Critical Company Law and Insolvency

1. Synopsis The question requires a critical discussion in light of recent corporate failures of the statement by Michael Schluter1, whereby he asserts if the legal institution of limited liability is morally wrong, it will be worth our while to modify or even remove it completely2. The question also asks the extent I agree with the statement that limited liability should be modified and/or abolished. It is proposed to structure the discussion as noted in the contents above in order to enumerate and discuss the main legal reasons for/against the limited liability concluding with a summary of the critical points at the end of the discussion.

2. Overview of Limited liability Legally speaking, limited liability is a concept whereby a person's financial liability is limited to a fixed sum, in particular a shareholder in a limited company is not personally liable for any of the debts of the company, other than for the value of his investment in that company. 2. 1 Historical Background of limited liability Morally rightly or wrongly, it is undeniable that the modern world is built on the legal institution of limited liability3.

In the UK, the first company-form firms were incorporated under the Joint Stock Companies Act 1844, although investors in such companies carried unlimited liability until the Limited Liability Act 1855. There was a degree of public and legislative distaste for a limitation of liability, with fears that it would cause a drop in standards of probity4 5 6. The 1855 Act allowed limited liability to companies of more than 25 shareholders, which was later reduced to seven by the Companies Act 1856. It is now possible for one person to form a private limited company, called a single member company7.

Similar institutional development of limited liability had been taken place in France and in the majority of the US states by 1860. By late nineteenth century, most European countries had adopted the principle of limited liability. Although it was admitted that those who were mere investors ought not be liable for debts arising from the management of a company, throughout the late nineteenth century there were still many arguments for unlimited liability for managers and directors on the model of the French socii?? ti?? en commandite8.

However such liability for directors was abolished under Companies Act 2006. By early twentieth century, the shareholder power has manifested itself in several dramatic instances, both in the US and the UK. In the US, shareholder activism increased after the collapse of Enron and Worldcom and exposure of their "creative" financial practices, leading to enactment of the Sarbanes-Oxley Act by Congress in 2002. In UK, there were legislative and non-legislative changes to reinforce the corporate governance of a company as a result of plethora of corporate scandals and failures.

On non-legislative side, corporate governance codes were developed that prescribed best practice in areas such as board structure9, and audit committees10 etc. following the Maxwell, Polly Peck and BCCI scandals. Their recommendations culminated in the issue of the revised Combined Code by Financial Services Authority in August 2003, by which the Listing Rules require listed companies to comply with the Code. On legislative side, the enactment of Companies Act 2006 marked a major change in the legislative framework in the UK, with more emphasis on directors' duties11 and derivative claims by members12.

More recently in the UK, the financial crisis of 2007-08, which the collapse and nationalisation of Northern Rock foreshadowed, produced a big upswing in business failures, predicating the UK could be on the slippery slope to harsher regulations against corporate failures. 2. 2. A glimpse of EC law and UK insolvency law The EC law and UK insolvency law play such a significant role in formulating the legal concept of limited liability that the analytic discussion of the doctrine would be insufficiently futile without due regard to the sources of the two laws.

Much of the impetus behind reform of English company law stems from UK membership of the European Community13. In essence, the most influential initiatives of European Community on the UK company law have as their base Article 54(3)(g) of the EC Treaty14. Generally, UK insolvency law deals with the insolvency of firms in the UK. The primary pieces of legislation are the Insolvency Act 1986 and the Enterprise Act 2002. In UK, the first recognised piece of legislation was the Bankruptcy Act 1542.

Bankrupts were seen as crooks and the court reasserted this sentiment by stating "bankruptcy is considered a crime and a bankrupt in the old laws is called an offender"15. But the industrial revolution's full swing had changed that. The Joint Sock Companies Act 1844 allowed companies to have "separate legal personality" distinctive from their investors. The Act's corollary, to bring the existence of these legal persons to an end was the Joint Stock Companies Winding-Up Act 1844, which was later reinforced by the enactment of Limited Liability Act 1855.

Before, if a company had gone bust, the people that lent it money could sue all the shareholders to pay off the company's debts. But the 1855 Act stated that members' liability would be limited to the amount they had paid in their shares. Henceforth, the Joint Stock Companies Act 1856 consolidated the companies legislation into one, and the modern law of corporate insolvency was born. 2. 3 Digress: a brief note of economic and social justification and criticism Why is limited liability such an entrenched characteristic of modern enterprise?

Before limited liability, shareholders risked going bust and few would buy shares in a company. The limited liability corporation is essential because it allows individuals to partake in risky ventures "without risking disastrous loss if any corporation in which they have invested becomes insolvent" and that without it "wealthy individuals would never make small investments in a corporation. "16 In other words, limited liability is to encourage enterprise17 18 19.

Secondly, Richard Posner argued that the legal institution of limited liability is the cheapest allocation of the risks20 and the benefits of putting a ceiling on the potential losses faced by shareholders far outweighed the cost of a slightly higher risk of debt default. Thirdly, in the absence of limited liability, the costs of collecting judgment debts would be astronomically high as creditors collected from wealthy shareholders who in turn would need to seek contribution from a large numbers of less wealthy shareholders21; thus causing disastrous disruption to the capital markets.

On the other hand, liability is morally viewed as a device to minimizing the social cost of private activities, and for forcing miscreant to internalize the full cost of their wrongdoing. In stark contrast, limiting liability can thus be perceived as subsidizing risky behaviour and allowing some wrongdoers to shirking their part of the costs of their actions and Michael Schulter supported this view22. 3. Arguments for and against limited liability - a legal perspective

In UK, limited liability can be achieved by private contractual arrangement, by the use of limited liability forms of corporation, by other statutory limits on liability, and by bankruptcy. Since the private contractual arrangement and statutory limits on liability are out of the scope of this assignment, I will focus my following discursive analysis on the other two: UK company law23 and UK solvency law.

While it is partly true, in some corporate failures, that the corporate wrongdoer can avoid their liabilities by abusing the doctrine of limited liability and leaving tens of thousands in deep anger and despair, it is also true that there are many protection provisions under the Companies Act 2006 and Insolvency Act 1986 for the creditors and other victims from the wrongdoings by the culpable persons, under the pretence of limited liability. 3. 1 Arguments under company law

Under the UK company law, there are essentially two issues in connection to the doctrine of limited liability in the light of corporate failure, namely foundational issues and constitutional issues. Foundational issues can be further analysed in the context of the nature of legal personality and lifting the veil of incorporation. Constitutional issues are subdivided into the following areas: i) The ultra vires doctrine and Turquand's rule; ii) Directors' duties and the protection of minority shareholders; and iii) Corporate governance

3. 1. 1. Foundational issues - the nature of legal personality and lifting the veil of incorporation A company, once incorporated, is a legal entity distinctive from the members that comprise the company. This principle was established in the leading English case of Salomon v Salomon24, in which the court held that once the company is legally incorporated, it must be treated like any other independent person with its rights and liabilities appropriate to itself. In other words, it can sue upon it or be sued upon it.

There are a number of statutory and common law exceptions to the Salomon principle and they are grouped under the heading of "lifting the corporate veil". In such situations the court disregards the corporate entity and pays regard instead to the economic realities behind the legal fai?? ade. There are a number of situations where the statute sets aside the corporate veil25. On the common law side, the court have "pierced" the corporate veil in a number of cases and thus it is difficult to deduce the overall guiding principles from the jumbled case law.

However, there are some general factors that the court would normally consider before piercing the veil. By and large, the separate legal personality of a company will be disregarded only if the court deems that there is: i) Fraud or sham: in Jones v Lipman26, the court held the company used as a fai?? ade to defraud the creditors of the defendant and in Gencor v Dalby27, the court tentatively suggested that the corporate veil was lifted where the company was the "alter ago" of the defendant; or

ii) "Single economic unit" theory28: some companies that act as a corporate group, may operate to hide behind the advantages of limited liability to the disadvantage of their creditors. The argument in favour of lifting the corporate veil in these circumstances is to ensure that corporate group which seeks the advantages of limited liability must also be ready to accept the corresponding responsibilities29.

The most recent case on this topic in the House of Lords30 suggests a stricter approach towards lifting the corporate veil and Lord Keith indicated that a departure from the Salomon principle was justified only in cases of a fai?? ade concealing the true facts; or iii) Small companies: piercing the corporate veil typically is most effective with smaller privately held business entities, where the control is absolute and where the business is an integral part of its owner. As such, the company itself can be seen as a mere agent for the shareholder.

The act of piercing the corporate veil remains one of the most controversial subjects in company law and it would continue to remain so. Overall speaking, the doctrine of piercing the corporate veil remains only an exceptional act orchestrated by the court. The court is most prepared to respect the rule of corporate personality31. Notwithstanding, there are general categories such as fraud or sham, agency and group companies are believed to be the most peculiar basis under which the court would pierce the corporate veil.