Chapter 7: Corporations and legal personality

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain the meaning and effect of limited liability
• explain meaning of LLPs and compare companies and partnerships
• analyse the different types of companies, especially public and private companies
• illustrate the effect of separate personality
• recognise instances where separate personality will be ignored
• explain the role and duties of company promoters
• describe the procedure for registering companies, both public and private
• describe the contents of model articles of association
• analyse the effect of a company's articles
• explain how articles of association can be changed
• describe the statutory books, records and returns that companies must keep or make.

1 The doctrine and veil of incorporation

Meaning

The company is separate legal entity (i.e. separate from its shareholders, the part owners and its directors, the managers).

Salomon v Salomon & Co Ltd (1897)

Lee v Lee's Air Farming Ltd (1960)

Macaura v Northern Life Assurance (1925)

Consequences of incorporation

There are a number of consequences of being a separate legal entity:

• Limited liability. A company is fully liable for its own debts. If a company fails, the liability of the shareholders is limited to any amount still unpaid on their share capital (or any amount they have agreed to contribute if the company is limited by guarantee).
• A company enters into contracts in its own name and can sue and be sued in its own name.
• A company owns its own property.
• A company has perpetual succession, irrespective of the fate of shareholders.
• The management of a company is separated from its ownership.
• A company is subject to the requirements of the Companies Act 2006 (CA06).
• Where a company suffers an injury, it is the company itself that must take the appropriate remedial action. This is known as the rule in Foss v Harbottle.

Foss v Harbottle (1843)

Facts: Two minority shareholders initiated legal proceedings against, among others, the directors of the company. They claimed that the directors had missapplied the company's assets.

Held: The court dismissed the claim and held that when a company is wronged by its directors it is only the company that has standing to sue.

2 Lifting the veil of incorporation

Meaning

The phrase 'lifting the veil of incorporation' means that in certain circumstances the courts can look through the company to the identity of the shareholders.

The usual result of lifting the veil is that the members or directors become personally liable for the company's debts.

Statutory examples

There are a number of occasions on which statute will intervene to lift the veil:

• S399 of CA06 requires accounts to be prepared by a group of related companies, therefore recognising the common link between them.
• Under the Insolvency Act 1986 (IA 1986), members and/or directors liable for wrongful or fraudulent trading may be personally liable for losses arising as a result. (See chapter 13).
• If a public company starts to trade without first obtaining a trading certificate, the directors can be made personally liable for any loss or damage suffered by a third party: S767 CA06.
• Under the Company Directors Disqualification Act 1986, if a director who is disqualified participates in the management of a company, that director will be jointly or severally liable for the company's debts.

Case law examples

Sham companies

The veil will be lifted only where 'special circumstances exist indicating that it is a mere facade concealing the true facts': Woolfson v Strathclyde Regional Council (1978)

Gilford Motor Co Ltd v Horne (1933)

Facts: An employee had a covenant in his contract of employment which stated that he would not solicit his former employer's customers. After he left their employment he formed a company to solicit those customers and claimed it was the company approaching the customers and not him.

Held: The court held that the company could be restrained from competition, as the previous employee had set it up to evade his own legal obligations. An injunction was granted against him and the company.

Jones v Lipman (1962)

Facts: Mr. Lipman contracted to sell his land and thereafter changed his mind. In order to avoid an order of specific performance he transferred his property to a company.

Held: The veil was lifted in order to prevent the seller of a house evading specific performance. An order of specific performance was granted against him and the company to transfer the property to the buyer.

Nationality

In times of war it is illegal to trade with the enemy. It may be possible to lift the veil of incorporation so as to impute to a company the same nationality as its members.

Daimler v Continental Tyre & Rubber Co (1916)

Groups

Although each company within a group is a separate legal entity, there have been a number of cases where the courts have lifted the veil between a holding company and its various subsidiaries. This has generally been done in order to:

• benefit the group by obtaining a higher compensation payment on the compulsory purchase of premises.
• benefit creditors of an insolvent company by making other companies within the group liable for its debts.

DHN Food Distributors v London Borough of Tower Hamlets (1976)

The above case can, however, be contrasted with the more recent case of Adams v Cape Industries (1990) which represents the current position:

Adams v Cape Industries (1990)

Test your understanding 1

In the context of company law explain:

Awhat is meant by, and what are the consequences of, the 'veil of incorporation' (5 marks)

Bunder what circumstances the 'veil' will be lifted. (5 marks)

3 LLPs

Ordinary (or general) partnerships lack the characteristics of a company in the sense that they do not have limited liability or separate legal personality. Over time the government was pressurised to recognise the needs of some partnerships (especially professional partnerships such as solicitors, accountants and auditors) to limit their liability and have separate legal personality without having to form a company. This resulted in the Limited Liability Partnerships Act 2000 (LLPs).

LLPs have similar features to private limited companies, for example, their members (i.e. not called partners) are not directly responsible for the debts of the partnership.

Company versus partnership

Test your understanding 2

(1)X Ltd, Y Ltd and Z Ltd have formed the XYZ partnership. If the partnership should become insolvent, which of the following statements is correct?

(2)In relation to E Ltd, a company limited by shares, which one of the following statements is correct?

(3)Mr X owns shares in Y Ltd. This means that Mr X:

4 Types of company

Introduction

Private company versus public company

The following table summarises the basic differences between public companies and private companies.

Test your understanding 3

(1)Which one of the following statements is incorrect in relation to a public company limited by shares?

(2)What is the main requirement of the Companies Act 2006 relating to a private company?

(3)Which of the following is a requirement for any public company?

Test your understanding 4

Spencer and his brother Trevor have decided to leave their employment as software engineers and set up a consultancy. Spencer has come to you for advice; he is unsure about the type of business organisation he should commence trading as.

AFill in the gap, delete as appropriate and complete the sentence.

BFill in the gaps, delete as appropriate and complete the sentence.

CDelete as appropriate.

DSpencer and Trevor may one day wish to become a public company. What are the main characteristics of this business entity?

5 Promoters

Definition

There is no statutory definition of a promoter.

According to case law, a promoter is a person who 'undertakes to form a company and who takes the necessary steps to accomplish that purpose': Twycross v Grant (1878).

The definition excludes people just acting in a professional capacity, such as accountant or solicitor.

Duties

A promoter is under a fiduciary duty to:

• disclose any interest in transactions to the company and not to make a 'secret profit'
• disclose any benefit acquired to an independent board and/or to the shareholders.

If a promoter does make a secret profit, the company may:

• Rescind the contract – but this is not always possible, e.g. if a third party has acquired rights under the contract.
• Obtain damages – but this requires the company to prove loss.
• Recover the profit – the company must prove that the promoter has failed to disclose his profit from a transaction.

Pre-incorporation contracts

A pre-incorporation contract is where a person enters into a contract before a company has been registered.

The position at common law is that a company, prior to its incorporation, does not have contractual capacity and after its formation it cannot ratify or formally adopt a pre-incorporation contract. The promoter is therefore personally liable under any such contract. (This is because a company does not legally exist until it is incorporated.)

Kelner v Baxter (1866)

S51 CA06 reinforces the common law position by providing that, subject to any agreement to the contrary, the person making the contract is personally liable. Clear and express words are needed in order to negate liability: Phonogram Ltd v Lane (1981).

The promoter can protect his position by:

• including a term in the contract giving the company the right to sue under the Contracts (Rights of Third Parties) Act 1999 (see Privity of Contract: Chapter 2)
• postponing finalising contracts until the company is formed
• entering into an agreement of novation (this involves discharging the original contract and replacing it with a new one) or assigning (transferring) the contract. All parties must agree
• agreeing with the company that there is no personal liability for the promoter
• buying an 'off-the-shelf' company, so it is ready to contract without waiting for incorporation.

Off-the-shelf companies

An 'off-the-shelf' company is one that has already been formed. Buying off the shelf has a number of advantages as follows:

• cheap and simple
• can trade immediately
• no problem of pre-incorporation contracts.

Test your understanding 5

(1)Which of the following statements is true in respect of a promoter in breach of their duty not to make a secret profit?

(2)Which of the following are correct?

(3)A company's contractual capacity before incorporation is limited in that it may:

(4)Tom ordered goods from Seller Ltd on behalf of H Ltd before H Ltd had obtained its certificate of incorporation. Tom signed the order 'Tom, for and on behalf of H Ltd.' Upon receipt of a certificate of incorporation, the board of H Ltd agreed that the company should adopt the contract with Seller Ltd.

Test your understanding 6

Alfred and Betty have carried on a business as a partnership for some years. They have now decided to incorporate their business.

AExplain the difference in liability for business debts between partners and shareholders.

BFill in the gaps, delete as appropriate and complete the sentence.

6 Registration

Documents to Registrar

The following must be submitted to the Registrar in order to form a company.

Note: As the model articles will apply if no articles are supplied, it is not a requirement that articles must be sent, although all companies will have articles.

Registrar's duties

On receipt of the above documents the registrar must:

• Inspect the documents and ensure that Companies Act requirements are fulfilled.
• Issue certificate of incorporation which is conclusive evidence that Companies Act requirements have been fulfilled: s15 CA06. The company exists from the date on the certificate of incorporation.

Trading certificate – public companies only

A plc cannot commence trading until the registrar has issued a trading certificate.

In order to obtain a trading certificate, an application must be made to the registrar which states:

• The nominal value of allotted share capital ≥ £50,000.
• That at least a quarter of the nominal value and all of any premium have been paid up (i.e. at least £12,500 of nominal capital).
• The amount of preliminary expenses and who has paid or is to pay them.
• Any benefits given or to be given to promoters.

If it trades before the certificate is issued:

• The company and any officers in default are liable to a fine.
• It is a criminal offence to carry on business, but any contracts are still binding on the company.
• The directors are personally liable if the company defaults within 21 days of due date.
• It is a ground for winding up if not obtained within one year: s122 IA 1986.

Test your understanding 7

Test your understanding 8

Adam and Ben have carried on business together in partnership for a number of years. They have now decided to operate their business through the medium of a private company limited by shares called AB Ltd.

AComplete this sentence.

BIn order to register a private company limited by shares the partners will need to submit the following documents to the registrar of companies.

CComplete this sentence:

DExplain the liability of Adam and Ben in the event of AB Ltd becoming insolvent.

Name of company

The name of the company must comply with the following rules:

• It must have limited (Ltd) or public limited company (plc) at the end as applicable.
• It cannot be the same as another in the index of names.
• it cannot use certain words which are illegal or offensive.
• It must have the Secretary of State's consent to use certain words (e.g. England, Chartered, Royal, National, University, Insurance, etc.) or any name suggesting a connection with the government or any local authority.
• It must avoid the tort of passing off (see chapter 3).

The Secretary of State can force a company to change its name in the following circumstances:

S77 CA06 allows a company to change its name by special resolution.

As discussed at the end of chapter 3 if a company feels that another company has a name which is too similar to its own, it may object to the Company Names Adjudicator.

Test your understanding 9

(1)Which of the following names could not without further consent be a permissible name under the Companies Act for a company, the main object of which is to contract refuse collection services for Westminster City Council?

(2)Which of the following statements is correct?

(3)A business has been registered under the name 'The Mark Jones Partnership Co Ltd'. What type of business organisation must this be?

7 Articles of association

Introduction

The articles of association form the company's internal constitution. They:

• set out the manner in which the company is to be governed and
• regulate the relationship between the company, its shareholders and its directors.

There are no mandatory contents.

Contents of Articles

Companies Act 2006 states that the articles should be contained in a single document which is divided into consecutively numbered paragraphs.

Articles should contain rules on a number of areas, the most important of which are as follows:

• Appointment and dismissal of directors
• Powers, responsibilities and liabilities of directors
• Director's meetings
• Member's rights
• Dividends
• Communication with members
• Issue of shares
• Documents and records

8 Legal effect of company's constitutional documents

S33 CA06 states that the provisions of a company's constitution bind the company and its members to the same extent as if there were covenants on the part of the company and of each member to observe those provisions. This means that the articles form a statutory contract between the company and its members, and between the members themselves,even if they do not sign them.

(1)The articles are enforceable by the company against the members.

Hickman v Kent or Romney Marsh Sheepbreeders' Association (1915)

(2)The articles are enforceable by the members against the company.

Pender v Lushington (1877)

(3)The articles also operate as a contract between individual members in their capacity as members.

Rayfield v Hands (1958)

However, the articles do not bind the company to non-members nor do they bind the members in any other capacity.

Eley v Positive Government Security Life Assurance Co (1876)

Beattie v EF Beattie (1938)

However, even where the articles are not a relevant contract for this purpose, the terms may be evidence of another contract made independently.

New British Iron Co, ex parte Beckwith (1898)

It is important in an examination question to check the capacity in which the person is claiming. Is it as a member, or in some other capacity, such as a director or an accountant? Obviously the articles have no effect as a contract between the company and a person who is not a member even if they are named in them and given apparent rights against the company. In Eley's case above, Eley's membership was irrelevant to his claim; as solicitor he had no claim – he was attempting to enforce an employment right not a member's right.

9 Alteration of articles

General rule

• The articles can usually be altered by a special resolution (75% majority).
• Copies of the amended articles must be sent to the Registrar within 15 days.

Exceptions

1. Entrenchment

It is possible to entrench some of the articles. This means that a specified procedure (e.g. unanimous consent) may be required to change them.

2. Members increase liability

S25 CA06 prevents a member being bound by any alteration made after he becomes a member that requires him to increase his liability or contribute further to the company.

3. Common law restriction

Any change to the articles must be 'bona fide in interests of the company as a whole': Allen v Gold Reefs of Africa (1900).

• It is for the members to decide whether the change is bona fide in the interests of the company as a whole.
• The court will not interfere unless no reasonable person would consider the change to be bona fide.
• If the change is bona fide, it is immaterial that it happens to inflict hardship or has retrospective operation.
• The change will be void if actual fraud or oppression takes place.
• An alteration is not invalid merely because it causes a breach of contract - but that does not excuse breach.

Greenhalgh v Arderne Cinemas Ltd (1950)

Brown v British Abrasive Wheel Co (1919)

Sidebottom v Kershaw, Leese & Co (1920)

Allen v Gold Reefs of West Africa Ltd (1900)

Southern Foundries (1926) Ltd and Federated Foundries Ltd v Shirlaw (1940)

Test your understanding 10

(1)Which of the following statements is/are correct?

(2)The articles of association of a company limited by shares form a contract between:

Test your understanding 11

Explain the meaning and effect of a company's articles of association, paying particular attention to the following issues:

Athe operation of the model articles of association

Bthe effect of the articles on both members and non-members

Cthe procedure for altering the articles of association.

10 Statutory books, returns and records

Registers

The registers must normally be kept at the company's registered office (although the register of members and register of directors' interests can be kept where they are made up) and must be available for public inspection by a member free of charge or by any other person for a fee.

Requests for inspection must provide details about the person seeking the information, the purpose of the request and whether the information will be disclosed to others. The company may apply to the court for an order that it need not comply with the request.

The register of directors' addresses should now contain service addresses rather than details of the directors' residential addresses. The service address can be simply 'the company's registered office'.

The company must also keep a separate register of the directors' residential addresses. Both the service and the residential addresses will need to be supplied to the Registrar of Companies.

The residential addresses will be withheld from the public register. However, they will generally remain available to the Registrar and certain specified public bodies and credit reference agencies.

Annual return

The annual return must be filed with the Registrar annually within 28 days of the return date (which is the anniversary of incorporation). The return must be signed by a director or a secretary. It must include:

• the address of the company's registered office
• the type of company
• the company's principal business activities
• details of directors and company secretary where applicable (see chapter 10)
• a statement of capital which states the total number of shares of the company, the aggregate nominal value of the shares and the amount paid up and unpaid on each share.
• for each class of shares, the right of those shares, the total number of shares in that class and their total nominal value.
• details of the members of the company as at the return date
• details of members who have cease to be members since the last return was made
• details of the number of shares of each class held by members at the return date.

Accounting records

The company must keep accounting records containing sufficient information to show and explain the company's transactions and its financial position.

At any time it should be possible:

• to disclose with reasonable accuracy the company's financial position at intervals of not more than six months
• for the directors to ensure that any accounts that needs to be prepared comply with Companies Act 2006 and International Accounting Standards.

In particular the records must show:

• daily entries of all money received and spent
• a record of assets and liabilities
• statement of stocks at end of the financial year
• statements of stocktaking to back up the above
• statements of all goods sold and purchased, showing the goods and the buyers and sellers (except in the retail trade).

Accounting records must be kept for three years in the case of a private company and six years in that of a public one. They should be kept at the company's registered office or at some other place thought fit by the directors.

Failure to keep sufficient accounting records is an offence by the officers in default.

Annual financial statements

Companies are required to produce annual financial statements for each accounting reference period. This includes a:

• balance sheet/statement of financial position and profit and loss account/statement of comprehensive income showing true and fair view
• directors' report stating the amount of any dividend and likely future developments.

The annual financial statements must be approved and signed on behalf of the board of directors and a copy filed with Registrar.

11 Chapter summary

Test your understanding answers

Test your understanding 1

AWhereas English law treats a partnership as simply a group of individuals trading collectively, the effect of incorporation is that a company once formed has its own distinct legal personality, completely separate from its members.

The doctrine of separate or corporate personality is an ancient one, but the case usually cited in relation to separate personality is: Salomon v Salomon & Co Ltd (1897). Salomon had been in the boot and leather business for some time. Together with other members of his family he formed a limited company and sold his previous business to it. Payment was in the form of cash, shares and debentures. When the company was eventually wound up it was argued that Salomon and the company were the same, and since he could not be his own creditor, his debentures should have no effect. Although lower courts had decided against Salomon, the House of Lords held that under the circumstances, in the absence of fraud, his debentures were valid. The company had been properly constituted and consequently it was, in law, a distinct legal person, completely separate from Salomon.

A number of consequences flow from the fact that corporations are treated as having legal personality in their own right.

ILimited liability

No one is responsible for anyone else's debts unless they agree to accept such responsibility. Similarly, at common law, members of a corporation are not responsible for its debts without agreement. However, registered companies, i.e. those formed under the Companies Acts, are not permitted unless the shareholders agree to accept liability for their company's debts. In return for this agreement, the extent of their liability is set at a fixed amount. In the case of a company limited by shares, the level of liability is the amount remaining unpaid on the nominal value of the shares held. In the case of a company limited by guarantee, it is the amount that shareholders have agreed to pay in the event of the company being wound up.

II Perpetual existence

As the corporation exists in its own right, changes in its membership have no effect on its status or existence. Members may die, be declared bankrupt or insane, or transfer their shares, all without any effect on the company. As an abstract legal person the company cannot die, although its existence can be brought to an end through the winding-up procedure.

IIIBusiness property is owned by the company

Any business assets are owned by the company itself and not the shareholders. This is normally a major advantage in that the company's assets are not subject to claims based on the ownership rights of its individual members. It can, however, cause unforeseen problems as may be seen in Macaura v Northern Assurance Co (1925). The plaintiff had owned a timber estate and later formed a oneman company and transferred the estate to this company. However, he continued to insure the estate in his own name. When the timber was lost in a fire it was held that Macaura could not claim on the insurance as he had no personal interest in the timber, which belonged to the company.

IVLegal capacity

The company has contractual capacity in its own right and can sue and be sued in its own name. The extent of the company's liability, as opposed to the members, is unlimited and all its assets may be used to pay off debts. The company may also be liable in tort for any injuries sustained as a consequence of the negligence of its agents or employees.

V The rule in Foss v Harbottle (1843)

This states that where a company suffers an injury, it is for the company, acting through the majority of the members, to take the appropriate remedial action. Perhaps of more importance is the corollary of the rule, which is that an individual cannot raise a legal action in response to a wrong suffered by the company.

BLifting the veil of incorporation

Test your understanding 2

(1)B

(2)D

(3)A

Test your understanding 3

(1)A

(2)D

(3)D

Test your understanding 4

A the Partnership Act 1890

B liability

C more

D A public limited company must have a minimum allotted share capital of £50,000 and a trading certificate.

Test your understanding 5

(1)A

(2)D

(3)D

(4)A

Test your understanding 6

APartners are liable for business debts to the extent of their personal wealth, whereas shareholders' liability is limited to the unpaid portion of their shares.

Bis

Test your understanding 7

(1)B

(2)A

(3)B

Test your understanding 8

A joint and several

B

C Certificate of incorporation

D Adam and Ben are only liable for any unpaid portion of the price of their shares.

Test your understanding 9

(1)B

(2)A

(3)B

Test your understanding 10

(1)C

(2)D

Test your understanding 11

AModel articles are prescribed by the Secretary of State. They apply where a company is formed without registering articles or where the articles registered do not exclude or modify the model articles.

A company:

• may adopt the model articles in full or in part;
• is deemed to have adopted the model articles if there is no express or implied provision to exclude them; or
• may draft its own unique articles.

BS33 CA06 states that the provisions of a company's constitution bind the company and its members to the same extent as if there were covenants on the part of the company and of each member to observe those provisions. This section has three effects.

I    The documents establish a contract which binds each member to the company. Thus in Hickman v Kent or Romney Marsh Sheepbreeders' Association (1920), the company was able to enforce an article against a member that provided that disputes involving the member and the company should go to arbitration.

II   The company is contractually bound to each of its members. On this basis in Pender v Lushington (1877) a member was able to sue in respect of the wrongful denial of his right to vote at a company meeting.

III  The articles constitute a contract between the members. In Rayfield v Hands (1958), the articles of the company provided that, where shareholders wished to transfer their shares, they should inform the directors of the company, who were obliged to take the shares equally between them at fair value. When the directors refused to purchase the plaintiff's shares, the court held that the directors were bound as members by the articles and therefore had to comply with the procedure set out there.

Articles only operate as a contract in respect of membership rights and obligations. Consequently it has been held that, although members can enforce them, non-members, or members suing in some other capacity than that of a member, will not be able to enforce promises established in the company's articles. In Eley v Positive Government Security Life Assurance Co (1876), the articles of a company stated that the plaintiff was to be appointed as the company's solicitor. It was held that Eley could not use the articles to establish a contract between himself and the company as those articles only created a contract between the company and its members. Although Eley was in fact a member, he was not suing in that capacity but in the capacity of solicitor, which was not a membership right.

CA company can normally alter its articles by passing a special resolution. However, if certain provisions are entrenched, they can only be altered by following the specified procedure; this may require unanimous consent.

Any alteration must be made 'bona fide in the interest of the company as a whole', although the exact meaning of this phrase is not altogether clear. It is evident that it involves a subjective element in that those deciding the alteration must actually believe they are acting in the interests of the company. There is additionally, however, an objective element. In Greenhalgh v Arderne Cinemas Ltd (1950) it was stated that any alteration had to be in the interests of the 'individual hypothetical member'.

In Brown v British Abrasive Wheel Co (1919) an alteration to the articles of the company was proposed to give the majority shareholders the right to buy the shares of the minority. It was held that the alteration was invalid as it would benefit the majority shareholders rather than the company as a whole. However, in Sidebottom v Kershaw, Leese & Co (1920), an alteration to the articles gave the directors the power to require any shareholder, who entered into competition with the company, to transfer their shares to nominees of the directors at a fair price. It was held that under those circumstances the alteration was valid as it would benefit the company as a whole.

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