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 morally viewed as a device to minimizing the social cost of private activities, and for forcing miscreant to internalize the full cost of their wrongdoing. In stark contrast, limiting liability can thus be perceived as subsidizing risky behaviour and allowing some wrongdoers to shirking their part of the costs of their actions and Michael Schulter supported this view.
- Arguments for and against limited liability – a legal perspective
In UK, limited liability can be achieved by private contractual arrangement, by the use of limited liability forms of corporation, by other statutory limits on liability, and by bankruptcy. Since the private contractual arrangement and statutory limits on liability are out of the scope of this assignment, I will focus my following discursive analysis on the other two: UK company law and UK solvency law.
While it is partly true, in some corporate failures, that the corporate wrongdoer can avoid their liabilities by abusing the doctrine of limited liability and leaving tens of thousands in deep anger and despair, it is also true that there are many protection provisions under the Companies Act 2006 and Insolvency Act 1986 for the creditors and other victims from the wrongdoings by the culpable persons, under the pretence of limited liability.
- Arguments under company law
Under the UK company law, there are essentially two issues in connection to the doctrine of limited liability in the light of corporate failure, namely foundational issues and constitutional issues.
Foundational issues can be further analysed in the context of the nature of legal personality and lifting the veil of incorporation.
Constitutional issues are subdivided into the following areas:
i) The ultra vires doctrine and Turquand’s rule;
ii) Directors’ duties and the protection of minority shareholders; and
iii) Corporate governance
3.1.1. Foundational issues – the nature of legal personality and lifting the veil of incorporation
A company, once incorporated, is a legal entity distinctive from the members that comprise the company. This principle was established in the leading English case of Salomon v Salomon, in which the court held that once the company is legally incorporated, it must be treated like any other independent person with its rights and liabilities appropriate to itself. In other words, it can sue upon it or be sued upon it.
There are a number of statutory and common law exceptions to the Salomon principle and they are grouped under the heading of “lifting the corporate veil”. In such situations the court disregards the corporate entity and pays regard instead to the economic realities behind the legal façade.
There are a number of situations where the statute sets aside the corporate veil. On the common law side, the court have “pierced” the corporate veil in a number of cases and thus it is difficult to deduce the overall guiding principles from the jumbled case law. However, there are some general factors that the court would normally consider before piercing the veil. By and large, the separate legal personality of a company will be disregarded only if the court deems that there is:
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Fraud or sham: in Jones v Lipman, the court held the company used as a façade to defraud the creditors of the defendant and in Gencor v Dalby, the court tentatively suggested that the corporate veil was lifted where the company was the “alter ago” of the defendant; or
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“Single economic unit” theory: some companies that act as a corporate group, may operate to hide behind the advantages of limited liability to the disadvantage of their creditors. The argument in favour of lifting the corporate veil in these circumstances is to ensure that corporate group which seeks the advantages of limited liability must also be ready to accept the corresponding responsibilities.
The most recent case on this topic in the House of Lords suggests a stricter approach towards lifting the corporate veil and Lord Keith indicated that a departure from the Salomon principle was justified only in cases of a façade concealing the true facts; or
- Small companies: piercing the corporate veil typically is most effective with smaller privately held business entities, where the control is absolute and where the business is an integral part of its owner. As such, the company itself can be seen as a mere agent for the shareholder.
The act of piercing the corporate veil remains one of the most controversial subjects in company law and it would continue to remain so. Overall speaking, the doctrine of piercing the corporate veil remains only an exceptional act orchestrated by the court. The court is most prepared to respect the rule of corporate personality. Notwithstanding, there are general categories such as fraud or sham, agency and group companies are believed to be the most peculiar basis under which the court would pierce the corporate veil.
- Constitutional issues – the ultra vires doctrine and Turquand’s rule
In UK company law, ultra vires describes acts attempted by a company that are beyond the scope of powers granted by the company’s constitutional documents. Acts attempted by a company that are beyond the scope of its conferred authority are void and voidable.
Several modern developments relating to corporate formation have limited the probability that ultra vires acts will occur and thus render the doctrine obsolescent. In the UK, the Companies Act 2006 greatly reduced the applicability of ultra vires in corporate law, although it can still apply to non-profit organizations. However, a shareholder may still apply for an injunction in advance to prevent an act which is claimed to be ultra vires.
Moreover, the rule in Turquand’s case ensures each bona fide outsider contracting with a company is entitled to assume that the internal requirements and procedures have been complied with. The position in UK common law on the rule is now superseded by S 40 of the CA 2006.
Prior to the enactment of Companies Act 2006, a bona fide third party entered into an ultra vires transaction with a company could not enforce the transaction because the transaction was regarded as void. Having said that, there were some exceptions to the doctrine. The CA 2006 precludes reliance of the corporate wrongdoer on the defense of ultra vires where the transaction is fully performed by a bona fide third party. Further, Similarly, under Turquand’s rule (now replaced by CA 2006), a company will consequently be bound by a contract made by a outsider acting in good faith, even if the internal requirements and procedures have not been complied with.
- Constitutional issues – directors’ duties and protection of minority shareholders
As artificial persons, companies can only act through human agents. The main agent who deals with the company’s management and business is the board of directors. Therefore, directors’ duties are a central part of corporate law and corporate governance and describe which obligations people owe to companies by virtue of their position as directors. Generally speaking, under the UK company law, the duties imposed upon directors are fiduciary duties, i.e., the duty of trust between agents and trustees. Moreover, the directors’ duties are several and the duties are owed to the company itself, and not to any other entity.
Historically, directors’ fundamental duty was to act in the interest of shareholders as a whole, but the overarching principle of duties has been expanded upon by the Companies Act 2006. The general duties, among others, imposed by the CA 2006 are summarized and explained in the following paragraphs.
Firstly, directors are strictly charged to exercise their powers only for a proper purpose. While in many instances an improper purpose is readily evident, Greater difficulties arise where the director, while acting in good faith, is serving a purpose that is not regarded by the law as proper. The seminal authority relevant to what amounts to a proper purpose is the Privy Council decision of Howard Smith v Ampol Ltd.
Secondly, a director must act to promote the success of the company for the benefit of its member as a whole. “Success” is not specifically defined for these purposes, but the government has stated that it usually means “long-term increase in value” for commercial companies. It also sets out six factors to which a director must have regards in fulfilling the duty to promote success. This represents a great departure from the traditional notion that directors’ duties are owed only to the company. Previously under the Companies Act 1985, protections for non-member stakeholders were considerably more limited.
Thirdly, a director must avoid a situation in which he has a direct or indirect interest that conflicts with the interests of the company. This rule is so strictly enforced that, even where the conflict of interest or conflict of duty is purely hypothetical, the directors can be forced to disgorge all personal gains arising from it. Moreover, directors must also declare to the directors of any interest, direct or indirect, in a proposed transaction or arrangement with the company. The law has hitherto divided conflicts of duty and interest into three sub-categories, which is stated below.
By legal principle, where a director enters into a transaction with a company, there is a conflict between the director’s interest and his duty to the company. This rule is strictly enforced and in UK, there is also a statutory duty to declare interests in relation to any transactions, and the director can be fined for failing to comply.
Directors must not, without the informed consent of the company, use for their own profit the company’s assets, opportunities or information. This prohibition is so less flexible that any attempt to circumvent it using provisions in the articles of association have met with limited success.
Directors cannot compete directly with the company without a conflict of interests arising. Similarly, they should not act as directors of competing companies, as their duties to each company would then conflict with each other.
Lastly, directors must not accept any benefit from a third party which is conferred because of his being a director or his doing or not doing anything in his capacity as a director. This duty will continue to apply after a person cease to be director in relation to things done or omitted by him while he was a director. Further, a benefit so obtained from a third party can only be authorised by the members of the company.
The CA 2006 expressly states that the consequences of breaching the above codified duties will be the same as the consequences for breaching the common law rule of equitable principle from which they are drawn. The remedies for breaches of the duties included:
- an injunction;
- setting aside of the transaction, restitution and account of profits;
- restoration of company property held by the director; and
- damages
Generally speaking, only the company can bring an action against a director to recover its losses for a breach of the above duties. The CA 2006 also provides shareholders with a new derivative right of action that will enable shareholders to bring an action against a director of alleged breach of any of the general duties.
- Constitutional issues: corporate governance
More recently, the expropriation of investors’ funds and large-scale corporate failures, as illustrated by the collapse of Enron, has resulted in a greater focus on the concept of corporate governance. Corporate governance is primarily the study of the power relations between the board of directors and company members who elect them. It also concerns other stakeholders, such as creditors, consumers, the environment and the community at large.
In the UK, a flexible model of regulation of corporate governance is adopted, known as the “comply or explain” code of governance. This is principle-based code that lists many recommended practices, such as: the separation of CEO and chairman of the Board, the introduction of a minimum number of NEDs and of independent directors, the designation of a senior NED, the formation and composition of remuneration, audit and nomination committees etc. UK publicly listed companies have to either apply those codes or, if they choose not to, explain why they decided not to do so. The monitoring of those explanations is left to shareholders themselves. The code has been in place since 1993 and has had drastic effect on the way companies are governed in the UK.
- Arguments under insolvency law
The UK insolvency law deals with the insolvency of firms in the UK and the primary pieces of legislation are the Insolvency Act 1986 and Enterprise Act 2002.
Under the IA 1986, there are a number of protection provisions preventing the corporate fraudster runaway without impunity in the event of corporate failure. These provisions are summarized and explained in the following paragraphs.
Firstly, although distribution of the company’s assets in liquidation must follow an order prescribed by the rules of IA 1986, the contributions to occupational pension schemes and employees’ remuneration must be paid first in the line under the category of preferential debts.
Secondly, under some circumstances, the court may consider to increase a defunct company’s assets to pay creditors by setting aside a previous transaction(s). These circumstances are as follows:
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Transactions at undervalue: under S238 of IA 1986, transactions at an undervalue may be set aside by court order if within two years before winding up begins, with a defence in S238 (5);
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Preferences: under S239 of IA 1986, preferences granted to creditors for security where there is some element of personal connection may be void;
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Fraudulent trading: under S213 of IA 1986, fraudulent trading is an offence and the court can order contributions from the directors guilty of it;
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Wrongful trading: the liquidator may invoke an offence of wrongful trading under S214 of IA 1986 and sue the guilty directors for contributions, which has a lower burden of proof than offence of fraudulent trading in (iii).
- Under S423 of IA 1986, transactions aimed to put aside assets beyond a creditor’s reach will be void.
- Misfeasance proceedings: Under S212 of IA 1986, the court may order to recover company property which may have been misapplied by those involved in running the company in the event of corporate failure.
- Summary
In conclusion, I don’t agree with Michael Schluter’s assertion that limited liability is morally wrong, thus worth our while to remove it completely. However, I do concede that we need to make some modifications to the existing law and regulations related to the doctrine to minimize the negative consequences. My arguments are fourfold and explained below.
Firstly, what is morally judged also implies what is politically motivated because what is right or wrong can vary according to the interests one is focused upon. More tellingly, one man’s sweet is another man’s poison. While it is true that corporate failure does cause massive job loss and put tens of thousands into deep anger and despair, it is also true the concept of limited liability has created wealth-beyond-imagination of many nations since its invention.
Secondly, the doctrine of limited liability is one of the institutional pillars of modern world and the economic and social arguments mentioned earlier justifiably support its continued existence. On the other hand, if the doctrine was removed completely and ultimately, the global economies would grind to a disastrous halt and the world economic activities would be put into a catastrophic jeopardy. Notwithstanding, the institution of limited liability is not perfect, but is unparallel.
Thirdly and metaphorically, the difference between medicine and poison is dosage. In other words, the most profitably feasible way to eradicate the ills of limited liability is through perfecting existing laws and regulations, not by tail wagging the dog. I suggest making the following modifications to the existing law and regulations:
- Enlarge the whistle-blowing role of the Combined Code of corporate governance and mandate it’s applicability to small-to-medium size companies, particularly for those owner-manager companies.
- Widen the scope of liability of attrition crimes (i.e., torts) under the company law and insolvency law.
- Reinstate the principle of lifting of corporate veil at common law to dismantle the façade of so called parent-subsidiary organizational relationships.
- Cultivate the general acceptance by the lordship of the principle of “enhanced shareholder value” enshrined in CA 2006 to hold directors accountable for their decisions to other stakeholders.
- Reduce the burden of proof and cost of derivative claims by minority members.
- Increase the statutory rights and responsibilities of other corporate officers and agents (e.g., auditor and company secretary) by adopting some provisions of Sarbanes-Oxley Act into the company law
Lastly, although the existing company law and insolvency cannot provide a watertight protection against the corporate rogues in the event of corporate failure, they do provide the instrumental remedies available to all stakeholders involved. Moreover, the laws also strike an expedient balance between social justice and economic growth.
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Word Count: 4’000
Bibliography
Articles
- Schulter, M. “Risk, reward and responsibility: limited liability and company reform” (June 2000) Cambridge Papers Volume 9 No. 2
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“The key to industrial capitalism: limited liability” (December 23rd 1999) Millennium Issue, Economist
- Shannon, H.A. (1931), “The coming of general limited liability”, Economic History Review Volume 2:267-91, reprinted in Carus-Wilson, pp 358-79
- Saville, J. (1956), “Sleeping partnership and limited liability, 1850 – 1856”, Economic History Review 8:418-33
- Amsler, C.F. et al. (1981), “Thoughts of some British economists on early limited liability and corporate legislation”, History of Political Economy 13:774-93
- Lobban, M. (1996), “Corporate identity and limited liability in France and England 1825-67”, Anglo-American Law Review 25:397
- Higgs, D. et al. “Review of role and effectiveness of non-executive directors”, January 2003, DTI Publications
- Smith, R. et al. “Audit committees combined code guidance”, January 2003, DTI publications
- Manne, H.G. (1967), “Our two corporation systems: law and economic”, Virginia Law Review 53: 262
- Halpern, P. et al. (1980), “An economic analysis of limited liability in corporation law”, University of Toronto Law Journal 30:117
- Easterbrook, F.H. & Fischel, D.R. (1985), “Limited liability and the corporation”, University of Chicago Law Review 52:89
- Mieners, R.E. et al. (1979), “Piercing the veil of limited liability”, Delaware Journal of Corporate Law 4:351
- Posner, R.A. (1976), “The rights of creditors of affiliated corporations”, University of Chicago Law Review 43:500
- Woodward, S. (1985), “Limited liability in the theory of the firm”, Journal of Institutional and Theoretical Economics 141:523-531
Cases
➢ Fowler v Padget (1798) 101 ER 1103
➢ Salomon v a Salomon & Co Ltd [1897] AC 22 (HL)
➢ Jones v Lipman [1962] 1 WLR 832
➢ Gencor ACP Ltd v Dalby [2000] 2 BCLC
➢ DHN Food Distributors Ltd v Tower Hamlets London Borough Council [1976] WLR 852
➢ Smith, Stone & Knight Ltd v Birmingham Corpn [1939] 4 All ER 116
➢ Woofson V Strathclyde Regional Council [1978] SLT 159; 38 P & CR 521
➢ Adams v Cape Industries Plc [1990] Ch 433 (CA)
➢ Royal British Bank v Turquand (1856) 6 E&B 327
➢ Howard Smith Ltd. v Ampol Ltd [1974] AC 832
➢ Aberdeen Railway v Blaike (1854) 1 Macq HL 461
➢ Regal (Hastings) Ltd v Gulliver [1942] All ER 378
➢ Hogg v Cramphorn Ltd [1967] Ch 254
➢ R v Grantham [1984] QB 675
➢ Re Produce Marketing Consortium Ltd [1989] BCLC 520
Books
➢ Sealy L. and Worthington S., 2007, Cases and Materials in Company Law, 8th edition, Oxford University Press Ltd
➢ Davies P.L., 2008, Gower and Davies’ Principles of Modern Company Law, 8th edition, Sweet and Maxwell
➢ Fletcher R., workbook of Company Law and Insolvency, 2008-09 edition, University of Northumbria
Statutes and Regulations
The Companies Act 2006
The Companies Act 1985
Article 3 of the Treaty of Rome
The Insolvency Act 1986
The Enterprise Act 2002
Financial Reporting Council’s Code of Corporate Governance (The Combined Code)
Legal Databases and Websites
Butterworths Lexis Direct:
Casebase:
Casetrack:
Justis:
Lawtel:
Schulter, M “Risk, reward and responsibility: limited liability and company reform” (June 2000) Cambridge Papers Volume 9 No.2
“The key to industrial capitalism: limited liability” (December 23rd 1999) Millennium Issue, Ecomonist
Shannon, H.A. (1931), “The coming of general limited liability”, Economic History 2: 267-91, reprinted in Carus-Wilson
Saville, J. (1956), “Sleeping partnership and limited liability, 1850-1856”, Economic History Review 8:418-33
Amsler, C.F. et al. (1981), “Thoughts of some British economists on early limited liability and corporate legislation”, History of Political Economy 13: 774-93
Since 1992, it has been possible for private companies to have a single member. These companies are subject to some special rules under Companies Act 2006
Lobban, M. (1996), “Corporate identity and limited liability in France and England 1825-67, Anglo-American Law Review 25: 397
Higgs, D. et al. “Review of role and effectiveness of non-executive directors”, January 2003, DTI publications
Smith, R. et al. “Audit committees combined code guidance’, January 2003, DTI publications
S 172 of Companies Act 2006
SS 261-3 of Companies Act 2006
Article 3 of the Treaty of Rome provides for 11 specific objectives for the Community
The article requires the Council of Ministers to issue directives for the purposes of “coordinating the safeguards which, for the protection of the interests of members and others, are required by Member States of companies or firms with a view to making such safeguards equivalent throughout the Community”
Lord Kenyon in Fowler v. Padget (1798) 101 ER 1103
Manne, H.G. (1967), “Our two corporation systems: law and economic”, Virginia Law Review 53: 262
Halpern, P. et al. (1980), “An economic analysis of limited liability in corporation law”, University of Toronto Law Journal 30: 117
Easterbrook, F.H & Fischel, D.R. (1985), “Limited liability and the corporation”, University of Chicago Law Review 52: 89
Meiners, R.E. et al. (1979), “Piercing the veil of limited liability”, Delaware Journal of Corporate Law 4: 351
Posner, R.A. (1976), “The rights of creditors of affiliated corporations”, University of Chicago Law Review 43: 500
Woodward, S. (1985), “Limited liability in the theory of the firm”, Journal of Institutional and Theoretical Economics 141: 523-531
Schulter, M., op.cit. pp 1
I will not discuss the topic on limited liability partnership as it’s legal characteristics relating to the concept of limited liability are more or less the same as those of a limited liability company
Salomon v A Salomon & Co Ltd [1897] AC 22 (HL)
Under Companies Act 2006, some provisions make directors and other officers liable for corporate wrongs in specified circumstances. For example, where a company officer misdescribes the company on a business letter or order form he is personally liable on the document unless the company pays.
Jones v Lipman [1962] 1 WLR 832
Gencor ACP Ltd v Dalby [2000] 2 BCLC
Lord Denning MR adumbrated the theory of “single economic unit” in DHN Food Distributors Ltd v Tower Hamlets London Borough Council [1976] WLR 852
Smith, Stone & Knight Ltd v Birmingham Corpn [1939] 4 AII ER 116
Woofson v Strathclyde Regional Council [1978] SLT 159; 38 P & CR 521
Adams v Cape Industries Plc [1990] Ch 433 (CA)
S 31 and S 39 of Companies Act 2006
Royal British Bank v Turquand (1856) 6 E&B 327
Exceptions are: (1) fortiori transaction and (2) doctrine of estoppel
It doesn’t meant that directors an never stand in a fiduciary relationship to the individual shareholders; they may well have such a duty in certain circumtances
Howard Smith Ltd. V Ampol Ltd. [1974] AC 832
These factors are: (1) the likely consequences of any decision in the long term; (2) the interests of the company’s employees; (3) the need to foster the company’s business relationships with suppliers, customers and others; (4) the impact of the company’s operations on the community and the environment; (5) the desirability of the company maintaining a reputation for high standards of business conduct; and (6) the need to act fairly as between members of a company.
For example, S 309 of CA 1985 permitted directors to take into account the interests of employees but which could only be enforced by the shareholders and not by the employees themselves.
Judgment by Lord Cranworth in Aberdeen Railway v Blaike (1854) 1 Macq HL 461
S 317 of CA 1985 (S182 – 187 of CA 2006)
Regal (Hastings) Ltd. V Gulliver [1942] All ER 378
Hogg v Cramphorn Ltd. [1967] Ch 254
A gift or transaction for consideration the value of which is considerably less than the consideration provided by the liquidated company is regarded as a transaction at an undervalue
Where the company has done anything or suffered anything to be done which had the effect of putting a person (usually a creditor or guarantor) in a better position in relation to the subsequent liquidation, this may be classed as a preference
R v Grantham [1984] QB 675
Re Produce Marketing Consortium Ltd (No2) [1989] BCLC 520