CASE EXAMPLE

Salomon v A Salomon & Co Ltd [1897] AC 22 (HL)

Mr Salomon owned and ran a profitable boot and shoe manufacturing business as a sole trader.

He wished to run his business through a limited company which he achieved by registering a company and selling his business to that company.

The statute governing company registrations at that time required seven subscribers to the memorandum of association, ie seven original members or shareholders. Mr Salomon satisfied this requirement by himself, his wife and his five grown-up children becoming subscribers (under the Companies Act 2006 only one subscriber or member is required). The initial nominal share capital of the company was £40,000. This was divided into 40,000 shares with a nominal value of £1 each. Seven £1 shares were issued, one being issued to each shareholder/member/

subscriber which made the initial issued share capital of the company £7. The first directors were appointed by the shareholders and were Mr Salomon and his two eldest sons.

The sale price of the business to the company was ‘the sanguine expectations of a fond owner’, rather than the market value of the business. In short, the business was sold to the company at an overvalue. In return for the business being transferred to the company, the

£39,000 purchase price for the business was ‘paid’ by the company to Mr Salomon in the following way:

n £9,000 was paid in cash (£8,000 of which, with no legal obligation to do so, Mr Salomon used to pay off debts of the business)

n 20,000 shares of £1 each were issued to Mr Salomon, credited as fully paid-up shares (ie the shares were regarded as having been paid for by Mr Salomon, not in cash but ‘in kind’, by the transfer to the company of £20,000 pounds’ worth of the business)

n A £10,000 secured loan note, or, ‘debenture’ was issued to Mr Salomon recording that the company owed Mr Salomon £10,000 pounds secured by a charge over the company’s assets.

Virtually immediately after the transfer, the profitability of the business began to decline. The company found itself in debt and unable to pay its debts as they fell due. Mr Salomon cancelled his loan note, the debenture, and the company entered into loan arrangements/debentures with Mr Broderip who became a secured creditor of the company. The company failed to pay interest on the loan when it fell due and Mr Broderip exercised his right, as a secured creditor, to have a receiver appointed. Shortly thereafter the company went into liquidation.

The company’s assets were sold by the liquidator to realise cash to pay both the secured and the unsecured creditors of the company.

Secured creditors are entitled to be paid before the unsecured creditors of a company (see Chapter 15). The proceeds of sale of the company’s assets were insufficient even to pay the secured creditor, Mr Broderip, in full. In these unhappy circumstances, the liquidator brought an action against Mr Broderip and Mr Salomon alleging the loan notes issued by the company were fraudulent and invalid. The liquidator was successful at first instance and in the Court of Appeal but was appealed to the House of Lords. Held: Mr Salomon had done nothing wrong, was not liable for the debts of the company, and the loans between him and the company and Broderip and the company were valid.

3.4.1 The first instance and Court of Appeal decisions

The first instance judge in Salomon decided that fraud was not established on the facts of the case. He did, however, use agency principles to decide that the company was Mr Salomon’s agent and on that basis he ordered Mr Salomon, the principal, to indemnify the company, the agent, for the debts the company had incurred as his agent. The Court of Appeal rejected the first instance agency argument. Lindley LJ preferred to hold that the company was the trustee of Mr Salomon who was the beneficiary. Lindley LJ described the company as, ‘A trustee improperly brought into existence by him to enable him to do what the statute prohibits’, therefore, he held, the beneficiary (Mr Salomon) must indemnify the trustee, the company.

SALOMON V A SALOMON & CO LTD

Lopes LJ regarded the family member/shareholders as ‘dummies’. What the Act required, he stated, were, ‘seven independent bona fide members, who had a mind and a will of their own’. According to Lopes LJ, ‘The transaction is a device to apply the machinery of the [1862 Act] to a state of things never contemplated by that Act – an ingenious device to obtain the protections of the Act, and in my judgment in a way inconsistent with and opposed to its policy and provisions’. He ordered that the sale of the business to the company be set aside as a sale by Salomon to himself with none of the incidents of a sale, but being a fiction.

3.4.2 The House of Lords decision

In dismissing the claims of the liquidator, members of the House of Lords totally disagreed with the decisions at first instance and in the Court of Appeal which, they said, had misconceived the scope and effect of the 1862 Act. Lord MacNaghten’s judgment was particularly lucid:

JUDGMENT

‘[T]hough 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 of them. Nor are the members liable, in any shape or form, except to the extent and in the manner provided by the Act.’

Writing in 1944, Kahn-Freund commented:

QUOTATION

‘In this country as elsewhere company law has, to a large extent, changed its economic and social function. The privileges of incorporation or of limited liability were originally granted in order to enable a number of capitalists to embark upon risky adventures without shouldering the burden of personal liability. … However, owing to the ease with which companies can be formed in this country, and owing to the rigidity with which the courts applied the corporate entity concept ever since the calamitous decision in Salomon v Salomon & Co Ltd, a single trader or a group of traders are almost tempted by the law to conduct their business in the form of a limited company, even where no particular business risk is involved, and where no outside capital is required …

The metaphysical separation between a man in his individual capacity and his capacity as a one-man-company can be used to defraud his creditors who are exposed to grave injury owing to the timidity of the Courts and of the Companies Act.’

Kahn-Freund, ‘Some Reflections on Company Law Reform’ (1944) 7 MLR 54

3.4.3 Separate legal personality and insurance

One area in particular in which difficulty arose as a result of the failure of businessmen to appreciate the ‘tyrannical sway’ the corporate entity metaphor holds over the courts is insurance of company property. In a triad of cases (Macaura (see below), General Accident v Midland Bank Ltd [1940] 2 KB 388 and Levinger v Licences etc Insurance Co (1936) 54 LL L Rep 68), insurance companies have avoided paying out under insurance contracts for which they have received premiums, based on the insured property being owned not by the party insuring it (the shareholder of the company), but, rather by the company itself.

Macaura v Northern Assurance Co [1925] AC 619 (HL)

After selling his property (timber) to a company in return for shares, Macaura, the sole shareholder of Irish Canadian Sawmills Ltd, insured the timber against fire in his own name.

CHAPTER 3 THE COMPANY AS A DISTINCT AND LEGAL PERSON

The timber was destroyed by fire and Macaura claimed on the insurance policy. Held: The property belonged to the company, not to the shareholder. Even though the timber had been destroyed by an insured event, Macaura had no insurable interest in the timber as ‘he stood in no “legal or equitable relation” to it’ and so could not recover under the insurance policy.

3.5 Limited liability: a concept distinct from separate legal personality

It follows inexorably from the separate identity of the company from its owners/

shareholders and managers/directors that if a company incurs debts, those debts are the debts of the company, owed by the company to the lender/creditor. Without more, the debts of the company are not the debts of any other person. This means that not even the owners/shareholders of the company are liable to pay any sum owed by the company to the lender/creditor. Any legal action to recover the debt must be brought by the creditor naming the company as the defendant in the legal action. The owners/shareholders of the company are not parties to the contract pursuant to which the sum owed (the debt) is due to the creditor therefore action against them will fail.

One important question that cannot be answered simply by referring to the separate legal personality of the company is this:

n what, if any, liability does an owner/shareholder of a company have to contribute money to the company to enable the company to pay its lenders/creditors?

The answer to this question depends upon whether the company in question is a limited or unlimited company.

3.5.1 Limited and unlimited companies

Owners of registered companies do not necessarily or always limit their liability to contribute sums to the company so that the company can pay the sums it, the company, owes to third parties: limited liability is an option available to incorporators of a registered company. As Figure 2.5 shows, it is possible to register a private company under the Companies Act 2006 with unlimited liability. Section 3(4) makes this clear.

SECTION

‘If there is no limit on the liability of its members, the company is an “unlimited company”.’

Unlimited companies are not popular vehicles for business organisations, but it is useful to focus on them here as they throw into sharp relief the difference between the concepts of separate legal personality and limited liability, concepts which are often treated as a single concept by students, resulting in misunderstanding. The liability of a shareholder to pay money into a company needs to be considered both when the company is trading, and when the company has ceased trading and is being wound up.

3.5.2 Shareholder payments to a company that is trading

A person can become a shareholder by acquiring shares in a company either from the company itself or from an existing shareholder. Most shares obtained from existing shareholders involve a stock exchange transaction. Most stock exchanges forbid trading in shares in relation to which any sum remains payable to the company by the shareholder.

For this reason, this section will concentrate on shares acquired from the company.

Acquisition of shares from an existing shareholder will not be considered further.

Shares may be allotted and issued by a company and acquired by a shareholder on a fully paid-up, partly paid-up or nil-paid basis. Shares are fully paid-up when the shareholder pays to the company the whole of the share price (the amount due to the company) on allotment. As long as the company continues to trade, the company has limited

company a company the liability of whose members to contribute to the company to enable it to pay its debts is limited by shares or guarantee

LIMITED LIABILITY: A CONCEPT DISTINCT FROM SEPARATE LEGAL PERSONALITY

no legal right to require a shareholder with fully paid-up shares to pay any further sum of money into the company. This is true, whether the company is a limited or unlimited company.

Where shares are obtained from a company on a partly paid, or nil-paid, basis the shareholder, at the time of allotment, does not pay to the company a part, or any part (as the case may be), of the price payable for the shares. In such a case the company is entitled to call upon the shareholder to pay to the company any part, or the whole, of the amount of the share price as yet unpaid, at any time.

The power to make such calls on shareholders, to determine when and how much, is ordinarily given to the directors of the company who must exercise the power in accordance with their duties to the company. The common law rule that all shareholders must be treated equally when calls are made (see Preston v Grand Collier Dock Co (1840) 11 Sim 327), can now be contracted out of by including a provision in the articles of association of a company permitting shares to be allotted on the basis that different calls can be made on different shareholders at different times (see s 581(a) of the Companies Act 2006).

Whilst a company continues to trade, the most a shareholder can be required to pay into the company is the price he has agreed to pay, but has not yet paid, for his or her shares.

3.5.3 Shareholder payments to a company that is being wound up

The law governing the obligation of a shareholder to contribute money to a company that has ceased trading and is being wound up is found in s 74 of the Insolvency Act 1986.

When a company is being wound up, it is essential to distinguish limited and unlimited companies.

The starting point for both limited and unlimited companies is s 74(1) which provided that:

SECTION

‘When a company is wound up, every past and present member is liable to contribute to its assets to any amount sufficient for payment of its debts and liabilities.’

In the event of a company being wound up, a shareholder, without more, is required to contribute to the assets of a company sufficient to enable the company to pay its creditors and meet its other liabilities. Note, however, that even in relation to an unlimited company, a member is not liable to contribute to debts or liabilities incurred by the company after he or she has ceased to be a member and also is not liable to contribute anything at all if he or she has not been a member for a year or more at the time of the commencement of the winding up (see s 74(2)(a) and (b)).

Section 74 goes on to make specific provision for a company limited by shares. Section 74(2)(d) provides:

SECTION

‘[I]n the case of a company limited by shares, no contribution is required from any member exceeding the amount (if any) unpaid on the shares in respect of which he is liable as a present or past member.’

In relation to a company limited by shares, whether a public or a private company, s 74(2)(d) of the Insolvency Act 1986 is the statutory basis on which the liability of shareholders to contribute to the company to enable it to pay its debts and other liabilities is limited. The limit is the amount (if any) unpaid on the shares. If that amount has been paid to the company, a shareholder is under no further obligation to contribute.

winding up the liquidation of a company

CHAPTER 3 THE COMPANY AS A DISTINCT AND LEGAL PERSON

3.5.4 Justifications for limited liability

Shareholders of the first registered companies did not have limited liability. As outlined in Chapter 1, the debate as to the costs and benefits limited liability would bring were still being debated in 1844, when the first incorporation statute was enacted. Although the debate was soon won by those advocating the beneficial consequences of limiting the liability of shareholders, limited liability was initially introduced for large companies only, that is, companies with a minimum of 25 shareholders that met certain minimum share value and issued share capital requirements (see s 1 of the Limited Liability Act 1855). This restricted availability was relaxed the very next year by the Joint Stock Companies Act 1856.

The key benefits of limited liability are:

n Encouragement of investment by members of the public in companies.

n Facilitation of the transferability of shares.

n Clarity and certainty as to the assets available to creditors of the company.

3.6 Corporate groups and separate legal personality

It follows from the separate legal personality of companies and the ability of a company to own property that one company can own shares in another company. This is the basis for the existence of corporate groups that can be, and are not uncommonly, made up of over one hundred companies, all owned, ultimately, by one parent company.

QUOTATION

‘The international group of companies – not the single company – has become the prevailing form of European large-sized enterprises, which business activity is typically organised and conducted through a network of individual subsidiaries located in several States inside and outside Europe.

The group management is the heart of this leading business organisation: the main reason for its success consists in the sophisticated and flexible management issuing from the optimal combination of central control exercised by the parent and local autonomy granted to subsidiaries. No successful regulation could ignore this central feature. Any EU legislation and/or recommendation on groups of companies should seek to maintain and enhance the flexibility of the management of groups in its international business activities.’

European Commission Internal Market and Services, Report of the Reflection Group on the Future of EU Competition Law, Brussels 5 April 2011 at p.59 A corporate group is a single economic entity. Public disclosure laws recognise this to the extent that accounts made available to the public must be compiled on a group basis (see Chapter 17). Fundamentally, however, company law sees a corporate group as a series of individual companies. Each company within the group owns its own property and is liable for its own debts and other liabilities. It is preservation of the reputation of the parent of a corporate group that in many cases will cause a parent company to ‘pay’

claims made against its subsidiaries, rather than any legal obligation to do so, for, as we have seen, a shareholder, and, therefore, a parent company, is not liable for the debts or other liabilities of the company. If the liability of a subsidiary is large enough, a parent company will incur the public opprobrium suffered from leaving it to ‘sink’, ie become insolvent, and leave creditors wholly or only partly paid. There is no law that prevents a parent company from doing this.

The right of one company to establish a wholly owned subsidiary company to perform risky operations and thereby protect the assets of other companies in the corporate group from the claims of persons damaged by the risky activity is clear in English law. It is not universally accepted as a satisfactory state of affairs and is not the case throughout Europe. Attempts to change the law to introduce parent liability for its subsidiaries have been made as part of the European Union company parent

CORPORATE GROUPS AND SEPARATE LEGAL PERSONALITY

law harmonisation programme, but, as we have seen in Chapter 1, the draft ninth company law directive containing proposals on this issue was withdrawn through lack of consensus and years passed with no expectation of it being revived. How to address groups forms part of the consultation on the future of European company law

In document Unlocking Company Law (Page 105-111)