1

Page no Introduction … … … … … 2

Examining the dictum …

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Summary and Conclusion

21

2

INTRODUCTION
In every Company Law book Salomon v Salomon1 is the case which is most recognised. The importance of this case lies in the fact that it establishes that the company is a totally different person from its incorporators. It offers the limited liability not only as a business vehicle for partners, but for even traders who take the full benefit of limited liability.

In this term paper I will discuss the dictum derived from Lord Halsbury’s judgement in Salomon v Salomon what are the pros and cons of the dictum, the reasoning why the House of Lords reached their conclusion reversing what the Court of Appeal said in relation to the agency point. The assessment of the limited liability doctrine which was originally intended to encourage passive investors to contribute to encourage trade and commerce, the most fundamental criticism to this doctrine, group of companies and when the court will lift the veil between the parent and its subsidiary. A mention must be made of shareholders as the owners of the company and creditors’ interest who lend the company money which directors have to take into consideration when they are conducting the affairs of the company. What forms of protection either under Common Law or statute does the law offer to them? are these measures of protection adequate?

At the end I will summarise what has been said previous and I will come up with a conclusion.

1

[1897] AC 22

3

EXAMINING THE DICTUM
Before examining Lord Halsbury’s dictum in the House of Lords, it is useful to restate briefly what the Court of First Instance and the Court of Appeal said. The Court of First Instance and the Court of Appeal thought that Salomon acted fraudulently when he held all the shares of his family members who had no interest in the company and that the formation of the company was not done properly and Salomon would have to indemnify the company’s creditors. In response to the Court of Appeal’s judgement in Broderip v Salmon2, Lord Halsbury LC in Salomon v Salomon3 said “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.”

This dictum raises issues relating to the legal entity, the debts and assets of the company (business), agency, and lifting the veil. I shall discuss every point individually. The legal entity point4

A

Lord Halsbury LC mentioned that “Either the company was a legal entity or it was not.” If we look at this part of the dictum, we may at first sight say that it represents the true position. Whenever there is a company, there will be a legal entity associated to it and it will have a separate legal existence5 from its incorporators, but is this all? or we must need in order to say there is a legal

2 3

[1895] 2 Ch 323 [1897] AC 22 4 I am indebted to Mr Jonathan Robinson, our Company Law lecturer, for clarifying this point 5 The Company Act in S13 (1) does not state expressly that the company will have a legal existence but it is implied that the company will have a legal entity from the time the registrar of companies will certify that the company has been incorporated

4 entity a special procedure to be followed? and can we still say that the company has a legal entity in the situation that fraud has been committed? Both judgement in the Court of First Instance and the Court of Appeal thought that Salomon had acted fraudulently. The House of Lords did not find any form of fraud or deliberate abuse of the corporate form, on the contrary Salomon was a victim in that he did his best to rescue his company by cancelling the debenture he took and raising them to an outside creditor who provided fresh loan capital.6 This honesty and good faith on the part of Salomon prevented him from indemnifying the company creditors. The House of Lords found there is a legal entity properly formed and there was no use of lifting the veil between Salomon and his company. Also another criticism lies in the fact that not only the company is recognised as a separate legal entity but also according to the proposed legislation of the limited liability partnership which, amended a very fundamental concept in Partnership Law in England and gave the LLP a distinct legal entity from its partners as a result the LLP will have most of the advantages associated with the company especially the limited liability.7

B

The Business Point

Lord Halsbury said “If it was, the business belonged to it and not to Mr Salomon.” As a result of the Court of Appeal refusal to recognise the existence of the legal entity and regarding the company instead as a myth and fiction, they thought that the business belonged to Aron Salomon. Lord Halsbury refused that proposition. It is submitted that this part of the dictum is right as a consequence of the separate personality the company as soon as it is registered will acquire all the assets which the shareholders contributed to the company. The company will be regarded as constituting its own assets. For example, the property will no longer be members’ joint property. Lord Wrenbury in MaCaura8 said “My Lords, this appeal may be disposed of by saying that the corporator even if he holds all the shares is not the corporation and that neither he nor any creditors of the company has any property legal or equitable in the assets of the corporation.” Not only the assets will represent
6

J Birds, A Boyle, Eilis Ferran, Charlotte Villiers, Company Law (Third Edition), Jordans, 1996, p 15 ; see also the judgement of Lord Halsbury, Lord Macanghten in Salomon v Salomon [1897], AC22 at 39, 53 7 Andrew Griffiths, “Professional Firms and Limited Liability : an Analysis of the Proposed Limited Liability Partnership” (1998), Company Financial and Insolvency LR 2, p 157.

5 the business of the company, but also the House of Lords recognised that the debts and liabilities will belong to that company and not to its shareholders.

C

The Agency Point

Lord Halsbury said “If it was not a legal entity there was no person and no thing to be an agent at all.” Vaughan William J in the Court of First Insatnce based his judgement on agency relationship, stating that the company had no personality of its own, being nothing more that an agent of Salomon the man. Lord Halsbury refused that finding and found the company cannot be an agent at all. Lord Macnagten in clear words said “The company is not in law the agent of the subscribers or trustee for them . . . .” Two observations must be made: why the House of Lords refused the existence of an agency relationship? and why did the House of Lords refused totally the proposition that the company can be an agent of its shareholders in certain circumstances? The House of Lords found a contradiction in the situation that the company is regarded as an agent of Salomon the principal. There will be two legal capacities, the agent (company) and the principal (Salomon). If we say that there are two legal capacities, the company will have a separate legal existence and separate legal entity from the principal. As a consequence the House of Lords denied in any form the presence of any agency relationship.

It is submitted that Lord Halbury’s dictum indicates that the company can never be an agent of its subscribers, but this is not true. Even the House of Lords after mentioning that the company cannot be an agent of its subscribers did not reject totally the suggestion that the company can be an agent in certain circumstances. In British Thomson-Houston Co Ltd v Sterling Accessories Ltd9 Tomlin L J clarified when the company will be an agent. He said “. . . the agency of the company must be established substantively and cannot be inferred from the holding of directors and control of shares alone . . . Any other conclusion would have nullified the purpose for which the creation of limited companies was authorised by the legislature.” Finally we can say that the general rule is that the company is not the agent or trustee for its

8 9

MaCaura v Northern Assurance Co [1925] AC 619 [1924] 2 Ch 33

6 members unless exceptionally this relationship is established that the company is acting as an agent.10

D

Lifting the Veil Point

The last part of the dictum should be construed with the first part. Lord Halsbury said “Either the limited company was a legal entity or it was not . . . and it is impossible to say at the same time that there is a company and there is not.” The House of Lords as said earlier, did not induce any form of agency relationship which will lift the veil between the company and Mr Salomon. Lord Halsbury’s dictum indicates that the court will be certain when it will lift the veil and when it will not. As said “the position adapted by England’s Company Law in the present context is both absolute and absurd”11, but it must be said that Adams v Cape Industry 12has clarified the position of English Law towards the legal personality of the company. English Law will disregard and lift the veil only in exceptional circumstances, and this will depend on the particular fact of the case which is in front of the judges, as we will see later on when we are discussing groups of companies.

THE ASSESSMENT OF THE LIMITED LIABILITY DOCTRINE
Historically, before recognising the limited liability, merchants sought methods of minimising their risk. One of the ways adopted was to share the risk between partners, another was to offer creditors a high return in case the company flourishes and prospers and not to recompense creditors in the situation that the company fails, also insuring against the risk in case of loss.13 The Limited Liability Act 1855 introduced the limited liability to become a legitimate feature of companies as far as English Law is concerned. But what do we mean by limited liability? What does this concept offer to the business world?

10 11

Murray A Pickering, “The Company as a Separate Legal Entity” [1968], Vol 31, MLR 481 Michael Whincup, “Inequitable Incorporation – the Abuse of the Privilege”[1981] 2 CL 158 12 [1990] Ch 433 13 Nicolas Grier, UK Company Law, John Willey and Sons, 1998

7 Limited liability is said to be a distinction feature of corporate law. It means that in the situation that the company is unable to pay its debts, members of the company will not have to contribute towards paying the company debts out of their own private funds, they are only liable to contribute to the amount they have paid or promised to pay for their shares. This concept is important to public companies entrepreneurs who needed to raise capital for large scale enterprises when limited liability was used for public companies.14 Also another importance lies in the fact that the business man who knows that his maximum liability to his creditors is the amount he has agreed to invest by a way of capital is more likely to take the risk.15 That is what the legislator originally wanted to encourage passive investors to contribute by a clear distinction between personal and business assets. The limitation of the liability of investors to the amount they put in their business is a privilege which can be abused at the expense of the creditors, especially unsecured ones, who will bear the risk of the business failure. As a result, they may lose their money in the situation that the company is declared bankrupt and no longer able to pay its debts. Critics of the limited liability doctrine criticise the limited liability doctrine in the sense that shareholders will reap all the benefits of risky activities, but do not bear all the costs which are borne by creditors,16 but is it more appropriate to shift the risk of business failure and let it be borne by one group rather than letting it rest as it falls? First of all, there is no business not associated with risk, every business man must take into consideration the failure of his business and someone must shoulder the risk under any rule.

It is said that one entrepreneur cannot bear a large amount of loss and shifting the loss from him to a wealthy group like large institutional investors will let the risk of the business failure spread out amongst all creditors rather than one person.17

Abusing the limited liability on the account of creditors lead some commentators to suggest that abolishing the limited liability doctrine will put a limit to these forms of

14

Paul L Davies, Gower’s Principles of Modern Company Law (Sixth Edition), Sweet and Maxwell, 1997 15 Andrew Hicks, “Corporate form : Questioning the Unsung Hero” [1997], JBL 306 16 Frank H Easterbrook, Daniel R Fischel, The Economic Structure of Corporate Law, Harvard University Press, 1996 17 Ibid

8 abuses in terms of protecting creditors, but what will be the result on the commercial world? Whatever hard things may be said about the limited liability, it has conferred very great benefit to the community, it has provided large sums of money for useful industrial undertakings and advanced the progress of industry and commerce. It is even said “that the limited liability has been co-extensive and inextricably linked with success of Western capitalism.”18 Let us assume that the limited liability is abolished. I think we will be back to the beginning again. Traders will create other methods to minimise their liability by agreement, contract and relying on insurance. Also, these forms of abuses which are taking place in relation to the limited liability are not the rule but exceptions; many businesses are prospering and flourishing without any difficulty. If there were some form of abuses taking place, can we say that the limited liability is no good to the world of commerce? In my opinion I think not, nothing is absolute although there are disadvantages associated with the limited liability, the advantages outweigh the disadvantages.

Instead of abolishing the limited liability doctrine, we should strengthen our laws in terms of protecting creditors. This aspect will be discussed later on.

ONE MAN COMPANIES
The Court of Appeal in Broderip v Salomon19 declared that Mr Salomon when he had incorporated the company with six dummies, was abusing the Companies Act. All shareholders must be honourable men, bona fide traders, none of them dummies.20 The decision of the House of Lords reversed the finding at the Court of Appeal and established the legality of the one-man companies. Limited liability was also available to sole traders who can limit their liability to the amount they put in their business. Soon after recognising the one man companies, many abuses of the corporate form took place. Limited liability was one way of defrauding creditors.

18 19

Andrew Hicks, “Corporate Form : Questioning the Unsung Hero”, [1997], JBL 306 [1895]2 Ch 323 20 LQR Vol II [1895]

9 This gap in the law started to induce commentators to address the problem. Kahn Freund thought that the best way to get out of this problem was to abolish the private companies and to lift the corporate entity in extreme cases for the benefit of the creditors.21 The Jenkins Committee appointed in the UK in 1959 mentioned the fact that the increase in registration fees might also solve the problem. While some of the suggestions were implemented, others were not.

It is now possible to establish a private company with one member as a result of the Companies (Single Member Private Limited Companies) Regulation 1992 (SI 1992/1699) which implements the European Council directive of 1899.22 Courts will not let the corporate form be used for the purposes of fraud or as a device to evade legal obligation. If the court is convinced that this is done the corporate veil will be lifted. Two cases illustrate this proposition. In Gilford Motor Company Ltd v Horne23 an agreement was made between the plaintiff and the defendant which prevented the latter from setting up a business competing with his employer. The defendant thought he was clever enough when he set up a new limited company to evade his obligation. The Court of Appeal were clear the company was formed as a device and accordingly ignored the separate legal personality and granted the plaintiff an injunction against the defendant and his company. Also in Jones v Lipman24 the court awarded specific performance against both the company and the defendant who had agreed to sell his property to the plaintiff in order to avoid that he set up his own business.

Finally we can say that in cases of the abuse of the corporate personality, the court will not hesitate in lifting the veil between the company and its members. Also under the wrongful trading provision, a parent company might be held liable to pay the debts of its subsidiary. I shall discuss this provision later on.

21 22

O Kahn Freund, “Some Reflection on Company Law” [1944], 7 MLR 54 See A Blake, H J Bond, Company Law (Fifth Edition), Blackstone Press Limited, 1996 23 [1933] Ch 935; see also Jennifer Payne’s article, “Lifting the Corporation Veil – A Reassessment of the Fraud Exception”, [1997], CLJ 56(2) 284 24 [1962] LWL R 832

10

GROUP OF COMPANIES
The question in relation to a group of companies is whether the court still applies the strict corporate entity principle and its attendant privilege of limited liability? or should the court look at the whole group as a single economic unit.

When does the court remove the protection offered by limited liability from directors or shareholders? and in the case of a parent company, is the parent liable for the debts of its subsidiary? When will the court allow creditors to reach the assets of share holders?

Two theories govern the relationship between the parent company and its subsidiary. The first theory is the legal separation theory which looks to every company as a separate legal entity of its own right and liabilities. The second theory is the economic entity theory which regards all the group as one single unit. According to English law the favourable theory is the legal separation theory viewed in Salomon v Saloman and Co Ltd and in Adams v Cape Industry. 25 If in the situation that a subsidiary is solvent, the parent company would not be liable to pay for the debts of its subsidiary since every company is regarded as a separate legal entity in law. This odd situation will let the parent company escape any liability in case it is conducting risky business through its subsidiary. Creditors, as a result of this, will suffer loss.

The doctrine of separate personality will be acted upon and recognised unless public interest and public policy demand that the legal entity should be disregarded. In this situation the courts either goes behind the corporate personality to see the individual members, or ignore the separate personality of each company constituted by a group of associated concerns.26 The former situation is called piercing the corporate personality, while the latter one is ignoring the corporate personality.

25

[1897] AC 22 and [1990] BCLC 479; see also Clive M Schmithoff “The Wholly Owned and the Controlled Subsidiary” [1978], JBL 218 26 See R Baxt, “Tension Between Commercial Reality and Legal Principle . . .” [1991], ALJ Volue 65, p 352

11

I shall examine agency, undercapitalisation, control. Abuse of the corporate form or fraud is also a situation when the court will lift the veil, but since it has been mentioned earlier in relation to one man companies, there is no point in mentioning it twice.

A

Agency

In order for the court to induce an agency relationship and accordingly lift the veil of incorporation between a parent company and its sibsidiary, an express agreement between the parties must be present and the subsidiary must follow the parent company's instruction as to how it should conduct its business. In Ebbw Vale DC v South Wales Traffic Licencing Authority27 the court refused to accept the existence of an agency relationship between a parent company and its wholly owned subsidiary despite the fact that the company in question was a mere shell, existing only in name and wholly owned by another company. In Smith Stone and Knight v Birmingham Corporation28 the business of the company was carried through a subsidiary company which was to all intents and purposes a department of its parent. The court laid down six factors to determine whether the subsidiary is agent of its parent company or not. (i) the profit of the subsidiary and the parent is the same; (ii) the persons conducting the business of the subsidiary appointed by the parent company; (iii) was the parent company the head and brains of the trading venture? (iv) did the parent company govern the adventure? (v) were the profits made by the subsidiary company made by the skill and direction of the parent company? (vi) was the parent company in effective and constant control of the subsidiary? Two observations must be made in relation to the previous factors. It is submitted that most important factor in determining and inducing an agency relationship between the parent and its subsidiary, the third and fourth factors, the subsidiary must be told by the parent how it should conduct its business and this is a functional control rather than a capitalist control. The other factors will determine whether the parent company is controlling its subsidiary, not inducing an agency
27

[1951] 2 KB 266; quoted in Michael Whincup’s article “Inequitable Incorporation – the Abuse of the Privilege”, CL Vol 2, No 4, p 158 28 [1939] 4 All ER 116

12 relationship as a ground for lifting the veil. This can be found in the Companies Act.29 In Adams v Cape Industry30, the agency argument was delivered by the plaintiff to support the proposition that Cape the parent company was present in the united state through its subsidiary, to enforce a judgement obtained in the united state against Cape. The courts recognised that Cape’s subsidiary acted as an agent in certain transactions, but this was not enough to show that an agency relationship existed between the parent company and its subsidiary. Some authors suggest31 that the legislator must develop a strong presumption that the parent used the subsidiary as an agent, therefore the parent company is liable for payment of the debts of its subsidiary, the parent company can repeat this presumption if it can prove that it neither authorised the transaction expressly or impliedly. I think adapting this approach might minimise the loss which creditors face and will solve a very unfavourable feature of English Company Law.

B

Under Capitalisation

An under capitalisation situation occurrs when a corporation carries on business without sufficient assets to meet its debts. Shareholders will escape personal liability by forming a corporation.32

The reason for allowing creditors to go beyond the assets of corporations is that the lower the amount of the firm’s capital, the greater the incentive to engage in risky activities.33 If we want to determine a situation of under capitalisation, we have to see the capital of the business and the risk of loss associated with it.

Unlike the USA courts, UK courts do not consider under capitalisation as a real ground for lifting the veil and pursuing the assets in favour of creditors.

29 30

See section 736, 736A, CA 1985 [1990] BCLC 479 31 Clife M Schmithoff, “The Wholly Owned and the Controlled Subsidiary” [1978], JBL 218 32 Michael Whincup, “Inequitable Incorporation – the Abuse of Privilege”, CL Vol 2, No 4, p 158

13 In Re F G Film34 the issues was whether a film made by an English company was a British film within the provision of section 25(i) of the Cinematograph Films Act 1938. The applicant was a company incorporated in England. It had a capital of £100. 90 of these shares were held by the American director and the remaining 10 were held by a British director. The Judge Vaisey J after having been satisfied that the company had no place of business, did not employ any staff and had a very nominal capital, come to the conclusion that the film was not a British film within the meaning of the 1938 Act.

We can mention that lifting the veil in case of under capitalisation to allow creditors to go beyond the assets of the under capitalised corporate debtor will let the debtor disclose his situation at the time of the transaction. The creditor that has the opportunity either not to transact or ask for prepayment or personal guarantees.35

The strictness of the legal entity implied in Salomon v Salomon and afterward in Adams v Cape makes the court reluctant to lift the veil except in exceptional circumstances. This position is contrasted to the American approach which does not set a high value on it, therefore courts will be likely to disregard it more often.

33

See Frank H Easterbook and Daniel R Fischel, The Economic Structure of Corporate Law, Harvard University Press, 1991 34 [1953] 1 WLR 483 35 See Frank H Easterbook and Daniel R Fischel, The Economic Structure of Corporate Law, Harvard University Press, 1991

14

SHAREHOLDER’S INTERESTS
Shareholders were regarded as the owners of the Company and its assets, they are the ones who appoint directors, who should run the company for their exclusive benefit, not withstanding any other constituency within the Company. As the law started recognising other groups,36 the law has gone through radical change, shareholders have become little more than bystanders,37 although they have a significant role to play in being able to appoint the board, approve irregular transactions and alter the constitution and, in the event that shareholders are not satisfied with directors’ management, they can simply disqualify the directors and appoint new ones in their place, or they may sell the shares and invest in another company.

The duty of directors to act in the interest of shareholders arises in relation to takeover bids which forbid directors from frustrating a take-over bid and thus depriving the members of an opportunity to sell their shares at an advantageous price.38 In Re a Company39 the court considered the duties of the directors of a private company to its general body of shareholders when there are two competing offers for their shares. Hoffman J answered : “directors are required to give shareholders sufficient information and advice to enable them to reach a properly informed decision and to refrain from giving misleading advice or exercising their judiciary powers in a way which would prevent or inhibit shareholders from choosing to take the better price.” In Heron International Ltd v Lord Grade40 the court recognised that directors’ duties toward shareholders collectively rather than on an individual basis and then only towards current and not future shareholders. Where a particular decision to be taken by the directors bears differently upon different classes of shareholders, their duty is to act fairly, having regard to the interests of all classes.41 Although these cases may seem to establish that there is a fudiciary duty on the part of the directors owed to

36 37

Interest of Employees: S – 309 – CA 1985 Ross Grantham, “The Doctrinal Basis of the Rights of Company Shareholders” [1988], CLJ 554 38 Parkinson, Corporate Power and Responsibility : Issues in the Theory of Company Law, Clarendon, Oxford, 1993 39 Re A Company (No 8699 of 1985), 1986 BCLC 382 40 [1983], BCLC 244 41 Henry v Great Northern Railway [1857] I De6 and J 606 at p 638, quoted in J Birds, A J Boyle, Eilis Ferran, Charlotte Villiers, Company Law, Jordans, 1996

15 shareholders, Lord Cullen42 argues that the duty only arises if directors take it on themselves to give advice to current shareholders.

In my opinion, it is submitted that the fact that directors stand in a fudiciary obligation toward the company and the company is regarded as a general body, shareholders are part of that body, therefore directors have to take care of shareholders’ interest since it is their company in the first place

CREDITORS’ INTERESTS

A

Common Law

As we have seen, the recognition of the courts to the company as a distinct legal person incurring its own debts and liabilities gave creditors no direct recourse against those people who run and manage the affairs of the company. Even in the circumstances that the company is declared bankrupt, members of it were not required to contribute in their own capital.

Directors of the company were not required to take into account creditors’ interest since directors do not owe any form of duty to either shareholders or creditors.43 Influenced by a wide range of authorities through the Common Law countries, the position has changed as far as English Law is concerned. In Liquidator of West Mercia Safetywear Ltd v Dodd44, the court held that the director of the company was personally liable to contribute to its liquidator in a sum of £4000 which he had diverted away from the company (to which it was due) and into the bank account of another company where it reduced an overdraft that he had personally guaranteed; as a result he disregarded the interests of the creditors. The case recognised that directors should take into consideration the interests of creditors when the company is insolvent. If we have established that directors owe such a duty, why should creditors
42 43

In International plc v Coats Paton plc [1989], BCLC 233 Multinational Gas and Petrochemical Co v Multinational Gas and Petrochemical Services Ltd [1983], Ch 258; see the judgement of Dilon L J, “. . . directors owe fudiciary duties to the company thought not to creditors present or future”; see also Percival v Wright [1902], 2 Ch 421

16 be protected in the first place? What do we mean by such a duty, when it arises and terminates? Is the duty owed to single creditors, or to creditors generally present and future ones?

Shareholders were regarded as owners of the company and creditors as the people who lend it money, creditors and shareholders have the same relationship to the company, both groups are making a capital investment and both expect to get their money back plus a return on their investments.45 Directors have to take into account of shareholders’ interest when the company is a going concern, but when the company becomes insolvent or insolvency threatens,46 the interests of the creditors become the interests of the company, since creditors will be the most effective constituency of directors’ misconduct. The duty on the part of the directors to take into account of creditors’ interest is explained in Winkworth v Edward Baron Development Co Ltd47 by Lord Templeman, who said : “the company owes a duty to its creditors to keep its property inviolate and available for repayments of its debts . . . A duty is owed by the directors to the company and to the creditors of the company to ensure that the affairs of the company are properly administered and that its property is not dissipated or exploited for the benefit of the directors themselves to the prejudice of the creditors. In the situation that the company is no longer able to pay its debts, creditors’ claims will be against the company property which is distinguished from the members and no longer in their name.” Judges do not specify whether directors owe a duty to creditors generally or to a specified group of creditors48 determining that it is important, since directors having placed themselves in a position of trust against the company assets may prejudice on a class of creditors on the account of the others (e.g. if directors decided to use the remaining assets to pay off the preferential creditors or to continue to trade in the hope that the company will prosper and can accordingly pay the debts of the unsecured creditors.

44 45

[1988] 4 BCC 30; quoted in L S Sealy, “Directors’ Duties – An Unnecessary Gloss” [1988], CLJ 175 Saleem Sheikh and Williams Rees, Corporate Governance and Corporate Control (First Edition), Cavendish Publishing Limited, 1995, Ch 4, “Creditors’ Interests and Directors’ Obligations”, p 111 141 46 Brady v Brady (1989), 3 BCC 535 (Court of Appeal) : [1988] 2 All ER 612; see note 45 above 47 [1986] WLR 1512 quoted in D D Prentice, “Creditors’ Interests and Directors’ Duties” [1990] 10, OJLS 265 48 See note 45 above

17 We can sum up by saying that directors should ensure that the assets of the company are kept to pay creditors whether preferential or unsecured, since they are the most effective constituency when the company is insolvent or doubtful insolvency; but what other form of protection does the law offer to creditors? Does the statutory provision relating to fraudulent and wrongful trading which also protects creditors diminish the Common Law ones? All these issues and others will be discussed under the next heading.

B

Statutory Provision

The abuse of the corporate personality by directors in a small type of business called the “phoenix syndromes”, who gave themselves excessive salaries and, after conducting business for a certain period, found themselves not making a lot of profit with lots of debts on the part of the company, would deliberately allow their companies to run into the ground so that they became insolvent, and after a while, setting up a new company known as a “phoenix company”, using the old business and re-employing the workforce without of course incurring any old debts, since creditors of the first company had no legal claims against the new one.49 In order to put a limit to these forms of abuses and others, the Cork Committee proposed certain protections to creditors and some of them were implemented in the Insolvency Law 1986.

I shall discuss the fraudulent and wrongful trading provisions (213, 214), making a comparison between both arguing whether these provisions are adequate measures for protection to creditors or not? Fraudulent trading is actionable as a civil offence in an insolvency situation and a criminal offence while wrongful trading is only available in civil courts.

Fraudulent and wrongful trading comes into effect when the company is insolvent at a time when its assets are insufficient for the payment of its debts and other liabilities.50 The object of these provisions is to protect the interest of the creditors and to encourage directors to take immediate steps on viewing their company as insolvent to place it in receivership administration or liquidation. The liquidator is the only person
49

This paragraph is adapted from Professor Ian F Fletcher’s article “The Genesis of Modern Insolvency Law – An Odyssey of Law Reform” [1987], JBL 365

18 who could enforce and bring these provisions into effect, within six years of the company going into insolvent liquidation.51 Intent to defraud creditors must be established on the part of any member of the company52 or a person who is or was a director, shadow director.53

Directors or other persons who, by virtue of their office or performance of their duties, contributed in any way on behalf of the company to act in a certain way which incurred its debt and against the company creditors will be made liable. The court has a wide discretion in terms of the amount of contribution that any member of the company has to pay “as the court thinks proper”, but the question here is who has entitlement to such contribution? Are the assets of the company available to satisfy all creditors or only those who were the victims under the fraudulent or wrongful trading?

According to Insolvency Law principles, the assets of the company in liquidation constitute a single pool available to all creditors, unless a creditor has a priority either by agreement or by statute.54 A defence is offered in relation to wrongful trading provision55 to the director, who satisfies the court that he took every step with a view to minimising the potential loss to the company’s creditors. Whether a director has done so or not is tested objectively depending on the position of the director and the status of the company he is employed in.

The prime criticism to the wrongful and fraudulent trading provisions is that it is only enforced not by creditors themselves, who cannot bring an action against the director or other people who acted fraudulently, but only by application of the liquidator. If the liquidators refrained from taking such action, creditors will lose one form of protection that the law has offered to them; also it must be noted that the liquidator might face some difficulty in establishing that the director or any member of the

50 51

Section 214(6), Insolvency Act 1986 Gore-Browne on Companies (Forty-fourth Edition), Boyle and Sykes, Jordans 1986 52 Fraudulent Trading, S 213(2), Insolvency Act 1986 53 Wrongful Trading, S 214 – “Introducing a shadow director is important in terms of protecting creditors since a parent company may be held liable to pay the debt of its subsidiary.” 54 D D Prentice, “Creditors’ Interests and Directors’ Duties” [1990], 10, PJLS 265 55 S 214(3), Insolvency Law 1986

19 company has acted fraudulently or dishonestly, and this provision will only come into place when the company has gone into insolvent liquidation.

OTHER FORMS OF PROTECTING CREDITORS
A Liability for acting while disqualified

Section 15 of the Directors’ Disqualification Act 1986 offers an important form of protection. For creditors who can bring action directly against any person who is a director or being concerned directly or indirectly in taking part in the management of the company to be liable for the debts of the company whether jointly or severally with the company.

The importance of this provision lies in two respects. The company does not have to be in liquidation and creditors can enforce this provision directly without the need for action by a liquidator. Unlimited liability of directors56

B

According to Section 306, 307 of the Companies Act 1985, a limited company can introduce a clause originally in its memorandum or by way of alteration which states that the liability of its directors should be unlimited in a winding-up procedure. Banks or other powerful investors might make this kind of provision as a requisite for providing their loans, although it must be noted that this provision is scarcely if ever invoked.

C

The use of the suffix “limited”

According to Section 25(2) of the Companies Act 1985 every limited company, either limited by share or by guarantee, is required to use the word limited “Ltd” or the Welsh equivalent after the last word of its name stated in the memorandum.57 This provision can be said to be for the advantage of creditors and their disadvantage. For their advantage, since they are warned of the position of the company, shareholders
56

A J Boyle, Richard Sykes, Leonard Sealy, Gore-Browne on Companies (Forth-fourth Edition), Vol 2, Jordans, 1986 57 Ibid

20 will not be liable to contribute more than the assets they have advanced to their company. For their disadvantage, since they cannot plead that they did not know they were dealing with a company, either limited by guarantee or shares. But what about the situation when shareholders deliberately conceal the exact position of their company? The law’s answer to this point is that a person or persons will be liable to a fine or for continued contravention to a daily default fine.58 In my opinion it is submitted that this form of protection is not adequate enough especially the compensatory aspect of it, since it does not offer real protection for creditors.

Also it must be mentioned that there are other forms of protection, such as the disclosure requirement on the company, enabling third parties to make the company search the Companies Registry. Creditors can take fixed or floating security to give them priority in the situation that the company has gone into insolvent liquidation. And powerful creditors might employ several strategies to reduce the risks associated with debt obligation by exercising some measure of control over the business affairs of the debtor company.

58

S 34 CA 1985

21

CONCLUSION
The House of Lords found that honesty and good faith on Salomon’s part prevented him from indemnifying the company creditors as they knew they were dealing with a legal person totally different from his incorporators. Limited liability at that time was also available to sole traders and large investors who wanted some form of limit on their undertakings.

The abuses which took place afterwards led some commentators to suggest abolishing the limited liability at all or at least to abolish the private companies, but what would be the effect of that on the commercial world? and are these abuses the exception or the rule? It is submitted that industry and trade will suffer as a result of many investors not contributing more than the amount they wish to invest, and we will be back at the beginning again. Traders will find a way to limit their liability under contract or insurance as they have done before.

Alteration of risk from shareholders to creditors and the abuse of the corporate personality and the limited liability associated to it does not mean that the limited liability is of no good; many companies are prospering and flourishing without any problem and these abuses are not the rule but the exception to it. The law started recognising the problem and formed methods of protecting creditors, either preventive or compensatory, preventive measures requiring directors to take care of creditors’ interests and compensatory measures relating to fraudulent and wrongful trading. But are these measures of protection adequate? In my opinion I do not think so, since they only enforced other provisions by a liquidator when the company was in liquidation and this does not address the problem either.

The judges also are not sure when to lift the veil between the parent company and its subsidiary only in exceptional circumstances will declare shareholders liable to pay the debts when they use the company in case of fraud or to evade legal obligation, but it’s a matter of the circumstances and there is no basic rule.

22 It is hoped that parliament will develop a coherent effective systematic way of evading the adverse effect which limited liability can have on creditors. As a result this will give limited liability its proper function and will avoid severe criticism of it.

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