Company Law

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Introduction … … … … … 2

Examining the dictum … … … … 3

Summary and Conclusion … … 21

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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

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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.

A The legal entity point4

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 [1895] 2 Ch 323 3 [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

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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.

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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 MaCaura v Northern Assurance Co [1925] AC 619 9 [1924] 2 Ch 33

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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 Murray A Pickering, “The Company as a Separate Legal Entity” [1968], Vol 31, MLR 481 11 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

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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

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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 Andrew Hicks, “Corporate Form : Questioning the Unsung Hero”, [1997], JBL 306 19 [1895]2 Ch 323 20 LQR Vol II [1895]

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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 O Kahn Freund, “Some Reflection on Company Law” [1944], 7 MLR 54 22 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

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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

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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

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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 See section 736, 736A, CA 1985 30 [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

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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

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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 take-

over 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 Interest of Employees: S – 309 – CA 1985 37 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

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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 In International plc v Coats Paton plc [1989], BCLC 233 43 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

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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 [1988] 4 BCC 30; quoted in L S Sealy, “Directors’ Duties – An Unnecessary Gloss” [1988], CLJ 175 45 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

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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

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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 Section 214(6), Insolvency Act 1986 51 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

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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.

B Unlimited liability of directors56

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

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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

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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.

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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.