Salomon's Case Salomon v Salomon

1
Salomon's CaseSalomon v Salomon Co Ltd 1897
AC 22

• A legal Presentation
• Prepared by
• Malcolm Craig
• Student Number 3067567
• Prepared for Sophie Riley
• LAWS3089 Corporate Law Regulation - Tuesday 6PM

2
Introduction

• A leading case confirming that liability can be
  limited as per the standard case of the limited
  liability company with a share capital, the
  liability of the members is limited to the amount
  unpaid (if any) on their shares. Salomons case
  is significant because it was not until the House
  of Lords handed down its decision, that a company
  was fully recognised as being a separate legal
  entity. As long as the necessary formalities of
  incorporation are satisfied, a new entity comes
  into existence which is separate and distinct
  from its directors and shareholders. This is so
  whether the company has a large number of
  shareholders or is, as in Salomons case, a
  company managed and controlled by one person.
• The principle of separate corporate personality
  as established by Salomons case and emphatically
  reasserted in later cases forms the
  cornerstone of company law. The authority of
  these cases is unshakeable and yet
  exceptionally, in some instances, the law is
  prepared to disregard or look behind the
  corporate personality and have regard to the
  realities of the situation. This approach,
  which has come to be known as lifting the veil
  of incorporation, is sometimes expressly
  authorised by statute and sometimes adopted by
  the court of its own accord.

3
Salomons Case - Protection of members from
liability

• Salomons case is a seminal decision stressing
  the independent nature of the corporate
  personality. The Companies Act 1862 (UK) required
  a minimum of seven associated persons before a
  new company could be registered. S owned a
  business. He desired to incorporate it, viz, set
  up a company and transfer the assets of the
  business to it. This was done, company entered
  into an agreement to buy Salomons business for
  39,000 pounds to be satisfied by the issue to
  Salomon of 20,000 fully paid 1 pound shares and
  debentures. In part payment for the business the
  company allocated debentures to him (in the form
  of a floating charge over the companys assets
  he therefore had priority through these over
  unsecured creditors). He controlled the company,
  and owned most of the shares.
• The company got into difficulties, Salomon
  borrowed 5,000 pounds from Broderip which he
  advanced to company (for this Salomon had his
  debentures cancelled and reissued to Broderip,
  retaining the residual beneficial interest in the
  debentures after Broderips debt was discharged.
  When Salomons interest payments fell into
  arrears, Broderip enforced his security and and a
  liquidator was appointed.After execution of
  Broderips security there remained a balance of
  indebtedness of 1,055 pounds secured by
  debentures. Salomon claimed his reversionary
  entitlement to this secured indebtedness which
  would have exhausted the funds in the
  liquidators hands to the total exclusion of the
  claims of the unsecured creditors. The liquidator
  resisted Salomon, initially by disputing the
  validity of the debentures, inter alia, on the
  ground of fraud.

4
Salomons Case - What did the Courts Decide?

• Simplifying the facts a little there was not
  enough in the company to pay out some of the
  debentures, and the unsecured creditors. The
  liquidation contended on behalf of the ordinary
  creditors, that the company was a mere nominee
  and agent of S that in substance S owed the
  money (just as he would have had he not
  incorporated) and that he could not rely on the
  corporate cloak he had erected to defeat the
  claims of the creditors. If the company could be
  disregarded as a sham and have no status in law.
  Was the situation one then in substance and in
  law that of an unincorporated sole trader?
• How did the courts deal with the situation?
• Vaughan Williams J, at first instance, held for
  the liquidator. His Lordship reasoned that
• the company conducted the business not in its own
  right, but as agent for Salomon
• Salomon, the principal, was bound under agency
  law to indemnify his agent, the company and
• the company as agent was entitled to a lien by
  operation of law on its principals assets in its
  possession.
• The lien took priority over the security for the
  debt owed to Salomon. liquidators claim amended
  to one for a declaration that liquidator was
  entitled to be indemnified by Salomon for
  unsecured debts of company for a lien on all
  sums payable by company on debentures. It was
  averred that the company was the mere nominee
  agent for Salomon. This conclusion rested on
  high degree of control which Salomon exercised
  over the companys affairs.

5
Salomons Case - What did the Courts Decide?

• Court of Appeal - Dismissed the appeal. It noted
  that the sale and transfer could not be ignored.
  But although the company became the owner of the
  business and conducted it as principal, the high
  degree of Salomons control and the fact that the
  six other shareholders were not independent still
  meant that the company was conducting the
  business on behalf of Salomon - it was not doing
  so as agent but as a trustee for Salomon. It was
  as if Salomon had transferred the business to the
  company requesting that it conduct the business
  as trustee for him.
• A trustee acting upon such a request is entitled
  under the law of trusts to indemnity against the
  beneficiary personally for debts incurred as
  trustee. Hence Salomon was liable to pay the
  liquidator the amount of the unsecured debts.
• Both Vaughan Williams J and Court of Appeal
  thought the Companies Act 1862 did not allow a
  sole trader to get limited liability by forming a
  company in which such shares as were not taken by
  him were held by his nominees on trust for him.
  Lopes Kay LJJ - It would be lamentable if a
  scheme like this could not be defeatedit never
  was intended that the company to be constituted
  should consist of one substantial person and six
  mere dummies, the nominees of that person,
  without any real interest in the companyTo
  legalise such a transaction would be scandal

6
Salomons Case - What did the Courts Decide?

• Alleged Fraud? - Lord Halsbury stated that
  Vaughan Williams J. appears to me to have
  disposed of the argument that the company (which
  for this purpose he assumed to be a legal entity)
  was defrauded into the purchase of Aron Salomons
  business because, assuming that the price paid
  for the business was an exorbitant onethe judge
  observes that when all the shareholders are
  perfectly cognisant of the conditions under which
  the company is formed and the conditions of the
  purchase, it is impossible to contend that the
  company is being defrauded.
• The House of Lords found for S. The company had
  not been set up as a fraud, and there was no
  objection to a sole trader incorporating.
  Accordingly, the company having been formed for a
  bona fide purpose, the rights and liabilities of
  the parties were to be determined on the basis of
  its independent existence as a legal person. This
  meant that the debentures were valid, and under
  the legislative provisions relating to
  priorities, they took priority over the unsecured
  debts owed by it.
• Lipton, P. Herzberg, A. 2002, Understanding
  Company Law, 11th Edition, Lawbook Company.
• Ford, H.A.J. Austin, R.P. 2003, Fords
  Principles of Corporations Law, 11th Edition,
  Butterworths.

7
Salomons Case - What did the Courts Decide?

• Lord Halsbury LC was of the opinion that the
  conclusion that the business was Solomons
  business and that the company was his trustee or
  agent involved a logical contradiction.
• The House of Lords maintained that the fact that
  Salomon Co Ltd was a one man company made no
  difference. Upon incorporation a separate entity
  is created even if all the companys issued
  shares were beneficially owned by the same
  person. Also Lord Macnaghten stated it cannot
  matter whether they are in the hands of one or
  many.
• It held that provided the formalities of
  incorporation were observed, it was not contrary
  to the intention of the Companies Act 1862 (UK)
  for a trader to gain limited liability and obtain
  priority as a debenture-holder over other
  creditors. A person may sell a business to a
  limited liability company of which the person is
  virtually the only shareholder and director. The
  company was a separate legal entity distinct from
  its shareholders and directors. It therefore
  followed that the company could be a secured
  debtor of its shareholders, thereby enabling them
  to rank ahead of its unsecured creditors.
• Lord Macnaghten - Nothing in the Act (Companies
  Act 1962) requiring that the subscribers to the
  Memorandum should be independent or connectedor
  have mind and will of their own... He also
  stated that The company is at law a different
  person altogether from subscribers to the
  memorandumcompany is not in law the agent of the
  subscribers or trustee for them.

8
What are the Legal Implications?

• No requirement that members be independent
• No requirement of substantial capital
• A company can contract with its controlling
  member - Under the separate entity doctrine a
  member, even a controlling shareholder, can
  contract with company -Lee v Lees Air Farming
  Ltd 1961
• The company continues to exist not withstanding
  changes to managers or controllers
• The companys property is separate from that of
  its members
• Tax advantage accruing by virtue of the fact that
  the company is a separate entity.
• The legislature can always change the tax statute
  so as to permit the lifting of the corporate
  veil in relation to tax matters.
• The company can enter into a contract
• The company can commit a crime
• The company can commit a tort under separate
  entity doctrine if an employee when acting within
  the scope of the employment commits a tort it
  will be the company and not its directors who
  will be vicariously liable to the victim.
• The company can litigate
• Lipton, P. Herzberg, A. 2002, Understanding
  Company Law, 11th Edition, Lawbook Company.

9
What are the Legal Principles?

• A company as debtor or creditor of a member or
  director - Small private companies commonly owe
  money to a proprietor of the company on a loan
  account. Salomons case showed the legality of
  that, not only was Salomon the proprietor, he was
  a creditor with security giving him priority over
  outside creditors who were unsecured. In other
  words the controlling shareholder was able to
  make himself a secured creditor with priority
  over external unsecured creditors.
• One person companies the separate entity
  doctrine - Even where a company has only one
  member it is a separate legal entity and its
  rights, privileges, duties and liabilities are
  separate from those of its sole member. It is
  capable of giving security over its property in
  favour of its member graphically shown be
  Salomon. As the litigation demonstrates, the
  matter of the one-person company was
  controversial. The emergence of
  one-shareholder/director proprietary companies
  got rid of a problem affecting domestic
  relations, that is, the inactive director was
  often a spouse, relative or domestic partner of
  the active proprietor.
• Legislation (s 588G) made directors personally
  liable without limit for company debts incurred
  when the company was insolvent. Directors,
  whether active or inactive could be liable for
  insolvent trading some cases imposing liability
  on spouse after relationship break-up.

10
Principle Confirmed - Application of Salomon

• The principle that a company is separate from its
  members has been confirmed in many important
  casesLee v Lees Air Farming Ltd 1961
• Mr Lee was a controlling shareholder in his New
  Zealand company and was employed by the company
  on a salary to work as a pilot. He was killed
  while working for the company and his wife sued
  the company under the Workers Compensation Act.
  The issue was whether he was an employee of the
  company or whether he was self-employed as
  claimed by the Workers Compensation Board. The
  Privy Council held thatthe company and Mr Lee
  were separate legal persons and that Mr Lee could
  therefore have a dual role as director and
  employee of the company. His wife was
  consequently entitled to compensation.
• Salomons Principle Corporate Groups
• Liabilities of directors of a number of
  associated companies i.e, Walker v Wimborne
  (1976),
• Holding company not party to a complex marketing
  agreement by its subsidiary - no inference of
  agency relationship between holding and
  subsidiary company i.e, Pioneer Concrete Services
  Ltd v Yelnah Pty Ltd (1987)
• Subsidiarys profits could not be regarded as
  profits of its holding company i.e, Industrial
  Equity Ltd v Blackburn (1977)
• Ford, H.A.J. Austin, R.P. 2003, Fords
  Principles of Corporations Law, 11th Edition,
  Butterworths.

11
Legal Principles - Contd

• "Veil of Incorporation" On incorporation a veil
  is said to be created between the Company on the
  one hand ( The Co as a separate legal entity) and
  the members, promoters and Controllers on the
  other.
• A strict application of the separate entity
  doctrine and limited liability can lead to
  undesirable results.
• Lifting the Corporate veil Where appropriate the
  corporate veil can be lifted to look behind the
  facade of the company and ascertain where true
  liability lies, ie, with Co, or promoters or
  controllers of Co.
• Veil can be lifted at
• Common Law
• Statute Law.
• On what grounds can a court depart from the
  separate entity doctrine (i.e, lifting the
  corporate veil at Common Law)?
• Where a company structure is used to perpetrate a
  fraud
• Where a company structure is used with the sole,
  or dominant, purpose of enabling another person
  to avoid an existing legal obligation
• Situation of agency corporate entities or
  groups of companies
• Under-resourced companies may be found to be
  agents of their controllers or to be shams or
  devices
• Whenever the interests of Justice require

12
What is the Legal Principle?

• Departure from the separate entity doctrine
  required by statute
• For some purposes the Legislature requires
  subjection of persons behind the corporate entity
  to rights or duties that arise out of acts or
  omissions of the company. In some legislation the
  requirement to look behind the corporate entity
  is stated expressly.But the requirement may also
  appear by implication from a statute.
  Corporations Act
• Directors liability for companys debts incurred
  during insolvent trading 588G directors are
  under a duty to stop a company incurring debts
  when it becomes insolvent. Under s95A92) a
  company is insolvent when it is unable to pay its
  debts as and when they become due and payable. If
  directors fail in that duty and the company is
  wound up in insolvency, they can be made
  personally liable for company debts incurred
  after company becomes insolvent or for debts
  which push company into insolvency.
• Directors liability where companys share
  capital transactions cause insolvency (588G)
• Directors liability for companys payment of
  improper dividends
• Directors liability for trustee companys debts
  where company lacks a right of indemnity out of
  the trust assets (s197)
• S588FB Uncommercial transactions
• S588V Liability of Holding Co for debt incurred
  by subsidiary
• S267 Charge given to company Officer
• Statute impliedly requiring a look behind the
  company ss 180-184, 197, 206E, 588G, 592, 598.

13
Considerations

• Do the mechanisms at common law and under the
  Corporations Law for lifting the corporate veil
  hold company controllers responsible for company
  debts in appropriate circumstances?
• Limited liability versus mechanism for fraud?

14
Next Steps

• Questions from audience
• Thankyou

15
Bibliography

• Ford, H.A.J. Austin, R.P. 2003, Fords
  Principles of Corporations Law, 11th Edition,
  Butterworths.
• Lipton, P. Herzberg, A. 2002, Understanding
  Company Law, 11th Edition, Lawbook Company.
• Salomon v Salomon Co Ltd 1897 AC 22 at
  29-30,33,47,49,50, 52-53 and 57, HL (LAWS3089
  Corporate Law Regulation Volume 1 Session
  2/2003, pp.126-129