Legal Principle of Separate Legal Entity for Companies

In the context of modern law having a legal entity has a special reference considering the set of varying rights and obligations it makes one eligible to.  Unlike the concept of biological entity, a legal entity does not essentially need to be a alive or human but need to be able to engage in legal relationships with other legal entities. One of the most interesting legal entities is a company structure which distinguishes itself from all the other business structures since unlike other, a company tends to possess a separate legal entity independent of the owners or shareholders. While, this understanding has now been etched in various statutes, however, this viewpoint commenced from a landmark case i.e. Salomon v A Salomon And Co Ltd [1897] AC 22 (Harris, 2013). In wake of the significance of this case, this case merits detailed discussion.

Mr. Aron Salomon had a shoe business. Since his sons wanted to become partners in the business, hence the father (Mr. A. Salomon) converted the business in the form of a limited company.  The company purchased Salomon’s shoe business for an excessive consideration of £39,000 and in exchange granted 20,001 shares in the company. There were only 6 shares remaining in the company which were given to other family members. Also, debentures to the tune of £10,000 were issued to A. Salomon by the new company in exchange of the working capital loan provided by him. After the formation of the company, the boot sales declined since government was the main customer and it decided to diversify the suppliers in wake of the ongoing strike so as to reduce dependence on any particular supplier.  As a result, the company failed and the remaining assets of the company were liquidated by A. Salomon to clear the debentures. In the process, there was nothing left for the unsecured creditors of the company. The company liquidator also felt that floating charge of the debentures should not have been settled using remaining assets of the company and hence the unsettled creditors decided to sue A. Salomon for recovery (Ciro and Symes, 2013).

The High Court and also the Court of Appeal found Salomon guilty. Infact, in the Court of Appeal, it was highlighted that Mr. A. Salomon had abused the limited liability associated with incorporation of a company. As a result, the company is merely a trustee of the primary shareholder i.e. A. Salomon and had been put in place so that Salomon can escape debt liability.  In this regards, it was also indicated that the ownership of one share each by the other six members of the family was infact carried out to ensure that the majority shareholder can carry out business while enjoying limited liability. However, the above verdict was overturned by the House of Lords as it was argued that the company was lawfully incorporated and therefore limited liability would apply. The underlying intention and the limitation of the statute regarding limited liability of company does not need to be considered by the judges. As a result, Salomon was relieved of the liability arising from the unsettled creditors of the company since it was a separate legal entity from the shareholders (Harris, 2014).

Salomon v A Salomon And Co Ltd Case

The above concept of company and shareholders being separate legal entity has been directly incorporated in the Corporations Act 2001 (Cth) through s. 124 which clearly highlights that company is a separate legal entity which is capable of entering into contractual relations (Cassidy, 2013). Additionally, there are additional sections which are present in order to delegate appropriate authority to agents so that contracts can be enacted with outside parties on behalf of the company.  Also, there are s. 129 and s. 128 in the Corporations Act which govern the contractual relation with outsiders and considers the company as principal which the employees and management as agents (Pathinayake, 2014).

In order to understand the legal basis of the separate legal entity principal, assume a company which has been duly incorporated with various members and directors. The company is a separate legal entity separate from the shareholders (both majority and minority). This implies that the various contracts for the business are enacted with the company and the management and employees are essentially agents which have been given specific powers to enact contracts with other parties on behalf of the company since the company cannot do this on its own. Owing to the legal principle of company having a separate identify from agents, hence the agents especially financial managers are able to take optimal decisions without fear of any liability arising on them provided they have acted honestly and with due care and diligence (Lindgren, 2011).

Additionally, owing to limited liability, the monitoring requirements by shareholders in relation to the decisions taken by management are reduced. In case of unlimited liability of companies which extends to owners, there would be a far greater monitoring and scrutiny of the management and the underlying decisions taken. This would have adverse impact on the economic efficiency owing to higher agency costs and trust deficit between management and shareholders (Harvey, 2009). This may also lead to increasing temptation on part of the owners to be managers which again could be disastrous.  Presence of limited liability also has aided the smooth and efficient functioning of the capital markets since the value of the company is not dependent on the wealth of the shareholders.  The separation of ownership also aids the diversification of the portfolio of investors which becomes possible only because they are aware that there risk is limited to the equity investment (Ramsay and Noakes, 2001).

Corporate Entity under Corporations Act 2001 (Cth)

In case of unlimited liability, the shareholders would limit their holdings since one bankrupt company could potentially lead to the investor being bankrupt.  Further, the legal principle of a separate legal entity for the company also resolves agency problem to an extent since there is possible transfer of shares and the underlying value is driven by the company performance alone and not by the wealth of the shareholders (Cassidy, 2013). As a result, the investors and shareholders are interested in rewarding the management and employees for higher performance since this generated wealth for them and leads to a win –win situation for both. It is apparent that the legal principle highlighted in Salomon case has played a vital role in the growth of modern organisations and the underlying economic efficiency that they have achieved which otherwise would have been impossible (Ciro and Symes, 2013).

In wake of the Salomon case, a key concern or threat which arises is the potential abuse of the limited liability provided by the company structure for causing farm to innocent outside parties. In order to ensure the same, the courts in selected case can pierce the corporate veil in order to ascertain if there is any wrongdoing or fraud happening in the name of the company. Further, post the Salomon case, there have been modifications in legislation globally to introduce various circumstances where the courts can legitimately ignore the separate identity of the company (Harris, 2013).

Infact, there is intense debate where the legal position taken in Salomon case would be tenable in the modern legal environment making the current environment less vulnerable to abuses of the limited liability clause associated with the company. This is apparent from the various related verdicts such as Pepper v Hart [1992] UKHL 3 and Re Spectrum Plus Limited [2005] UKHL 41 (Pathinayake, 2014). Also, unlike the approach taken by House of Lords at the time of Salomon case, the current approach adhered to by courts in relation to interpretation of Acts is to consider the underlying objective and purpose of the legislation. In Australian context, Acts Interpretation Act 1901 tends to endorse this position (Harris, 2014).

Even though courts in the recent past have been less apprehensive of lifting corporate veil but there is clear lack of coherent principles or case laws which are driving the same owing to which there is a lot of uncertainty in matters related to corporate veil piercing. A similar view has been highlighted by Rogers AJA in the Briggs v James Hardie & Co Pty Ltd (1989) 16 NSWLR 549, 558 case. Also, Herron CJ in the Commissioner of Land Tax v Theosophical Foundation Pty Ltd (1966) 67 SR (NSW) 70 case labelled corporate veil lifting as an “esoteric label” (Ramsay and Noakes, 2001).

The broad categories where piercing the corporate veil is considered appropriate include agency relations where company is an agent of a majority shareholder,  company formed for conducting fraud, establishment of a sham company, group companies where the group company in under control of parent along with cases where there is unfairness or injustice.  However, the individual piercing incidents tend to depend on a host of factors including nature of company (public or private), number of shareholders, context of case and underlying reason to pierce (Cassidy, 2013).

In wake of the above discussion, it may be recommended that while the certainty regarding piercing the veil still lacks but the law has come a long way since the time of the Salomon case with numerous checks and balances being inserted to prevent abuse. Further, the limited liability of company has enabled the modern day success and economic efficiency of this business structure. Hence, instead of changing law, there is a need to law down the basic principles in relation to piercing the corporate veil so as to reduce uncertainty and enhance procedural fairness and justice to all without giving up gains of this legal principle.

References

Cassidy, J. (2013) Corporations Law Text and Essential Cases  4th ed. Sydney: Federation Press.

Ciro, T. and Symes, C. (2013) Corporations Law in Principle 9th ed. Sydney: LBC Thomson Reuters

Gibson, A. and Fraser, D. (2014) Business Law. 8th ed. Sydney: Pearson Publications.

Harris, J. (2013) Butterworths Questions and Answers Corporations Law 4th ed. Sydney: LexisNexis Australia.

Harris, J. (2014) Corporations Law. 2^nd ed. Sydney: LexisNexis Study Guide.

Harvey, C. (2009) Foundations of Australian law 3rd ed. Victoria: Tilde University Press.

Lindgren, K.E. (2011) Vermeesch and Lindgren’s Business Law of Australia 12th ed. Sydney: LexisNexis Publications

Pathinayake, A. (2014) Commercial and Corporations Law 2nd ed. Sydney: Thomson-Reuters.

Ramsay, I.M. and Noakes, D.B. (2001) Piercing the Corporate Veil in Australia, Company and Securities Law Journal, Vol. 19 No.1, pp. 250-271