Incorporation

Upon incorporation a company comes into existence and thereby assumes legal personality having rights and obligations as it were like a natural person. The common law position is that once stipulated registration requirements have been met, a corporation becomes a judicial person distinct from its members or promoters. It can now own property, sue, be sued, and enter into contracts because of the law of the legal personality doctrine that the law attaches to incorporation.

Related to legal personality is limited liability. Limited liability dates back to the Joint stock Companies Act 1844 and the Limited Liability Act of 1855. It is a default rule which separates and protects the acquired property of a company from those of its members. The company pays its debts, and so do members pay their debts. That is to say the doctrine shifts the risk of business from the shareholders to creditors. When a company fails, the creditors swallow the loss instead of shifting it to the members, yet if all went well, members are residual claimants. This has undoubtedly helped to make possible the growth of the large modern companies that today dominate the private sector of the economy.

The exception to the rule is fraud or an express statement to the contrary short of which liability of members stops, at which each signed up to at the assumption of membership. Claims are therefore , legally confined to available assets of the company. Personal assets of members are not part of the company assets. If it were not a rule, investors would risk less in business for fear of losing personal assets should the business collapse.

Having limited liability ‘cheaply’ and ‘easily’ available is to remove unnecessary legal bars which can be an inhibition to progress of economic activity. Incorporation process should be straight forward, and cheap, and importantly once the company is incorporated the rule follows without question. But despite the arguments that the same protection offered to risk takers be accorded to the larger society, the rule has continued to be cheap and easily available. This is because of the following;

1. Business involves potential risks, limited liability comes in as a motivation in case of failure. This potentially attracts as many people into business through capital injection effectively becoming a ‘contracting tool and financing device’. Hence investors are certain that their personal assets are safe as the rule is a kind of security. Market forces are unreliable. The rule caters for this economic reality, and effectively allows room for honest business errors and commercial failures. It is this flexibility that business people enjoy which makes the rule a suitable business vehicle. This, in the long run, stimulates economic prosperity for a larger public good. Hence legislation and judicial processes in a way have to facilitate this economic process without necessarily being seen as legitimatizing any kind of corporate fraud.

2. A related argument is that, the rule permits firms to isolate different lines of business for the purpose of obtaining credit. This mechanism, Kraakman argues, ‘the assets associated with each venture can conveniently be pledged as security just to creditors who deal with that venture. The benefit accrues to creditors as well as they know the subsidiary they are dealing with, they would monitor it more closely to protect their interests.

3. As pointed out, when creditors know the subsidiary they are dealing with, it allows the stakeholders to closely monitor where their interests are most vested. Closer brings about accountability, transparency and quality management as the directors are cautious that their activities will get to the public domain. In a sense, there is quality service with a corresponding effect of increase in both that value and quantum of company property.

4. Further, the divisions in an economic unit into subsidiaries have other commercial advantages. ‘Product-based division of activity’ is a good example. These divisions encourage specialization with potential to attract specialists into the business. This is possible in a distinct subsidiary from a parent where directors enjoy relative autonomy in exercising skill and judgment for the benefit of only the subsidiary and its stakeholders as opposed to their colleagues in an agent subsidiary. For example in Scottish Co-operative Wholesale Society Limited v Meyer, the court held that a director on the board of a subsidiary company must act in the interests of a particular company alone whether he is in fact a nominee of the parent or not. The decision sets a default standard for directors, rule if it is shown that he acted malafide.

The court’s inconsistent but relatively strict application of the rule has received enormous criticism. Major concerns of cheap and easily available limited liability are; involuntary of funds in subsidiaries, and treatment of parent and subsidiaries as distinct entities. Coupled with the view that companies are so inexpensive and easy to incorporate and liquidate; it has given rise to new forms of abuses and fraud by people in control of, and running company businesses.

The arguments against cheap and easily available limited liability are as follows;

1. Decisions of courts have shown that attaching liability to a parent company is difficult even where the acts of a parent company are visible. The case of Kleinwort Benson v Malaysia Mining Corporation, the parent company issued ‘comfort letters’ to the subsidiary undertaking to meet any debt liability of the subsidiary on liquidation. With the parent’s consent, the subsidiary went on liquidation. Attempts to rely on these letters by the creditors to recover failed because the court held they were not legally binding on the parent.

With great respect to the learned Justices of Appeal, the parent must have understood the implication of issuing these letters. They would be, and in fact were relied on upon by the bank to arrange the 10million pound facility, and they did not form part of the loan facility. Though the law is that wholly owning a subsidiary would not make one liable for its subsidiary, cases ought to be distinguished to reach just conclusions. The parent company in this case sanctioned liquidation of the subsidiary, promising to meet any costs in the process. In the circumstances, the Court of Appeal ought to have confirmed the trial Judge’s decision. The parent company had an unfair economic gain, which in equality, and on policy grounds should have been entitled the bank to recover.

In Lindgren v L and P Estates, the Court of Appeal held that directors of a parent company have no duties to protect the interests of its subsidiaries where the subsidiaries have independent boards while in Smith, Stone & Knight Limited Birmingham Corporation, the court allowed the parent company to claim compensation on behalf of the subsidiary. In Kleinwort, the parent company avoided its obligation while in Smith, the parent company benefited from what ordinarily should have accrued to the subsidiary. The courts are even more reluctant when it is insolvency than solvency as was held of Re Polly Peck International Plc. The courts should be able to identify wrong acts of the parent in the subsidiary, and hold them liable; otherwise it encourages ‘phoenix companies’.

2. It is argued that because of cheap limited liability, temptations are high to transfer assets within the corporate veil. As subsidiaries are spread geographically, monitoring them by other stakeholders can be difficult. The nature and exact dealings between a parent and a subsidiary are difficult to ascertain. This gives room for perpetuation of fraud as many transactions can not easily be traced. ‘Intra group transfer may be used to ‘massage’ individual balance sheets’ and these can serve as vehicles to conceal significant transactions including fraudulent movement of assets.

Profits of subsidiaries area are easily siphoned to the parents’ base at the expense of the subsidiary and its stakeholders. Some subsidiaries will liquidate overnight, and others open the next day because costs are low at the expense of creditors and other stakeholders. Tracking these transactions and movement of assets between the parent and the several subsidiaries is undoubtedly complex. If not checked, it leads to enormous corporate crimes including tax evasion, and fraudulent trading.

3. Fraudulent trading is both ‘civil and criminal’. It is both a remedy and a form of abuse of limited liability. As a form of abuse: theses are transactions intended to defraud. Transfer of assets from one company to another, falsifying accounts, doctoring documents where none exists, and phoenix companies are the other examples of fraudulent trading. A company is incorporated today and liquidates tomorrow, and another with similar names is incorporated. This pattern of corporate mode is largely because companies are so inexpensive and easy to incorporate and liquidate. Yet perpetuators can easily hide behind the rule, and get away with the fraud. Potential culprits here are directors who are always in day to day management of a company.

4. There is the case of involuntary creditors. These include; employees or members of the public who are unsecured creditors. They have no direct duty owned by the company, and they do not enjoy the same protection as ‘normal’ trade creditors to have the opportunity to assess the risk of doing business. And this can allow parent companies to avoid liability without providing any compensation. Potential areas of abuse are labour and health.

Therefore as countries push for harmonization of company law, of interest should be particularly the initiatives at reforms considered above to the application of limited liability rule, namely; Whether we should develop the enterprise law, and regard group companies as ‘one economic unit’ for all purposes, or easily pierce the corporate veil in group companies. These issues require answers which must be designed based on the loopholes in the judicial systems and the legal provisions some of which I considered earlier. What is critical is that all stake holders in company matters need protection from fraud. The problem of fraud certainly needs combined judicial assertiveness, and legislative effort.