Separate legal personality (part 1)

October 2022

Marina Matyukhina helps LW (ENG) and LW (GLO) ACCA students understand the meaning of separate legal personality and identify situations when this separation can be disregarded Today saying ‘a company owns’ or ‘a company owes’ is commonplace and we understand that a company is a separate legal body that can have assets and liabilities.

However, only about 130 years ago the idea that a ‘mere fiction’ may own and owe something was seriously disputed. If today’s LLC owners travelled back in time to 1893, they could find themselves in the shoes of Mr Salomon.

Quite literally as he was a well-known London shoemaker struggling to prove in court that his bankrupt company’s debts were not his own.

For many years Mr Salomon had operated as a sole trader but then, following legal advice, he decided to take advantage of the newly available legal form and registered his business as a company. The move couldn’t be called entirely ‘treading a new path’. At that time, in July 1892, the Limited Liability Act 1855 had been in force for more than 37 years. However, there was no established common law practice of recognising a legal person’s assets and liabilities.

In 1893 a recession hit Mr Salomon’s business and Salomon & Co Ltd went into liquidation. The liquidator claimed that the company was merely a scheme to defraud the creditors and that it had a right of indemnity against Mr Salomon. The High Court and the Court of Appeal supported the liquidator’s stance.

However, Mr Salomon appealed to the House of Lords (nowadays the Supreme Court).

Unexpectedly, the Lords overturned the decision unanimously, pointing at its inner contradiction: a company could not be a ‘mere fiction’ (i.e., not exist) and simultaneously act as an agent of Mr Salomon. The boot was indeed on the other foot.

Lord Macnaghten also noted that the company creditors ‘had full notice that they were no longer dealing with an individual, and they had to be taken to have been cognisant of the memorandum and of the articles of association’.

In other words, the creditors were assumed to be able to assess their risks when dealing with a company.

This case is a landmark in UK company law.

Not only did it establish that a company was a legal personality separate from its owners, but also that it could enter into contracts, have assets and liabilities, and sue or be sued.

No body to be kicked, no soul to be damned?

This separation brings us back to the question fairly raised by the Lord High Chancellor of Great Britain, Edward Thurlow, a century before the Limited Liability Act was passed: what if a company is really defrauding the creditors? Who would be held accountable? Would it be possible to reach the people making decisions behind the corporate façade?

Today’s common law rules, combined with legislation, establish a number of cases when incorporation can be ignored and the creditors can hold the individuals behind the company to account. The procedure is also known as ‘lifting the veil of incorporation’.

So, who are the actors behind the veil? The four most common answers are: members (owners or shareholders), directors, employees, or other companies. In this article, we will explore the first two.

Behind the veil: members

First, when the company is created to evade existing legal obligations. As in Gilford Motor Co Ltd v Home 1933, where a former employee had a clause in his contract forbidding him to solicit company clients. However, he registered a company and tried to claim that it was his company attracting the clients, not himself personally.

Second, when it is in the public interest to reveal the nationality of the owners, for example, in times of war. In Daimler Co Ltd v Continental Tyre and Rubber Co (GB) Ltd 1917 a British company owned by the Germans was recognised as ‘capable of acquiring enemy character’ and therefore falling under the prohibitions of the Trading with the Enemy Act 1914.

Third, when the members are trying to avoid liabilities: whether to tax authorities as in Unit Construction Co Ltd v Bullock 1960 or to another person as in Jones v Lipman 1962.

Fourth, given a small ‘quasi-partnership’ of member/directors. E.g., Ebrahimi v Westbourne Galleries Ltd 1973, where two members acting together removed the third member from directorship and membership against their will.

This was judged ‘inequitable’.

Behind the veil: directors

Directors can be held personally liable for a company’s debts, and even criminally liable, in various circumstances.

First, when directors act with the intent to defraud. Also known as fraudulent trading, this is a criminal offence. The intent is often hard to prove, so similar rules apply to ‘wrongful trading’ when the directors knew that the company was insolvent but continued trading as usual.

Second, when a disqualified director took part in managing a company.

Third, if a public company started trading without obtaining a trading certificate, any loss incurred while trading without the certificate is also personal liability of the directors.

Fourth, directors abusing company names.

For example, if one year later after the DarkSide Ltd liquidation, its former director starts a new company named DarkSideRises Ltd, he or she is committing a criminal offence. The name likeness misleads the stakeholders into thinking that the business remained a going concern all this time.

The cases get even more curious when the actors behind the veil are also legal personalities.
These will follow in the next article.

• Marina Matyukhina, FCCA, LW tutor with FMELearnOnline. See next month’s PQ magazine for ‘Behind the Veil: Part II’