Company Law Essay

Peter James and Jenny Shorter are in business together designing and producing ladies hand-made clothing to order. They are based in Chelsea and trade under the name of J & S Fashions. They have not drawn up or signed any documents to form the business, or registered it with anyone. J & S Fashions has recently set up it own web page on the Internet, intending to gain customers that way and to expand. It has been suggested to Peter, by a friend in a pub, that it would make "sound business sense" to run the business as a limited company.

A] What legal sort of business organisation do Peter and Jenny currently have, with what financial implications for them and others?

B] What would Peter and Jenny have to do to form a company? Explain to them what procedures and documents would be involved, what would need to be contained in them and what the legal implications are for them of this change of type of business organisation.

C] Peter favours " The Direct Line Fashions Company Limited", with its modern, high tech. implications as a name for the new company; while Jenny likes the idea of "The Kensington & Chelsea Fashion Centre Company Limited ", as a name emphasising their local origins and giving an up market aura. What are the legal implications, if any, of these choices of name?

D] While the company formation process is going on Peter is offered a chance to buy a large quantity of velvet at a very advantageous price, if he can buy quickly. Peter signs the contract "Peter James - for and on behalf of the Direct Line Fashion Company Limited". What would be the legal position if the velvet is supplied but has not been paid for when the company, having been formed, soon fails and goes into liquidation?

E] The company, having been formed, enters into a contract to buy jewellery, which Jenny sees as ideal for customers to wear with clothes made by the company. The contract is drawn up in the company name and is signed by Jenny "Jenny Shorter - Director". Peter has not been consulted and knows nothing of this deal. What would be the position of the supplier if Peter and Jenny's company went into liquidation without having paid for the jewellery delivered under the contract?

Answer ALL FIVE sections and should quote Statutes and legal precedents in support of your answers where appropriate.

ANSWER A)

Peter and Jenny are currently trading as a partnership. A partnership is created in law when two or more persons agree to carry on a business together. This agreement can either be put in writing or oral. The law relating to partnerships is largely contained in the Partnership Act 1890 (hereafter "PA 1890"). Section 1 of the PA 1890 defines a partnership as:

"the relation which subsists between persons carrying on business in common with a view to profit."

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It is important to note at the outset that, unlike a company, a partnership does not possess a separate legal personality distinct from its members.

Generally speaking, Peter and Jenny can be advised that partners enter into a partnership agreement on the terms that they themselves have established through negotiation and accepted. They are contractually bound by those terms as a consequence, and those terms are susceptible to enforcement at law in the same way as ordinary contractual terms. This is the case unless a term is in conflict with the express provisions of the PA 1890, in which case it is unenforceable.

Although a partnership agreement is contractual in nature, at law the partnership is complicated by the fact that it also establishes a principal/agency relationship. Partners are simultaneously both agents of the other partners and the firm, and principals as regards their fellow partners. As a consequence, Peter and Jenny should be informed that partners owe equitable duties and possess equitable rights that flow from their being in a fiduciary relationship in relation to one another.

In addition to the general fiduciary duties to act with bona fides (good faith) in all dealings, sections 28-30 of the PA 1890 set out various specific duties.

Section 28 establishes a duty of disclosure. This stipulates that Peter and Jenny must render true accounts and give full information in relation to all partnership dealings and matters to each other. For example, in Law v Law (1905) one partner accepted an offer from another partner to buyout his share of the firm. Later the selling partner discovered that certain partnership assets had not been disclosed at the point of sale and he applied to court to have the contract set aside. It was held that there had been a breach of the duty of disclosure and that the contract could be set aside.

Section 29 sets down a duty to account. Peter and Jenny should be informed that partners must account to the firm for any benefit obtained from any transaction concerning the partnership directly or indirectly unless full disclosure has been made and consent has been obtained in advance. In common with all fiduciary duties, this duty is far reaching. In Pathirana v Pathirana (1967) A and R were partners in a garage that was owned by a company of which they were agents. R terminated the partnership and formed a new arrangement with the company in his sole name. The court held that the agency agreement was in law a partnership asset and R's use of it for his own purposes was in conflict with his fiduciary duty. A was deemed to be entitled to a share in the profits in the new undertaking.

Section 30 establishes a duty not to compete. A partner is liable to account to the partnership for any profits made in the course of any business in competition with the partnership business in which he is involved unless full disclosure and consent has been obtained in advance. The concept of competition in this context is discussed in the case Trimble v Goldberg (1906).

As to the question of partnership property, Peter and Jenny can be advised that property may be owned collectively by the partners and thus constitute partnership property, or it may remain the personal property of one partner although it is used by the partnership as a whole. Sections 20 and 21 of the PA 1890 are applicable in this context.

One distinctive feature of the partnership model is the unlimited liability of the partners. Peter and Jenny should bear in mind that each partner is personally liable for all of the debts of the partnership. This includes any debts incurred by any of the other partners in their dealings on behalf of the partnership. Any one partner has the capacity to bind the partnership by entering into a contract on its behalf.

Section 5 of the PA 1890 provides that every partner is an agent of the firm and the other partners. This means that Peter and Jenny have the power to bind each other in regard to business transactions they may enter into individually on behalf of the partnership. The partnership agreement may limit the powers of particular members, but this limitation may only prove effective if third parties have had proper notice of it. If a partner acts within the usual scope of the partnership business in a transaction and the third party has not been informed of limits on his powers the firm may remain liable. See for example Merchantile Credit v Garrod (1962).

In general a partner's implied authority extends to all normal business affairs of the partnership, including (but not exclusively) the power to: buy and sell the firm's goods; borrow money on the firm's credit; pledge the firm's assets as security for a loan; appoint employees; employ a legal representative to act for the firm.

It should be emphasised to Peter and Jenny that ach partner is responsible for the full amount of the firm's debts and liabilities. Third parties have the option to pursue recovery action against the firm collectively or against the partners individually. That said, where damages are recovered against one partner, the other partners owe a duty to contribute equally to the amount of the claim.

Peter and Jenny should note that liability on debts and contracts is joint between the partners under section 9 of the PA 1890. Section 10 of the PA 1890 provides that the liability of partners with regard to torts and other wrongs committed in the ordinary course of the partnership business is joint and several. This means that there is nothing to stop a third party taking successive actions against individual partners in order to recover the full amount of a claim. Civil wrongs committed outwith the scope of partnership business are the personal liability of the partner responsible.

ANSWER B)

Peter and Jenny can be advised that the incorporation of a company is a surprisingly simple process, but certain procedures must be strictly followed.

Peter and Jenny should be informed at the outset that companies differ from partnerships in that at law they are deemed separate legal entities from their members (or shareholders). A case in point is the celebrated Salomon v Salomon & Co (1897) in which the major shareholder in what was effectively a one-man company was distinguished from the corporate entity and allowed to step aside from the companies liabilities and to enforce a preferential debt against it. This is the chief legal implication inherent in the change from partnership to corporate status of which our clients should be made aware.

The consequences of the separate corporate identity are also important. The company has full contractual capacity and can sue and be sued in its own name. Moreover, each shareholder owes only limited liability under this form of business organisation. This means that Peter and Jenny will be liable only to the extent of the value of their shareholding in the company. The membership may also change leaving the company unaffected (this is known as perpetual succession).

Business property is owned not by the members but by the company itself: Macaura v Northern Assurance (1925). In the stated case this aspect of the corporate identity had serious consequences for its major shareholder, who had insured company assets (a timber plantation) in his own name just prior to a fire. Peter and Jenny must take care to ensure that insurance of the company assets is in order and in particular that it is drawn in the name of the company.

Having briefly discussed the consequences of incorporation we can return to advise Peter and Jenny as to the steps necessary to form a company.

The Companies Act 1985 (hereafter "CA 1985") lays down the procedure which must be complied with in order to establish a company capable of legal operation. Under section 10 of the CA 1985 a registered company is incorporated when specified documents are delivered to the Registrar of Companies. These documents are: the memorandum of association; the articles of association; and a statement giving details of the first directors and secretary of the company, complete with their written consent to act and the address of the company's registered office. Section 12 of the Act provides that a statutory declaration of compliance, confirming that all the necessary requirements of the CA 1985 have been met, must also be submitted.

The memorandum of association must state the companies capital structure, its powers and its objects. It must be signed by at least two subscribers from among the company's first shareholders.

In particular the memorandum must contain several specified clauses. These are discussed, in brief, below.

The name clause must set down the name of the company. Section 25 of the CA 1985 provides that the name of a public company must end with the words public limited company and that the name of a private company limited by shares or guarantee must have the word limited at the end of its name. The name cannot be the same as one already registered, it cannot constitute a criminal offence, be offensive or suggest an unauthorised connection with a public authority: section 26 CA 1985.

The registered office clause gives the country of domicile of the company's legal address - ie. England, Scotland or Wales.

The objects clause sets out the purposes for which the company has been formed. In the past this clause was often drafted in extensive terms and gave rise to difficult case law (on the ultra vires issue) but as a consequence of reform implemented by the Companies Act 1989 it now it is possible to form a general commercial company which is empowered 'to carry on any trade or business whatsoever' and 'to do such things as are incidental or conducive to the carrying on of any trade or business'. Section 3(A) of the CA 1985 is applicable.

The limited liability clause states that the liability of its members is limited. The authorised share capital clause states the maximum amount of share capital that the company is authorised to issue, which must be divided into shares of a fixed monetary amount. Lastly, the association clause provides the formal undertaking that the subscribers to the memorandum wish to form a company and that they agree to take the number of shares written opposite their name.

The articles of association can be described to Peter and Jenny as the company's internal rule book. The articles govern the rights of members and their relationship with the company. On this point it should be noted that section 14 of the CA 1985 states that the articles are to be treated as an enforceable contract on membership matters (but only on membership matters - third parties cannot be bound and members seeking to rely on the articles in regard to matters not strictly related to their membership will fail: Eley v Positive Government Security Life Assurance Co (1875).

The articles also cover the other internal workings and procedures of the company, such as the allotment and transfer of shares, directors powers and duties, the rights attaching to shares, and procedures for the convening and conduct of meetings.

Peter and Jenny have the option to draw up their own set of articles if they wish, but this is may be a lengthy, difficult and expensive procedure and they may prefer to adopt the model form of articles known as Table A, which is provided by the Companies (Table A-F) Regulations 1985. Peter and Jenny are free to modify Table A to their own specifications if they see fit to do so. This is the most popular option nowadays.

ANSWER C)

The choice of company name is an important decision and one that must be made within a predefined legal framework in the context of the full list of other companies on the register.

Peter's choice of name is "The Direct Line Fashions Company Limited". Unfortunately, this may prove to be ill-advised. This choice of name will expose the company to the threat of a so-called passing off action. Direct Line is a well established brand name associated with a leading insurance company. Passing off is an established tort which operates to prevent a company from piggybacking on the reputation of another company and thereby diverting business from that company. In Ewing v Buttercup Margarine Company Ltd (1917) the plaintiff was able to stop the defendants using a name which was suggestive of a link with his company. It is however pertinent to note that both companies were engaged in the dairy business and therefore the risk of confusion was greater than it might have been if the companies had operated in different sectors. See also Chill Foods (Scotland) Ltd v Cool Foods (1977).

However, Peter may draw confidence from the fact that in Stringfellow v McCain Foods GB Ltd (1984) the owner of the well known London night club was unsuccessful in preventing the potato chip manufacturer from calling their long thin oven chips by the same name. This is because the two businesses operated in totally different sectors and so the risk of confusion between the two, and thus the risk of diversion of business, was remote.

It is apparent that in this context the risk of confusion between an insurance company and a small hand-made fashion retailer is also remote. Therefore there is a possibility that any challenge made by Direct Line would prove unsuccessful, but perhaps Peter and Jenny would be best advised to choose a different name to avoid the threat of becoming involved in time consuming and expensive litigation altogether.

We are advised that Jenny prefers the idea of "The Kensington & Chelsea Fashion Centre Company Limited". Unfortunately "Kensington & Chelsea" is the designation of a royal borough in London and also included in the name of a local authority and this may also cause difficulties. The registrar may refuse to register the new company under section 26(2) of the CA 1985 if this name is selected.

Given that both the chosen names may be subject to challenge Peter and Jenny are probably best advised to use their imagination to come up with an alternative. Given that their options are almost infinite this should not prove to be too much of a burden.

ANSWER D)

Advice on this scenario requires consideration of the law relating to pre-incorporation contracts. Peter and Jenny should be advised that when a company promoter enters into a contract on behalf of a company that is yet to be incorporated a difficulty arises because the company does yet exist as an entity and cannot be bound by the terms of any contract made.

In the case Kelner v Baxter (1866) a contract for the delivery of goods was made on behalf of a company yet to be formed, with the aim that the company could sell the goods on incorporation. When the bill went unpaid the court held that the company could not be liable and that the promoter who had acted on behalf of the company was personally liable to pay the bill.

Confirming this common law rule, section 36C(1) of the CA 1985 provides that:

"a contract which purports to be made by or on behalf of a company at a time when the company has not been formed has effect, subject to any agreement to the contrary, as one made with the person purporting to act for the company or as agent for it, and he or she is personally liable on the contract accordingly."

Peter must therefore be advised that he risks personal liability to pay the bill for the velvet if the company fails before rendering payment on the contract. In Phonogram Ltd v Lane (1982) the court ruled that for a promoter to avoid personal liability the contract must include a term that expressly provide for his exclusion on the incorporation of the company. It is not known whether Peter has done this. For future reference Peter should also be advised that he should include a rescission clause in any pre-incorporation contract which allows him to rescind the contract if the company fails to be incorporated.

ANSWER E)

In answering this part we assume that the company (ostensibly incorporated for the purpose of making and selling hand-made clothing) has been formed as a general commercial company under section 3(A) CA 1985, or with objects wide enough to include the purchase of jewellery. If not it may be the case that the contract is deemed ultra vires.

If the company is now in liquidation the supplier must be advised to wait for the liquidator to ascertain and swell the company's assets before distribution can take place. Unfortunately as an ordinary trade creditor the supplier must stand in line behind other creditors etc before receiving payment. The costs of winding up, preferential debts, PAYE, National Insurance contributions, VAT and sundry taxes, an amount of salary and holiday pay, and floating charges will all be paid before unsecured ordinary creditors such as the jewellery supplier in this case.

The fact that Peter has not been consulted and knows nothing of the jewellery deal is not relevant to the question of liability. It is the company, as a separate and distinct legal entity, that is liable to pay the debt: Salomon v Salomon & Co (1897). The concept of limited liability refers, of course, to the members, not the company itself. The company's liability is always unlimited in the sense that it must discharge its liabilities as long as it has assets to do so. If there is any money left over after those calls on the assets that take precedence are discharged, the supplier may either receive full payment or part payment, subject to the amount of money remaining. Part payment may be in the form of, for example, 20p on the £1 or some other percentage, if insufficient money is available to discharge all unsecured trade debts.

Limited liability operates in this context to limit the potential liability of Peter and Jenny to meet the jewellery bill to the extent of the value of their shareholdings. Once Peter and Jenny have paid the company for their shares their liability is discharged completely and they cannot be made responsible by the supplier for making up the deficiency of the company if it fails to pay the jewellery bill in full.

This is the textbook answer to the question. In the real world, as owner-directors of a small private limited company, Peter and Jenny would most likely have been expected to give personal guarantees to major creditors of the company - who are well and painfully aware of the advantages of limited liability. As a consequence, in practice their liability might well exceed the value of their shares. Other assets they own may be in jeopardy. The question is silent on this point.

BIBLIOGRAPHY

Black's Law Dictionary
Bisacre, Smith and Keenan, Company Law for Students, (2002), Longman
French, Statutes on Company Law 2005-2006, (2005) Oxford University Press
Shepherd (ed.), Company Law Casebook, (1994) HLT Publications
Mayson, French and Ryan, Mayson, French and Ryan on Company Law, (2005) Oxford University Press

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