The Separate Legal Entity Principle

Introduction

The Separate Entity Principle is a fundamental principle of Company Law applied on a global basis. Pursuant to this principle, a company is treated as a distinct entity from its members. The separate entity rule pervades company law and has had wide reaching implications on theoretical and practical company law.

This essay is divided into two main parts. In the first part, we will discuss the concept of Separate Entity Principle, and evaluate the decision in Salomon case. In the second part we will analyze statutory exceptions to Separate Entity Principle and consider the circumstances in which and for the so-called ‘corporate veil’ may be lifted or pierced by the court.

A Double-Edged Sword — Separate Entity Principle

1. Outline Of Separate Entity Principle

Separate Entity principle was firstly illustrated in R v Arnaud case. In this case, a registering authority refused to register a ship on the ground that the owners of the ship include foreigners. The ship was owned by a (British) chartered company whose members happened to include foreigners. The court ordered the registering authority to register the ship on the basis that the (British) company was the ship’s owner rather than the members of the company. Nevertheless, the unanimous decision of the House of Lords in Salomon v Salomon & Co Ltd is regarded as a landmark in Company Law which confirmed that a company is a separate entity with distinct legal personality.

The facts of the Salomon case are: Mr. Salomon sold his shoe business to a company which he had set up for the purpose under the Companies Act. The registration under the Act was completed and the members of the company were Salomon and his family, particularly, Mr. Salomon received fully-paid shares and debentures to the value of ￡10,000 which he subsequently assigned to another party. Business declined and the company went into insolvent liquidation. The liquidator attempted to hold Mr. Salomon liable for the debts of the company with arguing that the whole transaction was a fraud on the company’s creditors and Salomon should not be allowed to benefit, additionally, the liquidator claimed the company was simply an agent of Salomon, as a result, he should indemnify the company (and its creditors) with respect to the debts incurred by the company.

In this case, the House of Lords held that :

1. Salomon was neither under liability to the Salomon Company nor to creditors of the Salomon Company.
2. Salomon’s debentures were validly issued.
3. Lord Halsbury LC remarked that statute had enacted the formal and procedural requirements upon registration of a company but did not enact requirements regarding the extent or degree of interest which may be held by each of the subscribers or as to the proportion if influence processed by one or the majority shareholder over the others.
4. The House noted that after registration of a company, although the business may be the same as before and the same hands receiving profits, but in law the company is not an agent of the subscribers or members.

However, it should be noted that the House of Lords in Salomon’s case really only decided that Salomon & Co Ltd was a company duly incorporated under the Companies Act 1862 (UK) though its seven shareholders were not truly ‘independent’: all of the statutory requirements were satisfied because the company had seven shareholders. In accordance with the decision of the House in Salomon case, we can summarize four points follow from the proposition that incorporated companies have a separate legal personality: (a) Company’s property is company’s property; (b) Company’s debt is company’s debt; (c) Companies can contract with their members, directors and outsiders; (d) Companies can commit torts and crimes.

These four points had been reasserted in many cases.

Firstly, the point—“Company’s property is company’s property”—had been applied in Macaura v Northern Assurance Co. In this case, the appellant Mr. Macaura’s claim for payment of insurance for his company, but his request was refused by five insurers, these insurers claimed that Mr. Macaura did not have an insurable interest for the insurance was bought in Mr. Macaura’s name rather than the company’s name. The court upheld the insurer’s decision and concluded that “the corporator, even if he holds all the shares, is not the corporation, and that neither he or any creditor of the company has any property, legal or equitable, in the assets of the corporation.” In the meanwhile, this decision that implies that although the principle is not in favour of the person registering the company, these principles should also be applied.

Secondly, the point—“Company’s debt is company’s debt”—had already been clearly addressed in Salomon case by the House.

With regard to the point—“Companies can contract with their members, directors and outsiders”— was indeed developed in Lee v Lee’s Air Farming Ltd. In that case, Mr. Lee’s accountant formed a company (Lee’s Air Farming Ltd), and Mr. Lee was the principal shareholder also the governing director of this company. The company contracted with farmers to perform aerial topdressing. Mr. Lee worked for the company as a pilot and received a wage for that work. In a work accident, Mr. Lee died then his wife claimed on a workers compensation insurance policy that the company’s solicitor had taken out naming Mr. Lee as an employee. The insurer denied liability on the ground that Mr. Lee could not be a servant because he was a director of the company. The Judicial Committee of the Privy Council upheld the claims made by Mrs. Lee and firmly rejected the insurer’s argument. Lord Morris quoted Lord Halsbury LC’s judgment in Salomon’s case, that company ‘was a real thing’ and noted that:

“… Always assuming that the respondent company was not a sham, then the capacity of the respondent company to make a contract could not be impugned merely because the deceased was an agent of the respondent company in its negotiation [of Mr Lee’s contract of service].”

The decision in Lee v Lee’s had also been applied in Industry v Bottrill (1999) case where the court pointed out that a sole shareholder can be employed by the company and will have rights under the Employment Rights Act 1996.

These solutions confirm that a company is able to employ one of its members under a contract of service including its principle shareholder.

Finally, Companies can commit torts and crimes. The decision in Lee v Lee’s case demonstrates that companies may be liable to tort since companies have a separate legal personality and are able to contract with others.

In sum, the Salomon case is regarded as a landmark in the UK’s Company Law since the Salomon case had established fundamental principles of Company Law. According to the Salomon case, a company is both an association of its members and a legal person separate from its members, “ a company’s property is owned by the company as a separate person, not by the members; the company’s business is conducted by the company as a separate person, not by the members; it is the company as a separate person that enters into contracts in relation to the company’s business and property”.

2. Evaluation Of The Decision In Salomon Case

A. Positive Arguments

The Separate Entity Principle has stood the test of time because it has meant the company does have practical utility. As a separate legal entity subject to limited liability and defined by share transferability, perpetual existence, flexible financing methods, specialised management, majority rule and the other attributes or consequences of incorporation, the corporation has many economically and socially beneficial functions.

Firstly, as a separate entity, by separating the management from investment a company enables the investing public to share in the profits without being involved in management of business, in the meanwhile, professional managers can be hired by a company to provide professional management of business and this may probably result in a better profit. Secondly, as a person created by law, the personality of the association is highlighted. A company can ‘live’ long enough to carry on certain business without worrying about biological death so it may reach the achievements made by generations of members. Thirdly, according to limited reliability principle, investors are merely reliable to the share which they subscribe for so that the risk of investment has been reduced.

In sum, company as a vehicle of business can collect huge amount of outside capital for business efficiently and provide considerable convenience and confidence to the investors, consequently, investments are encouraged. Furthermore, economic growth has been boost and the development of society is promoted.

B. Negative Arguments

The decision in the Salomon case has been criticized by many academic scholars. Professor Kahn-Freund even described it as “calamitous”, He claimed that the decision cause a number of problems, for instance, “How is it possible to check the one-man company and other abuses of company law?” The House of Lords confirmed the usage of the corporate form by individual traders and small partnerships in stressing the independent status of corporate personality, Tomasic and Bottomley mentioned this result in that private enterprises which do not seek to raise capital from the public can interpose an entity between themselves and their creditors. The Law Lords concluded that once completed the process of registration required by the Act, a company forms a legal entity separate from its shareholders, even where there is only a bare compliance with the provisions of the Act and where all, or nearly all, of the company’s issued shares are held by one person. Furthermore, Gower pointed out that the Court held that it was possible for traders not merely to limit their liability to the capital which they invested in the enterprise but even to elude any serious risk to the major part of that by subscribing for debentures rather than shares. Salomon’s case was not about “a dry point of construction.” noted in The Law Quarterly Review, The House of Lords emphasized on the separate identity of the legal form and essentially ignored the economic reality of a one-person company.

According to the criticism of the decision made in Salomon case, negative effects of the Separate Entity Principle may be concluded into two main aspects.

Firstly, the Salomon principles are weak in protecting interests of outside creditors. The Salomon case gives the benefits of limited liability to even apparently honest incorporators in circumstances which it is not necessary in order to encourage them to initiate or carry on their trade or business. According to the Separate Entity Principle, Management of business is separated from shareholders and due to the benefits of limited liability, shareholders are discouraged in monitoring and controlling their company’s commercial ventures. However, a limited company’s creditors must look at the capital, the limited fund of the company.

Additionally, pursuant to the Separate Entity Principle, subsidiaries can be easily abused to avoid debts by transferring assets between parent company and subsidiaries.

In sum, in accordance with the principle of Separate Entity, company is regarded as a separate legal entity. Thus, it is reliable to the debts of its own. Therefore, creditors of the company are prevented from claiming their rights directly to those real debtors (shareholders). This implies that, in practice, creditors (both contracting creditors and tort creditors include) bear more risk when they dealing with a limited corporation, by contrast, according to benefits of limited liability, shareholders of the company are highly protected by law and bear less risk of the insolvency of the company.

Secondly, the Separate Entity Principle provides an ideal vehicle for fraud. Ever since the Salomon case, legal doctrine regards each corporation as a separate legal entity. “When coupled with the consequent attribute of limited liability, the Salomon principle provides an ideal vehicle for fraud.” Nowadays, the form of corporation has been abused for the development of many different forms of fraudulent or anti-social activity.

3. Discussion Of Piercing The Corporate Veil

As discussed above, it is a fact that the application of the Separate Entity Principle has mostly beneficial effects for shareholders but it may work to the disadvantage of third parties, especially the creditors. Although in most situations this is as is intended by the Companies Acts, sometimes, however, the legislature and the courts have intervened where the Separate Entity principle had the potential to be abused or the application of the principle may lead to unjust consequences. This is known as ‘lifting the veil of incorporation’. This does not mean that a company is suddenly not incorporated (companies remain incorporated until deregistered pursuant to CA, Ch 5A). Indeed, it means that the fact of its incorporation will be ignored for the purposes of the impugned transaction the courts or the legislature have decided that in certain circumstances the company will not be treated as a separate legal entity.

1. Statutory Exceptions

A. Companies Act

As the form of group merges, the Law recoganised that treating each subsidiary in a group separately was misleading. Then lots of provisions were introduced into the Companies Act to recognize this fact. For example:

• • s.399 CA 2006 provides that parent companies have a duty to produce group accounts.
  • s.409 CA 2006 also requires the parent to provide details of the shares it holds in the subsidiaries and the subsidiaries’ names and country of activity.
  • s.993 CA 2006 which provides a not much used criminal offence of fraudulent trading

B. Insolvency Act

Additionally, the most important statutes concerning veil lifting issues are contained in Insolvency Act 1986. These provisions include ss.213—215.

Section 213 of the Insolvency Act 1986 is known as the ‘fraudulent trading’ provision. It is designed to deal with situations where the corporate form was used as a vehicle for fraud.

In pursuant to this provision, in the course of the winding up, if it appears to the court that “any business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose”, then on the application of the liquidator the court may “declare that any persons who were knowingly parties to the carrying on of the business in the manner above-mentioned are to be liable to make such contributions (if any) to the company’s assets as the court thinks proper.”

Section 214 of Insolvency Act concerns “wrongful trading”. In accordance with this provision, wrongful trading does not require proving an intent to defraud. Rather it simply requires that “a director, at some time before the commencement of the winding up of the company, knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, but continued to trade.” The section operates on the basis that “at some time before the company entered insolvent liquidation there will have been a point where the directors knew it was hopeless and the company could not trade out of the situation.” The reasonable director would not at this point continue to trade. If he does continue to trade he risks having to contribute to the debts of the company.

C. Summary

In sum, the legislature has always been concerned to enhance the protection of the interests of outside creditors and to minimise the extent to which the Separate Entity Principle could be used as an instrument of fraud. As mentioned above, different provisions affect the Separate Entity Principle in different ways and may be directly or indirectly. Indeed, these statutory exceptions to the Salomon principle perfect the principle.

2. Principles Applied By Courts In Piercing The Veil

Basically, the courts are in a difficult situation in deciding whether to lift the veil of incorporation or not. In these situations, the court must decide where the loss should lie. As we discussed above in Salomon and Lee v Lee’s, the strict application of Separate Entity Principle will consequently lead to an extreme result. Over time the court has swung from strictly applying the Salomon principle in these difficult situations to taking a more interventionist approach to try to achieve justice in a particular situation.

In this part, we will analyze three important cases in order to sought which principles the court will applied in piercing the veil of incorporation.

A. Discussion Of Adams V Cape Industries Plc

The key issue in this case was whether Cape was present within the US jurisdiction through its subsidiaries or had somehow submitted to the US jurisdiction. According to the Court of Appeal that could only be the case if the veil of incorporation is lift , either treating the Cape group as one single entity, or finding the subsidiaries were a mere façade or were agents for Cape.

In this case, when determining whether the company is a mere façade the motives of those behind the alleged façade may be relevant. The Court of Appeal focused on the motives of Cape in deal its US business through its various subsidiaries. The court concluded that although Cape’s motive was to try to minimise its presence in the US to avoid tax and other liabilities and “that that might make the company morally culpable but there was nothing legally wrong with this”.

With respect to the “agency” argument, the Court of Appeal did not find any legal objection (in respect of a holding company-subsidiary relationship), then the court concluded that the subsidiaries were independent and with no general power to bind the parent. Therefore Cape could not be present in the US through its subsidiary agent. Furthermore the court pointed out that:

“Our law, for better or worse, recognizes the creation of subsidiary companies, which though in a sense the creatures of their parent companies, will nevertheless under the general law fall to be treated as separate legal entities with all the rights and liabilities which would normally attach to separate legal entities.”

The courts finally refused to lift the veil and strictly applied the Separate Entity Principle.

In sum, the decision in Adams narrows the situations where the veil of incorporation is in effect lifted to three main situations.

(a) Where the company is a mere façade.

(b) Where the court is interpreting a statute or document (these statute or document is lack of interpretation) in order to reject fairness.

(c) Where the subsidiary is an agent of the company.

Additionally, this solution has been followed in cases such as Connelly v RTZ Corp Plc (1998)18, Ord v Belhaven Pubs Ltd (1998)19, and Lubbe v Cape Industries Plc (2001)20.

B. Discussion Of Smith, Stone & Knight Ltd V Birmingham Corporation

In this case the respondent wanted to compulsorily acquire premises upon which a business of waste paper was apparently carried on by Birmingham Waste Co Ltd (‘BWC’). An important fact is that BWC’s name appeared on stationery and on the premises. BWC was a wholly owned subsidiary of another company (‘P’) that owned the premises. The respondent would not have been liable to pay compensation to BWC for business disruption because its tenancy was terminable at will by P. However, P claimed that it really conducted the business and was therefore entitled to receive compensation.

The court noted that the main question was whether BWC was carrying on the business for itself or for P. To resolve this issue Atkinson J posed six questions: (a) Were the profits treated as profits of P? (b) Did P appoint who would carry on the business? (c) Was P the ‘head and brain’ of the business? (d) Did P decide what to do and what capital to employ? (e) Did P make profits from its skill and judgment? (f) Was P in effectual and constant control? The court uphold P’s claim primarily in the decision on the ground that BWC did not have its own resources and the business had not been transferred to BWC.

In sum, in considering whether or not to lift the veil of a wholly owned subsidiary, a considerable question is that whether it is an agency of parent company, and the questions raised by Atkinson J should be good criteria to measure in practice.

C. Discussion Of Gilford Motor Co V Horne

In this case, H was a former managing director of G and H made a promise in his contract with G that do not to solicit customers from his employer G at any time. However, H then set up a company Z to do so and He argued that while he was bound by the covenant the company was not.

In the decision of this case, the court lifted the veil of the company which H has set up and held H liable for breaching his contract with G. The court pointed out that the business Z’s rather than H’s, was a mere ‘sham’ or ‘cloak’; especially since the reason that Z’s creation enabled H to evade his covenant with G.

In sum, a court will not allow the company to be an instrument of fraud or illegality. Thus, the main point in this case is that the veil of incorporation will be pierced if there is fraud, in other words, the purpose of creation of a company is for a fraudulent or illegitimate.

D. Discussion Of DHN Food Distributors Ltd V Tower Hamlets London Borough

In this case, DHN ran a business from premises owned by its wholly owned subsidiary. The subsidiary had no other business except the leasing of premises to the parent company and its only assets were the premises leased to the parent. Additionally, the directors of the parent and subsidiary are the same. DHN claimed for compensation for compulsory purchase, however, the defendant argued that the owner of the land is the subsidiary of DHN rather than DHN itself.

In decision, the Court of Appeal held the claim of DHN and treated a group of companies as a single economic entity. The court concluded that, the test for disregarding the corporate veil was to see whether the holding and subsidiary company were so inter-related that the former had so-called dominant control of the corporate policy of the subsidiary, if so, the group of companies should be treated as a single economic entity.

In sum, the decision in DHN cases indicates that the veil of corporation can also be lift to the benefits of members. More importantly, the court treated a group of companies as a single economic entity on the ground that:

(a) the parent and subsidiary had the same directors;

(b) the parent and subsidiary had the same shareholders and had a common interest;

(c) the subsidiary simply owned property for the parent without any independent assets or capacity of decision.

E. Summary

As discussed above, we could conclude that the veil of incorporation will be pierced by the courts in cases in these circumstances:

(a) In cases of fraud or sham. These occur where individuals have used the separate legal entity to do something they are personally bund to do so.

(b) When an agency relationship is recognised by the court. If a subsidiary is considered as an agent for its holding company, the veil of incorporation will be lift thus the holding company will be liable to the subsidiary’s debts.

Besides the two main circumstances, the veil of incorporate may be pierced in circumstances such as Paramount Public Interest or Evasion of legal obligations.

Basically, the courts lift the veil and ignored the separate personality of incorporation where justice and require them to do so.

Conclusion

The Separate Entity Principle established in Salomon case is regarded as a double –edged sword. Debates concerning this principle will last and the question—‘whether the positive effects overweight the negative one’—is best to be left unanswered, since it is far too broad.

Despite of the criticism of the Separate Entity Principle, in my opinion, it has been very instrumental in promoting the developed of modern capitalism and it has generated immense social and economic wealth. The status of Separate Entity Principle as a cornerstone of Company Law should never be changed.

As the circumstances in certain cases are complex, strict application of the Separate Entity Principle will lead to an apparently unfair result. In order to defend justice in law, in certain circumstances, indeed, “the legislature can forge a sledgehammer capable of cracking open the corporate shell.” And, “even without statutory assistance, the courts have often been ready to draw aside the veil and impose legal liability on members and directors. ” Basically, the courts have ignored the principle of legal corporate personality in a number of circumstances, for example, where the protection of public interest is of paramount importance, where the company is formed to evade legal obligations and in some cases the courts implying that a company is an agent or trustee for its members.

Finally, it should be remembered that the Salomon case remains the general principle. If many textbooks deal with the question of “Lifting the veil”, these cases remain exceptional. The principle dealt with in the Salomon case is extremely strong and almost without exception. “The Principle of limited liability is not threatened and remains as solid as a rock.”

Bibliography

Mayson, French and Ryan on Company Law; Blackstone Press.

Kahan-Freund, Some Reflections on Company Law Reform, MLR, 1944

C. Schmitthoff, The Wholly Owned and Controlled Subsidiary, JBL 1978

Hicks & S. H. Goo, Cases and Materials on Company law, 6th edition, OUP

Cf. FH Easterbrook and DR Fischel, Limited Liability and the Corporation, 1985

Mayson, French & Ryan, Company Law, 25th edition, OUP

Tollinson, Piercing the Veil of Limited Liability, Delaware Journal of Corporate Law.

Roman Tomasic and Stephen Bottomley, Corporations Law in Australia, The Federation Press, Sydney, 1995

Simon Goulding, Principles of Company Law ,Cavendish Publishing Limited, London, 1996

LCB Gower, Gower’s Principles of Modern Company Law ,5th ed, Sweet & Maxwell, London, 1992

Insolvency Act 1986 .UK

Cases

R v Arnaud (1846) 9 QB 806

Salomon v A. Salomon and Co Ltd (1897) AC 22

Macaura v Northern Insurance Co (1925) AC 619

Lee v Lee’s Air Farming Ltd [1961] AC 12

Secretary of State for Trade and Industry v Bottrill (1999), 1 All ER 915

Adams v Cape Industries Plc (1990) Ch 443

Smith, Stone & Knight Ltd v Birmingham Corporation [1939] 4 All ER 116

Gilford Motor Company Ltd v Horne [1933] Ch 935

Jones v Lipman [1962] 1 WLR 832

D.H.N. Ltd v Tower Hamlets [1976] 1 WLR 852

Woolfson v Strathclyde RC [1978] SLT 159

Re a Company [1985] 1 BCC 99421

National Dock Labour Board v Pinn & Wheeler Ltd [1989] BCLC 647

Creasey v Breachwood Motors Ltd [1992] BCC 638

Ord v Belhaven Pubs Ltd [1998] 2 BCLC 447

Williams v Natural Life Health Foods Ltd [1998] 2 All ER 577

Lubbe and Others v Cape Industries plc [2000] 1 WLR 1545