Business and Corporate Law: Analysis of Lorraine and Brenda - Case Study Example

The assessment Lorraine and Brenda have been in partnership for many years in the antique trade in Essex. They have decided to incorporate their business as a private company limited by shares, called 'South East Antique Shop'. They will continue to trade in Essex but intend to have the company's registered office located in Chancery Lane, London. As an expert on corporate law you are requested to advise on the matters listed below: a. How can they minimize the risk to the assets to be transferred to the company should the business fail b. What provisions should be included in the Articles of Association to ensure that Lorraine and Brenda can retain control over the business c. To what extent can the company's financial affairs be kept secret from the public d. What statutory books and registers must be kept at the company's Chancery Lane premises and what may be kept at the trading premises in Essex What are the rights of the members, the creditors and the general public to inspect these books and registers e. To what extent, if any, could Lorraine or Brenda or both incur personal liability for the company's debts if the business fails f. Prior to incorporation, Lorraine, as promoter, entered into a contract to purchase office accommodation for 'South East Antique Shop' from Alfie; but now Alfie does not want to honor the contract. In this assignment the business, which has been trading successfully as a partnership for many years, has decided to become a private company limited by shares. As such, they will be incorporated and registered under the Companies Acts, the main one of which is the Companies Act 1985. Under this act, the company must have a registered office1, which Lorraine and Brenda wish to have at Chancery Lane, London. The Act allows two or more persons to form a company with limited liability for any lawful purposes by following the formal requirements of the Act2. A memorandum and articles of association, which are the rules that govern the running and relationships of the company must be provided to the registrar as part of this process.3 I will look at the specific concerns that Lorraine and Brenda have with regard to this process and its results and will advise them of the statute and case law that is relevant to their concerns. a. How can they minimize the risk to the assets to be transferred to the company should the business fail If the business were to fail, we would be looking at a situation of corporate insolvency. This is now regulated by the Insolvency Act 1986 which amended the law in this area. Before getting into the details that regulate insolvency under the act I would like to just review the basics which you may already be aware of. As you have been acting under a partnership for some years you will have a general idea of how your business is performing and the likelihood of its future success. I do not see the change from partnership to limited company effecting your trading prospects materially. Therefore, if you have been successful as a partnership there is every reason to expect this success to continue after the change to company. You will have been used to operating under the partnership in a situation of unlimited liability. This means that in the event of the business failing, you both personally would have been liable for all of the debts of the business and stood to lose your homes and all of your personal assets. Fortunately, under a company, you will be protected by limited liability and this means that your personal assets will not be used to pay off the debts of the company unless some kind of fraud or wrong dealing is at play. However, all the assets of the business will be available to creditors of the business, and therefore, you should be very aware that any assets you transfer to the business will not be protected by the principle of unlimited liability and will be available to creditors should the business fail. Therefore, one way to minimize the risk of such loss is to avoid transferring unnecessary assets from the partnership to the business. If the partnership owns assets that need not be transferred to the business, then you should keep ownership of them personally and they will thus not be available to creditors of the business. For example, if the premises you are trading out of is owned by the partnership, you should take ownership of it as individuals and then rent it to the business. The same could be true of vehicles if you are using them for both personal and business purposes. This tactic however, would only be successful with assets that genuinely and reasonably could be held as owned by you as an individual and not by the business. For instance, a delivery van with the name of the company painted on its side might fairly be assumed by creditors to belong to the business while the cars you both drive personally could fairly be assumed to be owned by you individually. You should be careful when retaining ownership of assets used by the business as the Insolvency Act provides that any director or other officer of the company who has misapplied or retained or become accountable for assets of the company, or who may have become guilty of a misfeasance or a breach of trust may be ordered by the court to return such assets or contribute to the assets of the company by such amount as the court sees fit.4 Therefore, while it is perfectly legitimate to allow the company only to own such assets as it needs, and not have ownership of any of your personal assets, if you were seen by a court as acting in breach of trust by artificially striping the company or denying it ownership of the assets that it is seen as using, then under section 212 of the Insolvency Act you could be made personally liable to contribute to the company as much as the court sees fit5, and this could be by more than you had withheld from the company. On a purely practical note also, it could be difficult for the business to receive credit or loans in the first place if it cannot show some amount of assets with which to back them up. b. What provisions should be included in the Articles of Association to ensure that Lorraine and Brenda can retain control over the business Lorraine and Brenda are right to consider this point now. While it may be that presently they are the only two members of the company, it is very possible that in the future, in order to raise capital or bring in expertise, other members will be allowed to join in the company and buy shares in it. If this were to happen, it is possible that control of the company could eventually fall from Lorraine and Brenda to other shareholders. Also, the articles of association are the correct place to deal with this concern as they govern the dealings of the members of the company between each other. As has been said in numerous cases, the articles regulate the rights of members 'inter se'.6 The most usual way to ensure that control can be maintained by present shareholders is to designate certain shares, which only the two present members presently own, as preference shares. Other shares can be designated as ordinary shares. This designation must be set out in the articles of association. For example, the Table A articles provide, 'Subject to the provisions of the Act and without prejudice to any rights attached to any existing shares, any share may be issued with such rights aor restrictions as the company may by ordinary resolution determine.'7 While preference shares can be used for a variety of purposes, such as to provide for the payment of a special preference dividend, Lorraine and Brenda could issue such shares with preferential voting rights. Alternatively, if they have already issued themselves with ordinary shares or they wish to do so, they could create a class of preference shares to issue to subsequent shareholders which, although have rights to dividends and profits, may have no voting rights. In this way Lorraine and Brenda can raise capital, bring in new members to the company, but retain full control of the running of the company for themselves. It must be noted that the various rights of different classes of shares must be either stated in the Articles, the Memorandum or in some other document that is registered with the Registrar of Companies. Another thing they may wish to do is restrict the transferability of their shares. So that if theirs are the only voting shares in the company, one of the partners cannot sell her shares to an investor and thus give her share of control to the new investor. This could be achieved by making it a condition that each of them must first offer their shares to the other before selling them to anyone else, or that they can only be sold to the other. This would have the effect of excluding the danger not that future investors dilute their original control, but that one of them doesn't sell her share of the control against the wishes of the other. Both situations should properly be dealt with to provide against the threat that control will not be wrested from either of them without her consent. c. To what extent can the company's financial affairs be kept secret from the public One of the potential disadvantages of operating as a private limited company is that there is far less privacy available to the business. While trading as partners, the accounts and finances of the company could be kept in relative secret. However, a company being limited in liability to the assets of the company, is subject to far more strict requirements of public disclosure which any member of the public can then rely on before deciding to deal with, or invest in, the company. Under section 226 of the Companies Act 1985, the company will have to prepare statutory accounts each year known as 'individual accounts'. This will basically require an end of year balance sheet and a profit and loss account. They will have to conform in their content to the requirements of schedule 4 of the act which lays out the accounting rules and standards that must be followed. The accounts, and necessary notes explaining them will have to give a true and fair view of the finances of the company for the year in question. The requirement that the accounts present a true and fair view means that if additional accounts, or notes or other document of explanation is required for this purpose, then this must also be submitted so that the objective is met. Also, where the statutory accounts would fail to give a true and fair view, they must be altered and explanations provided as to why, so that the true and fair view again will be given.8 In general, the following of current accounting practice and rules will satisfy the standard required by the act to give a true and fair view9. These accounts will be audited and submitted to the Registrar along with the auditor's report. Information relating to the company's shareholders and members, its share capital and its loan capital must also be disclosed to the Registrar. The dealings of the directors with the company will also be made public by being disclosed to the Registrar. These disclosures are made public by way of both the annual returns and accounts and director's reports. These will be therefore available to members of the public at the Companies Registry. They will also require to be available to members of the public who reasonably request them, at the company's registered office. Therefore, it can be seen that if privacy is a major concern, the private limited company is subject to strict publicity requirements that make such privacy very difficult, in fact I think it is fair to say impossible, to maintain. d. What statutory books and registers must be kept at the company's Chancery Lane premises and what may be kept at the trading premises in Essex What are the rights of the members, the creditors and the general public to inspect these books and registers The address of the company's registered office will be provided to the Registry of Companies.10 The register of members,11 the register of directors and secretaries12, the register of directors' interests13 and the register of charges14 must be kept at the registered office at Chancery Lane.15 As well as this you will also need to have the meeting's minute books and a copy of the director's contract of service. Any member of the public, for a small fee, and any shareholder, will be entitled to examine these documents between nine and five on business days, at your company's registered office on Chancery Lane.16 This will be for a period of at least two hours per day. You are entitled to close your office for up to thirty days per year but these dates must be advertised in the newspaper locally. You can charge members of the public a fee of 2.50 per hour for examination of your books at your registered office but shareholders must be allowed to do so for free. Also, you are required to provide the documents by mail to any party requesting them and paying the statutory fee. You are not required by statute to have such documents at your alternative location in Essex. e. To what extent, if any, could Lorraine or Brenda or both incur personal liability for the company's debts if the business fails As has been stated previously, Lorraine and Brenda will not be personally liable for the debts of the business should it fail. This is because the company, under law, is a separate legal person, as distinct from Lorraine and Brenda as two people can be. The members of the company are not liable for the debts of the company, which is corollary to the fact that they cannot strip it of assets or withdraw their capital without following the correct statutory procedure. This is also one of the reasons why the company's accounts must be made so public. Since no natural person is standing over the debts of the company and agreeing to pay them back, the finances of the company and its relationship with shareholders and directors are completely open to public scrutiny. Perhaps the most famous case stating the separate legal identity of a company is Saloman v Saloman17 although there are numerous other cases that say exactly the same thing. There are cases in which this corporate veil will not be successful however, in protecting the personal assets of the shareholders and these require to be looked at. The first is acting while disqualified. Under section 15 of the Company Directors Disqualification Act 1986 states that any person who acts as a company director while being disqualified from doing so can be held personally liable for the debts of the company. This applies when a person acts while being a disqualified person, while being an undischarged bankrupt or acts under the management of a person he knows to be disqualified or an undischarged bankrupt. The person can be liable personally for all the debts that arose during the time he was acting as such. Wrongful trading is another circumstance which may make the director personally liable for the debts of the company. This is laid down by section 214 of the Insolvency Act 1986 and applies when the company has become insolvent and has entered liquidation. Section 214 can be used against any director or shadow director who knew, or at some time before winding up ought to have known, that the company had no reasonable prospect of paying back a debt and nevertheless, allowed the company to conduct the business and get into the debt. The director can protect himself from such an action by convincing the court that he took every step with a view to minimizing the potential loss to the creditors of the company18. These steps are the steps that would be taken by the reasonably diligent person of the level of knowledge and skill that the director had and that he could be reasonably expected to have given his position in the company19. The third is fraudulent trading. This is laid down by section 213 of the Insolvency Act 1986 and provides that if any director trades or carries out business with the intent of defrauding the creditors of the company or the creditors of any other person or for a fraudulent purpose, they can be held personally liable for the debts of the company. This applies to the director and also to any other person who knew about the carrying out of business in this manner. The court can order the payment of the director or other person of the amount it thinks fit in the circumstances. Under section 458 of the Companies Act 1985, this has also been made a criminal offence and can be prosecuted whether or not the company is being wound up. The final way in which the directors could be personally liable for debts is if they act ultra vires, as per their powers as laid out in the company's memorandum and articles of association. According to common law, the old rule still applies that if a director knowingly does this, he can be personally liable to make good to the company any loss suffered as a result of the ultra vires transactions.20 While the law has been changed so that third parties cannot be prejudiced by ultra vires actions of a director, the position between the company and the director remains the same and the director will be personally liable. There is provision under section 727 of the Companies Act 1985 whereby the court can relieve the director of his personal liability to the company if it is satisfied that the director was acting honestly and reasonably and deserves to be excused for his conduct.21 However, the fact remains that it is a breach of fiduciary duty that can make the director personally liable to the company. f. Prior to incorporation, Lorraine, as promoter, entered into a contract to purchase office accommodation for 'South East Antique Shop' from Alfie; but now Alfie does not want to honor the contract. It is a fact that a company cannot enter into a contract before it exists.22 However, contracts can be entered into on trust for a company that can then adopt them once it is incorporated. Therefore, the best thing to have done would be if Lorraine had entered into a contract as a promoter for the company, which she did, but it could also state that it would be adopted by the company once it came into existence and would no longer bind her once the company adopted it. This would have two benefits, the first is that it would protect Lorraine from further contractual obligation once the company adopted it, and second, it would give the company a contractual right to adopt the contract. The case here however is not too detrimental to the company. Lorraine has entered into it and she has a valid contractual right. I would advise her to assign this right to the company, and the company could then take up all the rights that Lorraine had under the contract. There is also the case that if either the company or Alfie have acted in way conducive to there being a contract, and this has occurred since the incorporation of the company, a contract may be implied that will be binding on the two parties. This does not seem to be the case here. If there is no alternative to Alfie's premises, and if his breach has caused loss, I would advise that the company has Lorraine's rights assigned over to them so that they could sue under the contract. This concludes my advice. There are many benefits to incorporation which will make the conducting of business safer and better for Lorraine and Brenda than it had been while they were acting under the partnership. The only question that they should ask themselves is whether the increased cost and formalities, and the requirements to make their accounts private, are worth the benefits conferred. Bibliography Books: Dine, Company Law, 1998, 3rd ed. Macmillan Boyle and Bird, Copmany Law, 1995, 3rd ed. Jodans Charlesworth and Morse, Company Law, 15th ed. 1995 Legislation: Companies Act 1985 Insolvency Act 1986 Cases: Re Home and Colonial Insurance Co. Ltd. [1930] 1 Ch. 102 Welton v. Saffery [1897] AC 299 Lloyd Cheyham and Co. Ltd. v Littlejohn and Co. [1986] PCC 389 Saloman v Saloman [1897] AC 22 DHSS v Evans [1985] 2 All ER 472 Re Sharpe [1892] 1 Ch 154 Re Claridge's Patent Asphalte Co. [1921] 1 Ch 543 Rover International Ltd. v Cannon Film Sale Ltd. [1987] BCLC 540 Websites http://www.companieshouse.gov.uk/about/gbhtml/gba1.shtml#three http://www.deltacompliance.co.uk/Services/Recruitment/Contracts/Formation_Topics/formationguide.htm Read More