Under the concept of separate legal entity


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Under the concept of separate legal entity

  1. 1. Under the concept of separate legal entity, a company will becomes a body corporate that exists separately with its owner and distinct from its individual members and directors. In others word, the corporation is an entity just like human being created using legal and official purpose. A company once created by the law can only be terminated by the process of law. The company exist in its own capacity and making business, generate its incomes and revenues, incur its own specific losses, hire employees for many areas and pay for its own tax. It is betterto recognize the company as a separate entity because the owners can enjoy the limited liability and risk based on their investment in stock. However, under this concept, the company is treated in its own capacity. In addition, it has to be reminded that the company is not human nor a machine. Hence, it cannot operate by it ownself. Therefore, as for the essential requirement, the company must gather a group of people of different capacity and area to manage it ethically and represent it in their own vested authorities respectively. The separate legal entity has its roots in the landmark case of the English House of Lord in Salomon v A Salomon & Co Ltd1 .Looking on the earlier cases, separate legal entity principle can be seen firstly illustrated in R v Arnaud2 case. In this case, a registering authority refused to register a ship based on the ground that the owners of the ship include foreigners. The ship was owned by a British chartered company, whose members happened to include foreigners. The court ordered the registering authority to register the ship, on the basis that the British company was the ship‟s owner rather than the members of the company. However, the unanimous decision of the House of Lords in Salomon v A. Salomon & Co. Ltd is regarded as a landmark in Company Law which assured that a company is a separate legal entity together with distinct legal personality. In the modern business corporations, it can be seen that shareholder has its limited liability for the corporation‟s debts and obligations. Thus, it clearly creates a double-edged sword, which literally means it has both good and bad elements. However, the principle of this case occupies a remarkable position in the development history of company law. Meanwhile the following development since this case has gives some proves that the separate legal entity can be considered as double-edged sword. 1 [1897] AC 22 2 [1846] 9 QB 806
  2. 2. In the case of Salomon v A Salomon & Co Ltd, the facts of the case are as following.Mr. Salomon sold his shoe business to a company which he had set up for the purpose under the Companies Act. The registration under the Act was completed and the members of the company consists of Salomon and his family, particularly, Mr. Salomon received fully-paid shares and debentures to the value of £10,000, in which he subsequently assigned to another party. The business seen to be declined and the company went into insolvent liquidation. The liquidator attempted to hold Mr. Salomon liable for the debts of the company with arguing that the whole transaction was a fraud on the company‟s creditor and Salomon should not be allowed to benefit, additionally, the liquidator claimed the company was simply an agent of Salomon, as a result, he should indemnify the company (and its creditors) with respect to the debts incurred by the company. In this case, the House of Lords held that : 1. Salomon was neither under liability to the Salomon Company nor to the creditors of the Salomon Company. 2. Salomon‟s debentures were validly issued. 3. Lord Halsbury LC remarked that statute had enacted the formal and procedural requirements upon registration of a company but did not enact requirements regarding the extent or degree of interest which may be held by each of the subscribers or as to the proportion if influence processed by one or the majority shareholder over the others. 4. The House noted that after registration of a company, although the business may be the same as before and the same hands receiving profits, but in law the company is not an agent of the subscribers or members. However, it should be noted that the House of Lords decision in this Salomon's case really only decided that Salomon & Co Ltd was a company duly incorporated under the Companies Act 1862 (UK), even though its seven shareholders were not truly „independent' as all of the statutory requirements were satisfied because the company had consists of seven shareholders. Pursuant to the decision of the House in Salomon‟s case, we can summarize up to four points based on the proposition that incorporated companies have a separate legal personality: (a) Company's property is company's property;
  3. 3. (b) Company's debt is company's debt; (c) Companies can contract with their members, directors and outsiders; (d) Companies can commit torts and crimes. These four points had been reasserted in many cases. Firstly, the point on the company's property is company's property. This point had been applied in the case of Macaura v Northern Assurance Co.3 In this case, the appellant, Mr. Macaura has claimed for payment of insurance for his company, but his request was refused by five insurers. These insurers claimed that Mr. Macaura did not have an insurable interest for the insurance which was bought in Mr. Macaura's name rather than the company's name. The court upheld the insurer's decision and concluded that “the corporator, even if he holds all the shares, is not the corporation, and that neither he or any creditor of the company has any property, legal or equitable, in the assets of the corporation.” This decision implies that, although the principle is not in favour of the person registering the company, these principles should also be applied. Secondly, the point of company's debt is company's debt. In the earlier facts, it had already been clearly addressed in Salomon case by the House. Thus, this point specifically mentioned about the company responsibility towards its own debt. Moving on the point of where companies can contract with their members, directors and outsiders, it was indeed developed in Lee v Lee's Air Farming Ltd4 . In that case, Mr. Lee's accountant formed a company (Lee's Air Farming Ltd), and Mr. Lee was the principal shareholder also the governing director of this company. The company contracted with farmers to perform aerial topdressing. Mr. Lee worked for the company as a pilot and received a wage for that work. In a work accident, Mr. Lee died then his wife claimed on a workers compensation insurance policy that the company's solicitor had taken out naming Mr. Lee as an employee. The insurer denied liability on the ground that Mr. Lee could not be a servant because he was a director of the company. The Judicial Committee of the Privy Council upheld the claims made by Mrs. Lee and firmly rejected the insurer's argument. Lord Morris quoted Lord Halsbury LC's judgment in Salomon's case, that company „was a real thing' and noted that: 3 [1925] AC 619 4 [1961] N.Z.L.R 325
  4. 4. “… Always assuming that the respondent company was not a sham, then the capacity of the respondent company to make a contract could not be impugned merely because the deceased was an agent of the respondent company in its negotiation [of Mr Lee's contract of service].” The decision in Lee v Lee's had also been applied in the case of Industry v Bottrill5 , where the court pointed out that a sole shareholder can be employed by the company and will have rights under the Employment Rights Act 1996.These solutions confirm that a company is able to employ one of its members under a contract of service including its principle shareholder. Finally, companies is liable and can commit torts and crimes. The decision as stated in the case of Lee v Lee‟s Air Farming Ltd shows that companies may be liable to tort since companies have a separate legal personality and are able to contract with others. In conclusion, the Salomon case is famously regarded as a landmark in the UK's Company Law since this case had established fundamental principles related with Company Law. According to the Salomon case, a company is both an association of its members and a legal person separate from its members, “ a company's property is owned by the company as a separate person, not by the members; the company's business is conducted by the company as a separate person, not by the members; it is the company as a separate person that enters into contracts in relation to the company's business and property”. There are many arguments arises in the decision of Salomon v A. Salomon Co Ltd. It can either be in positive arguments as well as negative arguments. For positive side of the arguments, the separate legal entity principle has shown that it has clearly able to survive from time to time because it has meant the company does have practical utility. As a separate legal entity is subject to limited liability and defined by some attributes of incorporation, the corporation has many economically and socially beneficial functions. Firstly, on the matter of separate legal entity, by separating the management from investment, a company will enable to the investing public to share in the profits without being involved in any management of their business. In the meanwhile, professional managers can 5 [1999] EWCA Civ 781
  5. 5. be hired by a company for a reason to provide professional management of business and this may probably gives effect as in a better profit for the company. Next, as a person created by law, the personality of the association is highlighted. A company can „live' long enough to carry on certain business without worrying on the matter about biological death. Based in this statement, it may reach the achievements made by its next generations of members. Lastly, according to limited reliability principle, investors are merely reliable to the share which they subscribe for so that the risk ofinvestment has been reduced. In simple, company as a vehicle of business can collect huge amount of outside capital for business efficiently. It also provide considerable convenience and confidence to the investors. Consequently, the investors will make some investments as investments are fortified by the company. Furthermore, economic growth has been boost and the development of society is promoted. Meanwhile, there are also negative arguments arises. Among the negative arguments such as the decision in the Salomon case has been criticized by many academic scholars. One of the expert, Professor Kahn-Freund even described it as “calamitous” where he claimed that the decision cause a number of problems, for instance, “How is it possible to check the one- man company and other abuses of company law?”6 . The House of Lords confirmed the usage of the corporate form by individual traders and small partnerships in emphasizing the independent status of corporate personality. Other experts such as Tomasic and Bottomley mentioned this result in that private enterprises which do not seek to raise capital from the public can interpose an entity between themselves and their creditors7 . The Law Lords concluded that, once a person completed the process of registration required by the Act, a company forms a legal entity separate from its 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. Furthermore, Gower pointed out that 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 shares8 . Salomon's case was not about “a dry point of construction.” noted in The Law Quarterly Review, The House of Lords emphasized on the separate identity of the legal form and essentially ignored the economic reality of a one-person company. 6 Kahan-Freund, Some Reflections on Company Law Reform, MLR 1944 7 Roman Tomasic and Stephen Bottomley, Corporations Law in Australia, The Federation Press, Sydney 1995 8 LCB Gower, Gower’s Principles of Modern Company Law, 5th Edition, Sweet & Maxwell, London 1992
  6. 6. According to the criticism of the decision made in Salomon case, negative effects of the separate entity principle may be concluded into two main aspects. Firstly, the Salomon principles are vulnerable in protecting interests of outside creditors. The Salomon case gives the benefits of limited liability to even apparently honest incorporators in circumstances which it is not necessary in order to encourage them to initiate or carry on their trade or business. According to the separate legal entity principle, management of business is separated from shareholders and due to the benefits of limited liability, shareholders are discouraged in monitoring and controlling their company's commercial ventures. However, a limited company's creditors must look at the capital, the limited fund of the company. In addition, pursuant to the separate legal entity principle, subsidiaries can be easily abused to avoid debts by transferring assets between parent company and subsidiaries. In conclusion, in accordance with the principle of separate entity, company is regarded as separate legal entity. Thus, it is reliable to the debts of its own. Therefore, creditors of the company are prevented from claiming their rights directly to those real debtors (shareholders). This generally implies that, in practice, creditors (both contracting creditors and tort creditors include) bear more risk when they dealing with a limited corporation. By contrast, according to benefits of limited liability, shareholders of the company are highly protected by law and bear less risk of the insolvency of the company. Secondly, the separate legal entity principle provides an ideal vehicle for fraud. Ever since the Salomon 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.” Nowadays, the form of corporation has been abused for the development of many different forms of fraudulent or anti-social activity. In the context of Malaysian legal aspect, it can be seen in the case of Abdul Aziz bin Atan & Ors v Ladang Rengo Malay Estate Sdn. Bhd.9 This case concerns the proper application of reg 8 of the Employment (Termination and Lay-Off Benefits) Regulations 1980. All the shareholders of the respondent company by a written agreement sold and transferred their entire shares to a certain buyer in 1981. The main asset of the company 9 [1985] 1 CLJ 255
  7. 7. consisted of land on which the company appeared to have carried on the business of a rubber estate and oil palm. In November 1982, a claim, said to be for April 1982, was initiated under s 69 of the Employment Act 1955 for termination benefits under reg 8. The point in dispute was whether the estate was sold and if so whether a change of employer took place. The court held that, in dismissing the applicants‟ appeal: an incorporated company is a legal person separate and distinct from the shareholders of the company. In the present case there was no change whatsoever in the constitution of the respondent company. The company did not change its identity or personality. It continued to own all the assets of the estate which were an integral part of the business for the purposes for which the applicants were employed.