LLC Legal Analysis - Case Study Example

Limited Liability: Limited Liability can be defined as a shareholder's liability in a company which is limited to the value of his or her shareholding in the company. In a limited company, the liability of the members is limited to the amount remaining unpaid on the shares (The ICFAI University, 2005). The members of a limited company are only liable to contribute towards payment of its debt to a limited extent. No member can be called upon to pay anything more than the unpaid value of the shares held by him or the amount guaranteed by him. This is called limited liability1 (biz/ed). Liability of participants in a company and a partnership - the difference: A Company is a distinct legal entity whereas a partnership firm in not distinct from the several persons who compose it (The ICFAI University, 2005). When it comes to issue of liability, a partner's liability is always unlimited whereas that of shareholder may be limited either by shares or by guarantee. The main difference between a partnership and a limited company is that the liability of a company's shareholders is limited to the amount of the unpaid amount on the shares that they own2 (Complete Business Services Ltd). Partners on the other hand, can not restrict their liability i.e. as they have an unlimited liability and therefore can be held personally responsible for any unpaid debts the partnership incurs. In a partnership firm, partners are joint and severally liable for partnership debts. Thus if one partner engages in an activity which results in large debts, all partners, regardless of whether or not they had prior knowledge of the activities would be equally liable to make good any shortfall in funds from their personal assets. But this is not the case with a company. As discussed earlier, the liability of the participants in a company is limited to the amount of shares that are held by them in the company. Salomon vs. Salomon and the Corporate Veil The case of Salomon vs. Salomon & Co. Ltd., took place in the year 1879. According to the case, Salomon was a prosperous leather merchant who converted his company into a limited company named as Salomon & Co. Ltd. The company so formed consisted of Salomon, his wife and five of his children as members. The company purchased the business of Salomon for 39,000, and the purchase consideration was paid in terms of debentures worth 10,000 conferring a charge over the company's assets, and 20,000 shares of 1 each fully paid-up and the balance amount in cash. The company in less than one year ran into difficulties and liquidation proceedings commenced. The assets of the company were not even sufficient to discharge the debentures and nothing was left for the unsecured creditors. The unsecured creditors contended that though incorporated under the Act, the company never had an independent existence; it was in fact an alter-ego of Salomon, the other directors being his sons under his control. It was held by the House of Lords that "the company had been validly constituted since the Act only required seven members holding at least one share each. It said that nothing about their being independent, or that there should be anything like a balance of power in the constitution of the company3 (Ask Me Help Desk). The company is different person at law and though it may be that after incorporation the business is precisely the same as before, the same persons are managers, and the same hands receive the profits, the company is not, in law their agent or trustee. Hence, the business belonged to the company and not to Salomon." The court observed that the company was a separate person, a separate body altogether different from the shareholders and the transfer was as much as conveyance, a transfer of property, as if the shareholders had been totally different persons. It can be seen from the proceedings of the above discussed case that a company is given a distinct legal entity in comparison to the individuals who are managing the affairs of the company. This provides a 'veil' for the persons who run the incorporated company as its 'arms' and 'heads.' The courts generally consider themselves bound by the principle of separate legal entity and adopt a cautious approach while piercing a corporate veil (Farlex). However, there have been instances where the courts lift the corporate veil of an incorporated company either to expose the ingenuous persons behind the company or to find out the real purpose of incorporating it. The corporate veil is said to be lifted or pierced when the court ignores the company and concerns itself directly with the members or management4 (Cooper, 2002). The circumstances under which the court may lift the corporate veil can be broadly classified under two heads: 1. Statutory provisions: The following are the provisions pertaining to the lifting of the corporate veil: i. Reduction of Membership ii. Misrepresentation in the Prospectus iii. Failure to Refund Application Money iv. Mis-description of Company Name v. Fraudulent Conduct vi. Holding and Subsidiary Companies vii. Liability of Directors of Private Company in Liquidation 2. Judicial interpretations: the decisions of the court have always been intended to provide opportunities for an incorporated company to retain its identity. However, certain circumstances compel the courts to divert from the Salomon principle only to restrict any unjust result. While exercising discretion, the courts rely on the underlying social, economic and moral factors associated with the corporation. i. Protection of Revenues ii. Preventing of Fraud or Improper Conduct iii. Determination of the Enemy Character of the Company iv. Where a Company is used to avoid Welfare Legislation v. For Determination of the Technical Competence of the Company Limiting of Corporate Veil under special circumstances According to the case of Salomon vs. Salomon, the basic principle of the corporate veil is that company cannot be characterised as an agent of its shareholders unless there is clear evidence to show that the company was in fact acting as an agent in a particular transaction or series of transactions. The mere fact that one company is the subsidiary of another (even a wholly owned subsidiary) is not of itself sufficient to make that subsidiary an agent of its holding company5 (Middleton Potts, 2004). However, not withstanding these basic principles of separate legal entity and separate corporate personality, there have been certain situations in which the courts have shown limiting the corporate veil i.e. ignore or set aside the separate legal personality of a company. The following are the special circumstances - for the purposes of fraud or dishonestly for the express purpose of depriving a claimant of the ability to exercise his lawful rights; as a mere device or sham to evade a contractual or other legal obligation; as a mere faade to conceal the true facts; or Otherwise where it is established that there has been dishonesty or abuse of the corporate form. Absolute limited liability would tolerate the situations where the limited liability principle of risk transferring emanating from separation between ownership and control could be unduly undermined. Therefore, an investor, who owns large portion of corporation, will be keen on monitoring agent's behaviour or even himself becoming the manager of corporation. Once the investor becomes highly involved in making business decisions, the challenge of balancing his personal interests with the interests of corporation arises. If during this balancing process investor's personal interests win to the detriment of corporation's, or investor's behaviour is at odds with sound business practice, it is not fair to give to such an investor an advantage of limited liability. In such a situation fairness would require to depart from general rule of limited liability and to make an investor personally liable for corporation's liabilities, thereby limiting the corporate veil for this kind of circumstance (LEVICKAIT, 2004). In certain situations, investor's ability to make optimal investment decisions is potentially distorted if limited liability is treated as absolute6 (LEVICKAIT, 2004). If corporation is organized as to serve mainly one investor's interests, not only the interests of corporation, but also the interests of other investors are infringed: the latter are burdened with a higher risk of loosing their capital contributions and interest than it would be in the ordinary market circumstances. Thus, treating investors who do not unduly infringe separation of ownership and control and those who do infringe in the same way will not be fair. These kinds of situations also require the limiting of the concept of corporate veil. There have been instances when courts, employing undercapitalization factor in making determination whether to pierce the corporate veil "focus on whether, when corporation began its activities, it had sufficient financial resources to satisfy any losses likely to be generated by its business, activities, given the risks associated with that business." Thus courts look whether upon formation of the corporation shareholders actually contributed the equity to it42 and whether that equity was reasonable in certain type of business activity. Bibliography 1. Ask Me Help Desk. (n.d.). Ask Me Help Desk. Retrieved 02 13, 2008, from Ask Me Help Desk: http://www.askmehelpdesk.com/corporate-law/salomon-vs-salomon-24955.html 2. biz/ed. (n.d.). Economic Notes. Retrieved 02 13, 2008, from biz/ed: http://www.bized.co.uk/learn/economics/notes/liability.htm 3. Complete Business Services Ltd. (n.d.). The Differences between a Partnership and a Limited Company. Retrieved 02 13, 1008, from Company FAQs: http://www.companyfaqs.co.uk/business_entities/partnership_vs_company.html 4. Cooper, D. A. (2002). Piercing the Corporate Veil. UK: Carole Seawart. 5. Farlex. (n.d.). Piercing the Corporate veil. Retrieved 02 13, 2008, from The Free Dictionary: http://legal-dictionary.thefreedictionary.com/piercing+the+corporate+veil 6. ICFAI Center for Management Research ICMR. (2004). Financial Accounting & Financial Statement Analysis. Hyderabad: ICFAI Center for Management Research. 7. Int he shadow of the corporate veil: James Hardie Industries, 12 2004-05 (Law and Bills Digest Section August 10, 2004). 8. LEVICKAIT, I. (2004). Can the Corporate Veil be Pierced International Journal of Baltic Law , 6-12. 9. LondonLaw.com. (2002). The use or abuse of the Corporate Veil. London. 10. Middleton Potts. (2004). The Defence of Corporate Veil. Middleton Potts , 12-15. 11. The ICFAI University. (2005). Business Law for Managers. Hyderabad: The ICFAI University. Read More