#7397 - Separate Legal Personality - Business Associations I

Class 2: Separate legal personality

Each corporation is a separate legal person, bearing itsown liabilities. Incorporators enjoy limited liability.

Redmond [4-10]-[4-40].

Limited liability:

• Corporate personality serves the function of marking out an asset pool against which creditors of the enterprise have prior claims.

• Shareholders and directors are not liable for the debts of the corporation. The shareholder’s liability is limited to the amount of unpaid shares.

• The merits of limited liability:

  • Encourages investment by those with no interest or capacity for management participation.

  • Relieves shareholders from the burden of monitoring other shareholder’s capacity to contribute to company failure.

  • Encourages free liquidity of share capital.

  • The pricing mechanism reflects the worth of the share and not the holder’s capacity to contribute to the company’s deficiency.

  • Encourages entrepreneurial risk taking by companies because they can safely invest with out significant risk exposure.

  • The creditor has more risk if they do not monitor the company.

• Section 24 of the CA vests legal capacity and power of an individual in a company registered under the act. But its incorporal nature allows perpetual succession.

• The separate personality doctrine is present in Salomon. It marked the beginning of modern company law. It established argued Gower that there is legality in a one man company and it is widely criticised because it does not protect the little man who only sees the name of the company and does not understand the risks he runs granting credit to the company. But it showed there is complete separation of the company and its members.

• There are unsecured creditors like suppliers and torts victims. There are secured creditors who take security offered by the shareholder (secured guarantee of another’s obligations) and it can secure its own obligations with a floating charge or fixed charge. This is a form of company mortgage. Employees have been given a statutory priority.

• A benefit of limited liability is that small shareholders can afford to invest with small contributions and they don’t have to be experts or monitor if they don’t have time. The shares become more liquid. Massing capital for investment. Pension fund capitalism is allowed and they are protected by limited liability. You don’t have to sue all the shareholders- you only have to sue the corporation.

• Alternatives to limited liability? When you invest in Lloyds insurance you invest in unlimited liability and a few of those syndicates went backwards. The assembly of legal exceptions is an alternative.

Cases:

Salomon v Salomon & Co Ltd [1897] AC 22 (Extracted in Redmond [4.30])

• House of Lords decision.

• Mr Aron Salomon was a leather boot and shoe manufacturer. His sons wanted to become business partners, so he turned the business into a limited company. His wife and five eldest children became subscribers and two eldest sons also directors. Mr Salomon took 20,001 of the company's 20,007 shares. The price fixed by the contract for the sale of the business to the company was 39,000. According to the court this was "extravagent" and not "anything that can be called a business like or reasonable estimate of value." Transfer of the business took place. A case about the question of whether creditors could have sued the shareholder.

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

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

• In trial: Mr Salomon had to indemnify the liquidator against all the debts and the company was just an agent for Salomon. The company was found to be a sham and Salomon was personally liable in the trial court. He couldn’t receive any funds available to him and had to find the money to pay the unsecured creditors. Mr Salomon was the beneficiary of the operation of the company and he had used the company to do the same thing as when he was a sole trader. The company was a sham and a vehicle through which Mr Salomon had acted the same way as a sole trader. Many firms were partnerships in those days and had their reputation on the line in business. Mr Salomon was the principle and created a sham and so is liable to the creditors to bulk up the fund for the liquidator to distribute among them.

• The Court of Appeal dismissed the appeal. Lindley LJ thought the company was created even if it was for an illegitimate purpose. It was not principle and agent but the company was a trustee. It recognises there is property held in a fund and there are assets there.

• The HL overturned this decision. Salomon sues his own company for the secured loan. Can a shareholder sue his own company in the capacity of a creditor? He would scoop most of the funds left over as a secured company if he won. The internal arrangements of control and influence was irrelevant and whether it was at arms length was irrelevant. There was no evidence of serious under-evaluation of the sale so the fraud argument fell away.

• Lord Halsbury LC:

  • The proportions of the interest of each shareholder does not matter. One share is enough. If they are shareholders they are shareholders for all purposes.

• Lord MacNaughten:

  • Asked what was wrong with Mr. Salomon taking advantage of the provisions set out in the statute, as he was perfectly legitimately entitled to do. It was not the function of judges to read limitations into a statute on the basis of their own personal view that, if the laws of the land allowed such a thing, they were "in a most lamentable state"

  • When the memorandum is duly signed and registered, though there be only seven shares taken, the subscribers are a body corporate “capable forthwith,” to use the words of the enactment, “of exercising all the functions of an incorporated company.” Those are strong words. The company attains maturity on its birth. There is no period of minority - no interval of incapacity. I cannot understand how a body corporate thus made “capable” by statute can lose its individuality by issuing the bulk of its capital to one person, whether he be a subscriber to the memorandum or not. The company is at law a different person altogether from the subscribers to the memorandum; and, though it may be that after incorporation the business is precisely the same as it was before, and the same persons are managers, and the same hands receive the profits, the company is not in law the agent of the subscribers or trustee for them. Nor are the subscribers as members liable, in any shape or form, except to the extent and in the manner provided by the Act. That is, I think, the declared intention of the enactment. If the view of the learned judge were sound, it would follow that no common law partnership could register as a company limited by shares without remaining subject to unlimited liability...

• Lord Davey:

  • Every member of the company assented to the purchase and the company s bound by the unanimous agreement of its members.

• The principle from Salomon v Salomon, that upon incorporation the company is a separate legal entity from its incorporators, applies to wholly owned subsidiaries Briggs v James Hardie (1989)

What is a corporate capital structure?

• Limited liability corporation.

What was Salomon and Co’s capital structure?

• Debt and equity.

How many shareholders were there?

• 7. His wife and 1 daughter and 4 sons and himself. This was the minimum to have a corporation in the Act.

How many really counted? Why?

• Only Salomon because he held 20,000 shares and the rest only held one share each.

How many directors were there?

• Three. His two sons and Mr Salomon. They were the board of directors. They make decisions to manage the company’s business and assets. The shareholders hire and fire the directors.

How many really counted? Why?

• Only Mr Salomon really counted. He was a majority shareholder. Directors are appointed and fired by a normal resolution which only requires 50% of the shareholders present and Mr Salomon could never be defeated with his large shareholding.

In every day terms, what sort of Co was this?

• A family run company. He could make a will to leave shares to his family members.

What was the point of the sale of his business by Mr Saloman to the Co?

• He wanted the limited liability of a corporation and he wanted to pass the company on to his sons- perpetual succession.

• The dividends from the shares would give him income for his retirement if he is no longer an employee for the company.

• Before the transaction took place it was a sole trader run by Mr Salomon. He owned all the assets. He had debts and he was personally liable.

• In 1897 there was no such thing as a one person company....