1

Page no

Introduction … … … … … 2

Examining the dictum … … … … 3

Summary and Conclusion … … 21

 2

INTRODUCTION

In every Company Law book Salomon v Salomon1 is the case which is most
recognised. The importance of this case lies in the fact that it establishes that the
company is a totally different person from its incorporators. It offers the limited
liability not only as a business vehicle for partners, but for even traders who take the
full benefit of limited liability.

In this term paper I will discuss the dictum derived from Lord Halsbury’s judgement
in Salomon v Salomon what are the pros and cons of the dictum, the reasoning why
the House of Lords reached their conclusion reversing what the Court of Appeal said
in relation to the agency point. The assessment of the limited liability doctrine which
was originally intended to encourage passive investors to contribute to encourage
trade and commerce, the most fundamental criticism to this doctrine, group of
companies and when the court will lift the veil between the parent and its subsidiary.
A mention must be made of shareholders as the owners of the company and creditors’
interest who lend the company money which directors have to take into consideration
when they are conducting the affairs of the company. What forms of protection either
under Common Law or statute does the law offer to them? are these measures of
protection adequate?

At the end I will summarise what has been said previous and I will come up with a
conclusion.

1
[1897] AC 22
 3

EXAMINING THE DICTUM

Before examining Lord Halsbury’s dictum in the House of Lords, it is useful to restate
briefly what the Court of First Instance and the Court of Appeal said. The Court of
First Instance and the Court of Appeal thought that Salomon acted fraudulently when
he held all the shares of his family members who had no interest in the company and
that the formation of the company was not done properly and Salomon would have to
indemnify the company’s creditors.

In response to the Court of Appeal’s judgement in Broderip v Salmon2, Lord Halsbury

LC in Salomon v Salomon3 said “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.”

This dictum raises issues relating to the legal entity, the debts and assets of the
company (business), agency, and lifting the veil. I shall discuss every point
individually.

A The legal entity point4

Lord Halsbury LC mentioned that “Either the company was a legal entity or it was
not.” If we look at this part of the dictum, we may at first sight say that it represents
the true position. Whenever there is a company, there will be a legal entity associated
to it and it will have a separate legal existence5 from its incorporators, but is this all?
or we must need in order to say there is a legal

2
[1895] 2 Ch 323
3
[1897] AC 22
4
I am indebted to Mr Jonathan Robinson, our Company Law lecturer, for clarifying this point
5
The Company Act in S13 (1) does not state expressly that the company will have a legal existence but
it is implied that the company will have a legal entity from the time the registrar of companies will
certify that the company has been incorporated
 4

entity a special procedure to be followed? and can we still say that the company has a
legal entity in the situation that fraud has been committed? Both judgement in the
Court of First Instance and the Court of Appeal thought that Salomon had acted
fraudulently. The House of Lords did not find any form of fraud or deliberate abuse
of the corporate form, on the contrary Salomon was a victim in that he did his best to
rescue his company by cancelling the debenture he took and raising them to an
outside creditor who provided fresh loan capital.6 This honesty and good faith on the
part of Salomon prevented him from indemnifying the company creditors. The House
of Lords found there is a legal entity properly formed and there was no use of lifting
the veil between Salomon and his company. Also another criticism lies in the fact
that not only the company is recognised as a separate legal entity but also according to
the proposed legislation of the limited liability partnership which, amended a very
fundamental concept in Partnership Law in England and gave the LLP a distinct legal
entity from its partners as a result the LLP will have most of the advantages
associated with the company especially the limited liability.7

B The Business Point

Lord Halsbury said “If it was, the business belonged to it and not to Mr Salomon.”
As a result of the Court of Appeal refusal to recognise the existence of the legal entity
and regarding the company instead as a myth and fiction, they thought that the
business belonged to Aron Salomon. Lord Halsbury refused that proposition. It is
submitted that this part of the dictum is right as a consequence of the separate
personality the company as soon as it is registered will acquire all the assets which the
shareholders contributed to the company. The company will be regarded as
constituting its own assets. For example, the property will no longer be members’
joint property. Lord Wrenbury in MaCaura8 said “My Lords, 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 nor any creditors of the company has any property
legal or equitable in the assets of the corporation.” Not only the assets will represent

6
J Birds, A Boyle, Eilis Ferran, Charlotte Villiers, Company Law (Third Edition), Jordans, 1996, p 15 ;
see also the judgement of Lord Halsbury, Lord Macanghten in Salomon v Salomon [1897], AC22 at 39,
53
7
Andrew Griffiths, “Professional Firms and Limited Liability : an Analysis of the Proposed Limited
Liability Partnership” (1998), Company Financial and Insolvency LR 2, p 157.
 5

the business of the company, but also the House of Lords recognised that the debts
and liabilities will belong to that company and not to its shareholders.

C The Agency Point

Lord Halsbury said “If it was not a legal entity there was no person and no thing to be
an agent at all.” Vaughan William J in the Court of First Insatnce based his
judgement on agency relationship, stating that the company had no personality of its
own, being nothing more that an agent of Salomon the man. Lord Halsbury refused
that finding and found the company cannot be an agent at all. Lord Macnagten in
clear words said “The company is not in law the agent of the subscribers or trustee for
them . . . .” Two observations must be made: why the House of Lords refused the
existence of an agency relationship? and why did the House of Lords refused totally
the proposition that the company can be an agent of its shareholders in certain
circumstances? The House of Lords found a contradiction in the situation that the
company is regarded as an agent of Salomon the principal. There will be two legal
capacities, the agent (company) and the principal (Salomon). If we say that there are
two legal capacities, the company will have a separate legal existence and separate
legal entity from the principal. As a consequence the House of Lords denied in any
form the presence of any agency relationship.

It is submitted that Lord Halbury’s dictum indicates that the company can never be an
agent of its subscribers, but this is not true. Even the House of Lords after mentioning
that the company cannot be an agent of its subscribers did not reject totally the
suggestion that the company can be an agent in certain circumstances. In British
Thomson-Houston Co Ltd v Sterling Accessories Ltd9 Tomlin L J clarified when the
company will be an agent. He said “. . . the agency of the company must be
established substantively and cannot be inferred from the holding of directors and
control of shares alone . . . Any other conclusion would have nullified the purpose for
which the creation of limited companies was authorised by the legislature.” Finally
we can say that the general rule is that the company is not the agent or trustee for its

8
MaCaura v Northern Assurance Co [1925] AC 619
9
[1924] 2 Ch 33
 6

members unless exceptionally this relationship is established that the company is

acting as an agent.10

D Lifting the Veil Point

The last part of the dictum should be construed with the first part. Lord Halsbury said
“Either the limited company was a legal entity or it was not . . . and it is impossible to
say at the same time that there is a company and there is not.” The House of Lords as
said earlier, did not induce any form of agency relationship which will lift the veil
between the company and Mr Salomon. Lord Halsbury’s dictum indicates that the
court will be certain when it will lift the veil and when it will not. As said “the
position adapted by England’s Company Law in the present context is both absolute
and absurd”11, but it must be said that Adams v Cape Industry 12has clarified the
position of English Law towards the legal personality of the company. English Law
will disregard and lift the veil only in exceptional circumstances, and this will depend
on the particular fact of the case which is in front of the judges, as we will see later on
when we are discussing groups of companies.

THE ASSESSMENT OF THE LIMITED LIABILITY DOCTRINE

Historically, before recognising the limited liability, merchants sought methods of

minimising their risk. One of the ways adopted was to share the risk between
partners, another was to offer creditors a high return in case the company flourishes
and prospers and not to recompense creditors in the situation that the company fails,
also insuring against the risk in case of loss.13

The Limited Liability Act 1855 introduced the limited liability to become a legitimate
feature of companies as far as English Law is concerned. But what do we mean by
limited liability? What does this concept offer to the business world?

10
Murray A Pickering, “The Company as a Separate Legal Entity” [1968], Vol 31, MLR 481
11
Michael Whincup, “Inequitable Incorporation – the Abuse of the Privilege”[1981] 2 CL 158
12
[1990] Ch 433
13
Nicolas Grier, UK Company Law, John Willey and Sons, 1998
 7

Limited liability is said to be a distinction feature of corporate law. It means that in

the situation that the company is unable to pay its debts, members of the company will
not have to contribute towards paying the company debts out of their own private
funds, they are only liable to contribute to the amount they have paid or promised to
pay for their shares. This concept is important to public companies entrepreneurs who
needed to raise capital for large scale enterprises when limited liability was used for
public companies.14 Also another importance lies in the fact that the business man
who knows that his maximum liability to his creditors is the amount he has agreed to
invest by a way of capital is more likely to take the risk.15 That is what the legislator
originally wanted to encourage passive investors to contribute by a clear distinction
between personal and business assets. The limitation of the liability of investors to
the amount they put in their business is a privilege which can be abused at the expense
of the creditors, especially unsecured ones, who will bear the risk of the business
failure. As a result, they may lose their money in the situation that the company is
declared bankrupt and no longer able to pay its debts. Critics of the limited liability
doctrine criticise the limited liability doctrine in the sense that shareholders will reap
all the benefits of risky activities, but do not bear all the costs which are borne by
creditors,16 but is it more appropriate to shift the risk of business failure and let it be
borne by one group rather than letting it rest as it falls? First of all, there is no
business not associated with risk, every business man must take into consideration the
failure of his business and someone must shoulder the risk under any rule.

It is said that one entrepreneur cannot bear a large amount of loss and shifting the loss
from him to a wealthy group like large institutional investors will let the risk of the
business failure spread out amongst all creditors rather than one person.17

Abusing the limited liability on the account of creditors lead some commentators to
suggest that abolishing the limited liability doctrine will put a limit to these forms of

14
Paul L Davies, Gower’s Principles of Modern Company Law (Sixth Edition), Sweet and Maxwell,
1997
15
Andrew Hicks, “Corporate form : Questioning the Unsung Hero” [1997], JBL 306
16
Frank H Easterbrook, Daniel R Fischel, The Economic Structure of Corporate Law, Harvard
University Press, 1996
17
Ibid
 8

abuses in terms of protecting creditors, but what will be the result on the commercial
world?
Whatever hard things may be said about the limited liability, it has conferred very
great benefit to the community, it has provided large sums of money for useful
industrial undertakings and advanced the progress of industry and commerce. It is
even said “that the limited liability has been co-extensive and inextricably linked with
success of Western capitalism.”18 Let us assume that the limited liability is abolished.
I think we will be back to the beginning again. Traders will create other methods to
minimise their liability by agreement, contract and relying on insurance. Also, these
forms of abuses which are taking place in relation to the limited liability are not the
rule but exceptions; many businesses are prospering and flourishing without any
difficulty. If there were some form of abuses taking place, can we say that the limited
liability is no good to the world of commerce? In my opinion I think not, nothing is
absolute although there are disadvantages associated with the limited liability, the
advantages outweigh the disadvantages.

Instead of abolishing the limited liability doctrine, we should strengthen our laws in
terms of protecting creditors. This aspect will be discussed later on.

ONE MAN COMPANIES

The Court of Appeal in Broderip v Salomon19 declared that Mr Salomon when he had
incorporated the company with six dummies, was abusing the Companies Act. All
shareholders must be honourable men, bona fide traders, none of them dummies.20
The decision of the House of Lords reversed the finding at the Court of Appeal and
established the legality of the one-man companies. Limited liability was also
available to sole traders who can limit their liability to the amount they put in their
business. Soon after recognising the one man companies, many abuses of the
corporate form took place. Limited liability was one way of defrauding creditors.

18
Andrew Hicks, “Corporate Form : Questioning the Unsung Hero”, [1997], JBL 306
19
[1895]2 Ch 323
20
LQR Vol II [1895]
 9

This gap in the law started to induce commentators to address the problem. Kahn
Freund thought that the best way to get out of this problem was to abolish the private
companies and to lift the corporate entity in extreme cases for the benefit of the
creditors.21 The Jenkins Committee appointed in the UK in 1959 mentioned the fact
that the increase in registration fees might also solve the problem. While some of the
suggestions were implemented, others were not.

It is now possible to establish a private company with one member as a result of the
Companies (Single Member Private Limited Companies) Regulation 1992 (SI
1992/1699) which implements the European Council directive of 1899.22 Courts will
not let the corporate form be used for the purposes of fraud or as a device to evade
legal obligation. If the court is convinced that this is done the corporate veil will be
lifted. Two cases illustrate this proposition. In Gilford Motor Company Ltd v
Horne23 an agreement was made between the plaintiff and the defendant which
prevented the latter from setting up a business competing with his employer. The
defendant thought he was clever enough when he set up a new limited company to
evade his obligation. The Court of Appeal were clear the company was formed as a
device and accordingly ignored the separate legal personality and granted the plaintiff
an injunction against the defendant and his company. Also in Jones v Lipman24 the
court awarded specific performance against both the company and the defendant who
had agreed to sell his property to the plaintiff in order to avoid that he set up his own
business.

Finally we can say that in cases of the abuse of the corporate personality, the court
will not hesitate in lifting the veil between the company and its members. Also under
the wrongful trading provision, a parent company might be held liable to pay the
debts of its subsidiary. I shall discuss this provision later on.

21
O Kahn Freund, “Some Reflection on Company Law” [1944], 7 MLR 54
22
See A Blake, H J Bond, Company Law (Fifth Edition), Blackstone Press Limited, 1996
23
[1933] Ch 935; see also Jennifer Payne’s article, “Lifting the Corporation Veil – A Reassessment of
the Fraud Exception”, [1997], CLJ 56(2) 284
24
[1962] LWL R 832
 10

GROUP OF COMPANIES

The question in relation to a group of companies is whether the court still applies the
strict corporate entity principle and its attendant privilege of limited liability? or
should the court look at the whole group as a single economic unit.

When does the court remove the protection offered by limited liability from directors
or shareholders? and in the case of a parent company, is the parent liable for the debts
of its subsidiary? When will the court allow creditors to reach the assets of share
holders?

Two theories govern the relationship between the parent company and its subsidiary.
The first theory is the legal separation theory which looks to every company as a
separate legal entity of its own right and liabilities. The second theory is the
economic entity theory which regards all the group as one single unit. According to
English law the favourable theory is the legal separation theory viewed in Salomon v
Saloman and Co Ltd and in Adams v Cape Industry. 25 If in the situation that a
subsidiary is solvent, the parent company would not be liable to pay for the debts of
its subsidiary since every company is regarded as a separate legal entity in law. This
odd situation will let the parent company escape any liability in case it is conducting
risky business through its subsidiary. Creditors, as a result of this, will suffer loss.

The doctrine of separate personality will be acted upon and recognised unless public
interest and public policy demand that the legal entity should be disregarded. In this
situation the courts either goes behind the corporate personality to see the individual
members, or ignore the separate personality of each company constituted by a group
of associated concerns.26 The former situation is called piercing the corporate
personality, while the latter one is ignoring the corporate personality.

25
[1897] AC 22 and [1990] BCLC 479; see also Clive M Schmithoff “The Wholly Owned and the
Controlled Subsidiary” [1978], JBL 218
26
See R Baxt, “Tension Between Commercial Reality and Legal Principle . . .” [1991], ALJ Volue 65,
p 352
 11

I shall examine agency, undercapitalisation, control. Abuse of the corporate form or

fraud is also a situation when the court will lift the veil, but since it has been
mentioned earlier in relation to one man companies, there is no point in mentioning it
twice.

A Agency
In order for the court to induce an agency relationship and accordingly lift the veil of
incorporation between a parent company and its sibsidiary, an express agreement
between the parties must be present and the subsidiary must follow the parent
company's instruction as to how it should conduct its business. In Ebbw Vale DC v
South Wales Traffic Licencing Authority27 the court refused to accept the existence of
an agency relationship between a parent company and its wholly owned subsidiary
despite the fact that the company in question was a mere shell, existing only in name
and wholly owned by another company.

In Smith Stone and Knight v Birmingham Corporation28 the business of the company
was carried through a subsidiary company which was to all intents and purposes a
department of its parent. The court laid down six factors to determine whether the
subsidiary is agent of its parent company or not. (i) the profit of the subsidiary and
the parent is the same; (ii) the persons conducting the business of the subsidiary
appointed by the parent company; (iii) was the parent company the head and brains of
the trading venture? (iv) did the parent company govern the adventure? (v) were the
profits made by the subsidiary company made by the skill and direction of the parent
company? (vi) was the parent company in effective and constant control of the
subsidiary? Two observations must be made in relation to the previous factors. It is
submitted that most important factor in determining and inducing an agency
relationship between the parent and its subsidiary, the third and fourth factors, the
subsidiary must be told by the parent how it should conduct its business and this is a
functional control rather than a capitalist control. The other factors will determine
whether the parent company is controlling its subsidiary, not inducing an agency

27
[1951] 2 KB 266; quoted in Michael Whincup’s article “Inequitable Incorporation – the Abuse of the
Privilege”, CL Vol 2, No 4, p 158
28
[1939] 4 All ER 116
 12

relationship as a ground for lifting the veil. This can be found in the Companies
Act.29

In Adams v Cape Industry30, the agency argument was delivered by the plaintiff to
support the proposition that Cape the parent company was present in the united state
through its subsidiary, to enforce a judgement obtained in the united state against
Cape. The courts recognised that Cape’s subsidiary acted as an agent in certain
transactions, but this was not enough to show that an agency relationship existed
between the parent company and its subsidiary.

Some authors suggest31 that the legislator must develop a strong presumption that the
parent used the subsidiary as an agent, therefore the parent company is liable for
payment of the debts of its subsidiary, the parent company can repeat this
presumption if it can prove that it neither authorised the transaction expressly or
impliedly. I think adapting this approach might minimise the loss which creditors
face and will solve a very unfavourable feature of English Company Law.

B Under Capitalisation
An under capitalisation situation occurrs when a corporation carries on business
without sufficient assets to meet its debts. Shareholders will escape personal liability
by forming a corporation.32

The reason for allowing creditors to go beyond the assets of corporations is that the
lower the amount of the firm’s capital, the greater the incentive to engage in risky
activities.33 If we want to determine a situation of under capitalisation, we have to see
the capital of the business and the risk of loss associated with it.

Unlike the USA courts, UK courts do not consider under capitalisation as a real
ground for lifting the veil and pursuing the assets in favour of creditors.

29
See section 736, 736A, CA 1985
30
[1990] BCLC 479
31
Clife M Schmithoff, “The Wholly Owned and the Controlled Subsidiary” [1978], JBL 218
32
Michael Whincup, “Inequitable Incorporation – the Abuse of Privilege”, CL Vol 2, No 4, p 158
 13

In Re F G Film34 the issues was whether a film made by an English company was a
British film within the provision of section 25(i) of the Cinematograph Films Act
1938. The applicant was a company incorporated in England. It had a capital of
£100. 90 of these shares were held by the American director and the remaining 10
were held by a British director. The Judge Vaisey J after having been satisfied that
the company had no place of business, did not employ any staff and had a very
nominal capital, come to the conclusion that the film was not a British film within the
meaning of the 1938 Act.

We can mention that lifting the veil in case of under capitalisation to allow creditors
to go beyond the assets of the under capitalised corporate debtor will let the debtor
disclose his situation at the time of the transaction. The creditor that has the
opportunity either not to transact or ask for prepayment or personal guarantees.35

The strictness of the legal entity implied in Salomon v Salomon and afterward in
Adams v Cape makes the court reluctant to lift the veil except in exceptional
circumstances. This position is contrasted to the American approach which does not
set a high value on it, therefore courts will be likely to disregard it more often.

33
See Frank H Easterbook and Daniel R Fischel, The Economic Structure of Corporate Law, Harvard
University Press, 1991
34
[1953] 1 WLR 483
35
See Frank H Easterbook and Daniel R Fischel, The Economic Structure of Corporate Law, Harvard
University Press, 1991
 14

SHAREHOLDER’S INTERESTS

Shareholders were regarded as the owners of the Company and its assets, they are the
ones who appoint directors, who should run the company for their exclusive benefit,
not withstanding any other constituency within the Company. As the law started
recognising other groups,36 the law has gone through radical change, shareholders
have become little more than bystanders,37 although they have a significant role to
play in being able to appoint the board, approve irregular transactions and alter the
constitution and, in the event that shareholders are not satisfied with directors’
management, they can simply disqualify the directors and appoint new ones in their
place, or they may sell the shares and invest in another company.

The duty of directors to act in the interest of shareholders arises in relation to take-
over bids which forbid directors from frustrating a take-over bid and thus depriving
the members of an opportunity to sell their shares at an advantageous price.38 In Re a
Company39 the court considered the duties of the directors of a private company to its
general body of shareholders when there are two competing offers for their shares.
Hoffman J answered : “directors are required to give shareholders sufficient
information and advice to enable them to reach a properly informed decision and to
refrain from giving misleading advice or exercising their judiciary powers in a way
which would prevent or inhibit shareholders from choosing to take the better price.”
In Heron International Ltd v Lord Grade40 the court recognised that directors’ duties
toward shareholders collectively rather than on an individual basis and then only
towards current and not future shareholders. Where a particular decision to be taken
by the directors bears differently upon different classes of shareholders, their duty is
to act fairly, having regard to the interests of all classes.41 Although these cases may
seem to establish that there is a fudiciary duty on the part of the directors owed to

36
Interest of Employees: S – 309 – CA 1985
37
Ross Grantham, “The Doctrinal Basis of the Rights of Company Shareholders” [1988], CLJ 554
38
Parkinson, Corporate Power and Responsibility : Issues in the Theory of Company Law, Clarendon,
Oxford, 1993
39
Re A Company (No 8699 of 1985), 1986 BCLC 382
40
[1983], BCLC 244
41
Henry v Great Northern Railway [1857] I De6 and J 606 at p 638, quoted in J Birds, A J Boyle, Eilis
Ferran, Charlotte Villiers, Company Law, Jordans, 1996
 15

shareholders, Lord Cullen42 argues that the duty only arises if directors take it on
themselves to give advice to current shareholders.

In my opinion, it is submitted that the fact that directors stand in a fudiciary obligation
toward the company and the company is regarded as a general body, shareholders are
part of that body, therefore directors have to take care of shareholders’ interest since it
is their company in the first place

CREDITORS’ INTERESTS

A Common Law

As we have seen, the recognition of the courts to the company as a distinct legal
person incurring its own debts and liabilities gave creditors no direct recourse against
those people who run and manage the affairs of the company. Even in the
circumstances that the company is declared bankrupt, members of it were not required
to contribute in their own capital.

Directors of the company were not required to take into account creditors’ interest
since directors do not owe any form of duty to either shareholders or creditors.43
Influenced by a wide range of authorities through the Common Law countries, the
position has changed as far as English Law is concerned. In Liquidator of West
Mercia Safetywear Ltd v Dodd44, the court held that the director of the company was
personally liable to contribute to its liquidator in a sum of £4000 which he had
diverted away from the company (to which it was due) and into the bank account of
another company where it reduced an overdraft that he had personally guaranteed; as
a result he disregarded the interests of the creditors. The case recognised that
directors should take into consideration the interests of creditors when the company is
insolvent. If we have established that directors owe such a duty, why should creditors

42
In International plc v Coats Paton plc [1989], BCLC 233
43
Multinational Gas and Petrochemical Co v Multinational Gas and Petrochemical Services Ltd
[1983], Ch 258; see the judgement of Dilon L J, “. . . directors owe fudiciary duties to the company
thought not to creditors present or future”; see also Percival v Wright [1902], 2 Ch 421
 16

be protected in the first place? What do we mean by such a duty, when it arises and
terminates? Is the duty owed to single creditors, or to creditors generally present and
future ones?

Shareholders were regarded as owners of the company and creditors as the people
who lend it money, creditors and shareholders have the same relationship to the
company, both groups are making a capital investment and both expect to get their
money back plus a return on their investments.45 Directors have to take into account
of shareholders’ interest when the company is a going concern, but when the company
becomes insolvent or insolvency threatens,46 the interests of the creditors become the
interests of the company, since creditors will be the most effective constituency of
directors’ misconduct. The duty on the part of the directors to take into account of
creditors’ interest is explained in Winkworth v Edward Baron Development Co Ltd47
by Lord Templeman, who said : “the company owes a duty to its creditors to keep its
property inviolate and available for repayments of its debts . . . A duty is owed by the
directors to the company and to the creditors of the company to ensure that the affairs
of the company are properly administered and that its property is not dissipated or
exploited for the benefit of the directors themselves to the prejudice of the creditors.
In the situation that the company is no longer able to pay its debts, creditors’ claims
will be against the company property which is distinguished from the members and no
longer in their name.” Judges do not specify whether directors owe a duty to creditors
generally or to a specified group of creditors48 determining that it is important, since
directors having placed themselves in a position of trust against the company assets
may prejudice on a class of creditors on the account of the others (e.g. if directors
decided to use the remaining assets to pay off the preferential creditors or to continue
to trade in the hope that the company will prosper and can accordingly pay the debts
of the unsecured creditors.

44
[1988] 4 BCC 30; quoted in L S Sealy, “Directors’ Duties – An Unnecessary Gloss” [1988], CLJ 175
45
Saleem Sheikh and Williams Rees, Corporate Governance and Corporate Control (First Edition),
Cavendish Publishing Limited, 1995, Ch 4, “Creditors’ Interests and Directors’ Obligations”, p 111 -
141
46
Brady v Brady (1989), 3 BCC 535 (Court of Appeal) : [1988] 2 All ER 612; see note 45 above
47
[1986] WLR 1512 quoted in D D Prentice, “Creditors’ Interests and Directors’ Duties” [1990] 10,
OJLS 265
48
See note 45 above
 17

We can sum up by saying that directors should ensure that the assets of the company
are kept to pay creditors whether preferential or unsecured, since they are the most
effective constituency when the company is insolvent or doubtful insolvency; but
what other form of protection does the law offer to creditors? Does the statutory
provision relating to fraudulent and wrongful trading which also protects creditors
diminish the Common Law ones? All these issues and others will be discussed under
the next heading.

B Statutory Provision

The abuse of the corporate personality by directors in a small type of business called
the “phoenix syndromes”, who gave themselves excessive salaries and, after
conducting business for a certain period, found themselves not making a lot of profit
with lots of debts on the part of the company, would deliberately allow their
companies to run into the ground so that they became insolvent, and after a while,
setting up a new company known as a “phoenix company”, using the old business and
re-employing the workforce without of course incurring any old debts, since creditors
of the first company had no legal claims against the new one.49 In order to put a limit
to these forms of abuses and others, the Cork Committee proposed certain protections
to creditors and some of them were implemented in the Insolvency Law 1986.

I shall discuss the fraudulent and wrongful trading provisions (213, 214), making a
comparison between both arguing whether these provisions are adequate measures for
protection to creditors or not? Fraudulent trading is actionable as a civil offence in an
insolvency situation and a criminal offence while wrongful trading is only available in
civil courts.

Fraudulent and wrongful trading comes into effect when the company is insolvent at a
time when its assets are insufficient for the payment of its debts and other liabilities.50
The object of these provisions is to protect the interest of the creditors and to
encourage directors to take immediate steps on viewing their company as insolvent to
place it in receivership administration or liquidation. The liquidator is the only person

49
This paragraph is adapted from Professor Ian F Fletcher’s article “The Genesis of Modern
Insolvency Law – An Odyssey of Law Reform” [1987], JBL 365
 18

who could enforce and bring these provisions into effect, within six years of the
company going into insolvent liquidation.51 Intent to defraud creditors must be
established on the part of any member of the company52 or a person who is or was a
director, shadow director.53

Directors or other persons who, by virtue of their office or performance of their

duties, contributed in any way on behalf of the company to act in a certain way which
incurred its debt and against the company creditors will be made liable. The court has
a wide discretion in terms of the amount of contribution that any member of the
company has to pay “as the court thinks proper”, but the question here is who has
entitlement to such contribution? Are the assets of the company available to satisfy
all creditors or only those who were the victims under the fraudulent or wrongful
trading?

According to Insolvency Law principles, the assets of the company in liquidation

constitute a single pool available to all creditors, unless a creditor has a priority either
by agreement or by statute.54 A defence is offered in relation to wrongful trading
provision55 to the director, who satisfies the court that he took every step with a view
to minimising the potential loss to the company’s creditors. Whether a director has
done so or not is tested objectively depending on the position of the director and the
status of the company he is employed in.

The prime criticism to the wrongful and fraudulent trading provisions is that it is only
enforced not by creditors themselves, who cannot bring an action against the director
or other people who acted fraudulently, but only by application of the liquidator. If
the liquidators refrained from taking such action, creditors will lose one form of
protection that the law has offered to them; also it must be noted that the liquidator
might face some difficulty in establishing that the director or any member of the

50
Section 214(6), Insolvency Act 1986
51
Gore-Browne on Companies (Forty-fourth Edition), Boyle and Sykes, Jordans 1986
52
Fraudulent Trading, S 213(2), Insolvency Act 1986
53
Wrongful Trading, S 214 – “Introducing a shadow director is important in terms of protecting
creditors since a parent company may be held liable to pay the debt of its subsidiary.”
54
D D Prentice, “Creditors’ Interests and Directors’ Duties” [1990], 10, PJLS 265
55
S 214(3), Insolvency Law 1986
 19

company has acted fraudulently or dishonestly, and this provision will only come into
place when the company has gone into insolvent liquidation.

OTHER FORMS OF PROTECTING CREDITORS

A Liability for acting while disqualified

Section 15 of the Directors’ Disqualification Act 1986 offers an important form of
protection. For creditors who can bring action directly against any person who is a
director or being concerned directly or indirectly in taking part in the management of
the company to be liable for the debts of the company whether jointly or severally
with the company.

The importance of this provision lies in two respects. The company does not have to
be in liquidation and creditors can enforce this provision directly without the need for
action by a liquidator.

B Unlimited liability of directors56

According to Section 306, 307 of the Companies Act 1985, a limited company can
introduce a clause originally in its memorandum or by way of alteration which states
that the liability of its directors should be unlimited in a winding-up procedure.
Banks or other powerful investors might make this kind of provision as a requisite for
providing their loans, although it must be noted that this provision is scarcely if ever
invoked.

C The use of the suffix “limited”

According to Section 25(2) of the Companies Act 1985 every limited company, either
limited by share or by guarantee, is required to use the word limited “Ltd” or the
Welsh equivalent after the last word of its name stated in the memorandum.57 This
provision can be said to be for the advantage of creditors and their disadvantage. For
their advantage, since they are warned of the position of the company, shareholders

56
A J Boyle, Richard Sykes, Leonard Sealy, Gore-Browne on Companies (Forth-fourth Edition), Vol
2, Jordans, 1986
57
Ibid
 20

will not be liable to contribute more than the assets they have advanced to their
company. For their disadvantage, since they cannot plead that they did not know they
were dealing with a company, either limited by guarantee or shares. But what about
the situation when shareholders deliberately conceal the exact position of their
company? The law’s answer to this point is that a person or persons will be liable to a
fine or for continued contravention to a daily default fine.58 In my opinion it is
submitted that this form of protection is not adequate enough especially the
compensatory aspect of it, since it does not offer real protection for creditors.

Also it must be mentioned that there are other forms of protection, such as the
disclosure requirement on the company, enabling third parties to make the company
search the Companies Registry. Creditors can take fixed or floating security to give
them priority in the situation that the company has gone into insolvent liquidation.
And powerful creditors might employ several strategies to reduce the risks associated
with debt obligation by exercising some measure of control over the business affairs
of the debtor company.

58
S 34 CA 1985
 21

CONCLUSION

The House of Lords found that honesty and good faith on Salomon’s part prevented
him from indemnifying the company creditors as they knew they were dealing with a
legal person totally different from his incorporators. Limited liability at that time was
also available to sole traders and large investors who wanted some form of limit on
their undertakings.

The abuses which took place afterwards led some commentators to suggest abolishing
the limited liability at all or at least to abolish the private companies, but what would
be the effect of that on the commercial world? and are these abuses the exception or
the rule? It is submitted that industry and trade will suffer as a result of many
investors not contributing more than the amount they wish to invest, and we will be
back at the beginning again. Traders will find a way to limit their liability under
contract or insurance as they have done before.

Alteration of risk from shareholders to creditors and the abuse of the corporate
personality and the limited liability associated to it does not mean that the limited
liability is of no good; many companies are prospering and flourishing without any
problem and these abuses are not the rule but the exception to it. The law started
recognising the problem and formed methods of protecting creditors, either preventive
or compensatory, preventive measures requiring directors to take care of creditors’
interests and compensatory measures relating to fraudulent and wrongful trading. But
are these measures of protection adequate? In my opinion I do not think so, since
they only enforced other provisions by a liquidator when the company was in
liquidation and this does not address the problem either.

The judges also are not sure when to lift the veil between the parent company and its
subsidiary only in exceptional circumstances will declare shareholders liable to pay
the debts when they use the company in case of fraud or to evade legal obligation, but
it’s a matter of the circumstances and there is no basic rule.
 22

It is hoped that parliament will develop a coherent effective systematic way of

evading the adverse effect which limited liability can have on creditors. As a result
this will give limited liability its proper function and will avoid severe criticism of it.