual persons who direct and control the activities of a company. It does not necessarily lead to a denial of a company’s separate legal existence within a group. The differing nature of the control being exercised is important when trying to reconcile and explain decisions such as Littlewoods Mail Order v IRC, DHN v Tower Hamlets, Munton Bros v Secretary of State for Northern Ireland, Adams v Cape Industries, and The Coral Rose and others. These cases show that there can exist a degree of control over the operational decision-making function of a company, primarily and in the first instance, of a kind exercised by the organs of that company which, particularly when exercised within a group, is distinguishable from that control over more general policy and strategic areas of operation referred to by Scott J in Adams v Cape Industries.

Statutory Intervention Upon The Doctrine

How can subsidiary companies use existing remedies to avoid undue advantage-taking by the parent ?Statute has shaped major inroads upon the corporate entity doctrine both in the area of pending or actual insolvency as well as in cases of fraudulent, negligent or abusive control and manipulation of companies. In cases of fraudulent or wrongful trading under ss214, 214 and Insolvency Act (hereinafter referred to as IA) 1986, personal liability for the debts of the company can be visited upon directors and shadow directors. It is well-known that a director’s liability for fraudulent trading can only arise if the company is in liquidation. The purpose of the Insolvency Act 1986 is to compensate those who had suffered loss as a result of the fraudulent trading; Bank of India v Christopher Morris & 6 ors. In various other breaches of company legislation, personal liability for debt or loss can be imposed upon directors and controllers but these matters are not so much lifting of the veil but rather a statutory provision of remedies to prevent the Salomon v Salomon & Co principle being invoked as a defence.

In relation fraudulent trading is a measure whereby those persons, who have controlled the company’s enterprise and have done so with the intention to defraud creditors, may, on the application of a liquidator, be ordered to contribute to the assets of the company. Fraudulent trading represents an extreme form of conduct because proof of an ‘intention to defraud creditors’ is a difficult evidentiary obstacle to negotiate.

Wrongful trading occurs under s 214 when, in a winding up, it appears a company was permitted to continue trading in a manner which reduced a creditor’s chance of full repayment. If these situations arise then the court, upon the application of a liquidator, may announce that a director or shadow director knew or ought to have concluded that the company had no reasonable prospect of not going into insolvent liquidation. Moreover, if the director did not take every step that ought to be taken to minimise the loss to creditors, the court may declare that the director is personally liable to contribute to the assets of the company.

The definition of ‘shadow director’ questionably extends to a parent. Recently, Millett J in Re Hydrodan (Corby) Ltd examined the extent of this proposition holding that the directors of a parent were not ipso facto shadow directors of a subsidiary. He considered, obiter, that if the directors of a collective body gave directions to the directors of a subsidiary and the directors were accustomed to acting in accordance with these directions, the result would be to constitute the parent, but not the parent’s directors, a shadow director of the company. This is the clearest statement giving guidance to the scope of the term ‘shadow director’. The counter argument is that the term, from its inception, was never intended to be used in relation to the parent but rather individuals controlling ‘puppet’ directors. When invoked, the duty wrongful trading imposes on directors to protect the interests of creditors is extensive. If a finding of wrongful trading is made then the court may order the offender be personally liable to make such contributions (if any) to the company’s assets as the court thinks proper.

Directors’ Duties

Where the company is part of a group and has its own separate legal identity and its own separate creditors, the directors must carry on acting in the interests of the company rather than the group. Before the 2006 Companies Act, directors had the following common law duties: duty to act in the company’s best interests; duty to be diligent; duty to take early legal advice if the company gets into financial difficulty; duty to avoid conflicts of interest; duty to hold regular board meetings; duty to keep proper minutes and duty to satisfy themselves about administration and financial information.

Under the Companies Act 2006 (hereinafter refereed to CA 2006), directors’ duties are owed by a director of a company to the company, and are based on certain common law rules and equitable principles as they apply in relation to directors and have effect in place of those rules and principles as regards the duties owed to a company by a director. The general duties are to be interpreted and applied in the same way as common law rules or equitable principles, and regard must be had to the corresponding common law rules and equitable principles in interpreting and applying the general duties. A person who ceases to be a director continues to be subject to the duty in s 175 as regards the exploitation of any property, information or opportunity of which he became aware at a time when he was a director, and to the duty in s 176 as regards things done or omitted by him before he ceased to be a director. To that extent those duties apply to a former director as to a director, subject to any necessary adaptations. The general duties apply to shadow directors where, and to the extent that, the corresponding common law rules or equitable principles so apply. A director of a company must act within powers.

A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to (1) the likely consequences of any decision in the long term; (2) the interests of the company’s employees; (3) the need to foster the company’s business relationships with suppliers, customers and others; (4) the impact of the company’s operations on the community and the environment; (5) the desirability of the company maintaining a reputation for high standards of business conduct; and (6) the need to act fairly as between members of the company. Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, s 172(1) has effect as if the reference to promoting the success of the company for the benefit of its members were to achieving those purposes. The duty imposed by t