Company Law and Insolvency

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1.        Synopsis

2.        Overview of limited liability

  1. Historical background of limited liability
  2. A glimpse of EC law and UK insolvency law
  3. Digress: a brief note of economic and social justification and criticism
  1. Arguments for and against limited liability – a legal perspective
  1. Arguments under company law
  1. Foundational issues – the nature of legal personality and lifting the veil of incorporation
  2. Constitutional issues – the ultra vires doctrine and Turquand’s rule
  3. Constitutional issues – Directors’ duties and the protection of minority shareholders
  4. Constitutional issues – corporate governance
  1. Arguments under insolvency law
  1. Summary


  1. Synopsis

The question requires a critical discussion in light of recent corporate failures of the statement by Michael Schluter, whereby he asserts if the legal institution of limited liability is morally wrong, it will be worth our while to modify or even remove it completely. The question also asks the extent I agree with the statement that limited liability should be modified and/or abolished. It is proposed to structure the discussion as noted in the contents above in order to enumerate and discuss the main legal reasons for/against the limited liability concluding with a summary of the critical points at the end of the discussion.

  1. Overview of Limited liability

Legally speaking, limited liability is a concept whereby a person’s financial liability is limited to a fixed sum, in particular a shareholder in a limited company is not personally liable for any of the debts of the company, other than for the value of his investment in that company.

  1. Historical Background of limited liability

Morally rightly or wrongly, it is undeniable that the modern world is built on the legal institution of limited liability. In the UK, the first company-form firms were incorporated under the Joint Stock Companies Act 1844, although investors in such companies carried unlimited liability until the Limited Liability Act 1855. There was a degree of public and legislative distaste for a limitation of liability, with fears that it would cause a drop in standards of probity  . The 1855 Act allowed limited liability to companies of more than 25 shareholders, which was later reduced to seven by the Companies Act 1856. It is now possible for one person to form a private limited company, called a single member company. Similar institutional development of limited liability had been taken place in France and in the majority of the US states by 1860. By late nineteenth century, most European countries had adopted the principle of limited liability.

Although it was admitted that those who were mere investors ought not be liable for debts arising from the management of a company, throughout the late nineteenth century there were still many arguments for unlimited liability for managers and directors on the model of the French . However such liability for directors was abolished under Companies Act 2006.

By early twentieth century, the shareholder power has manifested itself in several dramatic instances, both in the US and the UK. In the US, shareholder activism increased after the collapse of Enron and Worldcom and exposure of their “creative” financial practices, leading to enactment of the Sarbanes-Oxley Act by Congress in 2002.

In UK, there were legislative and non-legislative changes to reinforce the corporate governance of a company as a result of plethora of corporate scandals and failures. On non-legislative side, corporate governance codes were developed that prescribed best practice in areas such as board structure, and audit committees etc. following the Maxwell, Polly Peck and BCCI scandals. Their recommendations culminated in the issue of the revised Combined Code by Financial Services Authority in August 2003, by which the Listing Rules require listed companies to comply with the Code. On legislative side, the enactment of Companies Act 2006 marked a major change in the legislative framework in the UK, with more emphasis on directors’ duties and derivative claims by members.

More recently in the UK, the financial crisis of 2007-08, which the collapse and nationalisation of Northern Rock foreshadowed, produced a big upswing in business failures, predicating the UK could be on the slippery slope to harsher regulations against corporate failures.

2.2.        A glimpse of EC law and UK insolvency law

The EC law and UK insolvency law play such a significant role in formulating the legal concept of limited liability that the analytic discussion of the doctrine would be insufficiently futile without due regard to the sources of the two laws.

Much of the impetus behind reform of English company law stems from UK membership of the European Community. In essence, the most influential initiatives of European Community on the UK company law have as their base Article 54(3)(g) of the EC Treaty.

Generally, UK insolvency law deals with the insolvency of firms in the UK. The primary pieces of legislation are the Insolvency Act 1986 and the Enterprise Act 2002.

In UK, the first recognised piece of legislation was the Bankruptcy Act 1542. Bankrupts were seen as crooks and the court reasserted this sentiment by stating “bankruptcy is considered a crime and a bankrupt in the old laws is called an offender”. But the industrial revolution’s full swing had changed that. The Joint Sock Companies Act 1844 allowed companies to have “separate legal personality” distinctive from their investors. The Act’s corollary, to bring the existence of these legal persons to an end was the Joint Stock Companies Winding-Up Act 1844, which was later reinforced by the enactment of Limited Liability Act 1855. Before, if a company had gone bust, the people that lent it money could sue all the shareholders to pay off the company’s debts. But the 1855 Act stated that members’ liability would be limited to the amount they had paid in their shares. Henceforth, the Joint Stock Companies Act 1856 consolidated the companies legislation into one, and the modern law of corporate insolvency was born.

2.3        Digress: a brief note of economic and social justification and criticism

Why is limited liability such an entrenched characteristic of modern enterprise? Before limited liability, shareholders risked going bust and few would buy shares in a company. The limited liability corporation is essential because it allows individuals to partake in risky ventures “without risking disastrous loss if any corporation in which they have invested becomes insolvent” and that without it “wealthy individuals would never make small investments in a corporation.”  In other words, limited liability is to encourage enterprise  .

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Secondly, Richard Posner argued that the legal institution of limited liability is the cheapest allocation of the risks and the benefits of putting a ceiling on the potential losses faced by shareholders far outweighed the cost of a slightly higher risk of debt default.

Thirdly, in the absence of limited liability, the costs of collecting judgment debts would be astronomically high as creditors collected from wealthy shareholders who in turn would need to seek contribution from a large numbers of less wealthy shareholders; thus causing disastrous disruption to the capital markets.

On the other hand, liability is ...

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