#10842 - Separate Legal Personality - Business Associations 1

[4.10] The nexus between corporate personality and limited liability – while distinct conceptually the two notions are functionally related.

In business, corporate personality has the function of marking out a pool of assets over which creditors have prior claims. Entity status partitions this pool from personal assets of stake holders
- Piercing the veil involves breaking this partition and exposing them to claims of creditor’s (and sometimes to relieve the company of the legal consequences of its status as a separate entity)
  - But absent such special circumstances, shareholders and directors are not liable for the debts of a corporation
  - Hence it can be said that the corporate personality is a precondition for limited liability; essentially this passes the risk of company failure on to creditors

[4.15] The merits and costs of limited liability

Some arguments in favour include: it encourages investment for those without a capacity for management, it relieves shareholders from the burden of monitoring fellow shareholders, it encourages liquidity and provides an accountability mechanism for management performances, market pricing impersonalises the share and thus divorces it from the capacity of the shareholder, it encourages entrepreneurial risk taking
- But these are affected by the structure of share ownership – particularly with the emergence of investment intermediaries and corporate group structures with a capacity for internal monitoring of the risk of business failure; the case for limited liability is much weaker in such circumstances
Limited liability also has its critics – some argue its benefits to shareholders are matched to creditors who may not have greater monitoring/risk-bearing capacity
- Hence tort claimants may be more vulnerable (as creditors) than contract creditors who can bargain for protection and rates of returns commensurate with risks undertaken.
- Hence limited liability can create a moral hazard problem in tort as enterprises can ‘externalize’ costs
Corporate personality favours such externalisation of social costs – shifting the risk to stakeholders and wider society
- This arises since not all costs of corporate operation are imposed by legislation – there will be a time lag in legislation and gaps in its coverage and effective barriers to private/[public enforcement create opportunities to disregard obligations – especially in relation to transnationals in countries with poor government/regulatory regimes
- Legal structure also favours externalisation as reflected in the calculus of self-interest = it encourages the corporation to locate activities into separate corporate structures and hence insulate group assets from the risk of failure
- Further, the more narrow moral compass of a corporation (as distinct from an individual who may feel personal responsibility) favours such externalisation

Some of the features different between corporations and natural persons are iterated – that of perpetual succession and its ‘artificial/soulless’ character
- But a Corporation can commit crimes, torts, and have defamation against it (NSWALC v Jones) (but can only claim money), it can be in contempt of court but must appear through a representative (Bay Marine v Clayton Country Properties)
- Also the HCA has held that a corporation isn’t entitled to invoke CLAW privilege in relation to self-incrimination in answer to a demand for production of documents under a statutory power (EPA v Caltex) unlike in the Canada and England
The HCA has also held that a reference to ‘residents’ does not extend to corporations (Australasian Temperance and General Life Assurance Society v Howe) and it is further unlikely that a “subject of the Queen”

[4.25] The separate personality of a corporation – This doctrine rests fundamentally on judicial doctrine – the starting point for an inquiry into it is often Salomon’s Case

[4.30] Salomon v Salomon & Co Ltd [1897] AC 22

Facts: Aron Salomon traded as a boot manufacturer. In 1982 he arranged for incorporation of the now respondent company – the seven subscribers being himself (holding 20,001 shares) and his family (1 each). The company entered into an agreement to purchase Salomon’s business for 39,000 to be satisfied by the issue of 20,000 fully paid 1 shares and debentures (floating charge) with a face value of 10,000. The balance of the purchase price (9000) remained unsecured.

During a recession in the business, Salmon borrowed 5,000 which he immediately advanced to the company. TO obtain this 5000 he cancelled his debentures, and reissued them to the creditor on terms that he retain the residual benefit. The company eventually went into liquidation and after the creditor took his security, 1055 remained on the debentures which Salomon claimed, thus exhausted the funds the liquidators had to satisfy other unsecured creditors.

Claim by the liquidator: The validity of the debentures is tainted by fraud and by suggestion at trial for a declaration that the liquidator was entitled to be indemnified by Salomon for unsecured debt and for a lien on the sums payable on the debentures since the company was a “mere nominee and agent” for Salomon

Held at First Instance (Vaughan Williams J): Made orders that the liquidator be indemnified by Salomon for the unsecured notes of the company and for a lien on all sums payable by the company on the debenture. His honour based his conclusion on the fact that the company was the “mere nominee and agent” for Salomon

Held, dismissing the Appeal (Lindley LJ): His honour was of the opinion that the legislature had not extended limited liability to sole traders. The company was like a “trustee” for Salomon as a beneficiary. Salomon is liable to indemnify the company and the creditors could only reach him through the company.

Lopes and Kay LJJ in the Court of Appeal made similar sentiments: They said the transaction was a ‘device to obtain the prevention of [the Act] in a way and for objects not authorised by the Act...and in my judgment in a way inconsistent with an opposed to its policy and provisions…To legalise such a transaction would be a scandal

Lord Halsbury thought that the main relevant inquiry was simply “whether the respondent company was a company at all” and as to answering this question the sole guide must be the statute itself:

The fact that 7 living persons held shares means the first condition of the statute is satisfied – the statute says nothing as to the extent of interest required, “one share is enough”
- Furthermore the statute says nothing about the motive of the shareholders is something the statute must recognizes – shareholders are shareholders. Even if the six of them were cestuis que trust the same conclusion would be reached
The provisions of the statute makes it essential to the artificial creation that the law should recognize only that artificial existence – quite apart from the motives of the conduct of the individual corporators

His lordship then went on to criticize the approach of the courts below – simply concluding that if the company satisfied the preconditions of the Act it is impossible to deny the validity of the transactions which it entered into. He then dealt with the argument as to fraud:

He noted that he was not satisfied that the price was an exorbitant one – and furthermore that if every member knows exactly what the true state of facts is (as was the case here) there can be no fraud.

Given that there was no fraud and no agency, and if the company was a real one, all the grounds sought to support the judgment are disposed of

Lord MacNaghten reiterated the facts, noting that Salomon’s decision was what anyone would have done – lent the company money, had the debentures cancelled and reissued them. He then went on:

He too criticized the approach of the trial judge – noting that the Act requires certain preconditions of 7 signatories and says nothing about whether they are relations or strangers – in fact almost every company formed under statute is eked out by clerks or friends
When a company is registered, the subscribers are a body corporate “capable forthwith of exercising all of the functions of an incorporated company” (relevant statute) – these are strong words.
- Companies don’t have a period of minority or incapacity and it is difficult to understand why a body corporate loses its individuality because its shares are issued to one person – the company is a different person altogether, it is not an agent or a trustee

He then went on to deal with the fraud issue

His honour noted that the fact that Salomon raised 5000 on debentures belonging to him shows his good faith and lawful purpose.
Though the unsecured creditors are entitled to sympathy they only have themselves to blame for trusting the company – while one can blame the law as to floating charges and suggest that creditors should have claims for debts incurred close to winding up that is not the law at present…and a great scandal it is

Lord Davey also thought the issue of fraud was not made out, noting that the price for which the company was bought was not so excessive as to afford grounds for rescission. And as regarded the cash portion of the price it should be observed that he held the bulk of the shares and the money required for payment came from himself.

The absence independent board material – all members assented to the company being purchased and hence the company is bound by this. It is impossible to say who...

#10842 - Separate Legal Personality - Business Associations 1

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