The Salomon principle and the corporate veil

As has been noted, a key feature of the company is that it is a legal person with a separate existence from the company’s members (i.e. shareholders where the company has shares) or its directors. From this separate personality flow many consequences.

The House of Lords’ decision in Salomon v A Salomon & Co Ltd established the separate identity of the company.

Aron Salomon and his boot and shoe business have done for company law what Mrs Carlill and her smoke ball did for the law of contract and what Mrs Donoghue and her adulterated ginger beer did for the law of tort.

Mr Salomon transferred his business to a limited company and he and six other members of his family subscribed the company’s memorandum; the purchase price was £38,782. Salomon took 20,001 shares and the six other family members took one share each. Debentures (loan stock) of £10,000 and £8,782 cash were paid to Salomon as the balance of the purchase price. The business foundered and was wound up with liabilities in excess of its assets by £7,733. The company’s liquidator claimed that the company’s business was still Salomon’s, in that the company was merely a sham to limit Salomon’s liability for debts incurred in carrying it on, and the repayment of Salomon’s debenture should be postponed until the company’s other creditors were satisfied. At first instance, Vaughan Williams J agreed with the liquidator. He held that Salomon’s sole purpose in forming the company was to use it as an agent to run his business for him.

The Court of Appeal reached the same conclusion but for different reasons. It took the view that the principle of limited liability was a privilege conferred by the Companies Acts only on genuinely independent shareholders and not on ‘one substantial person and six mere dummies’.

The House of Lords unanimously reversed the Court of Appeal decision. Lord Halsbury LC in Salomon v A Salomon & Co Ltd said:

I must pause here, to point out that the statute enacts nothing as to the extent or degree of interest which may be held by each of the seven [subscribers] or as to the proportion of influence possessed by one or the majority of the shareholders over the others. One share is enough. Still less is it possible to contend that the motive of becoming shareholders or of making them shareholders is a field of enquiry which the statute itself recognises as legitimate. If there are shareholders, they are shareholders for all purposes; and even if the statute was silent as to the recognition of trust, I should be prepared to hold that if six of them were the cestuis que trust of the seventh, whatever might be their rights inter se, the statute would have made them shareholders to all intents and purposes with their respective rights and liabilities, and dealing with them in their relation to the company, the only relations which I believe the law would sanction would be that they were corporators of the body corporate.

This case thus established one of the basic articles of faith of British company law, indeed of company law of all common law systems, that a company is a legal person independent and distinct from its shareholders and its managers.

However, owing to the ease with which companies can be formed in this country, and owing to the rigidity with which the courts applied the corporate entity concept ever since the calamitous decision in Salomon v Salomon & Co Ltd, a single trader or a group of traders are almost tempted by the law to conduct their business in the form of a limited company, even where no particular business risk is involved, and where no outside capital is required.

This state of affairs would not necessarily call for reform, if it were not for the fact that the courts had failed to give that protection to the business creditors, which should be the corollary of the privilege of limited liability.

Kahn-Freund continues (page 57):

What can be done? How is it possible to check the one-man company and other abuses of company law for purposes which it was never meant to serve? Is it conceivable that Salomon’s case can be abrogated by legislation? Could the interests of outside creditors be protected by a general clause under which persons owning a controlling interest in a company would be liable for its debts? Or could there be a provision according to which a company would be deemed to act as agent for the owners of controlling interests?

(p 229]

Notwithstanding such statements and occasional exceptional judicial instances apart, the principle of separate identity has been consistently applied.

In the New Zealand case of Lee v Lee’s Air Farming Ltd [1961] AC 12, which went to the Privy Council, Lee owned all the shares but one in the company that he founded. His wife held the other share. Lee was governing director of the company, whose business was spraying crops from the air. When he was killed in a flying accident while on company business, his widow was held to be entitled to recover compensation from the company for his estate as the company was quite separate and distinct from her husband, its employee.

It has sometimes been said that the American Realist school in jurisprudence explains far more about how judicial decisions are made than the system of precedent. Thus decisions may be put down to whether the judge has a fondness for, or aversion to, redheads, and what the judge has had for breakfast. This may explain some of the cases in this area of law, which are notoriously difficult to reconcile one with another.

It is proposed to contrast some cases here. The case of Lee v Lee’s Air Farming Ltd can be contrasted with Malyon v Plummer [1964] 1 QB 330. Here the claimant’s husband had been killed in a fatal accident. This had been caused by the admitted negligence of the defendant. The husband owned all but one of the shares in a company. He worked a six-day week for the company and was the only breadwinner. The claimant owned the other share and received a substantial salary for a limited amount of part-time work, which she performed on a casual basis. The wife sought to claim for the loss of her livelihood, asserting that when the husband was killed, the company was also effectively killed.

In the Court of Appeal, Sellers LJ said,

In my opinion, the inter-position of FP Malyon Ltd, if that is how it should be regarded, does not prevent the court assessing truly the loss which the wife has suffered. The husband’s business, FP Malyon Ltd, has been destroyed by the loss of the husband, and it is clear that the revenue was, in substance, derived from him. The decision in Salomon v Salomon Co need not blind one to the essential facts of dependency and require a finding of fact that is contrary to the true financial position as distinct from an artificial or fictitious one.

It is often difficult to reconcile the cases and to find a coherent body of doctrine in this area.

Two further cases may be contrasted: Buchan v Secretary of State for Employment and Ivey v Secretary of State for Employment [1997] 1RLR 80, on one hand and Secretary of State for Trade and Industry v Bottrill [2000] 1 All ER 915 on the other hand.

In Buchan v Secretary of State for Employment and Ivey v Secretary of State for Employment, the Employment Appeal Tribunal distinguished the Privy Council decision in Lee in two joined appeals. The two directors involved held a half and a controlling interest respectively in their companies. It was held that they were not employees for the purpose of making a claim against the National Insurance Fund.

The tribunal considered that such directors could block decisions at board level, including decisions relating to their dismissal, and that this was not consistent with being an employee. No doubt, the context of the dispute influenced the decision as the directors were seeking compensation as employees for dismissal. The Employment Appeal Tribunal took the view that it is not the purpose of the legislation to fund compensation for those whose businesses have failed.

However, in Secretary of State for Trade and Industry v Bottrill, the veil was not lifted. Bottrill was managing director of Magnatac UK Ltd. He held the only share. There was one other director. Bottrill had a contract of employment which set out all his duties, his hours, sick pay, etc. He paid tax and national insurance. The company became insolvent and he applied for a redundancy payment. It was held by the Court of Appeal, with Lord Woolff MR presiding, that it was a question of fact whether Bottrill was an employee or not. The fact that he was a controlling shareholder was not decisive. The question was whether there was a genuine contract. In the instant case the tribunal had been entitled to conclude that there was a genuine contract.

Two further cases may be contrasted.

In Macaura v Northern Assurance Company Ltd [1925] AC 619, where the owner of a timber business incorporated the business but continued to insure the property in his own name, it was held when the property was destroyed that he had no insurable interest and so could not claim on the policy. The property was no longer his; it now belonged to the company. It may well have been relevant in this case that the fire occurred soon after the insurance policy had been renewed. There was at least a hint in the case that this may have been a relevant factor in the decision. Is this a hint of arson?

Mr Kosmopoulos, as a sole shareholder of the company, was so placed with respect to the assets of the business as to have benefit from their existence and prejudice from the destruction. He had a moral certainty of advantage or benefit from those assets but for the fire. He had, therefore, an insurable interest in them, capable of supporting the insurance policy and is entitled to recover under it.

There is no suggestion that the law in Canada is materially different from the law in the United Kingdom. Common law countries all seem to suffer from the same confusion of clinging to the Salomon principles of the basic separation of the company from its controllers, while at the same time undermining it with a variety of exceptions and qualifications which are considered in this chapter. Those hoping for a clear and consistent message in this area will hope in vain, as the above cases demonstrate.

Demonstrating the separate nature of the company in R v Buxton and others [2010] All ER 215, the Court of Appeal held that a restraining order could be issued to safeguard a company from harassment.

While the decision in Salomon’s case has certainly been open to criticism, and the cases are far from consistent, in Adams v Cape Industries plc [1990] Ch 433, the Court of Appeal held that an English company, whose business was mining asbestos in South Africa, was not present in the United States through another member of the corporate group. Slade LJ had said: ‘… save in cases which turn on the wording of particular statutes or contracts, the court is not free to disregard the principle of Salomon v A Salomon & Co Ltd merely because it considers that justice so requires.’

In fact, Adams identified two further areas where the veil may be lifted, namely where the company is a ‘facade’ such as a fraudulent construct, and also where there is an agency express or implied.

However, the Court of Appeal’s view in Adams v Cape Industries plc has not always been followed faithfully. In Creasey v Breachwood Motors Ltd [1993] BCLC 480, Richard Southwell QC, sitting as a deputy High Court judge, allowed the substitution of one company for another as defendant holding the second company liable for the debts of the first. This decision, however, was itself disapproved in Ord & Another v Belhaven Pubs Ltd [1998] 2 BCLC 447 by the Court of Appeal. The defendant, Belhaven Pubs Ltd, appealed against a decision of Judge Alton whereby the deputy judge ordered that the claimants be granted leave to substitute Ascot Holdings plc as the defendant in an action brought by the claimants against Belhaven Pubs Ltd, claiming damages for misrepresentation and breach of warranty. The Court of Appeal held that, in the absence of any impropriety, sham or concealment in the restructuring of the Group, it would be wrong to lift the corporate veil in order to make the shareholders of the defendant company liable instead of the company itself.

However, the principle in Salomon’s case does give way to exceptions where the veil of incorporation is lifted. These are of two types: statutory and judicial.

First, the requirement for an intent to defraud and fraudulent purpose was not retained as an essential, and with it goes what Maugham J called ‘the need for actual dishonesty involving real moral blame’.

He continued:

The second enlargement is that the test to be applied by the court has become one under which the director in question is to be judged by the standards of what can reasonably be expected of a person fulfilling his functions, and showing reasonable diligence in doing so.

On the facts of the case, two directors of a fruit-importing business were held liable. The directors of the company had been warned by the company’s auditors of the company’s serious financial plight.

In this case, the judge ordered that the directors should contribute to the company’s assets the amount by which they had been depleted by the directors’ conduct, i.e. once again the aim is compensatory.

It is difficult to identify a consistent thread running through the decided cases indicating when the veil will be lifted. It seems to be, as the American Realists (commenting on the nature of legal decisions) indicate, dependent on the particular judge and what the judge has had for breakfast! However, it is possible to identify certain consistent themes in the cases.

As Murray Pickering in ‘The Company as a Separate Legal Entity’ (1968) 31MLR 481 has demonstrated, there is a remarkable range of judicial descriptions used where difficulties are experienced by the courts in separating the company as a legal entity from its members. These include, as Pickering notes, for example, ‘a mere nominee’, ‘a mere fraud’, ‘an agent’, ‘a trustee’, ‘a mere device’, ‘a myth and a fiction’ (Broderib v Salomon [1895] 2 Ch 323), ‘a pretended association’ (Salomon v Salomon & Co [1897] AC 22), ‘a bubble’ (Re Carl Hirth [1899] 1 QB 612), ‘an unreal’ procedure (Attorney General for Dominion of Canada v Standard Trust Co of New York [1911] AC 498), ‘an alias’, ‘a name’ (Re Darby [1911] 1 KB 95), ‘an artificial legal thing’, ‘a legal abstraction’ (Continental Tyre & Rubber Co (GB) Ltd v Daimler Co Ltd [1915] 1 KB 95), ‘mere machinery’ (Daimler Co v Continental Tyre & Rubber Co [1916] 2 AC 307), ‘a metaphysical conception’ (Lennards Carrying Co Ltd v Asiatic Petroleum Co Ltd [1915] AC 705), ‘a sham or bogus’ (R v Grubb [1915] 2 KB 683), ‘an abstract conception’ (Houghton & Co v Nothard Lowe & Wills Ltd [1928] AC 1), ‘a simulacrum’ (EBM Co Ltd v Dominon Bank [1937] 3 All ER 555), ‘a cloak’ (Gilford Motor Co Ltd v Horne [1933] Ch 935), ‘a mere alter ego’ (Pegler v Craven [1952] 2 QB 69), ‘an abstract being’ (Austin Reed Ltd v Royal Assurance Co Ltd [18 July 1956 CA] unreported), ‘a creature’ (IRC v Lithgows Ltd (1960) 39 TC 270), ‘a screen’ (Barclays Bank v IRC [1960] 3 WLR 280) and even ‘a blacksheep’ (IRC v Sansome [1921] 2 KB 492).

The court will lift the veil to prevent fraud or sharp practice. In Jones v Lipman [1962] 1 All ER 442, a vendor of land sought to evade a decree of specific performance of a contract for the sale of a piece of land by conveying the land to a company which he had purchased for the purpose of side-stepping the obligation.

The court held that the acquisition of the company and the conveyance of the land to it was a mere ‘cloak or sham’ to evade the contract of sale. The veil was lifted.

By contrast, in the Australian case of Electric Light and Power Supply Co Ltd v Cormack