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Business or businessman: Who to sue when things go wrong

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When can a third party claim against company members directly?

Instagram (arkimag)
Instagram (arkimag)

In law, a company is separate from its company’s members. It stands to reason — but in some circumstances a company member’s conduct is so bad that he or she could bear the brunt of a third party legal challenge.

Every registered company has a corporate personality, meaning that it has separate legal status from its members. If you work for a company, you won’t be liable for the company’s debts.

This key principle is called separate legal personality and the authority for it is the well known case of Salomon v Salomon & Co Ltd. The Court of Appeal judges focused on the company as a legal entity in itself, stating that “any company formed in compliance with regulations of Companies Act is a separate legal person”, and this means that members will have limited liability towards its debts.

As a result of Salomon, the general rule is that every company will be treated as a separate legal person and all of its members will have limited liability. However, the judiciary may well decide that this separation of personalities should not be maintained, so the veil of incorporation can be lifted.

The lifting of this metaphorical veil is designed to prevent the protection of limited liability being used for fraud and will only apply to members who created the situation, such as shareholders or directors.

One example of the court being prepared to lift the veil is when it is deemed that the company has been used as a ‘sham’ or ‘façade’ to hide a dishonest purpose. Take the case of Trustor SB v Smallbone, where it was ruled that it was appropriate to lift the veil because the company was a sham used for concealing money. As a result of the veil being lifted, the members of the company won’t be able to use their privilege of limited liability, and shareholder or director will be liable for any debts or dishonest actions of the company.

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The second exception to the Salomon principle is an agency. In the case of Rainham Chemical Works v Belvedere, the contract for an agency relationship goes with the grain of Salomon. However, in the case of Smith, Stone and Knight Ltd v Birmingham Corp it was argued that the proper claimant was the subsidiary company, which was a separate legal entity. The court held that possession by a separate legal entity was not conclusive. The subsidiary company was not operating on its own behalf but rather on behalf of the parent company. Therefore, the parent company was able to claim compensation. The closer the parent and subsidiary company are to each other — in terms of operating in the same manner or place — the more likely that they will not be considered as separate legal entities.

However, contrary to the Smith case, Adam v Cape Industries established that the law recognises subsidiary companies and, even though they are under control of the parent companies, they will be treated as separate legal entities with rights and liabilities of their own.

These two decisions vary so much in their judgments, and on the face look irreconcilable. It seems that the courts will simply lift the veil and ignore the separate personality of incorporation doctrine as and when justice requires them to do so.

The third category of exceptions to the Salomon rule is born out of the statute book. There are a number of exceptions found in legislation, most notably the Companies Act 2006. S399, which allows the courts to lift the veil and look behind it to see company’s accounts, being a key example.

Another is contained in s993 — an offence of fraudulent trading — and also confirmed in s213 of the Insolvency Act 1986. Fraudulent trading is when, in the course of winding up, business is carried on with the intent to defraud creditors. In the 1933 case of Re Patrick & Lyon Ltd (Unreported), a director of a company delayed liquidation for six months, in order to deprive the unsecured creditors of the right to challenge his debentures under s266 of the Companies Act. The veil was lifted, and the defendant was held liable for the debts of the company.

Courts may also be prepared to lift the veil of incorporation when there is an issue of tortious liability. Take the case of Lubbe v Cape PLC. Here, a claimant suffered injuries after being exposed to asbestos. He worked for a South African subsidiary of Cape (a company). The claimant wanted to sue Cape in London rather than in the South African subsidiary. UK courts accepted jurisdiction, given that the South African courts did not have the resources to hear the case. The matter was eventually settled, and it was held that the company owed a duty of care towards its employees. The case of Chandler v Cape PLC also confirmed that a parent company owes a duty of care to its subsidiary’s employees, therefore extending the situation in which company can be held liable for group operations.

Business is a complex game, and in certain circumstances the strict application of the separate entity principle could lead to an unfair result. So that’s why the courts have chosen to ignore the principle of legal corporate personality in some circumstances. It must, however, be remembered that the Salomon case remains the general principle and other circumstances are merely exceptions.

Lord Sumption summed this up pretty succinctly in Petrodel v Prest, when he stated that there was limited power to pierce the veil and it will only be used to prevent abuse of the legal system in cases where people are under a legal obligation, which is evaded on purpose. All of the above exceptions to Salomon’s rule prove his lordship’s point, that any exploitation of legal rights, corporate personality in this case, must be prevented.

Aleksandra Jarosz is a law student at BPP University.

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15 Comments

Anonymous

Why write something like this and publish it on Legal Cheek? It’s similar to writing an academic paper for the Daily Mail?

Please don’t tell me it’s for your CV.

Not Amused

Because law is by the people and for the people.

As a society we *still* cling to 19th Century paternalistic ideas that the normal person shouldn’t “worry their little head” about law. That is totally unjustifiable in a modern liberal democracy.

Law should be taught in schools. Every citizen has the right to know it. Instead there are almost no mainstream legal journalists (we have 1 and he’s freelance). The Today programme, our flagship news programme, is functionally legally illiterate.

There comes a time when we have to say “no”. This is “not on”. Articles like this are a brilliant effort to solve the problem of societal tolerance of legal illiteracy. EVERY such step is to be whole heartedly applauded.

Anonymous

you’re back!

Anonymous

Love them or loathe them, LC have Joshua Rozenberg writing for them so they are not exactly the Daily Mail. https://www.legalcheek.com/lc-journal-posts/joshua-rozenberg-supreme-court-to-sort-out-bedroom-tax-mess/

Aleksandra Jarosz

I shall not disappoint the first commenter to my first piece on LC; I would like to confirm that this and any future article I write is not ‘for my CV’, but is out of pure interest that I have developed whilst working as a court trial reporter at the RCJ for a year in 2012. LC created a great community for future and existing lawyers and I personally hope that they keep it up.

Randall

I just copied and pasted it for an opinion! Woohoo , more please. A Stack-v-Dowden update be handy.

Anonymous

Very ambitious of you…

Anonymous

I copied and pasted another article from LC for an opinion. The client is now asking why I am advising them to check out the top 10 lawyer diversity related cat memes on Instagram.

Jaxon

Stay with this guys, you’re hepinlg a lot of people.

Anon

There are a number of inaccuracies in this. For example, “Every registered company has a corporate personality, meaning that it has separate legal status from its members. If you work for a company, you won’t be liable for the company’s debts”.

1) There is a logical distinction between a company having legal personality, and members of a company not being liable for the company’s debts. It is possible to have the former, but without the latter (i.e. a company which can sue and be sued in its own name, but whose members are liable if the company cannot pay its debts).

2) Members of a company do not (necessarily, perhaps even usually) work for a company. For example, I am a member of British Gas, but I do not work for British Gas. It should go without saying that, in general, workers are not liable for the company’s debts.

The author could improve the article by explaining the reason behind limited liability. I suppose it is an economic one. (1) If companies did not have limited liability then passive investors would not exist: no-one would stick a few quid in British Gas if it meant that they could be liable for its debts. (2) Shares would not be freely tradeable: without limited liability it is obviously important to shareholder A that shareholder B is solvent and able to pay his share of the company’s debts, and so shareholder B cannot be allowed to sell his shares to vagabond C.

And then, what is the justification for ‘lifting the veil’? I don’t think simply saying it is about ‘exploitation of rights’ takes the argument anywhere, because it is a conclusion and not an argument. When is it an exploitation of rights to rely on limited liability? Is it ‘any time there are tort creditors’? ‘Any time the company is deliberately under-capitalized and there are tort creditors’? Is it ‘fraud’? And if so, is it fraud in a narrow sense, or a broad sense (which may be no better than ‘exploitation of rights’?)

I think you need to be careful with some of your examples of ‘lifting the veil’. I think there is a distinction between saying that the members are responsible for the debts of an insolvent company (which is lifting the veil), and saying that the director is liable to the company for things he did wrong that cause loss to the company. s 213 IA 1986 is in the latter category (see p 54 Sealy and Worthington, which says the same thing).

I don’t see what s 399 CA 2006 has to do with lifting the veil (in the sense in which it is used in this article, rather than in a vague, metaphorical sense).

James

Thank you for saving me from writing this myself! The author should be proud of writing what is a fairly good academic essay on company law. It is, in my view, no more than that, though, and, unfortunately, has a number of flaws.

The writer also cited Petrodel v Prest in the Court of Appeal, rather than the correct Prest v Petrodel in the Supreme Court.

The authority for separate legal personality is not Salomon v A Salomon & Co Ltd. The authority for Salomon’s company to have a separate legal personality was the Companies Act 1862, and the court’s decision merely recognised this.

Chandler v Cape plc did not “confirm that a parent company owes a duty of care to its subsidiary’s employees”. What is did was hold that in the very specific circumstances of the case, the test for having a duty of care was satisfied, in particular because both companies shared health and safety staff and Cape plc had actual knowledge of its subsidiary’s employees’ working conditions, and their risk of harm.

I suppose any article which begins by saying “a company is separate from its company’s members” is intended to have a wider readership than lawyers. It would be like starting an article for doctors with something like “a heart attack and cardiac arrest aren’t actually the same thing”.

Aleksandra Jarosz

Thank you for your comments. Constructive criticism is always welcome.

Teacher's Pet

You would hope that a 2nd year law student would know the difference between principal and principle.

Doh…

And what is happening in the first paragraph?!

Anonymoose

There is only one use of principal on this page, and that was in your comment. The spelling in the article is correct. Doh.

Teacher's Pet

Spelling in article has now been changed following my comment…

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