The Legal Nature of Corporate Groups

The issue in this essay is to critically analyse and evaluate the legal nature of corporate groups and the liability and responsibilities of interlinked companies; analysing the corporate group as a vehicle for global business and the need for regulation.

The assertion is that the current system of the group structure in the UK is reasonable as there is no physical evidence of corporate abuse by companies which has subsidiaries. Furthermore, imposing more regulations which would take away flexibility and strike at the limited liability basis of company law, which is the originality of the law itself, may put the whole company law system at a difficult position and may affect the basis of its origin; to restrict the risk of shareholders of a company only to the capital invested in the company so as to encourage people to invest.

Mayson and others stated that the Government, in its white paper quoted that “Company Law has a direct impact to enterprise as it can actively promote and encourage enterprise or hold it back and they are seriously committed to promoting enterprise and believes that company law reform has an important part to play in making it as easy as possible to start and run companies while maintaining adequate safeguards against abuse”

To analyse what was stated in the consultation paper that the regulation in place to safeguard abuse is enough, it is important to assess the legal nature and key features of the company by making special reference to the corporate group structure.

The doctrine of a corporation, as defined in Smith & Keenan, is a succession or collection of persons having at law an existence, rights and duties, separate and distinct from those of the persons who are from time to time its members. It has a corporate legal personality of its own that is quite separate and distinct from those persons associated with it; the shareholders, managers, employees, creditors, debtors and government agencies.

Being an artificial, non-real person (a legal fiction), a company cannot act by itself and needs others to act for it. These others are termed organs of the company. They include;

Shareholders: these set of people have a limited role in the company. They are sometimes referred to as subscribers or members of the company. They are in theory the owners of the company as they are the ones who sets up the company by investing their money, pass resolutions instructing that certain acts be carried out; and sets the constitution of the company which sets out the directors rights and duties towards the company.

Board of Directors; this is a collective term for directors sitting as a group. They are usually appointed by the shareholders and their duty is to implement strategic and operational goals of the company. Directors are the key organs of the company because they manage the day to day affairs of the company or delegate those powers to managers.

It has been said that “the company constitutes an association of a number of persons for a common object; being the economic gain of its members”

The key unique feature of a company is a separation of risk from ownership. The corporation form of a company allows the owners of the company to be separated from any risk involved in the running the company. In this way, shareholders and directors are protected from having their personal assets taken to satisfy the debts of the company. This is called limited liability. This means that the obligations placed on shareholders are only those relating to any unpaid amounts owed on their shares to the company. For shareholders, this is only to any unpaid shares (if any) whilst for directors, their liability is to only any personal guarantees given for the debt of the company or wrongs that they have incurred under the law in the running of the company.

The logic of the creation of a separate legal personality is viewed separately in a corporate group structure. It is however common for lager enterprise to systematize their dealings through a group of companies that consists of a parent/holding company and subsidiaries to minimise their risk and maximise their profit.

There are four ways in which the relationship of holding company and subsidiary may arise:

Where the holding company holds a majority voting rights in the subsidiary,

Where the holding company is a member of the subsidiary and has the right to appoint or remove a majority of its board of directors,

Where the holding company is a member of the subsidiary and controls alone, pursuant to an agreement with the shareholders or members, a majority of the voting rights in the subsidiary,

Where the subsidiary is a subsidiary of a company which itself a subsidiary of the holding company’.

However, this definition only stated what a subsidiary is and does not define what a group relationship is meant to be. The Companies Act went on to define a group structure in S.1162 as a company will be the parent if it has the right to exercise a ‘dominant influence’ over a company by virtue of provisions contained in the articles of the subsidiary, or by virtue of a control contract.

There are other reasons why a company form a group. This includes raising capital and facilitating external borrowing will be easy; and intercompany loans and transfer of assets will be permitted. Also, it may be convenient administratively, more proficient economically and more suitable geographically especially when overseas ventures are being carried out. It can therefore be inferred from the above that the corporate group structure allows for huge creation of wealth.

Most of the UK company law is founded in the common law and not until the late 18th century that the rule of limited liability was put into test. The case that fully affirmed the limited liability of companies is Salomon v Salomon

Mr Salomon had for many years carried on a previous business as a leather merchant. In 1892, he decided to convert his sole trader business into a private limited liability called Salomon & Co Ltd. Shareholders in the new company consisted of Salomon himself, his wife and five children. Mr Salomon sold the leather merchant business to the newly formed company for £39,000 and in return for the business; he would be given a cash value of £9,000, a debenture on the assets of the company in the value of £10,000 and 20,001 shares of the allotted 20,007 shares. His wife and children bought the remaining 6 shares in the company to comply with the law. As a result of the arrangement, Mr Salomon became the majority shareholder and the director of the company with two of his sons.

The company experienced some difficulties, became insolvent and went into liquidation. When the assets of the company were valued, the total was the exact amount that was owed to Mr Salomon; £10,000. As a secured creditor, Mr Salomon was to be paid his debts first and when he was paid, there were no available cash assets to pay the other creditors. The case went to the high court and it was argued that the company was set up as a sham.

In the High Court, Vaughn Williams J decided that the company cannot be said to be fraudulent but to allow a man who carries a business under another name, to set up a debenture in priority to claims by other creditors of the company would have effect on delaying and defeating his creditors. He further stated that Mr Salomon’s business was his own and no one else, he employed the limited liability company as his agent, and that as the principal, is personally liable to indemnify the debts of the agent and that in this case, it is clear that the relationship of principal and agent existed between Mr Salomon and the Company. Mr Salomon appealed to the Court of Appeal which affirmed the decision of the High Court but on a different ground. Lopes LJ stated that the Act contemplated the incorporation of seven independent bonafide members, who had a mind and will of their own, and were not a mere puppets of an individual who, adopting the machinery of the Act, carried on his old business in the same way as before when he was a sole trader. “To legalise such a transaction would be scandal”

In both decisions, although they had different reasoning, the both came to the same decision that Mr Salomon should be directly liable for the creditors’ debts.

However, Mr Salomon appealed to the House of Lords. The House of Lords came to a different conclusion. Lord Halsbury LC stated that the lower courts were wrong. He said that “Either a company was a separate legal entity or it was not. If it was, the business belonged to it and not to Mr Salomon”

Lord Macnaghten in his opening, stated that the artificial existence of the statute should only be dealt with and not the motives or conduct of individual corporators. Although, if it could be established that the provision of the statute on incorporation had not been complied with, the Lords can go behind the veil, declare the company invalid and hold the incorporator liable; however, if there is no proof, as the case here, it is impossible to dispute that once a company is legally incorporated, it must be treated like any other independent persons with its rights and liabilities appropriate to itself and the motives of those who incorporated the company are absolutely irrelevant in discussing the relevant rights and liabilities.

Further illustration of the Salomon principle is exemplified in Lee v Lee’s Air Farming and Macaura v Northern Assurance Co.

The Salomon principle demonstrated in Gramophone and Typewriter v Stanley is the earliest application of the Salomon principle within corporate groups.

For whatever reasons, there is little doubt that corporation sets up controlled subsidiaries for potentially massive wealth creation. The key issue is whether the courts and legislature of a particular country should give free reign to the benefits of separate legal existence of the company.

The effect of the decision of Salomon principle was in essence that although the law may have been enacted to protect individual shareholders from having a limitless risk, however because of its literal interpretation, companies are hiding behind the limited liability principle by creating subsidiaries which they have a considerable amount of control over, devolve their risk to as a limited liability company. As the courts said in Gramophone, it is not illegitimate to set up a subsidiary, although it may be morally wrong.

The application of the decision of Salomon in a group structure corporation caused a lot of controversy. The problem it created was that a company can be set up by the parent to make profits for them whilst the subsidiary owns all the risk involved and in the case the subsidiary becomes insolvent, the creditors will not be able to claim against the parent company because of the legal personality.

The decision in Gramophone also caused controversy on moral grounds that parent companies abuse the corporate status of limited liability when it comes to risk and maximisation of profit.

This led to the questions put before the court in subsequent cases that “is there an abuse of corporate status by parent companies?

The courts tried to find if there is an abuse of corporate status by parent companies and in some cases by taking the view that there are occasions when the separate legal existence of a company will not be allowed or its existence modified in some ways. The outcomes of such instances will often lead to a director or shareholder being linked to a company and as a consequence, held liable for the actions of the company. Such instances are referred to as lifting or piercing the veil of corporations.

The position of the courts when it comes lifting the veil or piercing the veil is unclear. Some clarification was attempted by Staughton LJ in Atlas Maritime Co SA v Avalon Maritime Ltd that “to pierce the corporate veil is an expression that I would reserve for treating the rights or liabilities or activities of a company as the rights or activities of its shareholders. To lift the corporate veil or look behind it on the other hand should mean to have regard to the shareholding in a company for some legal purpose”

It is imperative to consider occasions when the corporate veil is lifted and how it applies to the corporate group structure. To begin with, the courts are prepared to lift the veil where fraud, dishonesty or some improper purpose is found to exist.

As Lord Macnaghten suggested, the privilege of corporate personality will not be allowed to shield an individual or company who has some fraudulent or improper motive.

In Ebrahimi v Westbourne Galleries, Lord Wilberforce spoke of the fact that it should not be ignored that whilst a company has a personality of its own, behind the management of the company are individuals with rights, expectations and obligations. An academic writer believes that such instances show an example of the interest of justice considerations being in mind of the judges. Gilford Motors further illustrates that the court would not hesitate to lift the veil by calling an injunction, declaring the company Horne established to evade his legal obligations as being a sham. The courts shows that the lifting of veil due to a dishonest practice also applies to a group structure but in the case, it would not apply because there was knowledge that the dealings were made with a company that is part of a group structure who was acting in a way that will benefit the whole group as not necessarily itself.

Another instance when the courts will lift the veil is when it can be established that agency relationship exists. The courts will lift the corporate veil to find out whether the relevant company is an agent or not.

The general principles of agency is that a company or its members, having power to act as an agent may do so as agent for its parent company. If so, the parent company or its members will be will be bound by the acts of its agent so long those acts are within the actual or apparent scope of the authority. The test of agency in Salomon was that where one person or company that exercises total control over a company, would destroy the principle of separate legal entity but control alone is not enough. Agency can occur through a signing of an express agency agreement, which illustrate that there is a contract of agency or through apparent or ostensible authority, which can be inferred when to an outside party, understands that a company is acting on behalf of another and as a consequence decides to contract with the company.

The principle of agency within a group structure was first argued in late 18th century which the Wright J that agency existed because the head and seat and directing power of the American subsidiary was based in England and although the profits belonged to the American company, it was in fact carrying out business as an agent for its UK principal and the UK parent was liable to pay tax on the American companies profits. This was also affirmed in the early 19th century when the government wanted to pay compensation for a compulsory purchase of land from a subsidiary. The parent company argued that the subsidiary carried out business as its agent and the court agreed with this argument. The court found that the subsidiary was not operating on its own behalf but on the parent’s behalf because the close degree of control exercised by the subsidiary evidenced this. However, it was decided that the control through a shareholding alone could not have itself found an agency. However, the Lord Keithstated that the court should be reluctant in lifting the veil in a group of companies. He stated that in every instance, the Salomon principle must be observed, each company being a separate legal entity even if the companies were wholly owned by the same shareholder. He added that the veil should only be pierced where the circumstances are indicating a mere façade concealing the true facts. What he did not do is define what façade means. Façade was said to mean an intention to give third parties and the courts the appearance of creating legal rights and obligations that are different from those the parties intend to create. Therefore, in the absence of any wrongdoing, fraud or facade; the Salomon principle applies.

Where there exists a Group Economic or Enterprise entity, the court is likely to consider one or more separate legal entity companies in the group as one single economic entity because of the nature of control being exercised which can be linked with the agency principle. UK’s position on Single Economic Entity was envisaged in in DHN Food Distributors v London Borough of Tower Hamlets, when Lord Denning argued that for the present purpose, the group of companies was in reality a single economic entity and should be treated as one’. However, the DHN case is one exceptional case because group enterprise is not a strong ground for veil lifting or merely to achieve justice irrespective of the efficacy of the corporate structure. The decision in DHN case has led to a lot of outrage from group of companies who argued that it undermines the principle of corporation; the separate legal entity and the limited liability that each subsidiary enjoys.

However, when it comes to a community issue, the Institutions are far more willing to lift the veil and allow the reality of single economic entity be upheld if it can be shown that there are agreements between companies in the same group which will have effect of restricting or distorting competition.

These cases shows that clearly for the UK courts to accept any of these arguments, there has to be something more; shareholding or ordinary control is not enough and that there must be a great degree of closed control.

The UK Courts summarised the current approach to corporate group in Adams v Cape Plc. Slade LJ stated that there is no general principle that all companies in a group of companies are to be regarded as one and that the fundamental principle is that each company in a group of companies is a separate legal entity possessed of separate legal rights and liabilities. On the agency argument, he used the ratio in Smith to state that the court is bound to investigate the relationship between companies whose subsidiary is in a foreign country and if so on what terms if there were agency relationship. Secondly, on the facade argument, the court illustrated the case of Jones v Lipman as a well-recognised veil lifting category. Furthermore, the court quoted from Woolfson where Lord Keith stated that the veil should be lifted only where special circumstances exist indicating that it is a mere facade concealing the true facts and the motives of those behind the alleged facade must be considered in these special circumstances.

English case law has adhered to the Salomon principle in situations such as this and as Multinational Gas illustrates, has not developed principles which would allow a court to lift the veil of incorporation. The court went on to consider Roskill. L.J’s statement in The Albazero that there is no general principle that all companies in a group should be treated as one and that the court should not disregard the Salomon principle neither in the present case nor future cases merely because it considers it just to do so.

The decision led to a lot of criticism as it does not protect minority shareholders and creditors of the subsidiaries. This is because of the common law rule in Foss v Harbottle that no individual can bring an action if the alleged wrong is a matter which the company is competent to settle itself or which it can ratify or condone by its own internal procedure and a company most times chooses not to litigate.

This led to the question; should there be more regulations against group of companies, especially in making the parent company liable for its subsidiary’s actions to protect the minority shareholders and creditors of the subsidiaries?

As Rixon pointed out, the decision in DHN shows that the courts are only likely to disregard Salomon Principle only when they feel it is just and equitable to do so. Gallagher supported this view when he said that even when the veil is supposed to be lifted either because of agency, fraud or statutory, the court will always come to the conclusion that it was just and equitable to depart from the Salomon principle. The approach Wardman took was that the court will lift the veil when there is a sufficient degree of control on the group by the parent companies as that behind every company, there are humans making decisions. Muchlinski went further by disagreeing with the Company Law Review Steering Group [CLRSG] in their report on governance of group and risk reduction, that further regulation is needed. This is due to the fact that the CLRSG had put forward a weak proposal of elective regime of group liability. He also stated that there are OECD Guidelines for Multinational Enterprises that is sufficient to offer a minimum of agreed international standards of corporate social responsibility from which a developed body of national principles can emerge as greater regulation acts as a competitive disadvantage for the regulating system thereby becoming less attractive for foreign investors as well as relocation for home investors. Brian Cheffins, in his own opinion, stated that a mandatory rule (regulation) may have positive attributes but the negative attribute far outweighs the positive and that lawmakers should be cautious about using this approach in dealing with issues affecting company participants. He said that if there are mandatory rules, costs involved in compliance will outweigh the benefits, the rules may not operate as intended, the rules may bring in shifts of operations to countries which do not impose similar restrictions and companies may react to it by cutting back benefits the previously offered or by dismissing off workers.

Justifications for regulation closely follow the theories underpinning the company. In the USA, it is believed that state intervention in a group structure should be kept to a minimum. It is said to be an entrepreneurial approach which favours the individual; in the absence of fraud and wrongdoing, the state should not interfere and the courts should uphold the separate legal existence of the company as the formation of a company occurs from a pact by two or more parties to carry on commercial activities. This theory is said to be fiction and contractual theories. It is a different approach in certain countries such as China and Russia. They believe that the company should be seen as a concession of the state and as an instrument of the state that can be utilised by the state to pursue its objectives. This theory is known as Communitaire theory.The UK government did not adhere to the CLRSG report on more regulations on the group structure because the UK views the existence and operation of the company as a concession of the state as it is the state which grants the ability of a company to enjoy legal status. The approach to this theory shows limited regulation and veil lifting, always seeking to support wealth creation and entrepreneurial activity. This theory, as stated by Janet Dine to be Concession Theory, accepts only that the state has a role to play in ensuring the corporate group structure are fair and democratic as the state will not use the company to achieve its own objectives.

The principle in Salomon is that although the company in itself is an artificial legal person, however it is being managed by normal people. The state realised that since the theory adopted in UK is of limited interference; more regulation may have a negative impact on the economy and the reluctance of the courts to lift the veil to hold parent company liable for the action of its subsidiaries except in limited circumstances. The state believes that there are enough regulations protecting the minority shareholders and creditors but just needed reforms to encompass subsidiary companies in a group structure.

The Law Commission in its report made recommendations that the traditional common law duties of care and skill and fiduciary duties placed on the directors should be restated to provide greater clarity on what is expected of the directors and make law more accessible; to enable defects in the law to be corrected in relation to duties of conflicted directors; and to enable the fundamental question of scopein a way which reflects modern business needs and wider expectation of responsible business behaviour.

In a company, the location of managerial power resides with the board of directors and that managerial power is defined in the company’s constitution which is known as the Articles of Association (the Articles). In a large corporation, they usually have different types of directors. These include executive directors, non-executive directors and shadow directors.

The statutory restatement of the common law directors’ duties can now be found in Companies Act 2006and Insolvency Act 1986 which is the result of the idea that the director has two types of functions which are treated separately by the law.

The first function is the directors’ fiduciary duties to the company. These duties are;

Duty to act bona fide and in good faith in the interest of the company; including a requirement not to fetter their discretion or delegate it. This is essentially a subjective obligation but there are situations when the court will use an objectiveassessment to find the belief in the actions and if the genuine belief cannot be found, the director may said to be in breach of this duty. S.172 went on to define the interest of the company as the long term interests of its shareholders and in doing so, the stakeholdersinterest must be taken into consideration. However, they are not to oblige if it will not be in the interest of the company. The problems directors of a subsidiary face is if it is wholly owned or the majority shareholder is the parent company in a group structure instruct them to take an action that is in the best interest of the group as a whole but not to the subsidiary company, can it be said to be a breach? What the court said was that the proper test is whether an intelligent and honest man in the position of the company concerned, could have reasonably believed that the transactions were for the benefit of the company. This means that the director of the subsidiary should direct their minds specifically to their own company’s interest as opposed to interest as a group so as not to be judged to have failed their duty on the objective test. What the restatement also did was also gives some protection to creditors when it states that when a company’s solvency is in doubt, then the creditors interest intrude at that point and if the company becomes insolvent, the creditors interest becomes the duty of the directors. This goes along with their duty to exercise independent judgment when taking an action in the benefit of the company. The general rule, encapsulated by the Companies Act was that the directors will be in breach of their duty if they simply follow another’s instruction without considering and deciding whether what is proposed is in the interest of the company. This is an essential decision to limit the abuse on subsidiary by the parent company in a group structure as the directors can now have a valid reason to decline instructions from the parent companies if it is not in the best interest of the subsidiary without any repercussion. This duty also applies to shadow directors as they are bound to ignore the interest and wishes of their employer. The directors although may be exempted from the duty of discretion under s.173 if they decide to bind themselves to do whatever necessary to effectuate a contract which at the time of the contract they genuinely believed to be in the interest of the company as a whole.

Secondly, directors must exercise their powers for proper purposes as stated in Howard Smith Ltd v Ampol Petroleum Ltd. The principle is that where directors exercise a power with mixed motives and the courts found it to be improper, the director will be guilty of abuse of power.

Thirdly, there must be no conflict of interest or secret profit. The general principle was stated in Aberdeen Railway Company v Blaikie Bros that it is a rule of universal application that no one having such fiduciary duties shall be allowed to enter into engagement in which his personal interest conflicts with those of his company.

Lastly, directors are under a duty to exercise reasonable care, skill and diligence. This is an equitable duty which is connected to the standard of competence that is reasonably expected of directors. Romer. J. formulated a definable criterion for directors’ duties of care, skill and diligence in Re City Equitable Fire Insurance Co. He stated that a director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience (subjective test), that a director is not bound to give continuous attention to the company’s affair and that directors may leave routine conduct of business affairs in the hands of management. s.174 enhanced the standard of care current day directors have to exhibit to both objective and subjective standard which is reasonable because should the standard be higher, owners and managers of businesses who by risk and initiative attempt to make profit will be inhibited and also wealth creation which is the key feature of a corporate group will be hindered. The proper test was stated in s. 214(4) of the Insolvency Act 1986 which applies to directors upon going into insolvency. The section provides liability where a director carries on trading when he knew or ought to have concluded that there was no reasonable prospect of the company avoiding insolvency: the general knowledge, skill and experience that may be reasonably expected of a person carrying out the same functions as are carried out by the director in relation to the company (objective), and the general knowledge, skill and experience that the director has (subjective) the standard of care expected of a director was contained in the wrongful trading provision in s.214 (4) and the idea of reasonable director was recognised which is either an objective or subjective standard. A liability under s.214 may lead a director to be disqualified by the courts for a specified periodif the court is satisfied that the directors conduct makes him unfit to be concerned in the management of a company.

The second duty is to protect and preserve the assets for the beneficiary. These duties which were originally owed only to the company meant that only the company can enforce an action and it is also the company that can excuse a breach of duty although a breach of duty cannot be ratified in the situation of insolvency. This rule was first established in Foss v Harbottle that minority shareholders cannot sue for wrongs done to their company or complain of irregularities in the conduct of its internal affairs. The only exception is when the act complained is either fraudulent or the company is about to act beyond its capacity. Rather than enshrining the common law into the statute, what the law reforms did was redefine the law on derivative claim in s.260-269 and s.994-996 of the Companies Act 2006 and the claim is now known as statutory derivate claims.

This is a very good remedy for minority shareholders especially in a subsidiary of a group structure because the s.260 allows the minority