In spite of the obvious economic connection between companies within the same group, English company law has steadfastly maintained its policy of treating such companies as distinct legal entities

NOTE: This document does not provide legal advice it is only intended as a discussion draft to be updated and modified to fit the circumstances. The publishers and authors shall not be liable to any person with respect to any loss or damages caused or alleged to be caused directly or indirectly by the information or any mistake in this document. In particular, all statutory references should be checked and users are reminded that changes are continually being made to the law and the document will not be up to date. [25 August 2011]

GP06-1758

In spite of the obvious economic connection between companies within the same group, English company law has steadfastly maintained its policy of treating such companies as distinct legal entities.

Explain this statement. Consider the need for reform.

Contents

3Introduction

4Salomon v Salomon

5Lifting the veil of incorporation

5Fraud

5Faade or a sham

7Groups of Companies

10Adams & Others v Cape Industries plc

12Is there a need for reform?

14Conclusion

16Bibliography

16Books:

16Journals:

17Cases:

17Websites:

18Bill:

Introduction

In order to explain the statement this essay will explore the background to treating companies as distinct legal entities; review certain cases trying to pierce limited liability; discuss the application of these rules to groups of companies; and then consider whether there is a need for reform.

Over a century ago the English Courts established the basic principle of separate corporate personality: the corporation has a separate existence from the shareholder per Vaughan Williams J in Salomon v Salomon. A distinct legal personality can own and deal with property, sue and be sued in its own name and contract on its own behalf.

A company has a dual nature as both an association of its members and a person separate from its members. The companys property is owned by the company as a separate person, not by the members; the companys business is conducted by the company as a separate person, not by the members; and it is the company as a separate person that enters into contracts in relation to the companys business and property. The members are not personally entitled to the benefits or liable for the burdens arising, so their rights are restricted to receiving from the company their share of profits and their liabilities to paying the amounts due from them to the company.

The acts of the company are not the acts of the shareholder, and so the companys liabilities do not become the liabilities of the shareholders. This is perhaps the greatest privilege of incorporation: in a company the members have no individual liability to its creditors for debts owing by the company. This gives limited liability to shareholders whereby they are only liable up to the extent of their committed investment in the company. Salomon v Salomon

The separate personality of a company as distinct from its shareholders was established by the House of Lords in Salomon v Salomon & Co [1897]. This led to the veil of incorporation; that a registered company is a legal person separate from its members. The company is at law a different person altogether from subscribers to the memorandum per Lord Mcnaughten. It established the position in English law of the concept of separate legal personality for companies. It is the leading case on the fundamental importance of the separate personality of a company.

Mr Salomon was a boot and shoe manufacturer. At First Instance, it was held that the company had conducted the business as agent for Mr Salomon, so he was responsible for all debts incurred. The House of Lords rejected this approach a company may be said to carry on a business for and on behalf of its shareholders but this does not in point of law constitute the relation of principal and agent between them or render the shareholders liable to indemnify the company against the debts which it incurs. It was held that however large the quantity of shares and debentures owned by one man even if the other shares were held in trust for him the companys acts were not his acts, nor were its liabilities his liabilities; nor is it otherwise if he has sole control of its affairs as governing director. There was strong evidence of good faith and confidence in the company and the House of Lords found no evidence of fraud or deliberate abuse of the corporate form.

It is impossible to dispute that once the company is legally incorporated it must be treated like any other independent person with rights and liabilities appropriate to itself. The House of Lords affirmed that a company is not the agent of its shareholders, even if control is concentrated in only one shareholder. Once the company is legally incorporated it must be treated like any other independent person with rights and liabilities of its own.

Lifting the veil of incorporation

There are exceptions to the principle in Salomons case, where the veil is lifted, or pierced, and the law disregards the corporate entity and pays regard instead to the economic realities behind the disguise. Exceptions can be classified into those expressly provided by statute (such as in section 214 of the Insolvency Act 1986 which makes directors liable for wrongful trading) and those under judicial interpretation. To lift the veil of incorporation simply means to ignore or set aside the separate legal personality of a company.

Creditors have tried to pierce through this concept of a company being a separate legal entity. However Courts are very reluctant to let them do so unless there is evidence of fraud or a sham.

Fraud

The corporate form cannot be used for the purposes of fraud, or as a device to evade a contractual or other legal obligation. Where there is fraud or a deliberate breach of trust the courts show a willingness to set aside the corporate form. They pierce the corporate veil in order to achieve justice. Standard Chartered Bank v Pakistan National Shipping Corporation established that reliance upon fraudulent representation was in itself sufficient, irrespective of other matters, to lift the veil. This case also ascertained that the liability arose from having committed fraud, not by virtue of a position as director.

Faade or a sham

Special circumstances may justify piercing the corporate veil if the company structure is a mere faade concealing the true facts. The House of Lords confirmed in the case of Woolfson v Strathclyde Regional Council, where there were no grounds for treating the company structure as a mere faade, that there was no basis on which the corporate veil could be pierced.

This principle has been endorsed in numerous cases including by the Court of Appeal in Adams v Cape Industries plc. Bare guidelines as to the principles were set out in Adams, which is discussed in more detail below, it was held that the veil of incorporation may be lifted when: [first] it is possible to establish that there is an agency relationship between the parent and the subsidiary although exceptional facts will generally be needed to support this argument. Secondly it might be argued that the court should pierce the corporate veil, i.e. it should conclude that the company structure is a mere faade concealing the true facts applying Woolfson v Strathclyde Regional Council.

The essence of cases where piercing does occur involve situations where a corporate structure has been used by a defendant to escape limitations imposed on his conduct by law. Case examples demonstrating this are Gilford Motor Co Ltd v Horne and Jones v Lipman. In the first case, a former employee who was bound by a covenant not to solicit customers from his previous employers set up a company to do so. The court found that the company was merely a front and so granted an injunction to enforce the covenant not to solicit against both Horne and the company which he had formed as a cloak for his activities. In Jones v Lipman one of the most recognised categories in which the veil will be lifted was seen. Mr Lipman entered into a contract to sell land to Mr Jones. He then changed his mind, formed a company and transferred the land to the company as part of a plan to avoid the transaction. In this case the judge found the company was a device and a sham and so satisfied the faade test; there was a right to pierce the corporate veil.

Other situations are where a corporate structure has been used by a defendant to avoid such rights of relief as third parties already possess against him: case examples being Re a Company and Trustor AB v Smallbone. In Re a Company it was held that the evidence established that the defendant had created a network of English and foreign companies and trusts through which he could dispose of his English assets and, when the insolvency of the plaintiffs was imminent and after the alleged fraud had been committed, he had used this network to dispose of his assets. In these circumstances the court could pierce the corporate veil in order to achieve justice.

However Trustor AB v Smallbone confirmed that the courts will not tolerate any further erosion of the fundamental principle of the English Company Law that a company is to be regarded as a legal entity with separate legal personality, distinct from that of its members. There is no general power to lift the veil in the interests of injustice. Although in this case the company was shown to be a faade or sham and its acts of impropriety were linked to this device: the company was being used to conceal facts to avoid personal liability and so the veil was lifted. It was stated that for the veil to be lifted there had to be a link between the impropriety and faade. Groups of Companies

Behind the simplicity of the Salomon doctrine is the complex reality that most large businesses are carried on through the medium of groups of companies. This may be for a number of legitimate reasons such as opening a new business overseas which may be more sensibly conducted through a subsidiary so as to comply more easily with local requirements. Also there may be tax advantages or if the business is risky it may be commercially prudent to limit the exposure of the parent company.

The clear position in England is that the Salomon entity concept continues to apply and all companies in a group of companies are separate legal entities and are not the agents of their controlling shareholder. It is a feature of company law that it allows a group of companies to be arranged so as to separate liabilities for the various activities of the group. The fundamental principle is that each company in a group of companies is a separate legal entity possessed of separate legal rights and liabilities. However from time to time there have been arguments over whether the separate personalities of companies in a group of companies should continue.

It is sometimes argued that it is inappropriate in the modern business world where so much commercial activity is carried out in groups to rely on the strict Salomon approach. Various alternative approaches have been suggested and it has been argued that the law should develop an approach which would treat groups in a way that obligations and responsibilities would be attached to the group and not to individual companies. In this way it is argued the law would reflect the economic reality which is that a group of companys trade as a group, raise capital as a group, and are considered by those dealing with them as a group. A rebuttal of this idea is demonstrated by the case of Ord v Belhaven Pubs Ltd where the trial judge had viewed the whole group as an economic entity but was over-ruled by the Court of Appeal.

Also in the case of The Albazero [1977] where a cargo of crude oil which was transported by Concord Petroleum Corporation, a wholly owned subsidiary of Occidental Petroleum Corporation, the Court of Appeal reaffirmed the long established and now unchallenged by judicial decision that each company in a group of companies is a separate legal entity possessed of separate legal rights and liabilities.

The case of DHN Food Distributors Ltd. v Tower Hamlets London Borough Council [1976] offers an entirely different analysis. In this case there was the problem of compensation on the compulsory purchase of land; one company in the group owned the land and another conducted its business on the land. Lord Denning suggested the corporate veil could be lifted and that the companies were in reality a group, and should be treated as one. In the Court of Appeal Lord Denning MR stated that these subsidiaries are bound hand and foot to the parent company and must do what the parent company says virtually the same as a partnership They should not be treated separately. Goff LJ said look at the realities of the situation and pierce the corporate veil. This case though is not easy to reconcile with the bulk of the other cases on this subject.

A group of companies has multiple levels at which the relationship between the subsidiary and the parent company will be intertwined. The case of Woolfson v Strathclyde Regional Council established that the element of control is a central issue as to whether the corporate veil should or should not be lifted. Woolfson v Strathclyde Regional Council concerned the question as to whether a group of companies could be regarded as a single entity for legal purposes; here whether a subsidiary and parent company could be regarded as a single entity in order to enable them to claim compensation for disturbance on a compulsory purchase. This case was argued in the House of Lords two years after DHN Food Distributors Ltd., and Dennings views were disapproved of. It was held that the corporate veil could not be pierced as there were no grounds for treating the company structure as a mere faade.

Adams & Others v Cape Industries plc

Adams & Others v Cape Industries plc [1990] is probably the most important case establishing that the corporate veil should not be pierced just because a group of companies operated as a single economic entity. Cape an English company headed a group which included many wholly owned subsidiaries. The arguments for piercing the corporate veil were split into three. First, the single economic unit argument, being that a group of companies should be treated as a single economic entity. Secondly the argument in Woolfson v Strathclyde Regional Council which established that the veil can be lifted where special circumstances exist indicating that it is a mere faade concealing the true facts. Thirdly the agency argument.

On the first argument it was held that the mere fact that a parent and subsidiary are one entity for economic purposes should not mean they can be treated as one unit for legal purposes; each company in a group of companies is an independent entity. To lift the veil would require exceptional circumstances. On the second argument it was held that a companys separate personality should not be ignored simply because it is controlled by another person. Cape Industries plc had made a legitimate use of the corporate form and this did not constitute a ground for piercing the corporate veil. The third argument also failed as it is difficult to establish an agency relationship unless there is express agreement.

However in Creasey v Breachwood Motors Ltd [1992] an employee had a claim for unfair dismissal against a company. After the claim arose all assets of the company had been transferred to another company owned by the same individuals and the first company had been dissolved. The second company was added to the action. It was held that the court had power to lift the veil to achieve justice where its exercise is necessary for that purpose. However achieve justice has been suppressed in several influential Court of Appeal cases and Creasey has now been overruled in Ord. & Anor v Belhaven Pubs Ltd.In Ord. & Anor v Belhaven Pubs Ltd. [1998] the Court of Appeal refused to pierce the corporate veil. They rejected any idea that a group of companies could be regarded as a single entity except in very limited circumstances where there was some impropriety or the company was a faade concealing the true facts. The Court also expressly stated that the decision in Creasey should no longer be regarded as authoritative.

The Ord. & Anor case demonstrated the continued enthusiasm of the courts to uphold the concept of the separate legal personality of the company as set out in Salomon and to deny the courts the ability to look behind the veil of that corporate personality in any but the most limited circumstances. There was no fraud or impropriety in the actions of this group of companies and there was also no evidence of a sham. Before the veil can be lifted the court must be satisfied that a defendant acted pursuant to some improper or fraudulent motive creating or utilising a corporate faade as a sham or device to achieve something which it could not otherwise lawfully do.

This case endorsed Adams v Cape Industries plc and the principle that the separate legal personalities of the companies could not be disregarded on the basis that they were effectively a single economic unit.

The single economic unit argument obtains a more favourable response when raised before the European Court of Justice. In Viho Europe BV v Commission of the European Communities (supported by Parker Pen Ltd.) it was held that a company and its subsidiaries were to be regarded as a single economic entity for the purposes of art 85 (1) of the EEC Treaty.

Another case where the courts were involved in the issue of piercing the corporate veil was Carlton Communications plc, Granada Media plc v The Football League. The central issue was whether or not the liabilities of ONdigital were guaranteed by Carlton and Granada. Here two separate companies engaged in a joint enterprise through ONdigital. With the benefit of hindsight the football league found that it would have been wise to have obtained a guarantee from one or both of the shareholders. It was argued that a company having its own legal personality distinct from its shareholders was a trite law. However as neither of the shareholders had done anything improper (and had not given any enforceable guarantees) they were not liable.

Is there a need for reform?

The normal English law rules relating to fraud or sham apply to lifting the veil of incorporation within groups. The question is whether the law should go further because a company is within a group and so lift the veil more readily. Various arguments have been raised, such as two or more companies can function as a single unit but in law they are separate and the use of the Salomon principle within a group sometimes produces unjust and purely technical results.

As we have seen these sorts of arguments have been thoroughly tested in the courts in England and the courts have with the odd exception stood firm. Nicholas Murray Butler, the president of Columbia University, claimed that the limited liability company outweighed even electricity as the greatest single discovery of modern times. A company allows investors to pool their wealth and share risks while they get the benefit of limited liability. This concept has allowed enterprise to flourish and the wealth of our nation to grow. Given the benefits companies bring to our economic wealth it is not difficult to understand why the courts are reluctant to allow limited liability to be pierced. To give an example, in the shipping industry (which is a risky business) each ship is held through a separate company and if limited liability was removed the industry as we know it would collapse.

What may be a little more subtle are arguments put forward by animal rights activists, trade unions and other such organisations who argue that limited liability is used to avoid liability that should not be evaded. For instance victims of a tort find it challenging to attach liability to the parent corporate shareholder. As the case of Adams showed it is not illegal for companies to structure themselves with the calculated aim of avoiding liability.

The tort problem is a very real problem when considered against the trend of large companies of relocating hazardous activities to developing countries. The case of the Bhopal disaster in India is an illustration. The factory in Bhopal was one of 14 operated by Union Carbide. To lower costs, the selection of construction material, monitoring standards and safety equipment were sacrificed. There were frequent accidental leaks and workers were exposed to different substances. On the night of the disaster water entered a tank of toxic chemicals and triggered a reaction causing the release of a lethal gas mixture. The leak killed over 8,000 people and injured over 500,000. The legal problem that arose was that the plant in India was a subsidiary whereas the wealth was in the American parent company. If such a case came before the courts, it is difficult to see how the veil could be pierced because of the absence of a sham or fraud but justice seems to demand that it should be pierced as the policies of health and safety standards would have been directed by the attitude of the parent.

Perhaps in the UK an approach more like the US model could be adopted. In New York the courts will disregard the veil either when there is fraud or when the corporation has been used as an alter ego, this theory of liability allows for non fraudulent wrong attributable to the defendants complete domination over the corporation in question United Feature Syndicate Inc v Miller Features Syndicate Inc. This seems to go further than in England.

One way the law is being reformed which has a bearing on these issues is to make directors more personally accountable for their decisions. For instance at the time of writing the Company Law Reform Bill is about to enter the report stage in the House of Lords. Although it is not directly concerned with companys limited liability it does expand directors duties. Clause 156(1) provides that A director of a company must act in a way he considers, in good faith, would be most likely to promote the success of the company. Clause 156(3) imposes obligations on the directors that when considering this duty they must have regard to the likely consequences of any decision in the long term, to the interests of the companys employees, to the need to foster the companys business relationships with suppliers, customers and others and to the impact of the companys operations on the community and the environment. At the moment it is not clear what weight will be given to each of these areas. However these increased responsibilities (together with the expansion of the rights of shareholders to force a company to take action for its own benefit) will perhaps reduce the concern about problems within groups.

Conclusion

Salomon established that a company is a distinct legal entity, it has a separate existence from its shareholders, and this principle has been upheld for over a century. Over the decades the veil of incorporation has only been pierced in circumstances of fraud or where the company has been set up as a faade (to cover some impropriety). This law has been upheld in relation to groups of companies. Although Salomon was decided at a time when groups were not as abundant, the courts have dismissed attempts to distinguish groups from single companies. The cases demonstrate that groups of companies are treated in the same manner as a single company, that each subsidiary is a distinct legal entity separate from other companies including the parent company.

It is not at all clear that a good case can be made for reform of limited liability in groups of companies. As acknowledged in the Journal of Environmental Law, limited liability is beneficial, justifiable, desirable and also part of the social contract with entrepreneurs and investors. Firms working across borders have had to create ways of not only increasing competitiveness but also of managing the risks that come with venturing into hazardous industries and unfamiliar territories. The company is the most dominant legal vehicle employed by firms in conducting business. It forms the foundation of the market economy. The prevalence of limited liability of companies shows the importance of the economic advantages. It encourages risk to be shared more fairly and this encourages enterprise which in turn gives rise to profits which can be taxed to pay for schools and hospitals etc.

The separate legal personality of the company has been established for more than a century, the decades that have intervened have encouraged a belief in this principle but have also allowed exceptions to the concept when lifting of this corporate veil is permitted (in situations of fraud, or sham). However the courts have the power to continue developing the law in this area when public policy requires it. Thus there is currently the possibility of extension of the law at the courts discretion. My analysis of the law in this area leads me to the conclusion that the case for more radical reform of liabilities within groups has not been made. The law as it currently stands reflects the balance that is required between the needs of the economy and the needs of justice.

Bibliography

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Birds J., Boyle A.J., MacNeil I., McCormack G., Twigg-Flesner C., and Villiers C. Boyles & Birds Company Law (5th Ed.). Bristol: Jordan Publishing Limited. 2004.

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Ferran E., Company Law: Lifting the Veil. (1999)

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Cases:

Adams & Others v Cape Industries plc and another [1990] BCLC 479

Carlton Communications plc, Granada Media plc v The Football League [2002] EWHC 1650 (Comm)

Creasey v Breachwood Motors Ltd [1992] B.C.C 638

DHN Food Distributors Ltd. v Tower Hamlets London Borough Council [1976] 1 W.L.R. 852Gilford Motor Co Ltd v Horne [1933] Ch. 935

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Viho Europe BV v Commission of the European Communities [1996] Case C-73/95 PWilliams v Natural Life Health Foods [1998] 1 W.L.R. 830

Woolfson v Strathclyde Regional Council [1978] SC (HL) 90 HL (Sc)

Websites:

Griffiths M. Lifting the Corporate Veil http://www.accaglobal.com/publications/corpsecrev/44/895748. 01/03/2006

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http://www.accaglobal.com/publications/studentaccountant/36826. 01/03/2006

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Bill:

Company Law Reform Bill [HR]. Part 10 Company directors. Chapter 2 General Duties of Directors.

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