The Doctrine Of Separate Legal Personality Law Company Business Partnership Essay

Published Date: 02 Nov 2017

There were many problems which arose from the application of Salomon. Firstly, separate legal personality and limited liability. Although they are linked, they are not the same thing. Its difference will be highlighted via reference to the facts of the case.  

It is clear from the facts that Mr Salmon, in accordance with the Companies Act, registered his sole trading business, and thus, the company established its own identity in law. This concept of separate legal personality was emphasised by Lord Halsbury who stated that:

 ‘It seems to me 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’ [3] 

 It follows that the rights and duties of a corporation are not the rights and duties of its directors or members who are, most of the time, obscured by a corporate veil surrounding the company. [4] A good illustration of separate legal personality can be seen in the case of Lee v Lee’s Air Farming [196]. [5] This case concerned Mr Lee who incorporated a company, Lee’s Air Farming Ltd in August 1954. He wore three hats as far as the company was concerned. He was the vast majority shareholder [His solicitor was the only other shareholder], he was the sole governing director for life and he was an employee of the company [6] . He died in March 1956, to which his widow claimed she was entitled to compensation under the Workers Compensation Act 1992. The Court of Appeal of New Zealand Initially held that, Mr Lee did not fall under the ambit of the act due to all the positions he acquired, however this decision was reversed by the Privy Council who held that Mr Lee and the company were disconnected, in other words separate legal entities therefore the widow was entitled to compensation under the Act.

Limited liability is the logical consequence of the existence of a separate personality. The concept of limited liability was introduced by the Limited Liability Act 1855, its purpose was to generate economic growth in the wake of the industrial revolution as it encouraged entrepreneurs and investors to join forces to raise and trade capital. [7] Limited liability was a rationale in Salomon. Upon incorporation Mr Salomon’s personal liability for the debts of the business had changed from unlimited liability as a sole trader to limited liability as a shareholder in the company. [8] Limited liability is where the liability of an investor, upon insolvency is only attached to the amount of capital invested in the firm. In essence the shareholder does not have to surrender their own personal wealth, in order to help the company pay their creditors upon liquidation. For a small business, limited liability, gives them access to an avenue via which to escape the "tyranny of unlimited liability" [9] A limited liability company applies to both a private limited company, just like Salomon Co Ltd and public limited company, where shares are sold to the public on a stock . It also now applies to Partnerships via the enactment of the Limited Liability Partnership Act 2000.

Corporate personality and limited liability is sometimes accompanied by the potential abuse by entrepreneurs of the corporate structure. This was the basis of the Court of Appeals Judgement in Salomon. They held that the formation of the company was a sham and Mr Salmon was merely an agent for it. They also argued that the formation of the company was contrary to the true intention of the Companies Act as the Act required 7 shareholders in which Mr Salomon used his family members (wife and children) in order to fulfil the requirement, they had no interest in the company. One can also abuse the corporate form in the same manner as Mr Salomon as [they] may create a company to which the very object of the creation of the company and the transfer to it of the business is, that whereas the liability of the partners for debts incurred was without limit, the liability of the members for the debts incurred by the company shall be limited. [10] Such companies can be referred to as ‘One Man Companies’ if the only thing being changed is their liability with the individual still acquiring a number of post. An example of an individual abusing the corporate form can be seen in the case of Jones v Lipman [1962] [11] . In this case, Lipman conveyed his house to Jones through a written contract, however the contract was not completed and in order to avoid completion Lipman transferred the house to a company he created. Russell J, in the High Court, ordered specific performance against both Lipman and the company. In his judgement he further stated that:

The defendant company is the creature of the first defendant, a device and a sham, a mask which he holds before his face in an attempt to avoid recognition by the eye of equity [12] 

Lipman was hiding behind the shield of limited liability. It is important to note that such abuse may result in the Court disregarding the principle of limited liability thus holding the individual personally liable for the company’s debts. This is referred to as piercing the corporate veil.

Firstly, the most notable advantage of limited liability for a business entrepreneurship is linked to the minimisation of risk. This advantage is not only limited to shareholders, it also extends to some creditors. Shareholders hide behind the corporate veil, to which this protection encourages them to take reasonable risk. This risk is usually in the form of investments as there is a partition between the individual’s personal wealth and the companies assets, therefore, in the event of insolvency the business failure will not make the shareholder personally liable and accountable to creditors. However, risk also has the ability to encourage continued trade in circumstances where the health of the enterprise is critical, to the point of fatality. [13] Hansmannn and Kraakman (2000) also noted that limited liability serves to put the business assets of an individual out of reach of that individuals personal creditors [14] . However it should be noted that shareholders have the potential to only lose what they invested in to the company. Overall less economic risk means that shareholders are likely to invest more thus causing increased capital which is a true reflection of limited liability being described as a vehicle of economic growth. Powerful creditors, on the other hand, have priority over vulnerable creditors who cannot make a claim against shareholders etc. In the event of undercapitalisation of a company a creditors risk may be minimised if they have secured a charge over the company’s assets (fixed charge) or over the company’s stock (floating charge). Large creditors can further protect themselves by charging a risk premium which is additional interest so that if the business fails the creditors will be afforded compensation.

It is clear that the advantage imposed upon creditors is at the detriment of shareholders hence the reason Griffin stated that:

‘the advantage of limited liability [of shareholders] may, in one real sense be artificial because large creditors are likely to demand personal guarantees…[therefore] the company’s human constituents will gain little from having traded the enterprise as a limited liability company.’ [15] 

Secondly, a limited liability business is offered taxation advantages. Entrepreneurs are more inclined to invest in a business knowing that they are being paid dividends instead of being paid in the form of pay packets. Corporation tax on dividends is only 10% if profits are up to the level of £10,000 and 20% between £50,000 - £300,000, after deducting all expenses including director’s remuneration. [16] 

It is also important to note that directors are not exposed to National Insurance charges and therefore, not subject to the higher (personal) tax rules placed on sole traders or partnerships which can reach 40%. [17] 

Another way in which Corporations can benefit from tax minimising is through income splitting (encouraged by dividend imputation). [18] This is reflected in the case of Hobart Bridge Co Ltd v FCT (1951) [19] .

Thirdly, Members are protected from the companies’ liability and as such are protected from litigation. Limited liability controls floodgates of litigation as those with unlimited liability are exposed to court proceedings. Without such security, creditors would constantly be targeting people’s assets, making wealthy individuals very vulnerable. This allows directors to proceed with litigation in full knowledge that there will not be held liable. However, it appears that this will not stand the test of time as ‘directors of a near insolvent company who is not a party to the litigation could be described as the "real party" seeking their own benefit from the litigation and also controlling / funding the litigation, even where he has acted in good faith may be order to pay the Defendants cost’. [20] This can also be framed in terms of ‘piercing the corporate veil’ if the director is hiding behind in a litigation.

Fourthly, Limited liability means members of business entrepreneurships have a separate identity from the company, as I stated previously. This in itself offers numerous advantages for both the company and its members. A corporation has perpetual succession and will not cease to exist, if, for example the life of the members were to end. This is seen in the Australian case of Re Noel Tedman Holdings Pty Ltd (1967). [21] Â Similar to Salomon, the shareholders and directors were Mr Teadman and his wife. The legal existence of the company was not aborted, although they both died. The company also has the right to sue as established in Foss v Harbottle (1843). [22] In addition The company holds power over its assets, for example property, as in the case of Macaura v Northern Assurance Co. Ltd. (1925). [23] The House of Lords held that although Mr Macaura was majority shareholder he did not own the timber, it belonged to the company. Lord Wrenbury stated that:

"…even if he holds all the shares is not the corporation, and that neither he nor any creditor of the company has any property legal or equitable in the assets of the corporation." [24] 

The fact that members do not have a proprietary interest over the company’s assets can also be a disadvantage as in the case of Macaura who could not seek a claim under the policy for the destroyed timber.

Furthermore, Limited liability helps facilitate a public share market. In a company with limited liability the standard share price is influenced by the market’s perception of the company’s information. If the company is being operated under a system of unlimited liability then the value of the shares will be dependent upon the wealthy shareholder. Once again this will put wealthy shareholders, as opposed to poor shareholders at risk of being sued. Limited liability, therefore, promotes the development of a liquid market as opposed to hindering it, because with unlimited liability the shares will only be assed when the buyer’s private assets have been assessed.

Additionally, the Salomon principle, of Limited liability can be applied to the relationship of parent and subsidiary companies. Under law, they both have separate legal identities. Therefore if the subsidiary was to become insolvent the parent company will not be held liable, in other words they are not accountable for each other’s actions. Nevertheless, such separation can be a drawback to the parent company for example Barings Plc (in liquidation) v Coopers & Lybrand (no4) [2002] [25] a loss suffered by a parent company as a result of a loss at its subsidiary was not actionable by the parent – the subsidiary was the only proper claimant. [26] 

The Salomon principle provides an ideal vehicle for fraud.  Because of its malleability and facility for protecting directors and members against the claims of creditors, the corporate form has been responsible for the development of many different forms of fraudulent or anti-social activity. [27] As seen above in the case of Jones v Lipman

Finally Limited Liability encourages undercapitalisation as it is very easy for private limited companies to be incorporated thus endangering small trade creditors, consumers and tort victims. The law, therefore, frequently deprives the creditor, the consumer and the injured party of a remedy. [28] A limited liability corporation that is set up undercapitalised can be seen as an attempt, to carry out fraud by the directors and members who do not claim liability.

In the United States it has been stated, in the case of US v Milwaukee Refrigerator Transit Co. (1905) [29] "...where the notion of legal entity is used to defeat public convenience, justify wrong, protect fraud or defend crime, the law will regard the corporation as an association of persons." [30] This position is similar in the UK as the Court will remove the veil of corporation if they can prove such an event occurred.

It can be argued that the justifications of the Salomon principle may be problematic as it has the ability to be a two edge sword. However Salomon's case endowed companies with all the requisite attributes with which to become the powerhouse of capitalism [31] as it provides overall protection for shareholders and members in a business enterprise, in the form of limited liability and corporate personality. Its benefits have the potential to be further exalted if shareholders/members did not abuse their power. Their abuse has caused this area of law to be the subject of reforms for example imposing an obligation upon members of a private company to personally guarantee their debts up to the minimum prescribed level of capital [32] has been suggested. While such reforms would not eradicate abuses of the limited liability form, they would nevertheless go some way in proving a more secure commercial environment [33] .

To Encapsulate, The proponents of limited liability [and separate legal personality, both established in Salomon] have extolled it to such a degree, describing it as "the corporation's most precious characteristic" and heralding it as the instrument that has substantially contributed to enterprise progress, above all other legal innovations in company law. [34] Therefore, in essence as far as business entrepreneurship is considered Salmon is justified and will always been applied.