A MECHANISM WHICH UK COMPANY LAW EMPLOYS FOR PROTECTION AGAINST
POTENTIAL ABUSES OF LIMITED LIABILITY?
By:
MUHAMMAD
ISTKHAR
LLM (
Advocate of High Court
m.istkhar@gmail.com
Introduction
The principles of limited
liability and separate legal personality were originated by the Salomon case in 1897. The limited
liability means that the shareholders or members have the limited financial
responsibility regarding to the company’s debts to the creditors. The principle
of separate legal personality means that the company is a separate legal
personality and promoters have also the separate natural persons, neither the
company’s acts his acts, nor where its liabilities his liabilities. These
principles are special privileges of the incorporation which are granted by the
law for the developments of the trade, business and without taking any kinds of
risk. But the limited liability doctrine is abused by shareholders, parent and
holding companies. Against the abuses of
limited liability measurements are given by the common law and statute laws:
the common law is giving doctrine lifting the corporate veil and statute laws
are giving the other kinds of measurements to oppose the wrongful trade and
fraudulent trade. In this essay I will describe the principle of separate legal
personality, limited liability, abuses of the limited liability and
measurements against the abuses of the limited liability under the common law
and statute laws in UK Company Law.
Consequences of incorporation
After incorporation under
1.
Separate legal
personality
After incorporation a business
entity is converted to legal entity. A legal personality is distinct from the
people who compose it. For example, the court had decided in the case of Salomon v. Salomon & Company.[1]
Regardless of the extent of the particular shareholders interest in the company
and a sole share holder is controlling of the company affairs as its governing
director, neither the company’s acts his acts, nor where its liabilities his
liabilities and it is not sufficient reasons for ignoring the legal personality
of the company that the shareholders have the shares. Further Vaughan William J
says, in the Broderip.s claim[2]
that the company has separate legal entity and director could not use it as an
agent for his business and the company was entitled to indemnity against its
principal. This case is conforming that the shareholders have the separate
personality to the company. Furthermore in another case the court said that no
shareholder has any right to any item of property owned by the company[3].
Similarly H. Hansmann[4]
gives the concept of “corporation sole”
that means a single shareholder and company have the separate personalities,
responsibilities, and assets to each others. Further in another case the court
said that it is not the matter that the shareholders have the limited liability
but that a company is a separate legal entity and distinct from its directors,
servant, and other agents[5].
Similarly as in Lee case[6] it
was held that director has separate personality and company has also the
separate legal entity even the director’s roll was as the chief pilot of the
company as it is discussed in the Salomon
case. Moreover the second consequence of incorporation is discussed below:
2.
Limited
liability
Limited liability is also a
privilege due to incorporation, the principle of limited liability was
originated with the concept of separate personality from the case Salomon v. Salomon & Company. Now
the principle of the limited liability is protected under the section 3 of the
Company Act 2006 and section 74 (2) (d) of the Insolvency Act 1986. The limited
liability means that the shareholders or members have the limited financial
responsibility till their unpaid shares price about the company’s debts to the
creditors. The Gower suggests about the origin of the doctrine, "public opinion began to harden in favour of the extension of limited liability, particularly
when the slump of 1845-1848 drew attention to the consequences of its
action".[7] Further a writer says that the limited
liability means debts are incurred by the company are not the debts of the
individual members[8]. The
limited liability doctrine is beneficial for the big business and investment.
Similarly Andrew Hicks mentions in his article that[9];
“the
limited liability company was the means by which huge aggregations of capital
required to give effect to their discoveries were collected, organised and efficiently administered
....................limited liability now too generously conceded to
all-comers, no matter how substantial they may be?...... ”
There are many positive
attributes of limited liability: for example it is facilitates the operation of
equity markets[10], it has
on the distribution of risk associated with business failure, it is
satisfaction for the investor that they have not to indemnify creditors from
their personal assets[11]
and many others. In contrast the limited liability is abused by the members of
the company because the company is an artificial legal person and it needs any
natural person for carry on a business, at that time they abuse the limited
liability, for controlling their abuses, measurements are available under the
statutes and common law which are described hereinafter.
Abuses of limited liability and measurements against it
The
semblance of limited liability is an attractive weapon for directors to take
business risks and chances for the benefit of the company and its shareholders
to maximise potential profits without takings any
kinds of burden of personal liability[12].
Limited liability gives the incentive to the directors that they continue
business and trade without the fear of insolvency with the money of others[13].
Indeed the limited liability is a privilege of the company, it is granted for
the attraction of the investors[14],
to collect huge revenue, to trade for the benefit of the members, but unfortunately
the limited liability doctrine is abused by the promoters, directors, parents
or holding companies in different ways. Therefore the statute laws (for
example: UK company law, Company Directors Disqualification Act, Insolvency Act
and many others laws) and common law provide the protection measures against
the abuses of limited liability by the corporate personalities, directors and
members of the companies, which are elaborated below:
1.
Protection measures against the
abuses of limited liability under the common
law - lifting the veil
Lifting the corporate veil doctrine is that it
is a method which is used by the court to oppose the fraud, illegality and
irregularities[15]. The
general principle is: the company has the separate legal personality and limited
liability, this doctrine is accepted by the law and by the courts. The courts
are not interesting to interfere with the internal matters of the company but
in the exceptional cases. According to the Palmer’s Company Law the court can
‘lift the corporate veil’ and declare that a shareholder personally liable
according to the circumstances where there evidence is available about the
unlawful purposes and fraudulent activities are committed[16]
by the parent or holding companies or members (directors) behind the corporate
veil and under the shadow of the limited liability. Further Pennington says the
court can lift the corporate veil where:
“judicial
disregard of the principle where the protection of public interests is of
paramount importance, or where the company has been formed to evade obligation
imposed by the law”[17]
Similarly Gower and Davies say
that:
“where company
being ‘sham’ or ‘facade’ or agent of the shareholders or companies are the part
of ‘single economic unit’ or ‘interest of justice’ and require this result”.[18]
Under the above said purposes
and many others circumstances the court can lift the corporate veil for
preventing irregularities and illegalities, there are many cases in which the
court has lifted the corporate veil, examples are described below.
Jones v. Lipman[19], in this case the court lifting the veil, Mr Lipman had entered into a
contract with Mr.Jones for the sale of land. Later on
Mr. Lipman changed his mind and he formed a company
in order to avoid the transaction and conveyed the land to it instead. He then
claimed he no longer owned the land and could not comply with the contract. The
court found that company was facade and ordered for the specific performance.
Similarly in Gilford Motor Co. v. Horne[20],
in this case respondent was employee of the appellant. He made a contract that
after leaving the job he would not solicit the appellant’s customers. But he
formed a company and solicited the customers of the appellant’s company. It was
held that the company was formed as a cloak for his activities and contract
which was made between the two parties would be enforced. Further in Trustor v. Smallbone[21]
case the court lifted the veil and it was held that due to improperly
controlling and used as a device or facade in order to evade liability the
company was incorporated.
The veil of incorporation may
sometime be lifted to allow a group of associated company to be treated as one.
In the group of companies even each company has the separate legal entity,
corporate veil can be lifted by the court under the principle of “single
economic unit”[22] or
“interest of justice” As in the case of Adams
v. Cape Industries Plc[23]
the court lifting the corporate veil and on the bases of above written
principles the court impose the responsibilities on the parent company because
the subsidiary company is controlled by it. Similarly in DHN Food[24]
case parent company was declared the responsible on the behalf of the
subsidiaries companies.
The concept of lifting the
corporate veil is used in
i.
Peeping behind
the Veil
It is an offensive theory which
means that the court will lift the corporate veil and get information about the
persons and their involvement such as who are controlling the company, who are
the shareholders, what kinds their inter-relationship regarding the company
internal matters? Regarding the theory a very famous example is the Daimler case[27],
in this case the court applied this concept and got the information about the
directors and shareholders who were the German (enemy country) resident.
ii.
Penetrating the
Veil
It means that court will get
information about the powers of shareholders, their responsibilities regarding
the company’s matters, irregularities, fraudulent activities which were the
cause to damage the property of the company. For example in the Macaura case[28]
in this case court penetrating the veil and gets the information about the
irregularities with the company property. It was held that no shareholder has
any right to any item of company’s property.
iii.
Extending the
Veil
It means that the court will
ignore the separate legal entities of the various companies within a
group. The concept of extending the veil
has been used by the court in the case DHN
Food Distributors Ltd. v. London Borough of Tower Hamlets[29],
in this case the Lord Denning accepted the dictum of Gower that when a parent company own the all shares of the
subsidiaries which are bound hand and foot to the parent company and must do
just what the parent company says, therefore the parent and other
subsidiaries are considered the one.
iv.
Ignoring the
Veil
It is an extreme form of
lifting the veil, in which the court ignores totally the separately legal
personality of the company. Normally this approach is not adopted by the court
except in the special circumstances for example the company was not founded for
commercial purpose but as a means to cheat or defraud the creditors or to
circumvent laws.
The principle lifting the
corporate veil is a very strong measurement under the common law against the
abuses of the limited liability and the courts are using this way to oppose the
fraud and irregularities. Furthermore protective measurements, against the
abuses of limited liability, are available under the enacted laws, are
discussed below:
2.
Protection measures against the
abuses of limited liability according to
the statute law
The statute laws are providing
the protection measures against the abuses of limited liability. These measures
are available under the Company Act 2006, Insolvency Act 1986 and Company
Director Disqualification Act 1986, which are described hereinafter.
·
Measures against
the fraudulent trading
Fraudulent trading means that
the company continues to carry on business and to incur debts at that time when
directors knows, there is no reasonable prospects and creditors will not be
able to get ever back their money[30]. For example R. v. Grantham in this case the court gave the direction to the
jury that if they found guilty the fraudulent trading person then they can
convict. The company is separate legal personality and it has limited liability
doctrine is capable of being abused. For stopping such abuses the statute laws
are providing the criminal liability under the section 993 of the Company Act 2006
and civil penalty under the section 213 of the Insolvency Act 1986. The
criminal liability can be imposed under section 993 of the Company Act 2006 if
the company’s business is carrying on for committing the fraud the creditor.
The civil proceeding can be initiated and aggrieved party can demand the
compensation, if they take proceeding under section 213 of the Insolvency Act
·
Measures against
the wrongful trading
Wrongful trading means to abuse
the limited liability and to invest without considering the long term effects
of the decision and directors running up losses when the company is in deep
financial difficulty[32].
The civil proceeding can be invoked by the liquidator or on the application by
the creditor against the directors, under the section 214 of the Insolvency Act
1986, during the liquidation proceeding[33].
·
Powers of court
to grant relief in certain cases
Under the section 1157 of the
Company Act 2006, the default, negligence and breach of duty of any officer,
person who was employed in the company or directors of the company, was caused
the damage of the company’s property, the court may declare him responsible and
he has to compensate loss of the company.
·
Director
disqualification order
Under the section 4 Company
Directors Disqualification Act 1986, the court can make a disqualification
order against any person who has involved in the fraudulent trading or any
other fraud or breach of duty if it is appeared, during the course of winding
up the company or in front of court.
These laws are playing very
important role to opposing the limited liabilities abuses under the corporate
veil.
Conclusion
Limited liability and
separate legal personality are the special privileges, which were the
originated from the Salomon case, for
the business entity after the incorporation under the UK Company Act 2006. The
purpose of both principles is to facilitate the trade and business at large
level without investing the huge money and taking risk. But unfortunately these
doctrines were misused by the promoters, directors, shareholders, parent and
holding companies, therefore the concept of lifting the corporate veil was
developed within the centuries under the common law and now the statute laws
are also available against the abuses of the limited liability. These laws are
playing very important role for the safety of the creditors, shareholders and
opposing the illegality, irregularities, and preventing the fraudulent trade
and wrongful trading.
[1] [1897] AC 22
[2] Broderip v. Salomon (1895), CA, HL 15,16.
[3] Macaura v.Northern Assurance
[4] H.Hansmann
and R.Kraakman, ‘the essential role of organizational
law’ the yale
law journal, vol.110: 387, p.404
[5] [1998] 1 WLR 830, at
835, it is taken from the Boyle &
Birds’ Company Law 6th edn.( Jordan Publishing
Limited, 2007), P.63.
[6] Lee v. Lee’s Air Farming (1961), PC 17
[7] A. Small, ‘Limited
Liability- a Necessary Consequence of Incorporation?’ at: http://www.nuigalway. ie/law/GSLR/1998/art5.html
[8] Ibid
[9] A. Hicks, ‘Limiting the
rise of limited liability’ in R. Baldwin and P. Cane (eds),
Law and Uncertainty (Kluwer, 1997) It is taken from:
A. Hicks & S.H. Goo, ‘cases & material on company law’, 5th edn.
(2004), p. 86
[10] L.E. Ribstein,
‘Limited Liability and Theories of the Corporation’, (1991) 50
[11] B.R.Cheffins,
‘Company Law: Theory, Structure, and
Operation’, (Clarendon press
[12] O.
Kahn-Freund, ‘Some Reflections on Company Law Reform’ [1944] M.L.R. 54, 54.
[13] D.
Prentice, “Creditor's Interests and Director's Duties” [1990] O.J.L.S. 265,
265. It is taken from: F. Didcote, ‘Controlling the abuse of limited liability:
the effectiveness of the wrongful trading’ Provision’ [2008], I.C.C.L.R.373.
[14] O.
Kahn-Freund, ‘Some Reflections on Company Law Reform’ [1944] M.L.R. 54, 54.
[15] S. Ottolenghi,
‘From Peeping Behind the Corporate Veil, to Ignoring it Completely’ [1990] The Modern Law Review, 53:3, p. 338.
[16] 25th edn.
(
[17] Pennington, Company Law, 5th edn. (1985),
P.53, it is taken from: S. Ottolenghi, From Peeping
Behind the Corporate Veil, to Ignoring it Completely’ [1990] The Modern Law Review, 53:3, p.338.
[18] Gower and Davies, ‘Principle of Modern Company Law’, 8th edn. (
[19] (1962) 1 WLR 832
[20] [1933] Ch 935 (CA)
[21] [2002] BCC 795
[22]‘Gower in Modern Company Law’ 3rd ed. (1969), P.216, it is taken
from: F.G.Rixon, ‘Lifting the veil between holding
and subsidiary companies’ [1986] L.Q.R. 416.
[23] [1990] 2 W.L.R. 786, HL
[24] DHN Food Distributors Ltd. v.
[25] S. Ottolenghi,
‘From Peeping Behind the Corporate Veil, to Ignoring it Completely’ [1990] The Modern Law Review, 53:3. P. 340
[26] Ibid
[27] Daimler v. Continental Tyre Co. [1960]
[28] Macaura v. Northern Assurance Co. [1925] AC 619 (HL)
[29] [1976] 3 All ER 852
[30] [1984] Q.B. 675, CA. It
is taken from: Gower and Davies, ‘Principle
of Modern Company Law’ 8th edn. (
[31] Section 213 of the Insolvency
Act 1986
[32] A. Keay,
‘Wrongful trading and the liability of company directors: A Theoretical
perspective’ at: http://www3.interscience.wiley.com/journal/118695673/abstract
[33] F. Didcote,
‘Controlling the abuse of limited liability: the effectiveness of the wrongful
trading’ Provision’ [2008], I.C.C.L.R.373.