The Concept of Separate Entity Principle - Essay Example

Separate Legal Entities affiliation: Introduction In company law, the principle of separate legal personality remainsvital since 1897 during the evolution of the whole UK company law (De Lacy 2002 p.16). At the time, company legal relations based on human beings. However, today the legal relations extend to relations with companies as “legal” personality. The separate entity principle is global, and in accordance with this principle, the law treats a company as a distinct entity from its members. The separate entity rule embraces company law with diverse implications for both practical and theoretical company law. The first part of this essay discusses the concept of Separate Entity Principle while evaluating the decision in Salomon case. The second part analyses statutory exceptions in relation to Separate Entity Principle considering the circumstances in which the court may lift or pierce the corporate veil. A study by Grier (1997 p. 62) shows that the R v Arnaud case was the first to illustrate the Separate Entity Principle. An official authorized company failed to enlist a ship arguing that it belonged to foreigners. A British Chartered Company owned the ship although some of the company members were foreigners. However, the court ruled that the company should enroll the ship because the members of the company were not the owners of the ship but rather the British company. All the same, the landmark in company law confirming that a company is a separate entity with different legal personality is the Salomon v Salomon & Co Ltd. In the Salomon case, Salomon sold some shoes to his company registered under the Companies Act. The members of this company included Salomon and the relatives. Mr. Salomon got compensation of shares in full among other unsecured credits to the tune of 10000 pounds, which he consequently allotted it to a different party. The company later went into liquidation, and the liquidator tried to blame Mr. Salomon accountable for all the company debts. He argued that the entire corporation was a swindle to the creditors, and, Mr. Salomon deserved no benefit. In addition, the liquidator argued that the business was purely Salomon’s agent, meaning he should underwrite the corporation, and its creditors in relation to the company’s debts. However, according to Grier (1997 p. 68), the House of Lords ruled that Salomon was not liable to Salomon Company nor its creditors. The House of Lords held that Salomon validly acquired his debentures. According to Halsbury LC, once a business registers, the statute had enacted procedural and formal requirements. Lastly, the House argued that a registered company might continue its operations with the same hands taking the profits. However, according to law, this does not the company an agent of its members. Grier (1997 p. 68) argues that the House of Lords only considered Salomon’s Company to have appropriately incorporated this company according to Companies Act 1862 (UK). The registration was in order because despite the fact that the seven members were “not fully independent” they were all shareholders. The decision by the House of Lords regarding Salomon’s case regarding incorporated companies having separate legal personalities concludes that a company’s property is a company’s property. In a case by Macaura v Northern Assurance Company, Mr. Macaura claimed a payment for his company’s insurance (Dignam & Lowry 2012 p. 26). However, his five insurers refused to pay claiming that he had no insurable significance since he bought the insurance under his name instead of the company name. In this case, the court argued that holding all the company shares does not make the person a corporation. It argued that neither he nor his creditors own any company assets. This decision means that the law should uphold the principles even if the law did not favour the person who registers the company. According to Salomon’s case, the company’s debt is a company’s debt, and this clearly showed in Lee v Lee’s Farming Limited case. This company formed by Mr. Lee’s accountant made contracts with the farmers whereby they would carry out aerial topdressing. Mr. Lee was however, the governing director and the principle shareholder of this company working as a salaried pilot. Mr. Lee died during his duties and his wife applied for a worker’s compensation insurance for Mr. Lee as an employment. However, the insurance denied claiming that Mr. Lee was a director and not a worker (Dignam & Lowry 2012 p. 26). Nevertheless, the Privy Council’s Judicial Committee fully rejected the insurers claim and upheld Mrs. Lee’s claims. In this case, Lord Morris cited Halsbury LC’s judgment in accordance to Salomon’s case. He argued that the company was real and that Mr. Lee’s contract of service should not be disputed because he was an agent of the company in question during its negotiations. The ruling confirms that a company can still employ its principle shareholder based on a contract of service. Mr. Lee’s case clearly demonstrates that corporations can commit crimes and torts since they can contract other people, and they have separate legal personalities. In conclusion, Salomon’s case makes it a landmark because of its establishment of basic principles of Company Law in the UK. Salomon’s case proves that a company is not only an association with its members, but also it has separate legal personalities from them. This statement means that a company owns its assets as a separate person, and separately goes into contracts according to its properties and business. The positive arguments in relation to Salomon’s case and its decisions include confirming that companies have practical utility in relation to Separate Entity Principle. The corporations have many beneficial functions in both economic and social functions in relation to separate legal entity. These benefits are subject to flexible financial methods, specialised management, share transferability due to limited liability, and other consequences of the corporation. The public enjoys sharing of profits where a company separates management from investment as a separate entity. Meanwhile, the company can hire professional managers, which could result in higher profits. In addition, this person created by law remains in the highlights. Consequently, generations of members can reach the company’s achievements for many years without the worry of members’ deaths. After all, investors are only reliable to subscribed shares meaning fewer risks due to the limited reliability principle. For this reason, companies is able to gather enormous sums of outside capital, and convincing the investors hence promotes the economic growth. On the other hand, the negative arguments regarding Salomon’s case includes criticism from Professor Kahn-Freund who describes the case as “calamitous”. The professor argues that the judgment was an abuse of company law. The Professor feels that the House of Lords used the company form by personal agents to stress the sovereign position of corporate personality. Tomasik ET al. (2002 p. 24) argue that private businesses that do not collect public money can introduce an entity amongst selves and the creditors. According to the House of Lords in relation to Salomon’s case, after completing the company registration according to the Act, this company becomes a separate entity from its stakeholders. He argues that this separation occurs even when this is one of the many compliances despite one-person owning all the shares. The Law Quarterly Review notes, “this case was not about a dry point of construction”. The professor argues that the House of Lord totally overlooked the financial reality in relation to one owner and instead emphasised on separate identities. The above criticisms of Salomon’s case decision regarding the negative effects of this judgment show weaknesses in protection of external creditors. This case based on limited liability tends to benefit unnecessarily honest incorporators in order to persuade them on conducting businesses. Management of business according remains separate entities from the shareholders, and because of the benefits from limited liability, the shareholders become discouraged from monitoring the company’s financial ventures. Dignam & Lowry (2012 p. 26) argue that it is important for any creditor to monitor the company’s capital and their limited funds. In addition, companies may abuse their subsidiaries in order to keep away from amount overdue by moving assets from the mother company to its subsidiaries. Consequently, according to the principles of separate entities, a company is dependable on its debts, and this prevents the creditors from declaring their privileges from the shareholders whom, in this case, are the real debtors. This situation means that the creditors bear higher risks compared to the shareholders when dealing with limited companies. On the other hand, the limited liability benefits include the shareholders’ protection by company law bearing less risk in case of company insolvency. The Separate Entity Principle leaves room for fraud, and, unfortunately is a separate legal entity since Salomon’s case according to legal doctrines. Many cases have come up from regarding abuse of corporation companies and frauds among other anti-social activities. Of course, there are risks related to separate entity principles especially in relation to creditors. Most of the creditors bear the higher risk in corporate business and while creditors like the banks may afford the loss; other smaller financiers may fear conducting business with these limited corporations. In addition, the employees and the tort officers may not recover from the losses. Research shows that most of these small creditors like suppliers rarely ask for collaterals before delivery of the product or services. This approach poses a lot of vulnerability in case of company insolvency. However, the employees stand to lose more considering the loss of jobs and their dues. Unfortunately, the employees have no options of acquiring securities like the finance creditors, and most employees seem to have minimal information regarding the company’s financial operations. The creditors however have an advantage of entering into a contract even without collaterals. Hannigan (2012 p. 52) argues that there are no economic benefits from limited liability from a technical point of view with respect to private companies. The owners and managers remain the same people hence, and as a result, there is little monitoring of the company operations. In addition, there are no share markets for liability companies meaning they do not foster effective market share. Besides, limited companies encourage high risk taking in business because the management and directors tend to benefit more by shifting the company risks to their creditors. On the other hand, several fraud cases continue emerging from these limited liability companies since Salomon’s case. These frauds are a big disadvantage in any business operations because despite protecting the company directors, they pose a high risk to the creditors (Rickett 1998 p. 77). A good example is the $2 dollar company as commonly known whereby a small group of people set up a liability company. Later, these owners allow the company to incur very heavy debts in its name knowing very well that the company would not pay back. Once the creditors knock the doors to demand their debts, the owners argue that it is a limited company and for this reason, they hold no liability. Bottom of the harbor is another type of fraud related to separate entities whereby a company that is about to be insolvent deliberately transfers all of its assets to another incorporated company. The mother company applies confusing transactions concealing the design of the transactions mostly abroad. In order to defeat the investigations done by the regulators, these companies may sometimes change both the names and the physical addresses. It is important to note that the separate legal entities seem to favour only the company directors and the shareholders and leaving the creditors to suffer huge losses. In this regard, the courts have equally come up with solutions to favour these creditors although it is the Company’s Act intention to protect the liability companies. The legislatures and the courts have occasionally intervened in cases with abuse of separate legal entities. These interventions apply in cases of injustices, and this process refers to as unveiling the veil of incorporation. However, this process does not change the company from its limited corporation status. Instead, it means that the courts tend to ignore the status for as long as the case seems to have impugned transactions. In such circumstances, the courts will not treat this liability company as a separate legal entity. As a result, some statutory exceptions may apply since the law realized that it was misleading to treat each subsidiary in a group different. Nevertheless, the law introduced many provisions into the Company Act including parent companies’ duty to produce group accounts, and provide shareholders’ details. In addition, the Insolvency Act contains most of the vital veil lifting issues like the fraudulent trading provision that deals with situations where the company used corporate form for fraud. For this reason, in a case where a company intentionally uses this form to fraud, the liquidator may apply to the court arguing that any knowing parties carrying out fraud are liable for any related losses. Wrongful trading in Section 14 of Insolvency Act does not require proof of intended fraud (Dignam & Lowry 2012 p. 33). This happens in a case where the director may have known before insolvency that the company’s finances were in a mess, and nevertheless, continued operations. A reasonable director would stop any trades instantly, and, therefore the company has a case to answer. Conclusively, the legislature has always had the creditors’ interest ensuring equal protection to the directors, and the shareholders. In addition, the legislature’s intention is to minimise any frauds related to separate entities. It is not easy for the courts to lift the veil of this incorporation, and they must decide on whom to take the losses. However, with modernization the courts seem to apply more approaches that are conventional, while leaving out Salomon’s principle in order to achieve justice. In a case of DHN Food Distributors Ltd v Tower Hamlets London Borough (Dignam & Lowry 2012 p. 36), the company wanted to Ran its businesses in its subsidiary’s premises. Both the mother and the subsidiary companies had the same directors. The defendant in the case argued that the owner of the land was the same and so DHN would not receive compensation for compulsory purchase. The court of appeal in its decision held DHN’s claim treating the group of companies as a single economic entity since they had same directors. Conclusion While I may agree that legal entity is one of the greatest law contributions in business, study shows that it has some disadvantages too. This subject is too broad for a person to try to weigh on the advantages and disadvantages of separate legal entities. In other words, it is better to leave the question on which outweighs the other. The principle of separate entities in regards to Salomon’s case seems instrumental in developing of modern capitalism and its immense social and economic wealth. In addition, the House of Lord’s decision seems to have covered the small business enterprises creating several negative effects over time. Study shows that the judicial and the legislative actions have largely neutralised separate entities. The courts have occasionally tried to impose some legal liabilities on these directors despite lack of statutory assistance. Such unveilings occur where Salomon’s principle may cause injustices or other inconveniences. Some countries like Australia introduced improved legal facilities for their small businesses since Salomon’s case proved that liability companies only favor the large companies. References DE LACY, J. (2002). Reform of United Kingdom company law. London [u.a.], Cavendish. DIGNAM, A. J., & LOWRY, J. P. (2012). Company law. Oxford, Oxford University Press. GRIER, N. (1997). UK company law. Chichester, Wiley. HANNIGAN, B. (2012). Company law. RICKETT, C. E. F. (1998). Corporate personality in the 20th century. Oxford, Hart. TOMASIC, R., BOTTOMLEY, S., & MCQUEEN, R. (2002). Corporations law in Australia. Sydney, Federation Press. Read More