Companies and Separate Legal Personality
As you might already know, a limited company is treated as a separate legal entity meaning it is treated as a 'separate person' - any assets of the company are the property of the company itself and no one else's. The same goes for its debts.
The main effect of this is that when things go wrong and shareholders or directors of a company go bankrupt, their creditors (the people who lent them money) cannot go after the property of the company. That property does not belong to the shareholders and directors. Similarly, when a company goes bankrupt, its creditors cannot go after the property of the shareholders and directors. This is the whole point of limited liability.
How Sneaky Businessmen Abuse the System
- Where there is a system there are clever people making the most of it, and, naturally, some try to exploit it.
- In the latter case, the court will very rarely ignore the separate legal entity doctrine and treat directors and companies as one and the same. This is called 'piercing the veil of incorporation'.
- It must be stressed that this does not happen often and the expectation in a given case is that it won't happen. This is because one of the key benefits of incorporation is that directors can take risks without concerns that they themselves will be involved personally.
- Moreover, when it does happen the 'limited liability' part of incorporation is not affected at all. That is to say, although they are treated as being one person, the company will not be held liable for the debts of the directors and the directors will not be held liable for the debts of the company.
- The leading case is Salomon v Salomon & Co Ltd and shows the court's strong inclination to upholding the importance of the separate legal entity doctrine.
Salomon v Salomon & Co Ltd
Salomon was a sole trader dealing in leather. At the time, there needed to be at least 7 shareholders in order for a company to exist.
What did Mr. Salomon do that was so dastardly? He set up a company - Salomon & Co Ltd - by giving 6 of his family members a single share each, so that there were 7 shareholders.
Of course, in creating the company, he assigned himself as the managing director.This meant that he had full control over his sole trading leather business as well as over this new 'Salomon & Co Ltd' company.
What's the big deal? The big issue is that his next step was to make 'Salmon & Co Ltd' buy his sole trading business for a ridiculously high price.
Salmon & Co Ltd gave the following to Mr Salomon:
- £20,000 worth of shares costing £1 each (leaving him 20,001 shares in total)
('Charge' here means that if the company fails to pay the debt when it is due or on the terms agreed upon in the debenture, the company's assets will be sold in order to pay for it - just like in a mortgage where there is a 'charge' over a house - if you fail to pay your mortgage bills, the bank will repossess your house in order to pay for the debt you owe).
- £10,000 worth of debentures (a document that says the company owes a debt of £10,000 to Mr Salomon) which was charged over the company's assets
- £9,000 cash.
What were the effects of this transaction?
The most important effect of this is that Mr Salomon no longer had to risk all of his personal assets when doing business (remember, a sole trader has unlimited liability but a limited company does not). Instead, if his company went into insolvent liquidation (bankruptcy) then creditors would only be able to take from the company's assets and not his own.
However, since Mr Salomon also had £10,000 worth of debentures charged over the company's assets, if the company did go into insolvent liquidation, he - as a 'secured creditor' - would have first pick at the company's assets to satisfy the £10,000 owed to him. He therefore limited his liability as well as ensuring he would get lots of money in the event that his new company failed.
It is easy to see, then, that Mr Salomon benefited immensely from starting up a company with the aid of his family members: he gained limited liability and secured £9,000 (back then a very large sum of money) over the company's assets.
This all sounds great for Mr Salomon, what's the problem?
The loser in this is anyone that deals with Salomon & Co Ltd because no one can touch the company's assets to gain repayment for debts they are owed - the assets of the company would be sold to pay Mr Salomon's debt first.
This is exactly what happened: Salomon & Co Ltd ran into financial trouble and one of the creditors (realising there were not enough assets to satisfy all of the debts) challenged the validity of Salomon & Co Ltd as a company, calling it a sham. The Court of Appeal agreed with the creditor, but the House of Lords unanimously overruled the Court of Appeal and held that regardless of the fact that Mr Salomon's only motive in starting up the company was to avoid liability, the Companies Act was satisfied and therefore there was a real, legitimate company.
The Rare Exceptions
- Salomon v Salomon & Co Ltd remains good authority for the sanctity of the separate legal entity doctrine, but as stated there are rare exceptions.
- The main exception is that if incorporation contradicts the intentions of Parliament in statutes or the intentions of parties in contracts, it is for the court to ignore the concept.
- This is simply common sense: it would be out of place (in the case of statutes and parliamentary will) and simply cruel (in the case of contracts) to go against the clear intentions of those around them.
- The court is bound to carry out the will of parliament and since you can simply contract out of limited liability, it makes no sense to go against the written intentions of both parties to a contract.
Outside of Statutes and Contracts
Apart from that, there have been four different arguments seriously considered by the courts in the past when deciding whether to pierce the veil of incorporation.
- The 'Sham Companies' Argument
This is the most important argument to remember. The Court of Appeal in Adams v Cape Industries Plc (1990) explains 'there is one well-recognised exception to the rule prohibiting the piercing of the 'corporate veil' which is where a company is used as a 'mere façade concealing the true facts'. Even this argument is not too hopeful, however, because the court has been 'left with rather sparse guidance as to the principles which should guide the court in determining whether or not the arrangements of a corporate group involve a façade'.
- The 'Single Economic Unit' Argument
This is where it is claimed that a group of companies are actually just one company and so creditors can go after any assets of any company within the group. Typically this argument is raised where the wholly owned subsidiary (child) of a parent company does not have enough assets for creditors to satisfy their debts and so the creditors go after the assets of the parent company instead. Whilst the Court of Appeal was slightly positive about this argument in Adams v Cape Industries Plc (1990), saying that it is of value to consider when one company fully controls another for interpretation of intention in statutes and contracts, they otherwise shut down the possibility of raising it as an independent reason to pierce the veil of incorporation.
- The 'Agency' Argument
In the absence of a clear agreement (e.g. in a contract) there is no assumption that shareholders are the agents of their companies and so the agency argument simply does not work here. However, if a parent company authorises a subsidiary to act as an agent for them then, as long as the subsidiary acts within the authority granted to it, its actions will bind the parent company (allowing creditors to take from its assets where applicable).
- The 'Unlawful Act' Argument
In Re H, the defendants committed excise fraud and the courts decided to pierce the veil of incorporation and seize assets from the company the defendants owned and controlled together. What is interesting is that the company itself was not convicted but its assets were still taken. It could thus be argued that the courts are more inclined to pierce the veil where unlawful acts are perpetrated. Other cases involve Gilford Motor Co Ltd v Horn and Jones v Lipman. These are detailed below.
Cases where the Veil was Lifted
Gilford Motor Co Ltd v Horne (1933)
An employee was bound by a covenant to not solicit customers from his former employers but to get around this set up a company and did so anyway. The court said this was a mere front for Mr Horne's restricted activity and so granted an injunction to stop him (and the company) from doing it again.
Jones v Lipman (1962)
Having entered into a contract to sell his land, but then deciding he no longer wanted to sell, Mr Lipman created a company and transferred the land to it (claiming he could no longer sell his land as he did not own it).The court lifted the veil of incorporation and held that the company was a mere front for Mr Lipman, granting an order for specific performance to transfer the property.
Cases where the veil was not lifted
Lee v Lee's Air Farming Ltd
Lee was in the business of aerial topdressing - using aeroplanes to fertilise farmland. He formed a company of which he was the beneficial owner of all shares and the sole governing director. He also appointed himself as chief pilot. Unfortunately, he crashed and died. The question was whether, in his position as chief pilot, he qualified as a worker under the Workmen's Compensation Act so that his family could claim the insurance on his death. The court found that he did qualify, and did not lift the veil of incorporation to find that actually he was not a worker but the owner of the company.
- The conclusion can only be that the courts are very unwilling to pierce the veil of incorporation, shutting down most arguments on the matter.
- This leaves piercing the veil of incorporation to be placed in the pile of other legal actions such as frustration or non est factum in contract law which - although successfully raised in the past - are highly unlikely to help anyone again. Businessmen can rejoice in the safety of their assets.
- You didn't learn the term for nothing, however, since as stated the court does consistently pierce the veil for statutes and contract purposes.
fbruce on November 23, 2015:
Interesting article, thanks for taking the time to put this together.