CHAPTER THREE: EFFECTS OF INCORPORATION

CONCEPT OF INCORPORATION To start company business, the promoters of the company must register the company with the Registrar of Companies in accordance with the rules and procedure provided in the Companies Act 1965 (Malaysia) [CA 1965]. Without such registration of the company, the directors are not allowed to conduct business by using the company name. If it conducts business without registration, the business activities will be considered as illegal business and the directors will be personally liable for penalty for not complying with the provisions of the CA and they will also be personally liable for compensation to the creditors. These registration requirement and procedure are known as incorporation of the company. PROCEDURE OF INCORPORATION OF A COMPANY In earlier paragraph we have learnt that a company must be incorporated before it starts business. CA 1965 provides rules and procedure for the incorporation of the company. First the promoters of the company have to choose a suitable and distinctive name for the company. The proposed name of the company should not be similar to or nearly resembling to another registered business name. Therefore, prior to application for incorporation of the company, the promoters have to apply to the Registrar of Companies for the reservation of the proposed name so that it can be used as company name for incorporation purpose. After that the promoters have to prepare a memorandum of association and articles of association for the company. The proposed company name should be mentioned in the memorandum. The memorandum must mention the names of proposed directors, total share capital, objectives of the company business and other required information. Then the promoters have to fill in the prescribed form and pay the required fees for registration of the company. After the Registrar of Companies has received the application form and other required documents, he will verify the documents and information. If he is satisfied with the documents and information therein, he will register the company by issuing a Certificate of Incorporation. This certificate of

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incorporation is the conclusive proof of the incorporation of the company and from the date of incorporation it can start its business legally. EFFECTS OF INCORPORATION OF A COMPANY When the company has been registered and the Registrar of Companies has issued a certificate of incorporation, the company becomes a body corporate and it enjoys four facilities. These four facilities are known as four effects of incorporation. These four effects are: i) The company becomes a legal entity distinct and separate from its members; ii) It can sue and be sued in its own name; iii) It can own and sell property and iv) It Enjoys perpetual succession. Section 16(5) of the Companies Act 1965 (Malaysia) states about these four effects of incorporation of a company. i) Separate legal entity

After incorporation the company becomes an artificial legal person and law allows it to do business by using its own name. The directors are not allowed to do business in their names. The managing director can only sign the agreements on be half of the company. Therefore, after incorporation the company becomes a legal entity separate from its directors and other members. In case of liability to shareholders and the outsiders, only the company will be liable. The directors will not be personally liable to make good of losses or to pay to the creditors. To explain this company law principle we can refer to the case of Salomon v. Salomon & Com. Ltd1. In this case Mr. Salomon established a company where he was the managing director and owned about 95% shares in the company. The business was not successful and the company was wound up. The liabilities of the company exceeded its assets. A liquidator was appointed for the company. The liquidator contended that Mr. Salomon was the sole owner of the company and he himself conducted all the businesses of the company. So, he will be personally liable to pay all the debts to the creditors of the company. Held: The court held that in this case the company is a legal person distinct and separate from the members of the company and therefore only the company will be liable for its debts. Mr. Salomon will not be personally liable to pay the debts to the creditors. As the company has no money to pay to the creditors, they will not be able to get the payment. In Lee v. Lees Air Farming Ltd 2, Mr. Lee was the governing director of his company and a pilot of the aeroplane of the company. He was killed while
1 2

[1897] AC 22. [1961] AC 12.

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he was piloting the aeroplane for the company. The issue was whether he was a worker in the company. The Court held that he was a worker (an employee) of the company, because the company could appoint its employees as it enjoyed the status of a legal entity which is considered as distinct and separate from its members and directors. Above cases explain the meaning of legal person and separate legal entity status given to a company after incorporation. After incorporation it is presumed that the company as a person can conduct business itself and can employ required employees for its business as an employer. Therefore, the directors are not personally liable for their activities in the company business if they are done in good faith for the benefit of the company. In that case, only the company will be liable to others for any of its liability. The company can employ its employees as an employer. Hence, all the employees including the directors will be considered as workers of the company and are entitled to the benefits of workers under the Workers Compensation Act of a country. That situation was raised in the court in the case of Lee v. Lees Air Farming Ltd. The brief facts of the case have been written above. The issue in the case was that Mr. Lee was a worker of the company under the company law principle of separate legal entity and he was entitled to the compensation offered to the workers under the New Zealand Workers Compensation Act 1922. The Act provided that the employer was obliged to pay compensation for personal injuries including death to a worker of an employer arising out of and in the course of employment. To determine whether Mr. Lee was a worker of Lees Air Farming Ltd., the case was finally referred to the Privy Council as an appeal from the Compensation Court of New Zealand. In this case the Privy Council held that Mr. Lee was a worker under the New Zealand Compensation Act 1922 and the principles of company law. Under the principle of company law, the company was a separate legal person and Mr. Lee entered into a valid contract of employment with the company. ii) The company may sue and be sued in its on name While doing business the company may incur liabilities to others and others may similarly be liable to the company for business transactions. In such situations, the company may sue others to enforce its rights and others may sue the company for its liability to others. This is a status given to a company after incorporation which is not given to a sole proprietor

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business or a partnership business. In Foss v. Harbottle3, the court held that a company may sue to enforce its rights against others and it may be sued by others for its liability. The members of a company cannot sue to remedy the wrong done to the company by outsiders. Only the company can sue for any wrong done to it. This is known as proper plaintiff rule. The separate legal entity principle separates the members of the company from the company itself. Hence, only the company is entitled to take legal action against others to enforce its rights in its own name.4 Situation may arise when wrong done to the company not by outsiders but insiders such as directors. The directors may misuse their power and act for their personal interest jeopardising the companys interest or they may misappropriate or improperly apply the company assets. In such cases the members cannot sue the directors of the company for personal liability because of the proper plaintiff rule provided in Foss v. Harbottle. This rule states that in such cases the members cannot sue the directors as the wrong done to the company, so the company will take action against the wrong done. However, company cannot take such action when the directors are themselves involved in the mismanagement of the company and misapply or misappropriate of company assets; or acts against the interests of the minority shareholders; or commits fraud with the company. In such cases, the directors will simply refuse to take any legal action against themselves. Hence, the shareholders including minority shareholders should be given a right to sue the directors for doing wrong to the company. In such cases the directors will be personally liable to make good of the losses to the company and they also might be held not qualified to be directors of the company. In John Shaws & Sons (Salford) Ltd. v. Shaw 5, the court applied the proper plaintiff rule propagated in Foss v. Harbottle and held that the board of directors is the proper organ to commence an action on behalf of a company when any wrong is done to the company. Members or shareholders cannot bring such action to remedy the wrong done to the company. However, this decision cannot help the aggrieved minority shareholders as the directors are not interested to take action against themselves for the benefit of minority shareholders. Company law principle that states that only the company can sue for any wrong done to the company has shortcomings. Therefore, exceptions to this rule have already been developed by the courts.
3 4

[1843] 2 Hare 461. See the observation of the court in Foss v. Harbottle [1843] 2 Hare 461. 5 [1935] 2 KB 113.

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iii) The company may own property in its own name A corporation is entitled to buy and own property in its own name and can sell its properties by using its name like a person. This advantage is given to a corporation for the benefit of doing business easily and to avoid fraud by the directors. Whatever assets the company has it belongs to the company itself and the shareholders have no ownership right in those properties in the company. This is a well-established principle of company law from ancient times of company business. Hence, the majority shareholders cannot claim that they are the owners of the company properties. In insurance law, there is a principle that the insured must have insurable interest in the insured property. If he does not have such insurable interest he is not allowed to make insurance contract with the insurance company and when he has entered into such an insurance contract with the insurance company in disregard of the insurance law, he will not be entitled to claim indemnity in case the insured property is damaged by some unexpected insured incidents. The insurance company may refuse to pay indemnity to the insured on the ground that the insured has no insurable interest in the insured property. In Macaura v. Northern Assurance Co.6, Mr. Macaura was prima facie the sole owner of the company as he owned more than 90% shares in the company. Thinking that he is the owner of the company assets (timber estate) insured the company assets in his own name against destruction by fire with an insurance company. The timber was destroyed in a fire. The insurance company refused payment of indemnity to Macaura because, he did not have insurable interest in the company assets. Held: The House of Lords decided that Mr. Macaura had no insurable interest in the company assets as the shareholder. All the assets belonged to the company. Therefore, Mr. Macaura could not receive the indemnity from the insurance company. From the above decision we find that by virtue of the separate legal entity principle all property belongs to the company itself. The shareholders including the directors have no insurable interest in the company property. This is because of the peculiar company law principle of separate legal entity which allows the company to own property in its own name and becomes the only owner of the assets in the company. Hence, while
6

[1925] AC 619.

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insuring the property of a company against loss or damage by some unexpected incidence, the property must be insured in the company name and not in the name of one or more shareholders or directors of the company. iv) Perpetual succession of the corporation Perpetual succession means long time existence of a company or eternal survival of a company. By incorporation, a company achieves the status of perpetual succession. Such a status is not given to the sole proprietorship business or the partnership business. An incorporated company can survive forever. It never dies unless the company name is struck off the register of companies or the company is wound up in accordance with the provisions in the Companies Act 1965. It may happen that all the shareholders sell their shares and the new shareholders come in to continue doing the company business. In such situation, the company name would not be changed. The company will not change its identity or personality. The same company will continue doing business on be half of the new shareholders. Thus, company is not dissolved and it can continue doing its business for a long time. Partnership business usually does not enjoy such advantage as it is usually dissolved when all or some of the partners want to go out of the partnership business. At times situation may arise in partnership business when some of the partners retire and the existing partners do not feel good to continue the business and eventually the partnership is dissolved. In Abdul Aziz bin Atan v. Ladang Rengo Malay Estate 7, all the shareholders in a company sold their shares to others and new shareholders came in. The issue was before the court whether there has been a change of employer and identity of the company. The court held that the company did not change its identity or personality as the employer. The employer of the company is still the same as the company itself is the employer. Hence, it does not matter which shareholders go out and which shareholders come in. The perpetual succession principle of company law thus allows a company to continue its business even when all the shareholders sell their shares and new shareholders come in. Company law does not look at the new shareholders. It only looks at the company itself. It only look at whether there are at least two shareholders existing in the company and whether the company is solvent to pay back the debts of the creditors and whether it can continue doing business
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[1985] 2 MLJ 165.

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to make profit. As the company itself is the employer, no change in the employer does occur when new shareholders come in and new directors are appointed. Therefore, the company will remain the same and it will continue with the previous liability. The new and existing employees all will continue their service in the company and they will continue receiving the agreed benefits. In Re Noel Tedman Holdings Pty. Ltd.8, the company consisted of two members only, husband and wife. These two shareholders were also the only directors of the company. Both the shareholders died in a traffic accident and only one infant child survived in that accident. The issue before the court was whether to wind up the company or to continue with the existing company. As the company enjoys perpetual succession, it may continue doing business. In that case court had to find new shareholders and directors to represent and replace the deceased shareholders. As only one infant child of the deceased shareholders survived in the accident, he could not be made director. The articles of association of the company required approval of the directors before shares could be transferred under the will of a deceased member. There were no directors left in the company. Court could appoint new directors to rectify the problem but the articles of association of the company required that to appoint new directors, the members had to vote for such appointment. As there were no members left in the company the court allowed the personal representatives of the deceased members to appoint one director for each of them. Ultimately the company continued its business under the leadership of two new directors appointed by the personal representatives of the deceased shareholders. The new directors could assent to the transfer of the shares to the beneficiary (the infant child of the deceased husband and wife). From the above case study we find that intricate and complex situation may occur to challenge the survival of a company and the law can help it to continue doing business. Perpetual succession helps a company to do business for a long time. As the company continues with its previous liability, the creditors and other stakeholders of the company are safe. VEIL OF INCORPORATION After a company has been incorporated it becomes a body corporate and enjoys a status of a legal entity which is separate from its shareholders in the company. While doing business, all liabilities go to the company itself, the directors are not personally liable to the creditors or other outsiders for breach of contractual
8

[1967] QAR 561.

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obligation and so on. Thus, a veil (a face cover) is hung on the face of the directors of the company to protect him from personal liability and to transfer all the liability to the company itself. This principle in company law is known as veil of incorporation. Under the principle of veil of incorporation of a company the directors and members of the company will not be personally liable for any transaction, all the liabilities will go to the company. So, outsiders of the company including creditors can only sue the company for any liability of the company. They are not allowed under the law to directly sue the directors or members of the company for any liability. Under the principle of veil of incorporation the directors are not personally liable and they cannot be sued for personal liability. To explain this we can refer to the case of Salomon v. Salomon and Co. Ltd. where it was alleged by the liquidator that as Salomon was the sole owner and managing director of his company he would be personally liable to pay all the debts of the creditors as the company assets were not enough to pay to the creditors. When the case was referred to the court it held that company as a legal entity separate from its directors and members. For all the liability to others only company will be liable, Mr. Salomon as a director will not be personally liable to pay the debts to the creditors. However, the above common principle of veil of incorporation has undergone many changes in recent times about which we will discuss below under the heading lifting the veil of incorporation. Hence, we can say that the veil of corporation is not an absolute principle. It has many exceptions which have been developed over the time to protect the interest of outsiders who deal with the company. LIFTING THE VEIL OF INCORPORATION After registration of a company it achieves the status of an artificial legal person which is also known as a separate legal entity. The principle of separate legal entity allows a company to do business transactions with outsiders in its own name, can own property in its own name, can sue other business entities to enforce its rights and other business entities may sue it for its liability to them. The principle of separate legal entity separates the directors and other members in the company from the company itself. This principle makes the company itself liable for all its transactions with others and gives exemption to the directors from their personal liability. Outsiders including the creditors cannot sue the directors of a company to enforce their rights. They can only sue the company by using its name. This principle of liability in the company is known as veil of incorporation.

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Thus, the principle of separate legal entity and the principle of veil of incorporation (both principles have similar meaning) protect the controllers of the company from personal liability. The principle of veil of incorporation puts a cover (mask) in front of the controllers and managers of a corporation to protect them from their personal liability for company transactions. However, controllers of the company sometimes misuse separate legal personality principle by setting up a sham company to circumvent law or commit fraud. As a result outsiders of the company are affected if the controllers cannot be made personally liable together with the sham company. Considering the hardship suffered by the outsiders because of the veil of incorporation, courts have developed certain exceptions over the time to make the directors of a company personally liable to the outsiders. This effort of the judiciary to make the company directors personally liable has been widely known as lifting the veil of incorporation as the court removes the veil of incorporation in certain circumstances making the directors personally liable. Sometimes the court holds the directors and the company together liable for setting up a sham company to evade contractual obligation or commit fraud. The Companies Act 1965 (Malaysia) has also provided some exceptions where the directors of a company will be personally liable for their wrong doings. Therefore, in certain circumstances the directors and members of the company might be personally liable for their business transactions to the outsiders and the court may lift the veil of incorporation. Those circumstances are as follows: 1. Failure to maintain minimum two members in the company. When there is only one member in the company and that member continues doing business for more than six months without finding another member, he will be personally liable to the creditors for those transactions. Section 36 of Companies Act 1965 (Malaysia) states that if the membership of a company falls below the statutory minimum of two, any member who knowingly caries on business for more than six months is liable for all debts of the company incurred after the six month period; and the member and the company are also guilty of an offence. When the number of members in the company is reduced to less than two, it is the duty of the existing member to find at least another member within the next six months. Number of Members might be reduced to one for some reasons such as other shareholders have sold their shares and have gone out of the company etc. If the existing member fails to get another member within six

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months, he should not continue doing business until he gets another member. This is the law provided in section 36 of the Companies Act 1965. If the existing one member disregards this legal provision, he will be guilty of an offence together with the company. He will also be personally liable to pay all the debts incurred after the six months period mentioned above. 2. Contracting debts on behalf of the company when there is no reasonable ground of expectation that the company will be able to pay the debts. If the directors of a company contracts debts knowingly that the company will not be able to pay back the debts, the directors will be personally liable to pay the debts. In such a case the court may lift the veil of incorporation to hold the directors personally liable. An example of such a situation is that the directors buy certain goods for the company on credit knowing that the company will not be able to pay to the creditors. In this situation the directors will be personally liable to pay the debs to creditors in case the company is unable to pay. Sections 303(3) and 304(2) of Companies Act 1965 (Malaysia) explain such situation and condemn such practice by the directors. Such practice by the directors is considered unethical business practice. The Companies Act makes such practice an offence. Section 303(3) of the Act states: An officer who knowingly contracts a debt with no reasonable or probable ground of expectation of the company being able to pay the debt, is guilty of an offence. If the directors are involved in such transactions and they are found guilty under the above section, they will be liable to pay the debts personally 9. This is a punishment for the directors to deter them from committing such wrong again in future. Section 304(2) provides that: Where a person has been convicted of an offence under section 303(3) the court, on the application of the liquidator or any creditor or any contributory of the company, may, if it thinks proper to do, declare that the person shall be personally responsible without any limitation of liability for the payment of the whole or any part of that debt. In Lee William Leitch Bros. Ltd., The directors of the company carried on business even after the insolvency and purchased some goods on credit. During the transaction the creditors knew that the company would not be able to pay to the creditors. The court held that the company was carrying on business with intent to defraud the creditors. Hence, the directors of the company would be personally liable for the debts.
9

Section 304(2) of the Companies Act 1965.

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When the companys financial condition is not sound and the directors know that if it incurs new debts, it would not be able to pay back to the creditors, the directors should not make such contract of debts with other companies or persons. This is unethical business practice. Bad intention can be presumed from such transactions on the part of the directors. Therefore, such unethical transaction is condemned in company law and the directors are punished for the offence. Under section 304(2) of the Companies Act 1965 the directors will be personally liable to pay all such debts to the creditors. The liability to pay the debts will be without any limitation, which is a heavy punishment for them. This is a punishment given to the directors to be morally good and to follow the provisions in the Companies Act. 3. Fraudulent Trading If the business of a company has been carried out to defraud creditors or for a fraudulent purpose, the court may declare that any person who was knowingly a party to the carrying of the business in that manner will be personally liable for the debts of the company. This order may be made on the application of the liquidator or of a creditor or a contributory. Section 304(1) of the Companies Act 1965 provides: Persons who are knowingly party to fraudulent trading may be held personally liable to make such contribution to the assets of the company as the court may deem fit. Veil of incorporation is a corporate benefit offered to the company as well as to the directors of a company to protect the directors from their personal liability in the event of winding up of the company. Veil of incorporation provides also benefits to the company itself as the company can do business in its own name, can own property in its own name, can sue or be sued in its own name and enjoys perpetual succession. These benefits offered by the principle of veil of incorporation has been misused by some of the directors of companies to use the company as sham to disguise the fraudulent acts of the directors so that the creditors are not able to take legal action against them. Courts usually follow the separate legal entity principle established in Salomon case and it is not ready to depart from this principle. However, when compelling circumstances arise to justify thwarting the separate legal entity principle, courts make exceptions to the general rule and lifts the veil of incorporation in cases where fraud committed or an attempt is made to avoid a legal duty by setting up sham companies etc.

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In Re Darby10, A and B established X company and became directors in this company. They were the sole controllers of the company. There were some other shareholders who were the directors nominees. X company acquired a licence to work a quarry11. The directors of X company later set up another company name Y with the intention of selling the licence to it at an overvalue and they were also directors of Y company. Y company raised money from the public and paid to X company. The profits were divided among A and B and later Y company went into liquidation. A liquidator was appointed for Y company to collect and realize all the property of the company. The liquidator sued A contending that he is liable to pay all the secret profits that he has made out of the Y company. It was argued on be half of A that the profit was not made by A but it was made by X company. Therefore, the X company is only liable for such secret profit. A tried to abuse the principle of separate legal entity and establish Y as a sham company to disguise his fraud in making secret money. The court rejected the argument of A and held that A will be personally liable for committing fraud. In this case the court refused not ready to apply the principle of separate legal entity and lifted the veil of incorporation to find both A and his company liable for making secret money. 4. Signing in documents without mentioning the name of the company. It is a company law principle that while signing on any negotiable instrument or any contracts, the managing director of a company must write the company name in the instrument and on be half of the company he will sign it. If he signs the instrument without mentioning the company name therein, he will be personally liable for the consequences of the instrument. Usually the managing director signs his name above the company name to indicate that he is signing the instrument on be half of the company. In this regard we can refer to the statutory requirement provided in section 121(2)(c) of Companies Act 1965 which states: Where a person signs, issues or authorizes the signing on behalf of the company a bill of exchange, promissory note, cheque, etc. where the companys name is not stated is personally liable unless the company pays. 5. When dividend is paid in the absence of profit.

10 11

[1911] 1 KB 95. Quarry is a place from where large amounts of stone or sand are dug out.

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According to section 365(2)(b) of the Companies Act 1965 no dividends shall be paid to the shareholders of a company unless there are profits available. If director or manager of a company wilfully pays or permits the payment of dividends when there are no available profits, he is liable to the creditors of the company for the amount of the debts due to them to the extent by which the dividends exceeded the available profits. Such amount may be recovered by the creditors or by the liquidator suing on behalf of the creditors. The directors become personally liable to pay to the creditors because they paid dividend to the shareholders when there is no available profit of the company. In such cases, the dividend is probably given from the capital of the company which is considered as mismanagement of the company assets and putting the creditors in a risky position. Thats why the creditors have been given a right to sue the directors personally to pay back the debts when company capital is used to pay dividend. 6. When the principle of separate legal entity is used as a cloak 12 to disguise a fraud or to enable a person to evade his legal obligation. Businessmen sometimes misuse the benefit of the principle of veil of incorporation and the principle of separate legal entity. They use these principles as a cloak to disguise fraudulent acts or to evade legal obligation under contracts. If such a bad intention can be proved in the court, the court may lift the veil of incorporation and may make the company as well as the controllers of the company personally liable for such fraudulent acts or avoidance of contractual obligations. In Sunrise Sdn Bhd v. First Profile (M) Sdn. Bhd .,13 the principle of separate legal personality was used as a cloak to evade contractual obligation by the respondent. In this case the second respondent was a wholly owned subsidiary of the first respondent. First respondent controlled the management of the second respondent company. Second respondent had four pieces of land which the first respondent contracted with the appellant to sell. A sum of money was paid to the first respondent as deposit and part payment of the purchase price. However, the first respondent terminated the contract prematurely. The appellant filed an action inter alia claiming interlocutory injunction against the first respondent prohibiting it to dispose the land until the decision of the court. The issue before the court was whether the court could issue interlocutory injunction against the first respondent as the lands were belonged to the second
12 13

Cloak or sham is something which helps to hide something. [1996] 3 MLJ 533.

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respondent. Both the respondents were separate legal entities under the principle of company law. The court held that when the principle of separate legal entity is used by companies to evade their contractual obligation or duties, court could disregard the principle of separate legal entity and could lift the veil of incorporation of companies. In Jones v. Lipman14, The defendant made a contract to sell his house to the plaintiff. Later he refused to sell the house to the plaintiff. To evade his obligation under the contract he incorporated a company and transferred the house to the company. The company was wholly owned and controlled by the defendant. The defendant wrote a letter to the solicitors of the plaintiff stating that he was ready to pay compensation for breaching the contract. Plaintiff did not agree to take compensation. He filed a suit in the court and claimed specific performance of the contract against both the defendant and his company. The issue before the court was whether the court could issue the order of specific performance against the company as it was not a party to the sale contract. Court held that when a corporation is created as a device and a sham and it hold a mask before its eyes to evade the contractual obligation of the defendant, court could lift the veil of incorporation to find the company and the defendant liable. The court ordered both the defendant and his company to specifically perform the contract. In the above case the court found that the company was formed with the sole purpose of escaping the consequences of the sale contract. As it was an attempt to use the company as a mere cloak to evade the contractual obligation, the court refused the principle of separate legal entity propounded and established in Salomon case. In Gilford Motor Co. Ltd. V. Horne15, the defendant was the managing director of the plaintiffs company. In the employment contract of the defendant it was stated that defendant cannot solicit plaintiffs customers during his service with the plaintiff and after his resignation from the plaintiffs company. The defendant resigned from the plaintiffs company half way through the contract and set up a new company to do the same business. He solicited plaintiffs customers for his business in violation of this employment contract with the plaintiffs company. The plaintiff filed proceedings in the court to restrain the defendant and his company from soliciting his customers. It was argued in the court on be half of
14 15

[1962] 1 WLR 83. [1933] Ch. 935.

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the defendant that it is the defendants company which solicited plaintiffs customers and not the defendant. The plaintiff could not sue the defendants company and claim injunction against it as it was not party to the employment contract with the plaintiff. Held: The court held that the defendants company was set up as a mere sham to avoid the contractual obligation with the plaintiff. Therefore, the principle of separate legal entity will be disregarded. The court issued injunction against both the defendant and his company prohibiting them from soliciting plaintiffs customers. Sometimes, a person may set up a company to avoid the order of a court or to escape an undertaking given to the court. The company is merely used as a cloak to disregard the courts order or to escape the undertaking given to the court. In such a case the court may disregard the principle of separate legal personality and may find the defendant guilty for contempt of court for escaping the courts order or undertaking given to the court.16 Such a situation occurred in the case of Golden Million Cabaret and Night Club and others v. R Restaurant Sdn. Bhd. In this case the plaintiff ran the Golden Million Cabaret and Night Club in the R. Restaurant Sdn Bhd. R. Restaurant was wholly owned and controlled by Hotel Berjaya Sdn Bhd. Actually the restaurant was located in the Hotel Berjaya. A dispute arose between the plaintiffs and R Restaurant regarding the renewal of the plaintiffs licence to operate the nigh club. The plaintiffs obtained an interlocutory injunction restraining R Restaurant from interfering with their business until the decision is taken by the court. However, one night the plaintiffs found that the restaurant premises were locked in breach of the injunction order of the court. The plaintiffs filed a contempt case in the court and sought an order of committal for contempt of court against the directors of R Restaurant. It was argued by the defendants that the night club was not locked by R Restaurant but it was locked by the Hotel Berjaya. The court observed that the Hotel was used as a device and a sham to disguise the offence and to defeat justice. The court held that the Hotel Berjaya and R Restaurant were one entity and therefore the directors of S. Restaurant were guilty for contempt of court. In this case the court disregarded the separate legal entity of the restaurant and the hotel. The court lifted the veil of incorporation of the companies and treated them as one entity finding the directors of S Restaurant guilty of contempt of court.
16

See the decision given in Tiu Shi Kian v. Red Rose Restaurant Sdn. Bhd. [1984] 2 MLJ 313. The decision of this case was affirmed by the Federal Court on appeal in [1985] 1 MLJ 145.

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7. To treat a group of companies as a single economic entity when the holding company actually controls the management of the subsidiary or when fraud committed in the group. Sometimes it is necessary to treat a group of companies as a single economic entity so that it can take legal action claiming damages from others and other companies can take legal action against the group of companies to enforce their rights. When the court finds that it is the holding company which actually controls the management of the subsidiaries, court can treat them as a single company. To treat a group of companies as a single economic entity it becomes necessary to lift the corporate veil of all the companies in the group. For the interest of justice, courts can lift the veil of incorporation and can treat the group of companies as a single entity. In DHN Food Distributors Ltd. V. Tower Hamlets London Borough Council17, DHN was a holding company and it had two wholly owned subsidiary companies Bronze and Transport. Bronze had a freehold land from where Transport operated transport business. The holding company DHN also operated business on that land. All the shares in the subsidiaries were owned by DHN and the business of the subsidiaries was in fact the business of DHN. Tower Hamlets London Borough Council made a compulsory purchase order for the land under section 5 of the Land Compensation Act 1961. Compensation was paid to Bronze subsidiary company as it held the title deed on the land. However, because of compulsory acquisition of the land, Transport could not find alternative premises to operate its transport business. As a result, it was bound to cease its business and suffered loss. Therefore, DHN and its two subsidiaries filed a suit claiming compensation for causing disturbance in business operation. The issue in the court was whether DHN was entitled to claim compensation. Held: The court held that in fact the three companies in the group were like a single company as the holding company DHN controlled every movement of the subsidiaries and in fact the business of the subsidiaries was the business of DHN. Therefore, the court lifted the veil of incorporation in the group and treated the group of companies as a single economic entity entitling DHN to claim compensation for disturbance with its subsidiaries. The principle of separate legal entity may have two meanings. The first meaning is that the company is separated from its directors and members for the purpose of inter alia taking legal action against it. So, outsiders can only take legal action against the company and not against the directors of the company.
17

[1976] 1 WLR 852. This case was decided by the Court of Appeal of England.

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Directors are exempted from their personal liability in the company. Second meaning is that every company in a group of companies achieves a separate legal entity status. It means the holding company is a separate legal entity and all of its subsidiaries are also separate legal entities. So, all companies in the group are separate companies and they are separately liable to the outsiders for their wrongdoings. Notwithstanding such separate legal entity status and separate liability of each of the companies a group, the court sometimes treats the group of companies as a single entity when court finds that it the holding company which actually fully controls the business management of the subsidiary companies and it is convenient in the interest of justice to treat the group as a single entity. In such cases the court lifts the veil of incorporation to treat the group of companies as a single legal entity. In DHN Food Distributors Ltd. case, (explained above) the court lifted the veil of incorporation to treat the group of companies as a single economic entity. However, in the case of Hotel Jaya Puri Bhd. V. National Union of Hotel Bar & Restaurant Workers & Another , the court treated the group of companies as a single entity and held that it was not necessary to lift the veil of incorporation and held that such decision was not against the principle of separate legal entity and was not unreasonable. In Hotel Jaya Puri Bhd. V. National Union of Hotel, Bar & Restaurant Workers & Another18, a number of workers employed by the Jaya Puri Chinese Garden Restaurant Sdn. Bhd. were retrenched by the company as its business was closed due to loss. The restaurant was carried on in premises belonging to the Hotel Jaya Puri Berhad and both the hotel and the restaurant had the same managing director. A dispute arose between the National Union of Hotel, Bar and Restaurant workers representing the workers and the restaurant regarding the retrenchment. The Union alleged that the retrenched workers were in fact the employees of the hotel and they were actually dismissed and not retrenched by the restaurant. During trial the Industrial Court found that the workers were in fact the employees of the hotel as both the companies had the same managing director. The termination of service of the employees was a discharge of workers following the closure of business and not retrenchment as understood and accepted in industry. The court awarded two months basic salary and fixed allowances as compensation to the workers against the hotel. The Industrial Court treated the hotel and the restaurant as a single enterprise and passed the award against the hotel because the restaurant was in fact controlled by the hotel
18

[1980] MLJ 109.

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and both had the same managing director. The hotel applied to the High court to quash the award on the ground, inter alia, that the hotel was not the employer of the terminated workers in question. Held: The High Court affirmed the finding of the learned President of the Industrial Court that the hotel and the restaurant were in reality one enterprise and that it is the hotel which dismissed the restaurant workers. Therefore, the hotel had to pay compensation to the dismissed restaurant workers. Veil of incorporation can be lifted by the court in a group of companies where a majority shareholder in the group of companies committed fraud by making secret money and invested the money in different companies in the group. In Aspatra Sdn. Bhd. & Others v. Bank Bumiputra Malaysia Bhd. & Another 19, the respondents had brought an action against Mr. Lorrain Osman, who was a director of the first respondent and the chairman of the second respondent. It was alleged by the respondents that Mr. Lorrain Osman made secret profit of total RM 27,625,853 without their knowledge and approval. The respondents also made an ex parte application for a Mareva injunction to restrain Mr. Lorrain from transferring his assets out of the jurisdiction and also for an order of discovery against Lorrain to disclose the value, nature and whereabouts of all his assets. The court granted Mareva injunction to Lorrains assets in 38 banks and also to his shares in 109 companies including Aspatra Sdn Bhd for the purpose of restraining Lorrain from dissipating his assets up to the amount claimed in the writ. The court also granted an Anton Piller order against Aspatra Sdn Bhd which was subsequently varied and extended to other companies. Aspatra Sdn Bhd and the other companies affected were allowed to be joined as interveners in the Mareva proceedings to enable them to set aside the ex parte injunction and Anton Piller order against them. The applications to set aside the ex parte injunction and order were filed and heard in batches and eventually there were still 77 companies affected by the Mareva injunction which had not intervened. Out of these 77 companies, 12 companies had been discharged from the said orders on the application of the respondents. The injunction in respect of the remaining 65 companies remained in force, but as in the case of the 27 companies which had intervened, the terms of the injunctions were varied to enable the companies to carry on with their day to day business. The appellants appealed against such part of the order of the learned trial judge which dismissed the interveners application for cancellation of the Mareva injunction and Aspatras application for cancellation of the Anton Piller order made against them. One of the grounds of appeal was whether, in granting the Mareva injunction, Zakaria Yatim J. was correct in lifting the corporate veil of
19

[1988] 1 MLJ 97.

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the interveners and in holding that the assets of the interveners were the assets of Lorrain. Held: It was held that the court could generally lift the corporate veil in order to do justice, particularly where an element of fraud is involved. There was admittedly an element of fraud in the receipt of the secret profits alleged in this case and this was sufficient for the court to lift the corporate veil for the purpose of determining whether the assets of the company were really owned by them. Therefore, the trial court properly lifted the corporate veil of the interveners. SAMPLE QUESTIONS: 1. Khadijah, Mariam, Mursyida and Sham want to set up a restaurant as a private limited company. They seek your advice on how to set up a new company. Explain to them the procedure of formation of a new company under the Companies Act 1965 (Malaysia). 2. Mr. Abdur Rahman established a company Abdur Rahman & Co. In this company Mr. Abdur Rahman was the managing director and owned about 90% shares in the company. The business was not successful and the company was wound up. The liabilities of the company exceeded its assets. A liquidator was appointed for the company. The liquidator contended that Mr. Abdur Rahman was the sole owner of the company and he himself conducted all the businesses of the company. So, he will be personally liable to pay all the debts to the creditors of the company. Mr. Abdur Rahman appoints you as his solicitor. Advise him about his rights and liability under the company law principle of separate legal entity. 3. Explain the following: i) a company can sue and be sued in its own name; ii) a company can own property in its own name; iii) a company enjoys perpetual succession. 4. Explain the principle of veil of incorporation. Explain how this principle might be misused by the directors of a company. 5. In certain circumstances the corporate veil can be lifted. Explain those circumstances with the help of decided cases and relevant provisions of the Companies Act 1965 (Malaysia).

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