A Two-Edged Sword: Salomon and the Separate Legal Entity Doctrine

Introduction1. The decision of the House of Lords in Salomon v Salomon & Co Ltd [1]

evinces the accuracy of Gooley's observation that the separate legal entity doctrine was a "two-edged sword".[2] At a general level, it was a good decision. By establishing that corporations are separate legal entities, Salomon's case endowed the company with all the requisite attributes with which to become the powerhouse of capitalism. At a particular level, however, it was a bad decision. By extending the benefits of incorporation to small private enterprises, Salomon's case has promoted fraud and the evasion of legal obligations. Nonetheless, this article will argue that the overall balance is positive.

Salomon v Salomon2. At its most general level, the decision of the House of Lords in Salomon v

Salomon & Co Ltd was a good decision. Salomon's case is universally recognised as authority for the principle that a corporation is a separate legal entity.[3]

3. The case firmly established that upon incorporation, a new and separate artificial entity comes into existence. At law, a corporation is a distinct person with its own personality separate from and independent of the persons who formed it, who invest money in it, and who direct and manage its operations.[4] It follows that the rights and duties of a corporation are not the rights and duties of its directors or members who are, most of the time, obscured by a corporate veil surrounding the company.[5]

4. The recognition that a corporation is a separate legal entity in its own right is the foundation of modern corporate law: MacLaine Watson & Co Ltd v Department of Trade and Industry.[6] Indeed "[e]very system of law that has attained a certain degree of maturity seems compelled by the ever increasing complexity of human affairs to create persons who are not men...".[7] Consistent with this observation, Arnold states that "[o]ne of the essential and central notions which give our industrial feudalism logical symmetry is the personification of great industrial enterprise."[8]

5. Support for the principle of the separateness of legal personality, shared amongst academic commentators, has been unbroken in legislative and judicial circles. Notably, this principle is enshrined in section 124 of the Corporations Act. Similarly, the judiciary has, with minor exceptions, consistently reaffirmed the need to treat this legal doctrine seriously.[9] Subsequent English and Australian judicial decisions have upheld the Salomon principle.[10] In other words, since the decision in Salomon's case, the complete separation of the company and its

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members has never been doubted.[11] The ruling has, with few exceptions, stood the test of time.[12] But, why?

6. From a theoretical perspective, the answer is straightforward. All theories of the corporate entity agree on the practical need for the artificial personality with which the legal system invests corporations. Concession theorists, for example, regard corporate personality as a privilege granted by the state "for legal and business convenience".[13] Similarly, the contractarian school argues that "[c]orporation law reduces transaction costs by implying in every corporate charter the normal rights on which shareholders could be expected to insist", such as separate legal status.[14] This principle, the essence of corporate law, is said to operate as a default provision that facilitates corporate activity.[15] In many ways, this is the view taken by aggregate theorists who praise the role of the Salomon principle in assisting the formation of contractual relationships that constitute the backbone of voluntary aggregations of individuals that the law otherwise identifies as corporations.[16] Natural entity theorists' claims are not much different: advocates explain that the separate legal entity principle is important in giving legal effect to the natural fact that the corporation, as a consequence of human interaction and initiative, has its own will and capacity for action.[17] There would then appear to be theoretical unanimity on the practical need for the principle that a corporation is a legal entity entirely separate from its members. At issue, however, is what this entails and why the Salomon principle has proven so robust.

7. From a practical perspective, the answer to the question above demands a close attention to detail. The separate legal personality of a corporation is often the reason why a corporation has been favoured for the conduct of commercial enterprise or social organisation.[18] It is argued that:

Companies will be desirable or necessary when the arrangements that are to pivot on them are not conveniently or realistically to be erected directly around individual human beings... The individual human being is fickle, short-lived, and difficult to organise into larger-scale economic and political associations on a permanent basis.[19]

8. Thus, many commercial enterprises must be owned and managed by a body corporate rather than by its human owners directly, in person.[20] This is possibly due to the recognition in Salomon's case that incorporation achieves the interposition of a legal person between the natural persons who own and control it, and the business activity to be undertaken.[21] In essence, a corporation is "... an artificial person composed of natural persons".[22] Being a legal artifice, however, the company is metaphysical in form rather than physical.[23] Any difficulties this implies are overcome by virtue of subsection 124(1) of the Corporations Act which states that a corporation has the legal capacity of a natural person.

9. In line with the decision in Salomon's case, a registered company "is capable of performing all the functions of a body corporate" (see subsection 124(1)). In other words, the corporation is a legal entity distinct from its members. This is the

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fundamental attribute of corporate personality, from which all the other practical consequences flow.[24]

10. First, as a separate legal person, a registered company is capable of suing and being sued: Foss v Harbottle.[25] Second, a corporation has perpetual succession: Regal (Hastings) Ltd v Gulliver.[26] Third, a corporation can enter into contracts in its own name. Fourth, a corporation has power to acquire, hold and dispose of property: Macaura v Northern Assurance Co Ltd. However, this statutory list of attributes is not exhaustive. There are others.[27]

11. A corporation, for example, can contract with its controlling member (Lee v Lee's Air Farming Ltd) and can be the debtor, creditor or surety of a member (Salomon's case). Similarly, shares are transferable and transmissible. Likewise, corporations benefit from tax minimising through income splitting (encouraged by dividend imputation): Hobart Bridge Co Ltd v FCT.[28] Moreover, a corporation can enter into flexible financing arrangements by creating a floating charge. Finally, and "although it is not perhaps a logically necessary attribute of separate legal personality in modern law",[29] the liability of a limited company is limited: Salomon's case. A company is exclusively liable for obligations incurred on its behalf. Commercial enterprises with limited liability characterise almost all developed legal systems.[30]

[S]ome form of limited liability is essential if the maintenance and continuation of the system of private enterprise as is practised in advanced industrial capitalist societies is to continue.[31]

12. Relying on Easterbrook and Fischel, Farrar points out:

Limited liability arguably reduces the costs involved in the separation of ownership and control... First, limited liability reduces the need to monitor management and other shareholders. Secondly, limited liability and free transfer of shares with which it is arguably linked facilitate the market for control. This acts as an incentive to management to perform efficiently. Thirdly, limited liability, in adding to the marketability of shares improves the information fed to the market place by the increased volume of transactions. Fourthly, limited liability allows shareholders to diversify their holdings. Fifthly, it facilitates optimal investment decisions since a positive attitude to risk taking will ensue.[32]

Discussion13. The Salomon principle has stood the test of time because it has meant that

corporations do have practical utility. As a separate legal entity subject to limited liability and defined by share transferability, perpetual existence, flexible financing methods, specialised management, majority rule [33] and the other attributes or consequences of incorporation, the corporation has many economically and socially beneficial functions.[34]

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14. Primarily, a corporation enables the investing public to share in the profits of an enterprise without being involved in management. It also enables a single trader or a small partnership to carry on a business. Similarly, a corporation provides a structure for joint venture; holding family assets; continuing trusteeship; fund management; corporatised government enterprise; and, the co-enjoyment of property. Marshalling participants in large commercial enterprises and acting as a nominee to hold the legal title to assets are two other important functions.

15. At its most particular level, however, the decision of the House of Lords in Salomon v Salomon & Co Ltd was not a good decision. Professor Kahn-Freund went so far as to describe it as "calamitous".[35] Salomon's case established the independent corporate existence of a registered company, a principle of the greatest importance in company law.[36] But if applied inflexibly, as was the case in Salomon, it can shield parties unreasonably, to the detriment of persons dealing with companies.[37]

Corporate personality is essentially a metaphorical use of language clothing the formal group with a single legal identity by analogy with a natural person... [But] As Cardozo J said in the American case of Berkey v Third Avenue Rly [(1926) 244 NY 84 at 94-5]: "metaphors in law are to be narrowly watched, for starting as devices to liberate thought, they often end by enslaving it."[38]

16. In stressing the independent nature of corporate personality, the House of Lords legitimised the usage of the corporate form by individual traders and small partnerships: private enterprises which do not seek to raise capital from the public but are anxious to interpose an entity between themselves and their creditors.[39] The Law Lords concluded that once registered in a manner required by the Act, a company forms a new legal entity separate from the shareholders, even where there is only a bare compliance with the provisions of the Act and where all, or nearly all, of the company's issued shares are held by one person.[40] Furthermore, the Court held that it was possible for traders not merely to limit their liability to the capital which they invested in the enterprise but even to elude any serious risk to the major part of that by subscribing for debentures rather than shares.[41]

17. As noted in The Law Quarterly Review, Salomon's case was not about "a dry point of construction".[42] The House of Lords had sanctioned a change in ideas about what the company was and about the uses to which it could be put.[43] It gave priority to the separate identity of the legal form and essentially ignored the economic reality of a one-person company.[44] Basically, Goulding explains, the reason for criticism of Salomon's case is two-fold.[45] First, the decision gives even apparently honest incorporators the benefit of limited liability in circumstances in which it is not necessary in order to encourage them to initiate or carry on their trade or business. Second, the opportunities that the decision affords to unscrupulous promoters of private companies to abuse the advantages that the Corporations Act gives them by achieving a "wafer-thin" incorporation of an undercapitalised company.

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18. First, limited liability attracts small traders to the corporate form not because it represents an effective device with which to raise capital, but because it gives them access to an avenue via which to escape the "tyranny of unlimited liability".[46] Criticisms of limited liability are addressed at its impact on creditors and on society at large.[47]

19. The principle is that a limited company's creditors must look at the capital, the limited fund, and that only. Limited liability discourages shareholders from monitoring and controlling their company's commercial ventures. The company's creditors bear the burden of the risks inherent in dealing with limited liability companies. At issue is whether it is right that limited liability should operate to restrict the size of the company's capital. Different types of creditors have different capacities to protect themselves against these risks. While banks and similar financial creditors easily overcome such risks, the same cannot be said of trade creditors, employees and tort creditors. Because trade creditors rarely insist on security before they supply goods on credit, they bear a considerable part of the risk of corporate insolvency. Employees are in an even more precarious position. In stark contrast to finance and trade creditors, employees have no opportunity to obtain security or diversify the risk of their corporate employer's insolvency. Moreover, the majority of employees has minimal information about their employer's financial standing (but see the Corporations Act). While contract creditors bear a degree of risk when they deal with a limited liability company, they at least enter into the contract by their own will. This is not so for a company's tort creditors. Victims of torts committed by a company bear an uncompensated risk in case of the company's insolvency.

20. From a more technical perspective, the economic benefits brought about by limited liability are absent with respect to closely held or private companies. The reduction in monitoring costs, for example, is irrelevant because owners and managers are one and the same. Moreover, the benefit of fostering an efficient market for shares through limited liability does not apply as there is no market for the shares of closely held companies. Furthermore, limited liability encourages such companies to take excessive risks because the directors of closely held companies have more to gain personally by shifting the risk of commercial collapse to corporate creditors than is the case with public companies' directors.

21. Second, ever since the House of Lords handed down its decision in Salomon's case, legal doctrine regards each corporation as a separate legal entity. When coupled with the consequent attribute of limited liability, the Salomon principle provides an ideal vehicle for fraud.[48] Because of its malleability and facility for protecting directors and members against the claims of creditors, the corporate form has been responsible for the development of many different forms of fraudulent or anti-social activity. Fraud, in this context, cannot be precisely defined, but two tangible illustrations may elucidate the concept.

22. What is colloquially known as the "$2 company" is one notable example of corporate fraud.[49] This involves the situation where a small group of persons set up a limited liability company that is undercapitalised. The owners then cause the corporation to incur large debts in its own name, with little prospect of being able to repay the loans. When the company's creditors seek repayment of the

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debts, the owners argue that because the company as a separate legal person owes the debt, then neither the directors nor the members are liable.

23. Another instance of corporate fraud involves "bottom of the harbour" schemes.[50] Here, all of the assets of one corporation that is about to incur a large income tax liability are transferred to a new corporation incorporated for this purpose. This transfer is channelled through a confusing series of transactions involving other corporations and overseas corporate havens in an attempt to conceal the real design of the scheme. The original corporation might also change its name and address, and create false documentation so as to defeat the efforts of regulatory investigators. If investigators trace this shell of a corporation, they often find that straw men have been appointed in place of the original directors. The new corporation, now asset rich, is operated merely to fund further schemes for the people who have formed it, including activities as varied as the granting of unsecured interest-free loans by the corporation to the directors or to companies in which they have an interest; the use of corporate capital for the personal living expenses of directors or major shareholders; the payment of astronomical fees and other payments for management services; and, further tax minimisation by methods such as unrealistic asset valuations. Often, such schemes involve undercapitalised corporations carrying on a business as trustee for other persons as beneficiaries. By combining the corporate form with the malleability of the trust structure, creditors might be kept at even greater distance from those who manage the enterprise.

Conclusion24. The question of whether the negative aspects of the decision in Salomon's case

outweigh the good ones is best left unanswered for it is far too broad. One is inclined towards the view that the principle of separate legal entity established in Salomon's case has been instrumental in the development of modern capitalism and the immense social and economic wealth which it has generated. The House of Lords extended the principle so far as to cover small private enterprises. This move has had several negative consequences over time. However, it is also true that these have been largely neutralised by joint legislative and judicial action.

25. Indeed, "the legislature can forge a sledgehammer capable of cracking open the corporate shell."[51] And, even without statutory assistance, the courts have often been ready to draw aside the veil and impose legal liability on members and directors where to apply the Salomon principle strictly would lead to injustice, inconvenience or damage to government finances.[52]

26. Similarly, it should be pointed out that, following Salomon's case, all Australian jurisdictions, in a desire to ameliorate legal facilities for small commercial enterprises,[53] introduced provisions for private companies into their corporate law.[54] Experience since Salomon's case demonstrated that there was no reason why the benefit of limited liability should apply only to groups of business entrepreneurs. The Corporations Act takes this to its logical conclusion and sanctions the registration of one-person companies. In 1995, the First Corporate Law Simplification Act amended the Corporations Act to permit a proprietary

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company to be set up with one or more shareholders. Under another amendment, the minimum number of directors needed to be designated in a proprietary company was cut from two to one. Moreover, the Corporations Act states that any sort of company, not just a proprietary company, may be established with only one member and may continue to exist with only one member (section 114). It would appear then that the overall balance is positive and that the decision of the House of Lords in Salomon v Salomon & Co Ltd was a good decision.

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