Company Revision 1: Incorporation of Companies

Why form companies?

Limited liability: the investors (owners/shareholders) are not held personally liable for the debts of the company. As long as the company operates legally within the Companies Act 2006, directors and shareholder’s assets are protected in the event of liquidation or winding up.

Consequences: Loss of capital put into company + amounts unpaid on shares, unless:

• Liability in tort
• Directors liable by statute under wrongful/fraudulent trading
• Banks can bypass ltd. by way of personal guarantee when granting a loan

Other benefits:

• No corporation tax charged on first £10,000 of a company.
• Dividends: national insurance not charged on dividends.
• Large corporations prefer to deal with incorporated entities.
• Enhanced credibility and negotiation power/prestige
• Easier to raise capital, share for a joint-stock company, and easier to get loans from banks. The transferability of shares makes it easier to entice investors.
• Separate legal personality ➔ acts in its own name, separates person from business.
• Separation of ownership and management
• Perpetual succession ➔ the company continues to exists despite the death, bankruptcy, insanity, change in membership or an exit from the business of any owner or member, or any transfer of stock … (Re Lewis Wills Trust)
• Flexibility

Drawbacks

• Longer decision-making process
• Requirement of publishing accounts (time, cost, lack of privacy
• Go through a lot of formalities (immediate and on-going)

Development from Broderip v Salomon (CA) to Salomon v Salomon (HL)

Broderip v Salomon:

Facts: S owned a boot business. He formed a company, of which nominal (the maximum authorised) share capital is £40k. S sold the business to the company for £39k at an overvalue.

• Took £9k in cash
• £20k in shares
• And loaned the company £10k, of which he took a charge over the boot business

Company satisfied registration requirements, 7 members of his family each holding requisite minimum of £1. The company went into liquidation, did S have priority over unsecured creditors?

Issue: is S liable for the company’s debts

Claimants:

• Formation of the company was meant to default creditors, and should be set aside
• Argued that S was the promoter of, and stood in fiduciary relation to, the company ➔  entitled to indemnify the company.
• Value put on assets were excessive

CA Held :

Williams J (individual bankruptcy specialist) held that if the nominee had been a person, S would have been liable as principal. Here the fact that the nominee was a company made no difference. He considered the company to be S in another form, an alias.

CA found that the company was a mere scheme to enable S to carry on business in the name of the company and acquire priority over the creditors.

Williams J (FIRST INSTANCE): perfectly convinced that shareholders had no interest in the company

“As I have said, the company was a mere nominee of Mr. Salomon's, and it does not seem to me that it ought to make the slightest difference whether the nominee is a company or an individual - a person; and therefore I wish, if I can, to deal with this case exactly on the basis that I should do if the nominee, instead of being a company, had been some servant or agent of Mr. Salomon to whom he had purported to sell this business.”

“No charge of fraud covered by my previous observations is involved in the amended claim; but to allow a man who carries on business under another name to set up a debenture in priority to the claims of the creditors of the company would have the effect of defeating and delaying his creditors.”

“There must be an implied agreement by him to indemnify the company.”

“Under the Companies Act of 1862 a man may become what is called a private company so as to obtain the benefits of limited liability. I have already held, in a case where the founder of such a company had become bankrupt and the company claimed his assets, that the company was a mere fraud, and the Court of Appeal supported that decision.”

“In this case I propose to hold the same thing - that this business was Mr. Salomon's business and no one else's; that he chose to employ as agent a limited company; that he is bound to indemnify that agent, the company; and that his agent, the *332 company, has a lien on the assets which overrides his claims. The creditors of the company could, in my opinion, have sued Mr. Salomon.”

In conclusion: CA found a principle agent relationship, or that the company was a mere alias for Mr Salomon.

Lindley LJ (CA):

• S’s scheme is a device to defraud creditors. Should be disregarded
• This went against the intention of the Companies Act
• It did not intend the incorporation of sole traders (intent of Parliament)

Lopes LJ:

• Incorporation is perfectly legal, but it would be lamentable if a scheme like this cannot be defeated. A “trap to defraud creditors”.
• A ‘perversion’ to the Joint Stock Companies Act.
• Sale was to himself, thus a fiction, so creditor entitled to sue S himself.

Kay LJ:

• Dismissed first instance judge, saw to element of a principal – agent relationship
• But held that s7 stipulated shareholders must have been ‘bona fide’ shareholders
• Made no attempt to deny that the business belonged to S, but the sale was a mere fiction
• Distinguished Re Seamless Paper Box, shareholders were bona fide, so there was no misfeasance in that case
• Can be held a principal/agent relationship or a sham, but either way S is bound to indemnity the company.

Summary: all judges focused on the fact that the business remained the same.

Observation: judges are trying very hard to correct this deemed injustice. They viewed this as an abuse of statute. HJ Chang considered this a mere side effect of the many benefits (risk taking, capital mobilization) of a capitalist society.

Salomon v Salomon (HL):

Held: Proceedings were not contrary to the true intent and meaning of the CA 1862. The company was duly formed and registered and not a mere alias nor agent or trustee of the vendor. Thus, he was not liable to indemnify the company against creditor’s claims, as there was no fraud upon creditors or shareholders. The company (or the liquidator suing in the name of the company) was not entitled to rescission of the contract for purchase of the boot business.

Lord Halsbury:

• Need to look at provisions of statute.
• Found that the statute enacts “nothing as to the extent or degree of interest which may be held by each of the seven, or as to the proportion of interest or influence possessed by one or the majority of the shareholders over the others” (in other words need not be bona fide).
• “it seems to me to be essential to the artificial creation that the law should recognise only that artificial existence - quite apart from the motives or conduct of individual corporators”, you might be able to prove that the certificate of incorporation was a fraud, but cannot deny the whole process if done lawfully.
• “I confess it seems to me that that very learned judge becomes involved by this argument in a very singular contradiction. Either the limited company was a legal entity or it was not. If it was, the business belonged to it and not to Mr. Salomon. If it was not, there was no person and no thing to be an agent at all; and it is impossible to say at the same time that there is a company and there is not.”
• Considered the fact that S was a ‘pauper’, he broke now
• Held the the CA judges erred in not treating the company as an independent entity to S.

Lord Watson:

• Did not agree with first instance decision, which gathered that the company was in fact S, and that shareholders were ‘dummies’.
• Incorporation of the business cannot be disputed.
• Found that the charge of fraud on S has no foundation in fact.
• “But the apathy of a creditor cannot justify an imputation of fraud against a limited company or its members, who have provided all the means of information which the Act of 1862 requires; and, in my opinion, a creditor who will not take the trouble to use the means which the statute provides for enabling him to protect himself must bear the consequences of his own negligence.” (blame on creditors).

Lord Herschell:

• If the decision of the CA is to be upheld, then many companies will be considered agent of their owners and partners, and that defeats the purpose of the Companies Acts.
• Even a ‘one man’ company is legitimate.
• The company has been validly constituted.
• No requirements as to shareholders not being family members, or that they held equal shares
• The facts that shareholders are dummies, are irrelevant

Lord MacNaughten:

• “Though it may be that after incorporation of the business it is precisely the same as before … 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 manner provided by the Act”

Observations

• Otto Kahn-Freund: the law enacted the limited/unlimited dichotomy to protect capitalist ventures from shouldering risk ⇒ an economic and social function
• But may give rise to risk of defrauding creditors - a side effect
• “Separate legal entity is sometimes described as a fiction ⇒ but this fiction is the foundation of English company and insolvency law”.
• MacNaughten ⇒ found that other judgements were too harsh, more sympathetic
• Non sympathetic approach only applies to voluntary creditors, different approach to involuntary creditors (victims of tortuous wrongs)
• And now, for corporate groups, there are many levels of insulation.

Is this a wrong-turn in company law?

• No, because it follows the rule of law ➔ certainty outweighs risks and individual injustices
• Does not give judges too much power to interpret law in whichever way they want, this would disrupt the separation of powers.
• Need certainty for owners to calculate risks associated with conducted business
• As HJ Chang said, it encourages business activity, socio-economic development and that the risks of abuse are a side-effect that we have to accept for the ability to mobilize large amounts of capital.

The abuses: ability to defraud creditors, get out of debt, or changing name are remedied by s216 IA 1986. (restriction on re-use of company names).

Possible remedies

Agency argument:

• There is no presumption of agency (Salomon v Salomon).
• Agency can be a contractual self-help remedy, so that the resultant contract comes into effect between claimant and parent company.

Adams v Cape Industries

• Subsidiaries may have acted for parent company for specific purposes, it is a matter of fact that there was no agency.
• Agency only exists of the presence of the subsidiaries were effectively the presence of the parent company.
• This is especially unlikely if agency argument is raised ex post facto.

Liability in tort:

• Asbestos cases Adams v Cape, … v Cape
• Same conditions as in Caparo v Dickman (3 fold test):
• Was injury foreseeable?
• Was there proximity in the relationship?
• Was it fair, just and reasonable to impose a duty?
• Main question is proximity: what has the parent company done to give rise to an assumption of a duty of care?
• Arden J summarises events where special relationship does occur:
• Business of parent and subsidiary is the same.
• P has/ought to have superior knowledge about a relevant aspect of health
• S’s system was unsafe, and P knew/ought to have known this.
• P know/ought to have known that S would have relied on his superior knowledge on health and safety for employees’ protection.

Trust:

Pest v Petrodel:

• Trust law used to access assets
• That D sought to shield legal title being owned by companies he controlled
• Found: companies held assets on a resulting trust (as a matter of fact, not a mere presumption) for D.
• S24(1) Matrimonial Clauses Act ➔ requires property transfer on divorce

Obiter: Supreme Court considered  the doctrine of piercing the veil here.

Is it sensible to arrange company law in the interest of shareholders?

HJ Chang arguments summarised:

• Shareholders are the most mobile ⇒ they care the least for long-term future of company
• Prefer corporate strategies for short term profits, at the cost of long term investment
• Now shareholders are well protected, they lose only what they have invested, before people would be jailed for default of debt
• But now risks are capped
• Fraud is just a side effect of huge material progress
• Created dichotomy of ownership and control
• Emergence of more professional managers, who do not necessarily have ownership in the company ⇒ may work not in conjunction with owners’ interests
• Created a new strategy, called shareholder value maximization (which I believe is terrible for employment rates).

Shareholder value maximisation:

• Professional managers should be rewarded according to amount they give to shareholders
• Maximizing profits ⇒ cutting costs, wages, employment, squeezing suppliers, downsizing, etc…
• Highest possible share to shareholders ⇒ dividends and share buybacks (which increase value of shares, and benefit shareholders even more)
• Stock options account ⇒ managers hold shares in the company

Results:

• All these were financed by squeezing other stakeholders in the company
• Jobs cut, suppliers squeezed, outsourcing
• Income inequality soared
• US GDP actually falls
• Income per capita growth actually fell
• Government had to compensate by redistribution of income, taxes and subsidies

Micro-economics:

• Cut workers ⇒ more job intensity ⇒ tired ⇒ mistakes ⇒ lower product quality ⇒ bad reputation
• Heightened insecurity ⇒ threat of job cuts ⇒ workers will not invest in learning company relevant skills ⇒ slower growth

Shareholders

• Easiest to get out
• Not as committed as other stakeholders
• Workers, their livelihood, lots of skills may not be used elsewhere
• Suppliers, creditors depend on the company
• Ease of exit ⇒ unreliable managers for long term running of business

Remedies:

• Many countries in the world try to limit influence of ‘floating shareholders’
• Part-ownership by government (France-Renault, VW-Germany)
• Indirect ownership by state bank (France, Korea)
• Different voting rights for classes of shares, to enable founding families to have more control (Sweden)
• Formal representation for workers (labour unions)

Bad example: General Motors

• used to dominate global auto market
• because of shareholder profit maximization, now bankrupt
• constant downsizing and refraining from investment

Therefore: Companies should not be run in the interest of shareholders

• strategy not only bad in long-term
• but inefficient

Otto Kahn-Freund ⇒ found that the decision was calamitous, because it was tempting people to incorporate when they didn’t need to. Gone too far? Too inefficient?

Questions to ask:

• look at other stakeholders
• shareholder rights
• what does Friedman think of this?