Kahn-Freunds Observation, Salomon v Salomon - Case Study Example

Why Kahn-Freund’s observation that the principle of separate legal entities was ‘calamitous’ is no longer valid in the current state of Australian corporations’ law Introduction The principle of separate legal entity provides that a company exists as a completely separate legal entity from that of its shareholders.1 According to Khan-Freund, the principle has provided an avenue by which the interests of creditors to companies have been abused as a result of failure on the part of courts of law to overcome the rigidities provided by this principle.2 In this essay, the validity of this observation in light of the current state of Australian corporations’ law is presented. A brief discussion of the impact of the decision in Salomon v Salomon together with the justifications behind the decision is presented3. This is followed by a detailed analysis of whether the courts in Australia have followed the principle established in Salomon v Salomon. Throughout the essay, it is argued that in light of the current state of Australian corporations’ law, Kahn-Freund’s observation that the principle of separate legal entity was ‘calamitous’, is no longer valid. This so because the courts have not only established but also effected special structures that allow deviation from the principle, thus protecting the interests of creditors from possible abuse. The impact and importance of Salomon v Salomon The impact of Salomon v Salomon can be understood in terms of the legal ramifications the decision has had on the overall practice of corporations’ law in Australia. In general, the effect of the principle established in the case has been felt in the form of the need to protect the ‘corporate veil’ in cases involving corporations’ law.4 The impact of this principle has been demonstrated in several ways. For instance, its application has provided a legal framework by which the difference between the debts of a company and those of the shareholders is recognised.5 What this means is that unless there are legal exceptions, the principle implies that the shareholders of a company are not liable for the debts of the company. Also, since under the principle, a company is a separate legal entity from its shareholders, it follows that it can own property separately from its shareholders.6 This means that the shareholders of a company do not have control over the property held in the name of the company. Moreover, application of the principle means that the company, by virtue of being a separate legal entity, can get into contractual relationships with other persons.7 The importance of Salomon v Salomon can be evaluated in terms of the potential benefits of maintaining the principle of separate entity for corporations. One main importance of this principle is that it frees shareholders from managing the day to day operations of the company.8 Since these operations are left in the hands of the management, shareholders enjoy limited liability for the actions of the managers. Secondly, the principle of separate legal entity as established in Salomon v Salomon has been that the efficiency of the management has been enhanced.9 One reason for this is that the valuation of the company has relied on its performance rather than that of the shareholders. Justifications behind the decision There were several issues that formed the basis for the decision of the House of Lords in the Salomon v Salomon. Initially, the decision of the lower court was based on the premise that there was indeed an agency principle between Mr. Solomon and the company.10 Since the business was formed by Salomon, who not only had tight control of the business operations but also was the major shareholder, it was held that the business was an agent of Mr. Salomon. Although this argument was rejected by the Court of Appeal on the basis that an agency relationship cannot exist when there has been a sale and transfer of business, it was held that the company was a trustee and was therefore holding the business on trust for Mr. Salomon.11 The decision of the Court of Appeal was further informed by the relationship between Mr. Salomon and the other shareholders of the company as well as the shareholding structure that the company had.12 The justification of the House of Lords on reversing the decisions of the earlier courts was based on several issues. First, it was argued that the company is a separate legal entity. This was so since its incorporation was properly done in accordance with the provisions of the Companies Act 1862.13 What this means is that the fact that all the shareholders of the company were related does not have legal relevance under the provisions of the Act. The second justification for the decision, which was a logical conclusion from the first, was that the debenture given by the company was valid and as a result, Salomon was entitled to his claim against the company.14 What this means is that regardless of the degree of control that Mr. Salomon had over the affairs of the company, the fact that the company was a separate legal entity that had been properly incorporated means that Mr. Salomon was entitled to his claim against the company as a secured creditor. Whether Australian law and courts have followed the principle as stated Salomon v Salomon The question of whether the courts in Australia have followed the principle of separate legal entity as established in Salomon v Salomon can best be answered by examining how specific cases have been treated. It has already been stated that the impact of the principle established in Salomon v Salomon has been demonstrated in the way courts of law have sought to maintain the ‘veil’ of corporations. Although this has been the norm, there has been wide variation in the way this principle has been treated in courts of law.15 Several cases have demonstrated instances in which the principle has been upheld. For instance in Lee v Lee’s Air Farming Ltd, the matter before the courts was to determine whether Mrs. Lee, who was a shareholder of the company, could also be an employee of the same company.16 It was held that since the company existed as a separate legal entity, it was entitled to entering into contractual relationships with its members. This was similar to the matter before the court in Gilford Motor Co v Horne.17 However, there are several instances in which the courts in Australia have lifted the corporate veil, thus presenting exceptions to the rigid application of the principle of separate legal entity as established in Salomon v Salomon. This has been demonstrated under different conditions. For instance, under the provisions of the common law, courts have set aside the principle of separate legal entity in circumstances where it is used to avoid specific legal duties.18 For instance, in Jones v Lipman, the defendant entered into a contractual agreement to sell land to the plaintiff. However, the defendant transferred the land to a company he controlled before the earlier contractual agreement could be effected. The matter before the court was to determine whether the principle of separate legal identity could be set aside. It was held that the principle be set aside to ensure that the defendant fulfilled his contractual obligations. This position was similar to what was reached in Green v Bestobell, in which the matter before the court was to determine whether Green, who was manager at Bestobell, had breached his fiduciary duties by forming a separate company that competed with Bestobell for contracts. It was held that Green had indeed breached his fiduciary duties to Bestobell and, thus, the principle of separate legal entity was set aside under the provisions of common law.19 It has also been the practice of courts of law in Australia to set aside the principle of separate legal entity in circumstances where the company in question is acting as agent or partner of the controller. This has been demonstrated in different instances. In Industrial Equity v Blackburn, it was held that a subsidiary company could not be treated as a part of the holding company for the purpose of determining the profits of the holding company.20 In, Ascot Investments, (Aust., obiter), the matter before the court was to determine whether the company formed was a mere puppet of its controllers.21 It was held that since the company was designed as such, the principle of separate legal entity could be set aside. In this case, it can be seen that the practice has been that in cases where a company is regarded as a mere sham, the courts do set aside the principle of separate legal entities established. The same was applicable in Smith, Stone & Knight v Birmingham.22 Further, the veil of corporation has been lifted in circumstances where the courts determine that there is an indication in the common law that the principle of separate legal entity should be disregarded. One common example of such a case is Daimler Co. v Continental Tyre & Rubber.23 In this case, although Continental Tyre & Rubber was incorporated in England, the majority of its shareholders were German. The matter before the court was whether to uphold legislation earlier passed in England which prohibited companies from alien countries operating in the country. In this case, it was held that since the people operating behind the company were aliens, the company itself was. This way, the principle of separate legal entity was set aside. It has also been common for courts to disregard the principle in cases where there is unfair treatment on one of the shareholders of a corporation and that doing so will restore fair treatment in the corporation. In Ebrahimi v Westbourne Galleries, a partnership between two individuals was transformed into a company.24 With the addition of a third director, the board of the company voted to remove the plaintiff from the company. It was held that since the removal of one of the directors was unjust and unfair, disregarding the principle of separate legal entity was necessary. Conclusion It can be concluded that Khan-Freund’s statement about the principle of separate legal entity, as established in Salomon v Salomon being calamitous, is no longer relevant in the current practice of corporations’ law in Australia. Although the principle holds an important part in the law in establishing and safeguarding the rights of shareholders, its treatment can no longer be interpreted as being rigid in Australia. This is because in many instances, Australian courts of law have found it necessary to set aside this principle when making decisions in cases involving corporations’ law. Such instances have arisen from different provisions in the common law as well as in several statutes that are in force in the country. References Ascot Investments Pty Ltd v Harper [Aust., obiter]. Caroll, Robyn (1999). ‘Corporate Patents and Tort Liability’, in, Gillooly, Michael, The Law Relating to Corporate Groups. Sydney: The Federation Press Ltd. Daimler Co v Continental Tyre & Rubber [1916] Ebrahimi v Westbourne Galleries [1973] AC 360 Gilford Motor Co v Horne [1933] All ER Rep 109 Green v Bestobell [1982] 1 ACLC 1 Hannigan, Brenda (2012). Company Law. Oxford: Oxford University Press. Hill, Clare; Krusemark, James; McDonell, Brett and Robbins, Solly. (2012). Research Handbook on the Economics of Corporate Law. London: Edward Elgar Publishing. Industrial Equity v Blackburn [1977] HCA 59 Jones v Lipman [1962] 1 All ER 442 Tomasic, Roman, Bottomley, Stephen and McQueen, Rob, (2002). Corporations Law in Australia. New York: Federation Press. Kahn-Freund, O. (1994). Some reflections on company law reform. The Modern Law Review, 7(2): 54–66. Lee v Lee’s Air Farming Ltd [1960] 3 Marshall, Shelley; O’Donnell, Anthony; Jones, Meredith; Mitchell, Richard and Ramsey, Ian. (2011). Law, Corporate Governance and Partnership at Work: a Study of Australian Regulatory Style and Business Practice. Surrey: Ashgate Publishing. Pathak, Akhileshwa (2007). Legal Aspects of Business. New Delhi: Tata McGraw-Hill. Salomon v Salomon and Co Ltd [1897] AC 22. Smith Stone & Knight v Birmingham [1939] Wheelright, Caren, Australia, in, Anderson, Hellen. (2008). Directors’ Personal; Liability for Corporate Fault: a Comparative Analysis. Sydney: Kluwer Law International. Worthington, Sarah and Sealy, Len. (2007). Cases and Materials in Company Law. Oxford: Oxford University Press. Read More