Principles of Limited Liability and Corporate Personality

Introduction

This dissertation will discuss the principles of limited liability and corporate personality and the courts’ reluctance to disregard the corporate veil the principle called “piercing the Corporate Veil”. We shall consider the circumstances in which the Courts have been able to pierce the veil of incorporation and the reasons as to why they have in most cases upheld the decision in Salomon v Salomon & Co.

All companies in the United Kingdom have to be registered and incorporated under the Companies Act which governs the principle of limited liability hence giving the owners or shareholders a curtain against liability from creditors in the case of the company falling into financial troubles. This curtain so created gives the company a separate legal personality so that it can sue and be sued in its own right and the only loss to the owners or shareholders is the number of shares held in the company on liquidation with no effect on their personal assets.

This distinct separation between the owners or shareholders and the limited company is the concept referred to as the ‘veil of incorporation’ or ‘corporate veil’.

In conclusion, it shall be argued that the courts should lift or pierce the corporate veil to a significantly greater extent so as to hold erring shareholders or directors of a corporation liable for the debts or liabilities of the corporation despite the general principle of limited liability were the corporation has insufficient assets to off-set the creditor liabilities.

Limited liability and Corporate Personality

The principles of limited liability and corporate personality are the cornerstone of the United Kingdom company law since the Joint Stock Companies Act 1844, its consolidation in 1856 and the introduction of the Limited Liability Act 1855. These two principles have been so guarded by the courts as being fundamental to today’s company law by upholding the separate legal personality of a corporate entity.

However, whilst the original intention of the legislation was to help companies raise capital through the issue of shares without exposing the shareholders to risk beyond the shares held, the present attraction to incorporating a company is the advantage of shielding behind the curtain of limited liability which could be abused by some businessmen.

Limited liability

As stated above, the doctrine of limited liability was introduced by the Limited Liability Act 1855 as a means by which companies could raise capital by selling company shares without exposing the shareholders to unlimited liability.

The principle of limited liability shields the company owners, shareholders and directors or managers against personal liability in the event of the company winding up or becoming insolvent. In such an event the liability of its owners and shareholders is limited to the individual shareholding held as provided for by the Companies Act 2006 and the Insolvency Act 1986. This means that the members of a company do not have to contribute their personal assets to the company assets to meet the obligations of the company to its creditors on its liquidation but have to contribute the full nominal value of the shares held by individual shareholders. It should be noted here that such limited liability does not shield the limited company from liability until all its debts or assets are exhausted.

This principle has so been held since the House of Lords ruling in the Salomon case in which the Lords where of the view that the motives behind the formation of a corporation was irrelevant in determining its rights and liabilities as long as all the requirements of registration are complied with and the company is not formed for an unlawful purpose.

Much as a limited company has a separate legal personality, its decisions are made by directors and managers who should use the powers conferred unto them by the company board of directors and the memorandum and articles of association, and any abuse will entail personal liability by the officer concerned.

Limited liability encompasses both the small enterprise including one-man companies and big companies hence limiting the liabilities to company assets and not to any other personal assets.

This view has been endorsed in recent times through numerous cases as evidenced in a one-man company, Lee’s Air Farming. Lee was the majority shareholder and director in the company in which he was also the employee. He was killed on duty in an air accident and the court held that Lee and the company were two separate entities and hence entitled to compensation.

The courts will only in exceptional circumstances such as abuse, fraud or where the company was used as an agent of its owner disregard the doctrine of limited liability and hold members, shareholders or directors personally liable for the debts and other company obligations to the creditors in what has been termed the piercing or lifting of the “veil of incorporation”. One commentator puts it plainly that “in this age of high expectations, people (and they may be good people) want to have their cake and eat it as well……They find a limited company a very useful vehicle for carrying on business because it has a separate legal personality which is responsible for all the debts of the business.”

However, there are several statutory laws which allow for the principle of limited liability to be ignored in such situations as in the reporting of financial statements of group companies, corporate crime and insolvency which we shall discuss below.

Corporate Personality

A limited company is a legal person with an existence which is separate and independent from its members as long as all the formalities of registration are adhered with in line with the Act. The corporate identity entails the company can sue and be sued in its own right without affecting its owners’ or shareholders’ rights. It is trite law that the only plaintiff to a wrong done to a company is prima facie company itself and not its shareholders except in instances where there is a fraud against shareholders or the acts complained of are illegal.

The company has been held as having an independent legal corporate personality since it was first held in the case of Salomon v A Salomon & Co Ltd . To emphasise this point, Lord Macnaghten said that it seemed impossible “to dispute that once the company is legally incorporated it must be treated like any other independent person with its rights and liabilities appropriate to itself, and that the motives of those who took part in the promotion of the company are absolutely irrelevant in discussing what those rights and liabilities are”.

In this case, Salomon registered his company into a limited company under the Companies Act which required a minimum of seven (7) members for incorporation. Salomon became the major shareholder with his wife and children holding a share each but the company ran into financial problems leaving no assets for the unsecured creditors on liquidation.

Whilst the court of appeal held the company to be a ‘sham’ and an alias, trustee or nominee for Salomon and that the transaction was contrary to the true intent of the Companies Act the House of Lords reversed this decision and held that the company had been validly registered as required by the Act and hence had a separate legal personality from the shareholders. In arriving at this decision, Lord Macnaghten said that,

“The company is at law a different person altogether from the subscribers…….Nor are the subscribers, as members liable, in any shape or form, except to the extent and in the manner provided by the Act.”

This decision shows that the House of Lords identified that the important factor was the observance of the requirements and formalities of the Act which safeguarded the principles of limited liability and corporate personality. To date, this is the correct interpretation of the Company’s Act and it is important that the principle in maintained in the advancement of commerce.

It should be noted here that the principle of corporate personality does not affect the company creditors to a large extent as far as the recovery of the debts is concerned.

Following the decision in the Salomon case, Professor Gower has described a limited company as being ‘opaque and impassable’, whilst on the other hand it was described as ‘calamitous’.

Some commentators suggest that courts have been more inclined to the maintenance of the sanctity of the separate legal integrity of a company and have resisted the common law resolution of “peering under the skirts of a company to examine its linen (dirty or otherwise)” as can be observed from the numerous cases since the Salomon case.

The foregoing shows the importance to commerce of the incorporation of a company as it allows for continuity of the business transactions despite any changes in the owners, administrators, directors or shareholders of the company.

However, common law has in some exceptional instances ignored this principle in stances of abuse or fraudulent use of a sham corporate structure. The courts have ignored the corporate sham structure and peer behind the veil to identify the “directing mind and will” that control the company and such intervention being termed as lifting the veil, cloak or mask.

Whilst the courts have at times pierced the veil to benefit creditors when a company is placed under liquidation, there has been reluctance by the same courts to pierce the veil in instances which could have favourable results for shareholders.

The Directing Mind

A registered company is a separate and distinct legal entity, a body corporate possessing rights and made subject to duties being able to sue and be sued in its own right.

In the case of Lennard’s Carrying Co Ltd v Asiatic Petroleum Co. Ltd, the court held that, “…a corporation is an abstraction. It has no mind of its own any more than it has a body of its own; its active and directing will must consequently be sought in the person of somebody who for some purposes may be called an agent, but who is really the directing mind and will of the corporation, the very ego and centre of the personality of the corporation…..”

So we see here that the courts are willing to look behind the corporate veil as a matter of law so as to establish the directing officer behind the decisions and actions taken by the company.

The directing mind of a corporation is the senior person whose authority is derived from the company’s board of directors to perform the functions of the company as directed and for the benefit of the company.

In the course of business, such senior persons would then delegate their authority to other employees for the efficient running of the company in which case such employees’ actions or inactions would be considered as those of the “directing mind”.

Lord Reid further went on to define the “directing mind and will” of the company as the person who acts for the company as he acts as “the company and his mind which directs his acts is the mind of the company.……. He is not acting as a servant, representative, agent or delegate. He is an embodiment of the company or, one could say, he hears and speaks through the persona of the company, within his appropriate sphere, and his mind is the mind of the company. If it is a guilty mind then that guilt is the guilt of the company.”

Therefore, this would mean that the “directing mind and will” of the company is any employee who performs certain functions for the corporation as long as he has the authority to do so and does not act outside his mandate in which case he will be held personally liable.

In W illiams and another v. Natural life health foods ltd and mistlin, the case of a small one-person company, Sir Patrick Russell in his dissenting judgment pointed out that “the managing director will almost inevitably be the one possessed of qualities essential to the functioning of the company”, but that in itself does not mean that the director is willing to be personally liable to the company’s customers.

Therefore to convict a company, the court will go behind the status of the separate legal entity distinction so as to establish the “directing mind and will” of the company controlling its activities.

However, it has been identified that the principle of limited liability can be subject to abuse and in the circumstances were there is statute will not provide justice or equity, the courts have in such exceptional circumstances disregarded the principle and held the shareholders or directors accountable for their decisions in the running of the company. The process in which the courts have disregarded the principle of limited liability is called “piercing the corporate veil” which is the main discussion of this document.

One-man Limited Companies

The Council Directive 89/667 provides for the formation of one-man private companies hence moving away from the Joint Stock Companies Act 1856 requirements. This Directive highlights the advancement in commerce and as can be indentified from the Salomon case, Mr Salomon was the owner of the company and only registered the other six shares for his wife and children to fulfil the requirements of the Act.

The company owners in these one-man corporations are in most instances also the directors of their companies and could abuse the corporate structure by registering their personal assets as those of the company hence escaping personal liability.

The courts are prepared to pierce the corporate veil in a one-man company and treat assets of the company as “property held by the defendants” were the company is held to be an alter ego of the owner.

However, the courts have shown that they are not prepared to pierce the corporate veil even in one-man limited companies as long as they are properly registered as required by the Act.

In the case lee v Lee’s Air Farming mentioned above, Mr Lee incorporated Lee’s Farming Limited and was the director and controlling officer as an employee of the company. On his death in an air crush whilst on duty and the family claimed workers’ compensation. The court held that the company and Mr Lee were distinct and separate entities and hence Mr Lee was a worker in his own company.

Hence we see here the court’s upholding of the principle set down by the rule in Salomon v Salomon which has remained controversial with changing commercial activity and globalisation.

The courts have been more willing to pierce the veil in one-man companies were the owner of the company is usually the controlling officer and does not deal with the company at arm’s length. In the case of Wallersteiner v Moir , Lord Denning held that the subsidiaries were controlled by Dr Wallersteiner making them “puppets” which “danced to his bidding”.

Lord Denning is pointing out here that whilst the subsidiaries appeared to have a separate personality, they were in reality his agents or sham companies with no existence of their own and hence warranted the piercing of the veil.

This principle of corporate personality as established in the Salomon case has been extended to groups companies which we shall look at below.

Group Companies

Group companies comprise of the parent company with its subsidiaries carrying on their businesses not as a common enterprise or “single economic unit”, though portraying it as such to the outside world. The principle of limited liability applies to the subsidiary companies so formed as they are registered companies under the Act and as such each has a separate legal personality to the parent company and hence can sue and be sued in their own right.

The advantage of this arrangement to the group is that it limits liability to each subsidiary company in the group whilst sharing the group profits for the benefit of the group structure. Such group structures can lead to the parent company forming subsidiary companies to run its risky part of the business and hence insulating itself from liability in the event of the subsidiary company failing to meet its obligations to the creditors.

The effect of corporate personality in group companies is that each entity is legally independent and separate from other subsidiaries and the parent, hence each entity being liable for its own debts, which affirms the Salomon principle. However, Hobhouse LJ has argued that the courts should look at the whole group of companies as an economic entity.

On this subject, Lord Justice Slade said:

“Our law, for better or worse, recognises the creation of subsidiary companies, which though in one sense the creatures of their parent companies, will nevertheless under the general law fall to be treated as separate legal entities with all the rights and liabilities which would normally attach to separate legal entities”. This is still the law and an affirmation of the principle in the Salomon case.

In the case of Ord & Another v Belhaven Pubs Ltd, the proprietors of a company which was in the business of acquiring old pub premises, doing them up and then letting them to tenants, duly let a renovated pub building to Ord. There had been misrepresentations made by the company as to the potential profitability of the premises which only came to light some time later. By the time Belhaven Pubs Ltd had ceased trading and could not meet its debts. Ord sought leave to substitute the parent company.

The Court of Appeal held that the defendant company which had granted the lease was legitimate and had not been a mere façade for the holding company and hence could not be substituted.

This basic principle of separate legal identity has been re-affirmed more recently in the Court of Appeal decision in Adams v Cape Industries PLC . In this case, the defendant company was a member of a corporate group with a UK parent company. The employees in its US subsidiaries were injured by inhaling asbestos dust and had successfully sued the subsidiaries in US courts. They applied to enforce judgement against the parent company arguing that Cape had been present in the USA through its subsidiaries as they formed a “single economic unit”.

The Court declined to pierce the corporate veil and held that the “fundamental principle is that each company in a group of companies is a separate legal entity possessed of separate legal rights and liabilities…”

The principle in the case of Salomon was upheld on the basis that the subsidiary companies had been legitimately formed and hence were separate legal entities distinct from the parent company.

However, there is need to look at the economic realities or the corporations with the advancement in industry with the significance of globalisation and treat group companies as one economic entity just like the legislation has been put in place for group accounts and corporate tax purposes and in this vein should concur with Lord Denning who said that:

“I decline to treat the [subsidiary] as a separate and independent entity… The Courts can and often do draw aside the veil. They can, and often do, pull off the mask. They look to see what really lies behind. The legislature has shown the way with group accounts and the rest. And the Courts should follow suit. I think that we should look at the Fork Manufacturing Co. Limited and see it as it really is – the wholly-owned subsidiary of Littlewoods. It is the preacher, the puppet, of Littlewoods, in point of fact: and it should be so regarded in point of law.”

It is argued here that the courts should be more inclined to lift the Corporate Veil to a significantly greater extent in cases involving corporate groups and as Gower rightly observes that, the law can “go behind the corporate personality to the individual members or directors, or it can ignore the separate personality of each company in favour of the economic entity constituted by a group of associated companies.

The Corporate Veil

The corporate veil is the curtain that legally separates the company from its shareholders hence holding the company as having a separate legal personality and limited liability.

In curtailing any abuses of limited liability and the protection of creditors to both small and group companies, the courts have in certain instances, though reluctantly, looked behind the corporate veil to establish the true intent of the controlling officers of the company. The courts have in the rare circumstances ignored the corporate form and looked at the business realities of the situation so as to prevent the deliberate evasion of contractual obligations, to prevent fraud or other criminal activities and in the interest of public policy and morality.

Piercing the corporate veil has not been complicated in one-man companies were the owner is usually the director and hence the controlling officer as compared to group companies which have a layered structure.

The controlling officer will be held liable and asked to account for his actions so that the company can fulfil its financial obligations to its creditors in the event of company insolvency. In the case of Royal Brunei Airlines v Tan made clear.

Lifting the Veil of Incorporation

The corporate veil is a curtain that shields company shareholders and directors from personal liability by the principle of limited liability in the event of the company being insolvent and unable to fulfil its obligations.

The lifting of the corporate veil concept describes a legal decision where the limited company shareholders or directors are held liable for the debts or other liabilities of the corporation contrary to the principle of limited liability.

Whilst there is strict liability legislation to prosecute erring limited companies for statutory offences but were there is insufficient statutory protection, the common law remedy of piercing of the corporate veil is imposed by the courts so as to put liability on the controlling officer (directing mind) of the corporation.

However, the courts have been reluctant to rebut the principle of limited liability and only in exceptional circumstances have they been willing to pierce the corporate veil to establish the true facts. In this way, certain individuals or parent-companies responsible for the company’s actions are held liable so at to account for their decisions as shareholders or directors. Generally, the UK corporate law holds that the shareholders, directors or parent-companies are not liable for corporate obligations of the companies or subsidiaries they control hence maintaining the principles of limited liability and separate legal corporate personality.

The principles of separate legal personality and limited liability have been long recognised in English law and that the shareholders or directors are not liable for the debts of the company as long as it is properly administered. However, in exceptional circumstances, the courts have been prepared to look behind the company and establish the actions or inactions of the directors and shareholders using the process known as “piercing the corporate veil”.

Some commentators have argued that the decision in Salomon gives the “unscrupulous” promoters of limited companies an opportunity to abuse that Companies Act which is not in the spirit in which the Act was enacted.

Piercing the corporate veil is the process whereby the court ignores the principle of corporate personality and holds the shareholders or directors liable for their actions so that they meet the company obligations in their personal capacities. The courts will pierce or the “veil” were the corporate structure has been used as an instrument of fraud or to circumvert the law.

It has been argued that whilst the courts have used the doctrine of “piercing the corporate veil” though reluctantly, it is still not well understood leading to uncertainties in the legal process. Some commentators have argued that the exceptional circumstances in which the courts have justified the piercing of the corporate veil is uncertain as evidenced by the number of contradictory decisions by the courts. Goulding further argues that ‘it is not possible to distil any single principle from the decided cases as to when the courts will lift the veil’ due to the diversity of the cases, though they are more willing in cases of extreme abuse.

In the leading case on this subject, Salomon v Salomon discussed above, the House of Lords maintained that “individuals could organise their affairs as they wanted and that if they chose to do so via incorporation they were entitled to the protection of limited liability as long as the incorporation was in accordance with the formal rules of the relevant legislation”.

Though it is English trite law that the incorporation of a company protects the members from company liability by the principle of limited liability, there are both statutory and common law exceptions to the principle in cases of abuse of the corporate structure.

Statutory Exceptions

Gower and Davies argue that the courts are willing to lift the veil were statutory wording of a particular statute is explicit and specifically provides for it.”HIT_2″ name=”HIT_2″> The courts have resisted the temptation to pierce the veil because they consider it just to do so though they are more willing in exceptional circumstances or were they feel that the shareholders or directors are concealing the true facts.

Tortious Liability

The company is vicariously liable for any torts committed by its employees or agents whilst acting in the course of the official duties and ‘shall not be called into question on the ground of lack of capacity’ whilst the employee or agent remains the primary tortfeasor.

It is therefore clear that the “directing mind and will” of the company can sometimes be personally liable for torts, for which the company is also liable, for their fraudulent acts though done on behalf of the company.

There are various Acts which specifically provide for the lifting of the corporate veil under both civil and criminal jurisdictions which impose strict liability on limited companies.

Duty to prepare Group Accounts

Whilst each company in a group of companies has a separate legal corporate identity and hence required to prepare individual company accounts, section 399 (2) requires that the parent company prepares group accounts at the end of the financial year so as to “give a true and fair view of the assets, liabilities, financial position and profit or loss”. In this way, it can be concluded that the Act looks at the group of companies as a ‘single economic entity’ and in effect lifts the corporate veil contrary to the principles of corporate personality and limited liability without affecting the corporate structure.

Failure to obtain a trading certificate

The Act prohibits a registered company from trading or obtaining credit before obtaining a trading certificate and any directors or shareholders not adhering to these provisions are in contravention of the Act. Any directors or shareholders breaching the Act shall be jointly and severally liable to indemnify the third parties for any loss or damage suffered as a result of the company’s failure to comply with its obligations. Here the legislation is explicit and a director or shareholders breaching the law will be held liable for the company’s obligations before the trading certificate is obtained hence a statutory piercing of the veil of incorporation.

Liability of a disqualified director

The Act gives the courts wide powers to make a disqualification orders and bar a person from holding the position of director or any other management positions of a company on grounds of breaches of company law or matters other than criminal convictions and such disqualification shall not exceed 15 years.

The person disqualified from being a director but who in contravention of the disqualification order, continues to act as director shall be personally liable for all the debts that the company incurs when he was so acting. Equally, any person who knowingly acts on the instructions of a disqualified person shall be jointly and severally liable for the company debts with the disqualified director.

We see here that the legislation has removed the veil on disqualified directors and hold them liable for actions they undertook on behalf of the company hence concurring with Lord Denning’s forceful assertion that “the legislature has shown the way……And the courts should follow suit.”

Insolvency Act 1986

The Insolvency Act 1986 provides exceptions to the principles of limited liability and corporate personality, were there is breach of the company structure to defraud creditors. We look at these exceptions below which when breached leads to the piercing of the veil of incorporation and the directors or shareholders are held personally liable for continuing to trade whilst knowing that the company was in financial difficulties and would not survive.

Fraudulent Trading

This act provides that on winding up, any officer deemed to have knowingly used the company business structure to defraud creditors will be personally liable for the debts of the company and will have to contribute to the discharge of the debts. This Act reduces the chances of the use of the Salomon principle as an instrument of fraud by directors who should have known the true intent of their actions.

Wrongful Trading

Wrongful trading applies where the director of an insolvent company allows the company to continue trading on credit or getting credit with the knowledge that there was no reasonable prospect of the company avoiding liquidation. In such situations and on the application of the liquidator, the Act empowers the courts to lift the ‘veil of incorporation’ of an insolvent company and hold the company directors liable and to make a contribution to the company’s assets.

Some commentators argue that the impact of this section has been a “great disappointment” due to varied judicial approaches which has created a high degree of legal uncertainty and hence a low number of successful court actions.

However, the significance of the Act is that any directors who permit a company to continue trading when there is no prospect of repaying trade debts and avoiding liquidation shall incur personal liability by the courts piercing the ‘veil of incorporation’ for the benefit of the creditors.

Phoenix Companies(The Phoenix Syndrome)

The “Phoenix Companies” refers to a situation where one company is put into insolvent liquidation and another company with the same or similar name is registered with a view of defrauding the creditors by transferring the company assets to a new company.

The Insolvency Act 1986 s 216 provides that anyone who was a director of a company during the 12 months before it went into insolvent liquidation shall become personally liable if he becomes involved with the management of a company with a name similar to that of the insolvent company or a name similar as to suggest that they are associated. Section 217 empowers the courts to lift the corporate veil in such cases and hold the director jointly and severally liable with the company for the debts of the “Phoenix Company” so formed.