The Rule in Salomon vs Salomon and Company Limited - Research Paper Example

The rule in Salomon v Salomon & Company Limited This essay examines the rationale and the impact of the decision in Salomon v Salomon & Company Limited1 on English company law. In doing so, the essay will analyze the case, discuss the rationale of the decision and look onto the significance of the decision on English company law. INTRODUCTION The principle of a company‘s separate legal personality is a fundamental principle of company law. This principle creates an independent entity which can be distinguished from its shareholders and directors. When a company is legally incorporated, it exists as an artificial person with its own rights and obligations. The principle was first established in the landmark case of Salomon v Salomon & company Ltd. The House of Lords in this case recognized the independent nature of a corporate entity. The House of Lords observed that a company is a separate entity separate from its shareholders. This principle has stood the test of time and remains a fundamental concept of company law to date. The current company law recognizes companies as separate entities which can sue and be sued in their capacity as legal persons.2 SALOMON V SALOMON & COMPANY LIMITED Salmon was a leather merchant who specialized in the production of leather boots. He ran his business as a sole proprietor but when his sons expressed interest in the business he incorporated it into a limited company. During that time the requirements for incorporation required at least 7 shareholders. Salomon was the managing director of the company with 20,001 shares while six of his family members each had a single share in the company bringing the shares to a total of 20,007. Salomon also obtained£10,000 debentures from the company. There was a decline in the sale of boots which saw the company go into liquidation. The company’s liquidator contended that Mr Salomon‘s secured debt should not be honored as he was the majority owner of the company. The issue before the court was whether the liquidator could succeed in recovering the secured debt held by Salomon.3 The applicable rule in this case is that a company is an artificial person with rights and obligations separate from those of its shareholders. A company is a separate legal entity with rights of its own. A company that is properly incorporated, therefore, is independent of its shareholders. The separate legal personality accorded to a company means that the company can enter into transactions as a separate person from its shareholders. Additionally, an incorporated company is limited in liability. Limited liability means that the liability of shareholders of the company is limited only to the extend of their investment in the company. This, therefore, implies that the shareholders of the company cannot be held personally liable for liabilities beyond their contribution towards the company. In case the company is liquidated, the liability of its shareholders is only proportionate to the quantity of shares they hold in the company. Salomon & Company Limited was properly incorporated as per the Companies Act. Incorporation gave the company a legally recognizable status of an artificial person with rights and obligations of its own. The Act did not impose limitations on the composition of the shareholders of a company apart from requiring a minimum of 7 shareholders. Despite Salomon & Company Limited being made up of close family members, it is noteworthy that the company was properly incorporated as per the Act. The Act also did not provide any limitations on the number of shares held by each shareholder. Although Salomon held a substantial portion of the company‘s shares with the other shareholders taking the least shares possible, the company was properly incorporated. The company being properly incorporated, therefore, acquired the status of a separate legal person. The liability of its shareholders was limited to their contribution towards the company. The shareholders of the company, including Salomon, were separate and distinct from the company and thus could not be held personally accountable for the company’s liabilities.4 In Salomon v Salomon, the lower courts were of the opinion that Salomon had abused the privileges accorded by incorporation and those of limited liability. The court stated that the company had been a scheme to limit Salomon’s liability. However, the House of Lords overturned this decision. The House of Lords observed that the company had been formed according to the required procedure. They also noted that the composition of the shares was irrelevant as the statute did not provide any limitations on its composition. The court held that the company was a separate person and the business did not belong to Salomon but to the company. The court, therefore, concluded that Salomon was not liable except to the extend of his shares in the company. The court also found that since the company was a separate legal person it could enter into transactions with any one including its shareholders and, therefore, the secured debt was valid. SEPARATE LEGAL PERSONALITY A company‘s separate legal personality, as established in Salomon v Salomon, is a widely recognized principle in company law. This concept is fundamental to company law as it allows a company to enter into transactions, sue and be sued in its capacity as a legal person. An entity with a legal personality can also incur debts and protect its shareholders from personal liability. The rationale in Salomon v Salomon was also followed in Lee v Lee‘s Air farming Limited.5 In this case, Lee formed a company which was involved in applying fertilizers on farms. Lee was the majority shareholder with 2,999 shares out of the company’s 30,000 shares. He was also the sole director of the company and worked as the chief pilot. Unfortunately, Lee died in a plane crash. His wife, Mrs. Lee, brought a claim for compensation under the Workers Compensation Act for the death of her husband. The relevant law required that a person had to be a worker for such claims to succeed. The court of appeal found that Lee was not a worker since he was also an employer. In its decision, the court noted that the relationship of master servant had not been created and the two offices were incompatible. The Privy Council, however, noted that Mrs. Lee was entitled to the compensation as Mr. Lee was a worker. The court noted that it was possible for Lee to have a contract with a company in which he was an owner. The reasoning in this case was that the company was a separate legal entity and could enter into a contract with Lee. The company and Lee were separate legal persons and, therefore, Lee qualified as a worker for the company.6 In Macaura v Northern Assurance Company Limited7, Mr Macaura sold the timber in his estate to a company for 42,000 fully paid shares. The transaction made Macaura the sole owner of the company. He also had a £19,000 unsecured credit with the company. Mr Macaura took out an insurance policy with Northern Assurance, which covered losses due to fire. Macaura, however, took out the policy in his own name and not that of the company. A few weeks later there was a fire which destroyed the timber. Macaura sought to claim compensation from the insurance company for the loss of the timber. The insurance company refused to compensate Macaura for the loss. The insurance company contended that the timber was owned by the company and not by Macaura. Because the company was a separate legal entity, Northern Assurance claimed that there was no obligation to pay Macaura any money. Macaura went to court to compel the insurance company to pay. The House of Lords in its decision observed that the insurance company was not under any obligation to pay Macaura since the timber did not belong to Macaura, who had insured it, but belonged to the company. The court further noted that there was no legal or equitable relation between Macaura and the timber. Macauras‘relation was with the company and not with the timber; therefore, the insurance company did not have to pay Macaura anything. From the decision in Lee v Lee and that in Macaura v Northern Assurance it is clear that courts treat companies as separate legal person from their shareholders. The principle established in Salomon v Salomon is central to company law as it allows companies to operate as separate legal persons. PIERCING THE CORPORATE VEIL The essence of the separate legal personality is that individuals who own a limited company cannot be held personally responsible for the debts of the company. However, in certain circumstances the courts may ignore the principle of separate legal personality and hold shareholders or owners of a company liable for its debts. This concept is referred to as piercing the corporate veil. Piercing the corporate veil, however, cannot be done every time it seems fair to pierce the veil. Courts do not pierce the veil merely because justice demands so and piercing is done in very rare circumstances as decided in Adams v Cape Industries Plc8. In this case a group of employees were suing Cape industries for damages due to asbestos diseases they had suffered while working for the company’s subsidiary. The employees could only succeed in their suit if Cape industries were considered to be present in America through their subsidiary. This would imply that the separate legal personalities of the two companies, the subsidiary and the parent company, could be ignored. The court in rejecting the claim by the employees emphasized that the subsidiary was a separate legal entity distinct from its parent company.9 The outcome in this case makes it clear that the corporate veil can only be pierced in very few instances. An instance where the corporate veil can be pierced is where the company was created for fraudulent purposes as decided in Jones v Lipman.10 In this case Lipman agreed to sell a house to Mr. Jones for a price of £5,250. Lipman later changed his mind and refused to honor the deal. He further conveyed the house to a company he had incorporated to avoid specific performance. The court, in ordering specific performance, noted that the company was incorporated fraudulently by Lipman in order to escape equity. The outcome in this case confirmed an earlier decision in Gilford Motor Company Ltd v Horne.11 In this case Horne, who was a former managing director at Gilford, had entered into a non compete contract with the company. Horne was later fired by the company. In breach of the non compete contract, Horne set up a business and undercut Gilford prices. In order to circumvent the non compete clause in his contract with Gilford, Horne incorporated a company to conduct the business. Subsequently, Gilford brought an action alleging that the company was set up fraudulently to hide Horne’s illegitimate activities. In granting an injunction, the court of appeal noted that the company was formed in order to conceal the intentions of Mr. Horne. It is noteworthy that courts are reluctant to pierce the corporate veil unless the circumstances in the case require it to do so. For courts to pierce the corporate veil, the company should have engaged in fraudulent activities or failed to follow corporate formalities. Another instance where the court may pierce the corporate veil is where statutory provisions require it to do so. The separate legal personality of a company is a creation of statute and it can be set aside by statute, for example the Insolvency Act of 1986.12 SIGNIFICANCE OF THE DECISION IN SALOMON V SALOMON The decision in Salomon emphasized the independent nature of legal entities. The principle has a wide implication on company law as it gives companies a practical utility. The outcome in Salomon has several implications on company law. The first implication of separate legal personality is that a company’s property belongs to the company and not to its shareholders, managers or directors. This point was applied in Macaura v Northern Assurance Company where the court noted that Macaura did not have an insurable interest in the timber because it did not belong to him but to the company. The court stated that even if a shareholder holds all the shares in a company he is not the company and, therefore, does not have ownership over the company’s property. The separate legal personality applies even in cases where the owner has a profitable interest in the company’s property and it would be detrimental to the shareholder to have the separation. Another implication is that a company’s debt belongs to the company and cannot be extended to its shareholders unless to the extend of their fully paid shares. This point was discussed in Salomon v Salomon and is the essence of limited liability of a company. This concept allows for the separation of the company’s assets and those of its shareholders. Limited liability is advantageous to shareholders as their assets are shielded from the liabilities of the company. This encourages investment by shareholders without the risk of losing their personal assets in case of insolvency.13 The third implication the decision in Salomon v Salomon has on company law is that a company, as a separate legal person, can enter into contracts with other persons, including its shareholders. This point was developed in Lee v Lee‘s Air farming Ltd. The position was also confirmed in Industry v Bottne14r where the court noted that a sole shareholder of a company can be employed by the same company and derives employee benefits just like any other employee. Additionally the concept of separate legal personality implies that a company can commit crimes and torts. The ability of a company to enter into contracts means that companies can be sued for breach of contract. Separate legal personality of a company separates the management of a company from its investors. This allows investors to share in the profits of a company without involvement in the company’s activities. Separation of investors from management also allows the company to employ professional managers to manage the company and this result in better returns. The limited liability of investors in a company also discourages shareholders from controlling the operations of the company. The recognition of a company as a separate legal person also ensures perpetuity. Separate legal personality thus allows the company to operate as a vehicle for business transactions and enables it to operate efficiently, collect capital from investors and reduces the risk associated with investment.15 CONCLUSION The decision in Salomon v Salomon established the principle of a separate legal personality of a company. This principle is a fundamental aspect of company law as it ensures that a company is recognized as an artificial person. This recognition distinguishes the company from its shareholders. The distinction is important as it allows the liability of shareholders to be limited to the amount of shares they hold in the company. Additionally, this recognition allows a company to enter into contracts with other entities. Cases Adams v Cape Industries Plc (1990) Ch 443 Gilford Motor Company Limited v Horne (1933) Ch 935 Industry v Bottril (1999) ICR 592 Jones v Lipman (1962) 1 WRL 832 Lee v Lee‘s Air farming Limited (1961) AC 12 Macaura v Northern Assurance Company Limited (1925) AC 619 Salomon v Salomon & Company limited (1897) AC 22 Bibliography Beck, A. (2010). Introduction to company law. [Wellington, N.Z.]: New Zealand Law Society, Family Law Section and Property Law Section. Bourne, N. (2008). Bourne on company law. New York: Routledge-Cavendish. Goulding, S. (1996). Principles of company law. London: Cavendish Pub. Grier, N. (2014). Piercing the Corporate Veil: Prest v Petrodel Resources Ltd. Edinburgh Law Review, 18(2), pp.275-279. Hannigan, B. (2009). Company law. Oxford: Oxford University Press. Ireland, P. (2008). Limited liability, shareholder rights and the problem of corporate irresponsibility. Cambridge Journal of Economics, 34(5), pp.837-856. Kershaw, D. (2009). Company law in context. Oxford: Oxford University Press. Macey, J. and Mitts, J. (n.d.). The Three Justifications for Piercing the Corporate Veil. SSRN Journal. Read More