Limited Liability A history of Salomon v Salomon

INTRODUCTION

The concept of limited liability is, as some modern corporate law scholars believe, as important an invention as electricity and the steam engine.  This might be too extreme a comparison, nevertheless, the importance of limited liability in the corporate, legal and even the international trade realm cannot be denied.

So, what is limited liability? Limited liability can be defined as a legal structure of an organisation or business, where a corporate loss will not exceed the amount invested in to the organisation. This basically means that private assets of the directors/shareholders of the business will be safe if the business fails.

In order for limited liability of directors and shareholders to exist, the company in question must be incorporated. Incorporation is the process by which a new or existing business becomes a registered company. Once a company is incorporated, it automatically develops its own legal/corporate personality which is separate from the directors/shareholders. This therefore means that the company now has rights, obligations and liabilities separate from its directors/shareholders.

HISTORICAL BACKGROUND

The existence of limited liability can be traced back to the Limited Liability Act of 1855. However, several shortcomings existed, for example, companies could only be formed by royal charter or Acts of Parliament. Over the years, companies could be formed by the subscription of members and the registration of particulars in a central registry. These changes made it easier for individuals to incorporate companies but several judges dismissed cases, opining that individuals were only trying to avoid potential debts by incorporating their businesses. It was not until the landmark case of Salomon v A. Salomon and Company [1897] A.C. 22 that the concept of limited liability was crystalized as a fundamental core in corporate law.

Salomon v A. Salomon and Company [1897] A.C. 22

Salomon ran a boot making business as a sole proprietor. Due to a bad economy, his business started suffering, as a result, he incorporated a company compromising of himself and his family, named Salomon Ltd, and transferred his sole proprietorship to the company for a sum of £39,000. Out of the £39,000, the company retained £20,000 and instead gave Mr. Salomon 20,001, out of 20,007(nominal value of £1 per share), of shares in the company. The remaining six shares were held by Salomon’s family members. Additionally, Mr. Salomon further also received a floating security debenture of £10,000.

The company, ran by Mr. Salomon as managing director, still couldn’t pick up business and fell upon hard times. As a result, Mr. Salomon attempted to save the business by selling his debentures to a Mr. Edmund for £5,000 and subsequently lending the £5,000 to the business and charging an interest rate of 10%.

Despite all of Salomon’s efforts, the company still went into liquidation. At this point, the company was valued at £6,000.  This amount was just enough to pay off Mr. Edmund (£5,000), who was a secured creditor. At the same time, Mr. Salomon intended to rely on his equitable interest in the debentures to claim the remaining £1,000, arguing that he should be treated as a secured creditor and be paid ahead of the unsecured creditors who were owed by the company.  The unsecured creditors argued that Mr. Salomon and the company were the same person and as a result, Salomon should not have priority over them.

Therefore, the issue that arose was whether Mr. Salomon, who was the majority shareholder of Salomon Ltd, would be personally liable to pay off the debts the company owed to the unsecured creditors.

Both, the High Court and the Court of Appeal declared the company to be a myth and that Salmon had incorporated the company contrary to the intent of the Companies Act 1862. Furthermore, the courts also declared that the company, Salomon Ltd, was an agent of Mr. Salomon and as a result, concluded that Mr. Salomon should be liable to pay the debt incurred by the company during the course of its agency.

However, on further appeal to the House of Lords, the decisions of the High Court and the Court of appeal were overturned. The House of Lords held that as long as a company was duly and properly incorporated, it should be seen as an independent person under the eyes of law. This ruling therefore meant that Mr. Salomon was not personally liable to pay the debts of the company and also established the “corporate veil” between the company and its owners/shareholders

It is the establishment or the creation of the so called “corporate veil” which leads to this case being so essential. The House of Lords in establishing the corporate veil created a separation between the identity of the company (separate legal identity, as mentioned above) and the identity of the owners/shareholders.

Over the years the ruling in the Salomon case has been upheld in several other high profile case such as Macaura v Northern Assurance Co Ltd [1925] AC 619

 

WHEN CAN DIRECTORS AND SHAREHOLDERS BE PERSONALLY LIABLE? (EXCEPTIONS TO THE CONCEPT OF LIMITED LIABILITY)

Exceptions to the concept of limited liability arise when courts look at the company and its corporate body (owners, directors and shareholders) as one entity. This is normally referred to as “piercing the corporate veil” or “lifting the corporate veil”.

When the corporate veil is “lifted” or “pierced”, it makes the Company’s officers liable for the debts of the company. This means that the officer’s personal can be at risk to pay off any debts of the company in question.

The corporate veil can be lifted/pierced in the following situations.

1. Wrongful trading – wrongful trading is deemed to have occurred if a director knew or ought to have reasonably known that the company is insolvent or going towards insolvency and did not take every reasonable measure to ensure creditor’s losses are minimized.
2. Fraud – The case of Standard Chartered Bank v Pakistan National Shipping Corporation  [2002] UKHL 43, perfectly highlights how the courts view fraud with regards to the corporate veil and limited liability. In this case, the courts held that no one can claim that they committed fraud on behalf of someone else (this being a company with separate legal personality), in an attempt to avoid personal liability arising from the fraudulent actions.
3. Evasion of legal duty – This principle holds that the corporate veil will not protect directors/shareholders where the directors/shareholders have legal rights against them, which are independent from the company and, they attempt to use the company’s separate legal personality to avoid personal liability.  This was the ruling by the supreme court in the case of   Petrodel Resources Ltd v Prest (2013)
4. Agency – a company can act as an agent if its members i.e. directors/shareholders authorize the company to do so. In such cases, individual members are bound by the acts of the company (agent) as long as those actions are within the scope of authority. Therefore, the director/shareholders may potentially become personally liable for the acts of the agent company.

 

ADVANTAGES AND DISADVANTAGES OF LIMITED LIABILITY COMPANIES.

Now that we have identified what limited liability is, its historical foundations, how it is created i.e. the veil of incorporation and separate legal personality and its exceptions, we shall take a look at the advantages and disadvantages of limited liability.

Advantages

1. Minimising personal liability –the most common and the most obvious advantage that comes along with separate   legal personality and limited liability. In fact, it is possibly the core reason why individuals incorporate companies. As discussed earlier, when a body corporate. This means that if the company runs into financial difficulty, the personal assets of the body corporate will not be used to pay off the companies debts hence meaning the directors/shareholders have limited liability.

Directors/shareholders can be limited by share or guarantee.  When a shareholder is limited by shares, their liability is limited to the amount they paid or are due to pay for the shares that they own.  When a company is limited by guarantee, there are members instead of shareholders. These members are normally liable to pay an amount they have previously guaranteed to pay in case the company runs into financial difficulty and has to pay of its debts. In most cases, the amount guaranteed by members in £1.

2. Improved taxation strategy and efficiency- limited companies pay less in corporation tax than sole traders paying basic or higher rate income tax. Currently, limited companies pay a fixed 19% corporation tax.

Furthermore, a limited company offers much more flexibility when it comes to tax strategy. Owners of limited companies can reinvest surplus cash back into the business for future costs and expenditures. This means that owners would withdraw less money and thus pay less personal income tax but also ensures the business is liquid enough for any future financial difficulties.

3. Better protection for your company name – when incorporating a company, owners have to choose a company name. This name has to be distinct and cannot be the same or similar to another existing business, which is a limitation, but at the same time, your registered name cannot be used or registered by another business. This sort of protection is not enjoyed by sole traders.
4. Creates a better image for your business – incorporation will lead to a better professional image of your business, this naturally adds more integrity and prestige to a business. Furthermore, this increased integrity may open several avenues and improve business since some companies especially those dealing with IT and finance are only willing to do business with incorporated companies.

 

Disadvantages 

1. Restrictions on company name – an incorporated company will be restricted when it comes to selecting their name. A company cannot register itself under a name which has already been selected by an existing company. Additionally, there are also some statutory restriction to selecting a company name.
2. Less discrete – limited companies must be registered at Companies House, incorporation requires the payment of a incorporation fee which is also an added disadvantage. Once a company is incorporated, all of its personal and company information will become public record.
3. An incorporated company must adhere to strict regulations –Procedures exist when withdrawing money, filing tax returns, annual accounts and record keeping such as the minutes of all meetings and recording the decisions made by directors and shareholders.

 

IN SUMMARY

Limited liability is a product of separate legal personality. This separate legal personality of a company is created and separated from the personality of the individual officers.

The historical foundations of limited liability have existed long before the case of Salomon v Salomon, however, it was this aforementioned case which led to the concept of limited liability and separate legal personality being crystalized as a core element in corporate law. Despite the strengthening of the concept of limited liability by the Salomon case, it is subject to exceptions, just like any other legal concept.  These exceptions are known as “lifting” or “piercing” the corporate veil.

The advantages of limited lability are clear to see but, as mentioned above, disadvantages do exist as well. Therefore, it is up to every individual to decide whether or not to incorporate their business based on what suits them best.

HOW WE CAN HELP.

AI Law is a full – service commercial law firm with a team of experienced commercial lawyers. We strive to understand our client’s business, ethos, and aims which ensures we approach each matter in a way that is unique and value-building to each client.