Company law UK

Situation:

Don, Dan, and David are the sole directors of TOPCO Ltd., a company which has two subsidiaries: Quickshop Ltd., and Speedwell Ltd.  Quickshop Ltd. has three local outlets. The three decided to take a long-lease in two more stores, expecting an increased profit potential. However, the landlord of the two stores was not willing to let Quickshop Ltd. to lease in the two stores because of the limited financial liability of the company.

The three therefore decided to register a third subsidiary, Homefreeze Ltd. which offers a frozen food delivery system. Their shares in Quickshop and the lease of the two other shops were sold at a profit to lend the money to Homefreeze Ltd. based on a charge on the company’s profit. Homefreeze Ltd. however did not fare in business, and was now in the state of bankruptcy. The new owners of Quickshop Ltd. were arguing that any additional profit made by the former owners by a transfer of an interest in five shops should belong to them.

Advise:

According to the UK Company Law (recent reform bill), the profits earned by the former directors belonged solely to them.  In the supplementary provisions of the new UK Company law, it is clearly stated that those who are only members of a limited liability company can participate in the division of profits (based on the company’s article). It reads (sec. 37), “In the case of a company not having a share capital any provision in the company’s articles, purporting to give a person a right to participate in the divisible profits of the company otherwise than as member is void.”

If the articles of Quickshop Ltd provide that members of the company can participate in the division of profits earned in a given period, then the former owners have the right to claim the profits made by the sale, since they are company matters, taking to the fact that they were also sole owners of the company. If the company has an unlimited liability (big corporations), then the act of sale may be deemed inconsequential or illegal.

Nevertheless, because Don, Dan, and David entered into a legal contract with Homefreeze (which is a company matter), then it is assumed that the directors’ power to enter in a contract is legally binding. The same law provides that the directors of a company have full rights to enter transactions with other parties, which is deemed as company matters.

It reads (sec 40), “In favour of a person dealing with a company in good faith, the power of the directors to bind the company, or authorise others to do so, is deemed to be free of any limitation under the company’s constitution.” The binding power of the directors includes the right to dispose the assets of the company under a legal transaction.  The new owners therefore should adhere to the contract made by the company (since Don, Dan, and David represent the company).

Hence, since the new owners of the company were not the ones who entered to the contract, then their binding power as directors remains limited in this case. The contract entered by the former owners is legal if we are to base it from the law. Although the company is differentiated from its owners, the company remains a property of the owners, and hence has the full rights to dispose it under existing laws. Since there was no indication in the company’s constitution that the former owners can enter into a transaction that would transfer the ownership of the company even when it is not in the state of bankruptcy, Don, Dan, and David, can rightfully claim the earnings from the sale.

It is also indicated in law (sec. 40, b) that “a person dealing with the company is not bound to enquire as to any limitation on the powers of the directors to bind the company or authorise others to do so, is presumed to have acted in good faith unless the contrary is proved, and is not to be regarded as acting in bad faith by reason only of his knowing that an act is beyond the powers of the directors under the company’s constitution.”

Henceforth, if the three former owners are proven to have acted in bad faith in the transaction (like putting the company to a financial disability), then can be a chance for the new owners to claim the additional profits (interest) from the sale. It is also stated in law (sec 40, b-3) that “the limitations on the directors’ power under the company’s constitution include limitations deriving from (a) from a resolution or of any class of shareholders, or (b) from any agreement between the members of the company or of any class of shareholders.” It is clear then the contract which specifies that the profits of the sale of Quickshop Ltd. should belong to the sole owners (Don, Dan, and David) remains legal and binding even to the new directors.

The former owners of Quickshop Ltd. however can be liable for debts owed to the suppliers of equipment for the Homefreeze venture. Since the money lent was charged on the company’s assets, the former owners of Quickshop Ltd. therefore may be responsible for the company’s winding up. They hold some shares in the company; hence the so-called limited liability system provides the necessary mechanism for making the shareholders responsible for any financial problem of the company.

The UK Company Law of 1989 reads, “The director/s have a duty of care to the shareholder(s) of the company to act in the company's best interests even where doing so might come into conflict with their own personal interests. The concept of a company being a fully separate legal entity to the director/s is accepted in English & Welsh law save where they have acted in a fraudulent and/or reckless manner which could not be deemed reasonable by normal standards - In which case, the corporate "veil" can be lifted fully exposing the individuals behind a company to the full rigors of both civil and criminal law.”

Hence, since it was clear that Homefreeze Ltd. was on the verge of a financial collapse, Don, Dan, and David, even if they were not directors have an obligation to face criminal or civil charges. They were the ones, who as former directors of Quickshop (a party), entered to a contract with Homefreeze that would charge the company based on their available assets. The three gets the profits from the sale but experiences less risk from the financial status of Homefreeze.

It should be noted that the new UK Company law was created by the British parliament to stimulate the growth of micro-businesses in the UK, especially those concerned with companies having limited liabilities (Experts embrace new company law, 2005).  The goal was to reduce red tape in the system and to small investors to engage in economic activities with low risk.  It also provides that company owners and directors can engage in contracts that will reduce the liability of the company, in cases where the company’s profit level is above is marginal costs.

Since the three were the promoters of Homefreeze, on this condition, they may be held liable, only to the extent that they were promoters and not as shareholders.  Under the new law, the shareholders of the company can only be responsible for their share of fraud or negligence. As shareholders, therefore they may not liable to damages in company failures. But as promoters or as charged creditors, they may face full responsibility of any company failure as in the case of Homefreeze.

In the winding up process, they also do not have priority in the winding up process, even though they were secured creditors since the law provides that all shareholders shall be deemed responsible for their share of fraud or negligence in case of a company failure. Even if they charge the company based on its available asset, still they are liable in their share of negligence. It is noteworthy that in the new law, the shareholders may be directed by law to provide reimbursement in cases of a financial collapse of a company to which they are attached in order to reinstate the financial status of the company.

The three however cannot be charged for wrongful trading since the UK Company Law of 1985 (unreformed provisions) provides that any person may engage in business contracts so long as it prescribes to the goodwill of the parties involved – the goodwill may be interpreted as the constitution of the company or existing laws on domestic trading of stocks. The three entered to a rightful contract as to mode of payment of Homefreeze.

It is noted that, “If required, an individual/company may partly pay for a share issue but this is done simply to allow for flexibility, eventually the full amount must be paid up within a certain period of generally no more than 5 years or as laid down in the company's Memorandum & Articles of Association” (UK Company Law Guide, http://www.scfgroup.com/business-services/cf-uk-law-guide.html.)

Hence, the payment to be made by the company to Don, Dan, and David was through a gradual transfer of share. This mode of payment is seen as a just compensation for the creditors of the company to allow greater flexibility and unlimited liability.  Hence, it is not correct to say that Don, Dan, and David own some share of the company as part of the interest of the debt and the total amount of debt. The debt is transformed as shares in the company for a time period specified by law.  The parties may adhere or not to this form of agreement.

The winding up process in Homefreeze is limited only to the shareholders and the directors, and, of course, to parties who had financial transactions related to the winding up process.  In the case of Homefreeze, no other companies were seen as “connected” to the financial collapse of the company. If for example the directors of Homefreeze entered into a contract with another company or private individual that eventually led to the collapse of the company, the directors are liable. The other party may also be held liable if proven that he has knowledge of the “relative economic injustice” in the contract.

References

Company Law Reform Bill [HL]. Sessions 05-06 Internet Publications.  URL http://www.publications.parliament.uk/pa/ld200506/ldbills/034/06034.15-21.html#j36. Retrieved August 25, 2007.

Experts embrace new company law.2005. URL http://www.contractoruk.com/news/002379.html. Retrieved August 25, 2007.

UK Company Law Guide. 2007. URL http://www.scfgroup.com/business-services/cf-uk-law-guide.html. Retrieved August 25, 2007.

UK Company Law of 1985 and 1989.  2006. Published from the Parliament Journal 165(18).