L2 - formation and lifting the veil PDF

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Lecture 2 – Company Formation and Lifting the Corporate Veil Sources of Company Law Statute The Companies Act 2006 represents the first comprehensive restatement of English (and general UK) company law. The 2006 Act reforms some important areas of company law, and also consolidates much of the pre-existing UK company’s legislation. It replaces the previous major statute in this area, the Companies Act 1985. Comprising a total of 1300 sections, the Companies Act 2006 is the longest statute in British legislative history. The Companies Act 2006 governs limited companies and plc’s, it does not cover sole traders. The Common Law Although the majority of a company’s formal operations are today governed by statute (and, in particular, the 2006 Act), it nevertheless remains the case that some of the most fundamental and important legal features of companies in the UK are dependent on longstanding common law and equitable rules developed by the English (and Commonwealth) courts. Classification of Business Enterprise Sole Trader There is no legal distinction between a trader’s person assets and business assets, meaning legally personality does not exist for sole traders. Sole traders can not rely on limited liability, as this does not exist for sole traders. Sole traders can be sued and made bankrupt for any business debts incurred and owed. Business assets can be repossessed in satisfaction of trader’s personal debts. Partnership A partnership is formed by a contractual agreement between two or more individuals. The partnership, which is a private association of individuals, does not have the right to limited liability. There is no legal personality attached to a partnership and therefore unlimited liability can be stipulated as to which partner is responsible for which percentage of the debts. Partnership Act 1890 Any one partner can be sued for the debts and liabilities of the partnership as a whole (ss 9, 10 & 12). Partnership’s assets can be repossessed in satisfaction of partners’ personal debts. Necessary to establish mutual trust amongst partners. Traditionally, partnerships in the UK could not consist of more than 20 partners, with limited exceptions to the rule including firms of solicitors, accountants and stockbrokers (CA 1985, s 716). BUT – This requirement was repealed in 2002, with the effect that partnerships can now be formed with any number of partners (although prudential considerations will no doubt continue to restrict their size).

Ultimately, partnerships have the same characteristics as a sole trader. Company Companies are formed by public registration (the state is directly involved). The company has a separate legal personality from its members (i.e. as an entity, it exists autonomously and independently from its members). The company has a perpetual life (at least until it is struck off the public register), therefore can outlive its initial founding members. The company’s members cannot be pursued individually for debts owing by the company, which amounts to limited liability. The debts are the companies, not the founding members. To create a company, the founder must register it with Companies House. The members of a company enjoy limited liability: i.e. they are not liable for any of the company’s debts beyond the amount of their initial investment in its share capital (CA 2006, s 3(2); IA 1986, s 74(2)(d)). The company has a centralised management structure, meaning that membership of a company (unlike that of a partnership) does not entail the automatic right to act as an agent of the company in commercial transactions, or to otherwise intervene in day-to-day business decisions. This centralised management structure is normally a board of directors that oversee and manage the company. This ties into Adam Smith’s idea of unchecked powers of directors, which ultimately leads to corruption. Formation of a Company Factors to Consider in Deciding Whether to Incorporate a Business -

Limited personal liability for business debts owing Ability to separate business (company) affairs from personal affairs (unless company’s debts are personally guaranteed by member(s)) Members will not individually face legal proceedings in the event of the company’s liquidation Business need not be dissolved on death, retirement, etc. of members (perpetual succession) Transferability of membership Financing flexibility: companies have exclusive power to create ‘floating charges’

Companies Limited by Shares -

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Ltd and Plc – limited and public limited companies o Only lose money invested in the company By far the most common type of company (in the UK and globally) Members only personally liable for amount unpaid on shares subscribed for in the company (CA 2006, s 3(2); Insolvency Act 1986, s 74(2)(d)) o Liable to pay for shares that you have committed to pay but not yet paid Members will more commonly be referred to as ‘shareholders’ of the company

Bankruptcy refers to an individual that cannot pay debts, insolvency refers to a company that cannot pay debts. Companies Limited by Guarantee -

Fairly uncommon, used mostly for charitable organisations Members only personally liable up to the specific amount that they undertake to contribute to the company’s assets in the event of its being wound up (CA 2006, s 3(3); IA 1986, s 74(3)).

Normally charities will use this type of company as they are showing that the charity is in the public interest and therefore, donations won’t be lost. Unlimited Companies Unlimited liability companies -

Uncommon Separate legal personality, therefore members cannot be sued personally for debts and liabilities of the business while the company is a going concern BUT – On winding up of company, members are liable to contribute any amount sufficient for repayment of its debts and liabilities (CA 2006, s 3(4); IA 1986, s 74(1)(2) (a) – (c))

Registration of a Company 1. Memorandum of Association S8 – The memorandum of every company must state: - That the subscribers wish to form a company under the 2006 Act - That the subscribers agree to become members of the company - That the subscribers agree to take at least one share each in the company - Signatures of member(s) 2. Articles of Association This is the most important document that must be completed. It is a much more complex document that the Memorandum of Association. Essentially, the Articles of Association are the rules of the company, it governs the internal practices of the company and sets out what directors should and shouldn’t do. 3. Application Form This form states: - The company’s proposed name (ONLINE PAPER ON ULTRA) - The company’s domicile in the UK

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Whether (and how) the liability of the company’s members is limited Whether the company is to be a private or public company (on which, see below) A ‘statement of capital and initial shareholdings’, detailing the total number of shares in the company subscribed for, the nominal value of each share, and the number and value of shares subscribed for by each individual member (s 10) The names and particulars of the company’s directors and secretary The intended address of the company’s registered office

4. Statement of Compliance This is a formal declaration by the subscribers that the registration requirements of the 2006 Act have been complied with. The registration fee was reduced to £12 to reflect Tony Blairs idea of’ think small first’. Once the fee has been paid, the registrar of companies shall register the company and issue a formal certificate of incorporation (s 15). However, the registrar may refuse to register a proposed company if he is not satisfied that the requirements of the Act with respect to registration have been complied with (s 14). Most commonly, the registrar will refuse to register a proposed company where he identifies a problem with the subscribers’ choice of company name. Restrictions on Choice of Name -

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Suffix requirement: “limited” or “ltd” for a private company, and “public limited company” or “plc” for a public company (ss 58(1) & 59(1)) (on the distinction between private and public companies) It cannot be the same as the name of an existing company in the index (s 66) It must not, in the opinion of the government, be offensive or such that its use would constitute a criminal offence (s 53) It must not suggest a connection with a government or public authority, unless so authorised by the government (s 54) It must not be prohibited or restricted as a result of any special regulations made by the government under the 2006 Act (ss 55 to 57) It must not, in the government’s opinion, be liable to mislead and harm the public (s 76) It must not be prohibited under the common law on the ground that its use gives rise to the tort of ‘passing-off’

Companies ‘Phoenix companies’: where a company goes into insolvent liquidation, any person who was a director (or shadow director) of that company during the previous 12 months is, for a period of 5 years afterwards, prohibited from setting up a new company with a name suggesting an association with the old company (IA 1986, s 216). R v Registrar of Companies, ex parte Attorney General 1991

This concerned a company that sought to operate a prostitution business, and this was included in their object’s clause. The registrar had previously refused to register the names Prostitute Ltd; Hookers Ltd; and French Lessons Ltd; however eventually allowed the company to incorporate using the name of Lindi St Clair (Personal Services) Ltd. The Crown appealed against this registration on public interest grounds. Note – In the case of a public company, a special ‘trading certificate’ must also be obtained from the registrar before it can commence business. Certified Public Accountants of Britain v Secretary of State for Trade and Industry 1997 Jacob J offered the following test: What the court has to do is to decide on the evidence whether the name of the company gives to a misleading indication of the nature of it activities as to be likely to cause harm to the public. It is not sufficient to show that a name is misleading; a likelihood of harm must be shown too. However – In many cases the latter will follow from the former, but this is not necessarily so: it is difficult to imagine harm, for instance, if a company called Robin Jacob (Fishmongers) Ltd in fact carried on a business of bookbinding. Private Companies v Public Companies S755 Companies act 2006 Public companies are more powerful than private companies, but private companies are more common. Only public companies can offer securities to the general public. A public company will usually offer its securities for sale on a regulated stock exchange (e.g. the London Stock Exchange or Alternative Investment Market) in order to raise finance for expansion of its business. The two main forms of security issued by public companies are: (a) ‘risk’ capital, which is normally in the form of shares or ‘equities’; and (b) loan capital, which is usually in the form of long-term ‘bonds’ or ‘debentures’. Minimum Share Capital Requirement for Public Companies Only In order to begin doing business and/or exercising its borrowing powers, a public company needs a special ‘trading certificate’ from the registrar of companies. The registrar will only issue a trading certificate to a public company if satisfied that the ‘authorised minimum’ value of its share capital is £50,000 (or the prescribed euro equivalent) (ss 761 – 763, 767). Different Registration Requirements A public company’s certificate of incorporation must expressly state that it is a public company, otherwise it will be regarded as a private company (s 4(1) – (2)). Without this, the law will assume it is a private company. Different Suffix Requirements for Company Names Private companies must have ‘limited’ or ‘ltd’ suffix, whilst public companies must have ‘public limited company’ or ‘plc’ suffix (ss 58(1) & 59(1)).

Minimum Number of Directors A public company must have at least 2 directors, whilst a private company needs to only have one (s 154). Qualification of Company Secretary The directors of a public company must take all reasonable steps to ensure that the company secretary has the requisite legal knowledge and experience to enable him to discharge his official functions (s 273). There is no equivalent requirement for private companies. Disclosure of Requirements for PLCs All companies whose shares are traded on a regulated market in the United Kingdom must comply with onerous disclosure requirements laid down by the official UK Listing Authority, the Financial Conduct Authority (FCA), including: - The requirement to produce half-yearly financial reports for shareholders (in addition to the company’s statutory accounts and reports) - The requirement to produce interim management statements for shareholders on a half-yearly basis (or, alternatively, quarterly financial reports), detailing any changes in the company’s financial position; and - The obligation to ensure that ‘inside’ information is made publicly available, so as to minimise the risk of insider dealing. Managers The creators of public companies lose control over that company. Shareholders have no say over the running of the company and are purely there for financial investment only. This is because shareholders can be anyone and therefore, will not have market knowledge in the same way directors/ managers do. s.170 – 177 of the Companies Act oversees the duties of directors. However, this statute is quite limited and allows for difficulties to arise in proving that a director has acted wrongly. Directors are allowed to ‘forgive’ other directors when committing a wrong, and because no one knows who the company is, this ultimately means that directors forgive themselves. Private companies have the choice of who they have as shareholders and how many they have. Private companies have to advertise and sell their shares and can’t limit who they allow. Division Between Management and Residual Ownership Partnership

Partners are formally empowered to manage the business of the partnership (Partnership Act 1890, s 5). Partners are also the residual owners of the partnership: i.e. if the partnership is wound up and its assets distributed in satisfaction of its debts, the partners stand only to receive the amount, if any, left over after all the company’s creditors have been paid in full. Company Companies are characterised by a formal division between management and residual ownership: • The company’s business is managed by a board of directors appointed by the members (see Draft Model Articles, article 3; Table A, article 70). The directors are essentially employees of the company and hence will receive a fixed wage from the company (the company being their employer). • The residual owners of the company are its members (or ‘shareholders’): the members/shareholders are normally entitled to receive periodic distributions of the company’s profits in the form of ‘dividends’. However, the level of dividend paid to shareholders in any year is usually at the discretion of the company’s directors, and unpaid dividends are not classed as debts in the event of the company’s winding up (IA 1986, s 74(2)(f)). • The shareholders of a company stand ‘last in line’ in the event of terminal distribution of the company’s assets. But – In contrast to the partners in an unincorporated business, the shareholders of a company have no formal powers of management over the company’s business (besides their right to appoint its directors). Abuse of the Corporate Form Salomon v Salomon & Co Ltd 1897 “it seems to me impossible to dispute that once the company is legally incorporated it must be treated like any other independent person with its rights and liabilities appropriate to itself, and that the motives of those who took part in the promotion of the company are absolutely irrelevant in discussing what those rights and liabilities are.” The idea behind the corporate veil is that because companies are seen as separate entities from their founders, there is a protective veil covering up the actions of the directors and managers of a company. In some circumstances, this veil can be lifted to expose the actions of those running the company. Lifting the corporate veil helps to promote justice, however, in most circumstances, the company will have more money that the directors and therefore it is better to sue companies than directors if money is the desired outcome. Multi-Corporate Group Enterprises Re Southard Ltd 1979 per Templeman J: “A parent company may spawn a number of subsidiary companies, all controlled directly or indirectly by the shareholders of the parent company. If one of the subsidiary companies, to change the metaphor, turns out to be the runt of the litter and declines into insolvency to the dismay of the creditors, the parent company and other subsidiary companies may

prosper to the joy of the shareholders without any liability for the debts of the insolvency subsidiary.” Lifting the Corporate Veil – What Does it Mean? There is no definition of what this term means and so many cases try to explain it. -

Per Lord Denning in Littlewoods Mail Order Stores Ltd. v. IRC, Incorporation does not fully: “ cast a veil over the personality of a limited company through which the courts cannot see. The courts can, and often do, pull off the mask. They look to see what really lies behind.”

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Staughten LJ in Atlas Maritime v Avalon Maritime (The Coral Rose) thought that: ‘ To pierce the corporate veil is an expression that I would reserve for treating the rights or liabilities or activities of a company as the rights or liabilities or activities of its shareholders. To lift the corporate veil or look behind it, on the other hand, should mean to have regard to the shareholding in a company for some legal purpose.’

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Judicial discretion (and also legislative action) allows the separate entity principle to be disregarded where some injustice is intended, or would result, to a party (either internal or external to the company) with whom the company is dealing

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Similar practice in United States: Decision in Berkey v. Third Avenue Railway 1927

Policy Arguments in Favour of Corporate Veil Lifting -

Parent companies Corporate torts Undercapitalisation (sham companies)

Lifting the Corporate Veil – Statute S213 Insolvency Act 1986 – Fraudulent Trading This only applies to a company that is being shut down. Where a company is being shut down and fraudulent trading is proven, the directors become liable as the corporate veil will be lifted. There must be intent shown, meaning it must be shown that the directors knew about the intent to defraud. S213 Insolvency Act 1986 Fraudulent Trading (1) If in the course of the winding up of a company it appears that any business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose, the following has effect. (2) The court, on the application of the liquidator may declare that any persons who were knowingly parties to the carrying on of the business in the manner above-

mentioned are to be liable to make such contributions (if any) to the company’s assets as the court thinks proper. Fraud demands a high standard of proof and so is difficult to apply Re Patrick & Lyon Ltd 1933 – ‘actual dishonesty…real moral blame. The problem would be establishing intent. Since there is also the criminal offence of fraudulent trading (CA 2006, s. 993), the proof required to establish civil liability under s. 213 is the criminal test: beyond reasonable doubt. Re Augustus Barnett & Son Ltd 1986 An attempt to make a parent company (Rumasa) responsible for the debts of its subsidiary, Augustus Barnett, failed. This was largely because the case was decided under the fraudulent trading provisions where the rule is that in order for liability to arise there has to be evidence that some party has carried on the company's business in a fraudule...