Law of Associations 200018 Semester 2, 2002

Copyright 2002 Thomas Feerick Lecturer School of Law, UWS

Lecture 5

Week 5

CORPORATE PERSONALITY
1. OVERVIEW

This lecture has two parts. Part 1 discusses the concept of incorporation and its main consequences. These consequences flow from the basic point that in law a company is separate from its members and management. Part 2 considers the circumstances in which the so-called corporate veil may be lifted or pierced. In this context it is shown that a court may decide (or be obliged) to ignore the fact of incorporation and treat a particular matter or transaction as if there was no company interposed. 2. THE CONSEQUENCES OF INCORPORATION

The main consequence of incorporation is the incorporated thing (eg. company) becomes a distinct legal entity: it is a legal person (ie, capable of holding legal rights and having legal obligations) which exists separately from its members and controller(s). The above principle was illustrated in R v Arnaud (1846) 9 QB 806, where a registering authority refused to register a ship on the ground that some of the ship s owners were foreigners. The ship was owned by a (British) chartered company whose members happened to include foreigners. The court ordered the registering authority to register the ship on the basis that the (British) company was the ship s owner rather than the members of the company. The unanimous decision of the House of Lords in Salomon v Salomon & Co Ltd [1897] AC 22 (the facts are recited below) is often cited as the authority which settled the point that a company has a distinct legal personality. In Salomon s case, Lord Halsbury LC said: the learned judges [below] appear to me not to have been absolutely certain in their own minds whether to treat the company as a real thing or not. If it was a real thing; if it had a legal existence, and if consequently the law attributed to it certain rights and liabilities in its constitution as a company, it appears to me to follow as a consequence that it is impossible to deny the validity of the contract into which it has entered.

However, it should be noted that the House of Lords in Salomon s case really only decided that Salomon & Co Ltd was a company duly incorporated under the Companies Act 1862 (UK) even though its seven shareholders were not truly independent : all of the statutory requirements were satisfied because the company had seven shareholders. At least four points follow from the proposition that incorporated companies have a separate legal personality: Company s property is company s property; Company s debt is company s debt; Companies can contract with their members, directors and outsiders (and visa versa); and Companies can commit torts and crimes. While some writers have categorised these points as being either advantageous or disadvantageous, this obviously will depend on the standpoint from which the value judgment is made. Is it from the standpoint of the company, its shareholders or an unpaid creditor? (a) The Company s Property

R v Arnaud (1846) 9 QB 806 demonstrates the basic point that the controllers of a company (ie., its directors or shareholders) do not own the company s property the company does. In Macaura v Northern Assurance Co Ltd [1925] AC 619, five insurers refused to pay the appellant s insurance claim on the ground that he did not have an insurable interest. The appellant Mr Macaura had sold all of the timber then standing upon his land to a company, in which he was a shareholder and creditor, for 42,000. After the assignment, Macaura had insured the timber against fire damage by policies in his own name. The House of Lords upheld the insurers refusal to pay. Lord Buckmaster s decision represents the Court s view: The appellant could only insure either as a creditor or as a shareholder in the company, and if he was not entitled in virtue of either of these rights he can acquire no better position by reason of the fact that he held both characters. As a creditor his position appears to me quite incapable of supporting the claim Turning now to his position as a shareholder, this must be independent of the extent of his share interest. If he were entitled to insure because he held all the shares in the company, each shareholder would equally be entitled if the shares were indifferent hands. Now, no shareholder has any right to any item of property owned by the company, for he has no legal or equitable interest therein. If he were at liberty to effect an insurance against loss by fire of any item of the company s property, the extent of his insurable interest could only be measured by determining the extent to which his share in the ultimate distribution [upon winding up] would be diminished by the loss of the assets a calculation almost impossible to make. Lord Wrenbury shortly observed that:

This appeal may be disposed of by saying that the corporator, even if he holds all the shares, is not the corporation, and that neither he or any creditor of the company has any property, legal or equitable, in the assets of the corporation. This case would not be decided the same way today under the Insurance Contracts Act 1984 which dispenses with the common law rule requiring the insured to hold an insurable interest before being entitled to benefit under the insurance policy. (s 16) The Corporations Act reflects the common law principle that companies can own property. For example, s 119 provides that upon registration a company becomes a body corporate; s 124(1) states that a company has the capacity of a natural person. It follows, therefore, that a registered company can acquire the same kinds of proprietary rights that a natural person may acquire. (b) The Company s Debts Just as a natural person can incur debts, so may companies. However, it must be recalled that a company is a legal abstraction the existence of which is evidenced by a certificate rather than any physical presence. It follows, therefore, that a company cannot act except through a natural person (ie., a conduit), but in such a case the company is the actor . Thus, persons (legal or natural) may act in various capacities: 1. 2. 3. 4. In their own right and on their own behalf (ie, as principal); In their own right but as trustee for a company; On behalf of a company (ie, as agent); As the company (ie, alter ego).

In Salomon s case, Vaughan Williams J and the Court of Appeal failed to accept the (4th) proposition that a company may carry on a business and incur debts in its own right, and it does not necessarily act as an agent or trustee for a natural person just because that person happens to control the company (eg, own the majority of shares). In Salomon s case, Mr Aron Salomon caused Salomon & Co Ltd to be incorporated and then sold his business to the company for about 39,000. Since the Companies Act 1862 (UK) stipulated that companies had to have at least seven shareholders, Aron, his wife and his five children subscribed for one share each. Aron and his two sons were the directors. Salomon & Co Ltd purchased Aron s business in the following manner: Aron received 20,000 shares (as if Aron had paid 20,000 for the shares and the company had then repaid 20,000 of its debt to Aron); The company paid some cash to Aron; and The balance of the purchase price was left outstanding as a (secured) debt due to Aron. (ie., Aron took 10,000 in debentures which charged the assets of the company).

The company subsequently encountered financial difficulties. Aron and his wife advanced some money to the company but that was not enough. Aron then borrowed 5,000 from Broderip and on-lent that money to the company. The company then issued debentures to Broderip (who became a secured creditor of the company). A liquidator was appointed to the company after it failed to pay interest on Broderip s debentures, whereupon it became apparent that there was barely enough money to pay the (secured) debt to Broderip: in which case there would be nothing for unsecured creditors. The liquidator sought inter alia to set-aside the secured debt on the ground that Aron was really the principal (ie., the debtor). Vaughan Williams J found for the liquidator on the basis that: the company was not conducting the business in its own right but as agent for Aron; Aron (principal) had to indemnify the company (agent); Thus the agent was entitled to a lien over the principal s assets in its possession (ie., Aron s business); and The lien took priority over the debentures. The Court of Appeal dismissed Aron s appeal on the basis that while the legal effect of the transfer of his business could not be ignored, in virtue of the fact that the six other shareholders were not truly independent of Aron, the company was really conducting the business as Aron s trustee. The House of Lords reversed the courts below. Lord Halsbury LC observed that: Either the limited company was a legal entity or it was not. If it was, the business belonged to it and not to Mr Salomon. If it was not, there was no person and no thing to be an agent at all; and it is impossible to say at the same time that there is a company and there is not. Lord Macnaghten stated that: The company is at law a different person altogether from the subscribers to the memorandum and though it may be that after incorporation the business is precisely the same as it was before, and the same persons are managers, and the same hands receive the profits, the company is not in law the agent of the subscribers or trustee for them. (c) Company Contracts

Just as individuals can enter into contracts, so can companies. However, there is a complication in the analogy with natural persons because a contract requires consensus ad idem (ie., meeting of minds), and yet a company has no mind or will of its own. Thus,

Professor Ford prefers to regard a company as a legal entity rather than a person (HAJ Ford et al, Principles of Corporations Law, 11th ed at p 105). However, companies can be regarded as persons in the limited sense that they can do everything that natural persons may do through others. Furthermore, companies may also be deemed to have knowledge or notice. The cases considered thus far also provide authority for the proposition that a company may contract with its shareholders and directors. Lee v Lee s Air Farming Ltd [1961] AC 12, develops this point. In that case, Mr Lee s accountant formed a company (Lee s Air Farming Ltd) in which: Of the 3,000 issued shares, Mr Lee held 2,999 shares and his solicitor took the other (as bare trustee for Mr Lee); and Mr Lee was the governing director with substantial powers. The company contracted with farmers to perform aerial topdressing. Mr Lee worked for the company as a pilot and received a wage for that work. Mr Lee died in a work accident and his wife claimed on a workers compensation insurance policy that the company s solicitor had taken out naming Mr Lee as an employee. The insurer denied liability on the ground that Mr Lee could not be a servant because he was a director of the company. The Judicial Committee of the Privy Council firmly rejected the insurer s argument. Lord Morris opinion is instructive: It cannot be suggested that, when engaged in the [topdressing work], the deceased was discharging his duties as governing director. Their Lordships find it impossible to resist the conclusion that the active aerial operations were performed because the deceased was in some contractual relationship with the respondent company. That relationship came about because the deceased, as one legal person, was willing to work for and make a contract with the respondent company which was another legal entity. A contractual relationship could only exist on the basis that there was a consensus between the two contracting parties. It was never suggested (nor, in their Lordship s view, could it reasonably have been suggested) that the respondent company was a sham or a mere simulacrum. It is well established that the mere fact that someone is a director of a company is no impediment to his entering into a contract to serve the company. If, then, it be accepted that the respondent company was a legal entity, their Lordships see no reason to challenge the validity of any contractual obligations which were created between the respondent company and the deceased. [Lord Morris quoted Lord Halsbury LC s judgment in Salomon s case, that company was a real thing .] Always assuming that the respondent company was not a sham, then the capacity of the respondent company to make a contract could not be impugned merely because the deceased was an agent of the respondent company in its negotiation [of Mr Lee s contract of service].

(d)

Company Torts and Crimes

Although Lee v Lee s Air Farming was a case of strict liability, it demonstrates the point that a company may be liable in tort or contract toward its directors and shareholders (and visa versa) because it is a separate legal person. 3. LIFTING THE VEIL OF INCORPORATION

The fact that a company is treated as a separate legal person may work to the disadvantage of third parties. This is especially so in cases where creditors have negotiated with a natural person who then disclaims personal responsibility for the transaction on the basis that a company was the real actor and they were merely its conduit. It is, therefore, perhaps not surprising that the so-called veil of incorporation may be penetrated in certain circumstances that are prescribed by the common law and statute. However, this does not mean that a company is suddenly not incorporated (companies remain incorporated until deregistered pursuant to CA, Ch 5A), but it does mean that the fact of its incorporation will be ignored for the purposes of the impugned transaction. It is hard to predict whether a court will pierce the corporate veil and its occurrence is somewhat freakish . While it is difficult to rationalize the cases in which the veil will be lifted, it is useful to describe the legal categories under which they fall. In Pioneer Concrete Services Ltd v Yelnah Pty Ltd (1986) 5 NSWLR 254, Young J noted that the categories were: (a) (b) (c) (d) (e) (f) (g) Agency; Fraud; Group enterprises; Trusts; Enemy; Tax; The [Corporations Act] itself.

Each category will be considered in turn. (a) Agency

While it was held in Salomon s case that a company is does not necessarily act as agent for its majority shareholder, it does not follow that a company cannot act as an agent for its shareholder(s) or director(s). Since a company is a separate legal person, it could agree (expressly or impliedly) to act as agent. Hence, it is necessary to consider in each case whether there are facts that establish the relation of agency. In Smith, Stone & Knight Ltd v Birmingham Corporation [1939] 4 All ER 116, the respondent wanted to compulsorily acquire premises upon which a waste paper business was

ostensibly carried on by Birmingham Waste Co Ltd ( BWC ) - ostensibly by BWC in the sense that BWC s name appeared on stationery and on the premises. BWC was a wholly owned subsidiary of another company ( P ) that owned the premises. The respondent would not have been liable to pay compensation to BWC for business disruption because its tenancy was terminable at will by P. However, P claimed that it really conducted the business and was therefore entitled to receive compensation. Atkinson J said the main question was whether BWC was carrying on the business for itself or for P. To resolve this issue Atkinson J posed six questions: Were the profits treated as profits of P? Did P appoint who would carry on the business? Was P the head and brain of the business? Did P decide what to do and what capital to employ? Did P make profits from its skill and judgment? Was P in effectual and constant control? Atkinson J decided to uphold P s claim primarily because BWC did not have its own resources and the business had not been transferred to BWC. In Pioneer Concrete Services, Young J could not infer an agency between the parent and subsidiary because, unlike the subsidiary, the parent deliberately did not join in the promises in cl. 3 of the contract in that case. (b) Fraud

A court will not allow itself to be an instrument of fraud or illegality. Thus, Professor Ford observed that the main point in Gilford Motor Co v Horne [1933] Ch 935, was that the veil of incorporation will be overlooked if there is an unrebutted inference that one of the reasons for the creation of an intervening company was to evade a legal or fiduciary obligation. In Gilford Motor Company v Horne, H had promised in his contract of employment as managing director of G that he would not at any time solicit G s clients. H subsequenlty formed a company ( Z ) with his wife. Z then solicited G s clients. The court held that the defendant s assertion, that the business Z s rather than H s, was a mere sham or cloak ; especially since one of the reasons for Z s creation was so that H could evade his covenant with G. The court therefore decided to overlook the fact of Z s incorporation (or the fact that Z actually owned the business) and thus held H liable for breaching his contract with G. In Pioneer Concrete Services, Young J suggested (implicitly) that fraud would have to be either the sole or dominant purpose in order to invoke the principle in Gilford Motor Co.

(c)

Group Enterprises

The Court of Appeal observed in Adams v Cape Industries Plc [1991] 1 All ER 929 that: Our law, for better or worse, recognizes the creation of subsidiary companies, which though in a sense the creatures of their parent companies, will nevertheless under the general law fall to be treated as separate legal entities with all the rights and liabilities which would normally attach to separate legal entities. Thus, as observed in Pioneer Concrete Services, a parent company normally cannot claim for itself the benefits of a contract made between its subsidiary and a third party, nor will it normally be liable under such a contract. In Briggs v James Hardie & Co Pty Ltd (1989) 16 NSWLR 549, Rogers AJA stated that, in the present state of the case law, it was not possible to say what evidence would warrant lifting of the corporate veil. It was not enough simply that the parent had control of the subsidiary. Note, however, that an increasing number of statutory provisions lift the corporate veil in group situations: vertical, horizontal or diagonal. Especially see: Corporations Act: ss 588V588X (suspected insolvent subs.), and ss 259B, 259C, 260A (dealings in group shares etc the group is treated as an economic unit). (d) Trusts

Companies may agree (expressly / impliedly) to act as trustee for its directors or shareholders, just as they may agree to act as agent. There might also be a constructive trust. (e) Enemy

R v Arnaud (1846) 9 QB 806 (non-enemy foreigners). (f) Tax

While companies are commonly utilised for legitimate tax-planning purposes, it would be naive to suppose that the courts would allow the corporate veil to be used as a device to evade liability to contribute to the Revenue. Taxation legislation apprehends this stratagem and lifts the veil when it is used to evade or avoid tax liability. (g) Corporations Act

Since the essence of limited liability is that a company s debt is a company s debt, directors usually are not responsible for the company s debts. This rule invites abuse: if it is applied rigidly, then there is no pecuniary incentive for directors to ensure that the company can and will honour its obligations to pay a debt / perform a contract. While insolvency will be discussed later in this unit, note that s 588G casts personal liability (criminal and civil) upon directors for failing to prevent insolvent trading by their company. Section 588G(1) stipulates the conditions that activate s 588G: The director was a director at the time when the company incurred the debt;

The company was insolvent at the time or pushed into insolvency; There were reasonable grounds to suspect the insolvency; and The debt was incurred at or after the commencement of the Act Civil Penalty Provisions & Criminal Offences Company officers can only benefit from the protective shield of incorporation if they do not contravene the civil penalty provisions or commit criminal offences. Contravention of Civil Penalty Provisions: Section 1317E (1) states that a court must make a declaration of contravention if satisfied that a person has contravened one of the following provisions: Officer s duties ss 180(1), 181(1) and (2), 182 (1) and (2), 183(1) and (2); s 209(2); ss 254L, 256D(3), 259F(2) and 260D(2);

Related parties rules

Share capital transactions Financial reports Insolvent trading Etc.

s 344(1); s 588G(2);

When a contravention order is made, the court may order a precuniary penalty of up to $200,000 if the contravention: Materially prejudices the interests of the corporation ; or

Materially prejudices the corporation s ability to pay its creditors; or Is serious. The court also may order a person to compensate a corporation for damage resulting from the contravention: s1317H. Section 1317J(1) states that ASIC may apply for: A declaration of contravention; A pecuniary penalty order; or A compensation order.

Sections 1317J(2) allows the corporation to apply for a compensation order.

Criminal Offences: There is no criminal offence associated with breaching s180 (duty of care and diligence of director or officer). However, there may be a criminal offence if the breach of duty is accompanied by an element of recklessness or intentional dishonesty. For example, s184 states that a director or other officer commits an offence if they: (a) are reckless; or (b) are intentionally dishonest;

and fail to exercise their powers and discharge their duties: (c) (d) in good faith and in the best interests of the corporation; or for a proper purpose.

Furthermore, a person may commit a crime if they breach a particular section with dishonesty: eg, s209(3) [breaching s 208 with dishonesty]. Also see: s 1311 [General penalty provisions] and Schedule 3 5 years imprisonment. [penalties] up to $200,000 and

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