Assess the likelihood of Sid and Kenny avoiding personal liability for the debts of the company

Student I.D. 11207984

Question 3

Assess the likelihood of Sid and Kenny avoiding personal liability for the debts of the company. [20 Marks]

Answer

This question deals with directors avoiding personal liability for debts of a company, especially within the category of fraud, which is applicable to this scenario. This question also deals with lifting the corporate veil as if the directors are found to be liable the veil will need to be lifted, so as to expose the members whom are found to be liable.

When a company is incorporated it is treated as a separate legal entity distinct from its promoters, directors, members, and employees and hence the concept of the corporate veil, separating those parties from the corporate body has arisen.

The company as a separate entity was firmly established in the landmark decision in Salomon v. Salomon &Co Ltd. In this case Salomon, a sole trader, sold his manufacturing business to Salomon & Co Ltd. (a company which he incorporated) in consideration for all but six shares in the company, and received debentures worth £10,000. The other subscribers to the memorandum were his wife and five children who each took up one share. The business subsequently collapsed, and Salomon made a claim, on the basis of the debentures held as a secured creditor. The liquidator argued that Salomon could not rank ahead of other creditors due to Mr. Salomon and the company was one. The House Of Lords held that Salomon & Co Ltd. was not a "sham". As the debts of the corporation were not the debts of Mr. Salomon because as they were two separate legal entities, and once the artificial person has been created "it must be treated like any other independent person with its rights and liabilities appropriate to itself".

The principle established in Salomon v. A. Salomon Co Ltd, that a company is a legal entity entirely separate and distinct from the members of that company, and directors will not incur personal liability for acts done in their capacity as such.

However it is well established that, in certain situations the English Courts are willing to look behind the company and pierce the corporate veil. The situations include an agency relationship, groups of companies and cases where a company was used as a "sham" or fraud.

In the light of this scenario, the issue is that Sid and Kenny have set up a company called “Justincase Ltd” and sell most of the assets of “Flash Ltd” in case the company become insolvent after receiving a hefty fine.

It is an offence for persons to be involved ...

This is a preview of the whole essay

It is an offence for persons to be involved in trading by a company to defraud creditors (Companies Act 1985, s.458) The activity of selling assets to a “sham” company, without the prior knowledge of the shareholders is seen as fraud, and Justincase Ltd. is seen as a mere cloak or sham of this fraud. A director of a company who is aware of impending insolvent liquidation may also be made liable to make such payment as the courts think proper (Insolvency Act 1986, s.214), for example the amount by which the company’s assets were depleted by the Director’s misconduct as in Re Produce Marketing Consortium (No.2).

If in the course of the winding up of a company it appears to the court that any business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose, those individuals can be called upon to contribute to the debts of the company. In Re Todd Ltd, for example, a Director was found liable to contribute over £70,000 to the debts of the company because of his activities. Section 213 of the Insolvency Act 1986 provides that any person who is or was knowingly a party to fraudulent trading by a company whose business is being carried on with intent to defraud creditors or other persons, may be liable to pay the debts of the company. Criminal penalties can also be imposed for fraudulent trading under Section 458 Companies Act 1985.

It is well established that the courts will not allow the corporate form to be used for the purposes of fraud or as a device to evade a contractual or other legal obligation.

This narrow exception is established in the cases of Gilford Motor Co. v. Horne and Jones v. Lipman. On these authorities, the court will disregard corporate personality where the corporate form is used exclusively as a device to evade an existing, fully crystallised contractual or other legal obligation.

In the Gilford Motor Company case, the Court of Appeal was clear that “the company was formed as a device, a stratagem, in order to mask the effective carrying on of business of Mr. Horne”.

In the later case of Jones v. Lipman, it was held that the company here was a "mask that Mr. Lipman holds before his face in an attempt to avoid recognition by the eye of equity".

When applying the fraud exception to pierce the veil of incorporation, there are a number of issues, which have to be considered in order to apply the exception. The issues that need to be considered are the motives of the fraudulent person, the character of the legal obligation being evaded and the timing of the incorporation of the devise company.

The first issue regarding the motive of the fraudulent person(s) is important to establish, as an element of deception is necessary in the fraud exception.

In Gilford Motor Co v. Horne and Jones v. Lipman the defendants clearly intended to deceive the plaintiff by using the corporate form to deny the plaintiff by using the corporate form to deny the plaintiff a legal right. Also in the Court of Appeal in Adams v Cape it was stated that motive of the fraudulent person is relevant.

The second aspect of the fraud exception to succeed is that the defendant must intend to deny the plaintiff a pre-existing legal right. Therefore if the legal right crystalises before the corporate form is used to evade the right then the exception would be satisfied because the defendant intends to use the company to deny the plaintiff that legal right and the mental element is satisfied. This aspect of the exception will also suffice, where the legal right crystalises after incorporation, but before the use of the corporate form to evade the legal right.

The third aspect that needs to be considered is the timing of the incorporation of the device company, this aspect was the reason why the fraud exception was not considered in Creasey v. Breachwood Motors Ltd.

It is irrelevant that the device company has been formed with the view to carrying out the fraud or was already in existence and the carrying on its own business as long as the device company has been used as a tool to effect the fraud.

Assuming that selling the assets of Flash Ltd to Justincase Ltd and hence now owned by Justincase Ltd., which is owned and run by Sid and Kenny was fraudulent. Then therefore it is necessary to establish whether the veil between Sid, Kenny and Flash Ltd. can be lifted to gain access to the assets sold to Justincase Ltd.

The above question as to whether the corporate veil could be lifted was discussed in Gencor ACP Ltd. v, Dalby, which also the diversion of assets to an offshore company.

In the case of Gencor ACP Ltd. v. Dalby it was held that Dalby and B the offshore company were liable to account for the profits and commissions made on new or second hand plant sales that ACP could have supplied.

Furthermore, it was seen appropriate in this case to lift the corporate veil in regard to B Ltd. because it was an offshore company wholly owned and controlled by Dalby, everything it did was alone on his direction alone. It had no staff and was incapable of carrying on business without Dalby and was in substance little other than Dalby's offshore bank account held in a nominee name.

Therefore B Ltd. was simply a creature company used by Dalby to receive profits for which he was accountable to and in those circumstances it was right for the court to lift the veil.

In conclusion it seems that due to the circumstances in which Sid and Kenny set up and sold assets to Justincase Ltd, the courts would be likely to lift the corporate veil and impose personal liability on Sid and Kenny for the debts of the company.

Salomon v A. Salomon and Co Ltd. [1897] A.C. 22

National Dock Labour Board v Pinn and Wheeler

Macpherson J. said that "it is only in special circumstances, which indicate that there is a mere façade

Concealing the true facts, that it is appropriate to pierce the corporate veil".

Smith Stone & Knight Ltd. v. Birmingham Corporation [1939] 4 ALL ER 116 (KBD)

DHN Food Distributors v LB Tower Hamlets [1976] 1 WLR 852.

However subsequent application of the groups' approach has been limited. The House of Lords has limited

The application of this approach to wholly-owned subsidiaries in the later decision of

Wilson v Strathclyde Regional Council (1978) SC (HL).

Gencor ACP Ltd & Ors v Dalby [2000] 2 BCLC 734 (ChD).

Re Produce Marketing Consortium (No.2) [1989] 5 BCC 569

Re Todd Ltd [1990] BCLC 454

Referred to as the "fraud exception"

Gilford Motor Co. v Horne [1938] Ch 935 (CA).

Jones v Lipman [1962] 1 ALL ER 442

Lawrence L.J.

"…I agree with the finding by the learned judge that the defendant company was a mere channel used by the defendant Horne for the purpose of enabling him, for his own benefit, to obtain the advantage of the customers of the plaintiff, and that therefore the defendant company ought to be restrained as well as the defendant Horne"

Jones v. Lipman [1962] 1 ALL ER 442

Adams v Cape Industries Plc (1990) 2 WLR 657;

Creasey v Breachwood Motors Ltd [1993] B.C.L.C 480 (QBD

Jones v Lipman [1962] 1 ALL ER 442

Gilford Motor Co. v Horne [1938] Ch 935 (CA).

Gencor ACP Ltd v. Dalby [2000] 2 BCLC 734 (ChD)