"British company law has failed to come to grips with the problems posed by purely groups of companies. Adams v Cape Industries shows the dark side of this failure"

Explain and Discuss this Statement.

In order to analyse the problems posed by groups of companies in British company law, it is essential to understand that the primary benefit of incorporation (excluding for the purposes of this work any fiscal advantages) is to acquire limited liability status. This essay will examine why the courts have been reluctant to "lift the veil" even if the interests of justice would seem to demand it.

The starting point is that upon incorporation a metaphysical entity emerges from the ideas and aspirations of a human mind that is recognised, in law, as having a legal personality of its own, together with the rights, duties, obligations and liabilities that could normally be associated only with a natural person. Once created, the human mind(s) responsible retire into the background and control, as directors or shareholders, from a distance the creature created, receiving any profits yet safe in the knowledge that should the creature not behave as anticipated they are well protected and liable only to the limit of their shareholding or undertaking. The creature on the other hand, may wreak havoc upon the community; incurring liabilities of its own of many tens of millions of pounds until its final expiration through insolvency or winding up and leave its creditors unable to enforce payment from its creators.

So conceptually challenging was this scenario that when the issue of limited liability and the protection afforded to the company’s creator was first considered[1] their Lordships considered it a "device to defraud creditors" [2] and that it would be "...lamentable if a scheme such as this could not be defeated". [3]

The House of Lords were not so reluctant and appreciated the benefits afforded to investors. In reversing the Court of Appeal’s decision, their lordships considered that "the company is at law a different person altogether from the subscribers...and it may be that after incorporation the business is precisely the same as it was before, and the same persons are managers and the same hands receive the profits". [4]

Just as the single entrepreneur may seek to protect his personal assets by incorporation and the resulting limitation of his liability, so too may existing companies take advantage of the same device to create another entity, separate from their own, that affords them the ability to speculate on a venture without risk to the group as a whole and to discard the failure as the "runt of the litter".[5] Such ventures may have benefits to the company by way of market share or advantageous trading prices for the parent company or alternatively, have such a high degree of inherent risk that has the potential to create liabilities from which the parent may not survive. Such was the case in Adams v Cape Industries plc [6] where the company was involved in the production and sale in the United States of Asbestos with the (retrospectively) foreseeable flood of litigation.[7]

Given that the principle of limited liability applies equally to both the single entrepreneur and the corporate group, it is necessary to examine why the latter is the cause of some concern.

The answer lies in the fact that a creditor of a single company can easily identify the shareholders and assets of the company and ascertain what the extent of his loss may be should the company be unable to service his debt. The company accounts are public records and open to inspection and the creditor will be deemed to have notice of the status of the company as a whole. With the corporate group, problems may arise in such identification as when dealing with a subsidiary or even sub-subsidiary of the parent group. Here the creditor may find that while he is intending to deal with a major company with many assets, he is in fact dealing with a subsidiary with the minimum share capital and devoid of assets even though the directors and shareholders remain the same. Due to the concept of a separate legal identity, he will not be able to recover any debt owed by the subsidiary from the group as a whole save in the rare event that he is able to show an agency relationship[8] or that the subsidiary is a mere façade that allows the courts to pierce the corporate veil.[9]

However, it is considered that in commercial transactions a creditor of a company may exact a price that reflects the amount of risk that he exposes himself to and therefore is able to create a fair bargain.[10] Alternatively, he may create a contractual relationship whereby the parent contracts to honour the debts of the subsidiary. Further, large financial institutions and creditors are able to exact "cross guarantees" whereby each company forming part of the group guarantees not only its own indebtedness but also that of the other companies forming the group. By this method, the creditor is concerned with the entire assets of the group and need not concern himself with the assets of individual subsidiaries. The disadvantage in such cross guarantees is that should one subsidiary encounter financial difficulties it may well bring down the entire group, including profitable going concerns should a creditor call in the debt of one of the subsidiaries.[11]

So far, we have focused on voluntary contractual relationships and limited liability, but what of the involuntary creditor who has no financial interest in the company save for when he suffers injury from a tort committed against him? As has already been mentioned, a company, as a separate legal entity, can sue and be sued and is equally capable of committing tortious acts for which it will be liable. The unfortunate effect of limited liability for tort victims is that it enables a corporate group to "plan" for a worst case scenario and ensure that a subsidiary that is likely to commit the tort, and hence be liable for damages, has the least assets and its liquidation would have little detrimental effect on the group as a whole.

This seemingly callous approach has received judicial endorsement by their lordships in the Court of Appeal where Slade LJ stated;

"... [The] purpose of the operation was in substance that Cape would have the practical benefit of the group’s asbestos trade in the United States of America without the risks of tortious liability. This may be so. However, in our judgment, Cape was in law entitled to organise the group’s affairs in that manner and ... to expect that the court would apply the principle of Salomon v. A. Salomon in the ordinary way".[12]

This recognition by the Court of Appeal of a parent company organising its affairs so as to avoid tortious liability has seemingly gone unnoticed by the Company Law Review Steering Group, who prefer to view any tortious liabilities as more likely to be of a contractual nature rather than potential actions in negligence and state that;

"... [There] are circumstances in which we regard it as entirely proper for a holding company to segregate an activity in a subsidiary with the risks of liability, including tortious or delictual liability, in mind. Many torts are closely linked with contractual liabilities, for example liability for professional services and misrepresentation and product liability... Defining the circumstances in which use of limited liability in this way should be regarded as abusive would be difficult. Nor are we aware of cases where parent companies have engaged in such abuse." [13]

Not only appearing unaware of the Adams[14] case, the group then appears to suggest that any issues arising from under-capitalisation and operation of companies so as to "unduly" risk insolvency are issues best left to insolvency law which is to neatly avoid the problem at source.[15]

Hannigan suggests that the strict adherence to the Salomon[16] principle is inappropriate in the modern business world where recognition ought to be given to the group commercial activities that could not have been envisaged in 1897[17] and that obligations, responsibilities and, one supposes, liabilities should attach to the group as a whole so as to reflect the "economic reality".[18]

Judicial support for this argument can be found in Lord Denning MR’s judgement in DHN Food Distributors Ltd v Tower Hamlets LBC [19] where his Lordship considered that the companies were so closely bound together that it was unnecessary for them to use a "conveyancing device" to enable to parent company to qualify for compensation under a compulsory purchase.

This approach has been firmly rejected and the House of Lords went as far as to doubt whether the correct principles of when piercing the corporate veil was permissible had been applied.[20]

As the creation of a "separate legal entity" with limited liability is possible by both the individual entrepreneur as well as the corporate group are the circumstances when imposition of liability upon the parent justified? If the corporate group is to have the liabilities and obligations of its subsidiaries imposed upon it as Hannigan [21] suggests and when there exists no contractual or agency relationship or indeed, no hint of a façade with which to pierce the corporate veil why should the entrepreneur escape the same fate? After all, both the entrepreneur and the group have instigated the creation of this legal creature and through finance and investment given it its lifeblood. If the cross-guarantee scheme of the larger creditors is evidence of a "single economic unit", why then is the entrepreneur’s acceptance of a charge over his family home by the bank so as to raise capital for the creature any different? Both "parents" must, at least during gestation, feed their offspring with finance and so the situations when the piercing of the veil is necessary would appear to be equally justified in both circumstances. To allow the entrepreneur to avoid liability for his creation whilst imposing a liability upon a group for its subsidiary is to ignore the fundamental principle of incorporation as being the personification of a company and its legal personality.

To impose liability upon a company’s parent regardless of that parent’s status (whether group or individual) would be to impose liability upon the parents of all companies, and at a stroke, deter practically all new ventures into commerce which may have even the slightest element of risk to the parents assets.

Total Words (Inc Footnotes) 1696

[1] Broderip v Salomon [1895] 2 Ch 323 CA

[2] [1885] 2 Ch 323 at 339 per Lindley LJ

[3] Ibid at 340-341 per Lopes LJ

[4] Salomon v Salomon & Co Ltd [1897] AC 22 at 51 HL per Lord Macnaghten

[5] See Re Southard Ltd [1979] 3 All ER 556 at 565 Per Templeman J

[6] [1990] BCLC 479.

[7] And the abandonment of a wholly owned subsidiary to liquidation to avoid further liability.

[8] Smith, Stone & Knight Ltd v Birmingham Corpn [1939] 4 All ER 116 where so complete was the parent companies control over the subsidiary that Atkinson J thought the subsidiary a simulacrum of the parent and nothing more than a legal entity.

[9] Jones v Lipman [1962] 1 All ER 442 where a company was formed to which property was transferred solely to evade existing obligations.

[10] Company Law Review Modern Company Law for a Competitive Economy, Completing the Structure 2000 URN 00/1335 at Para 10.58

[11] See Facia Foorwear Ltd v Hinchcliffe [1998] 1 BCLC 218

[12]Adams and Others v. Cape Industries Plc. and Another CA [1990] Ch 433 at 544 per Slade LJ

[13] [FN 9 Ante] at 10.59

[14] Op Cit [FN 12]

[15] Ibid

[16] Salomon v Salomon & Co Ltd [1897] AC 22

[17] Ibid

[18] Hannigan Company Law LexisNexis Butterworths 2003 London at 75

[19] [1976] 3 All ER 462 at 467

[20] Woolfson and Another v. Strathclyde Regional Council (1978) 38 P & CR 521 per Lord Keith of kinkel

[21] Op Cit [FN 18]

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