Case Analysis: Salomon v A Salomon and Co. Ltd (1897)

This Case Analysis of Salomon v A Salomon & Co. Ltd. is a landmark case that has established an important principle that a company has a separate legal entity and its corporate veil should not be pierced so as to protect the interest of the shareholders and uphold the true spirit of the Companies Act.

This principle is regarded as the core of, not only the English company law but of the universal commercial law regime. The House of Lord in this case decided that since a company has a separate legal entity and thus at the time of liquidation, the shareholders cannot be made personally liable for the loss of the company.

Introduction

A company is a legal person in the eyes of law. It is regarded as an artificial person. A company is separate and independent from its members and this enables the members not to be liable for the acts of the Company. As such even if a shareholder holds the majority of the shares of the company he is free from the burden of the acts of the company.

Court: House of Lords

Title of the case: Salomon v. A Salomon & Co. Ltd

Citation: [1896] 11 WLUK 76

Decided On: 16 November 1896, At House of Lords, UK

Judges: Lord Halsbury LC, Lord Watson, Lord Herschell, Lord Macnaghten, Lord Morris, Lord Davey

Facts of the case

The appellant, Aron Salomon, carried on his business as a leather merchant and wholesale boot manufacturer. In order to limit his liability, he came up with the design of transferring his business to a joint stock company, rules of which were to be dictated by the Companies Act 1862. A preliminary agreement to settle the terms of transfer of the business was entered on 20 July 1892 between the appellant and Adolph Anholt, who served as the trustee of the future company, one of the terms of which was to make part payment in terms of debentures to the appellant.

The business of the appellant was perfectly solvent and financially sound at the time of its sale to the joint stock company. The company hence formed, exclusively consisted of the vendor/ appellant and his six other family members – his wife, his daughter, and his four sons. The limited company, thus formed, had an authorized capital of 40000 shares of 1 Pound each. Out of these shares, only 20007 shares were issued and subscribed, of which 20001 were held by the vendor (appellant), and the other 6 shares were held by each member of his family.

All the terms of sale were known and duly approved by the members of the family. Besides the subscription of 20001 shares by the appellant, 10000 debentures forming floating security were also issued to him in the part payment of the share purchase money.

The Memorandum of Association was also executed duly, wherein the chief object for the formation of the company was stated to be the realization of the terms and conditions stated in the provisional agreement of 20 July 1892. The MoA was duly registered and thus, after the other legal formalities, the company was incorporated under the name of "Aron Salomon and Company, Limited ".

These enormous number of shares held by the vendor gave him the power to outvote other members of the family. Further, he was also appointed as the managing director of the company. All of these led to the centralization of power into his hands. However, in this due course, all the requirements of the Companies Act 1862 have been duly complied with.

Out of the said no of debentures issued to the appellant, he used 100 debentures as security to obtain an advance of 5000 Pounds from one Mr. Edmund Broderip. However, due to a discrepancy in the allotment of debentures to the appellant, fresh debentures were ultimately issued to Mr. Broderip at 8% interest.

Unfortunately, the joint stock company of the appellant became insolvent and there was a default in payment of interest on debentures to Mr. Broderip, who in turn, instituted a legal action so as to enforce his security against the assets of the company. Consequently, a liquidation order was passed and a liquidator was appointed at the instance of the other unsecured creditors in order to realize the money out of the said assets.

It came to be observed that if the money extracted from the sale of assets was used to service the debt and interest of the debentures of Mr. Broderip, then a balance of 1055 Pounds would be left, which was supposed to be further used to satisfy the debenture debt of appellant. As known under the Companies Act, it was only after satisfying the claims of the debenture holders, that the monetary claims of the other creditors could be met.

Hence, the acute shortage of funds for the satisfaction of the monetary claims of the unsecured creditors, which amounted to a whopping amount of 7733 Pounds, thereby left the creditors distraught. Mr. Broderip was paid off. However, the liquidator (on behalf of the company), so appointed by the other creditors, sought to pay off the creditors without honoring the debenture debt of the appellant, as a result of which the appellant sued the liquidator (the company).

The appellant sued the company at the trial court and claimed that as per the Companies Act, his joint stock company was duly registered and incorporated and that the claims of the secured debenture holders should be first satisfied before honoring the claims of unsecured creditors. The liquidator, lodging a counterclaim on behalf of the company against the appellant claimed fraud upon the company and creditors and demanded to rescind the agreement dated 20 July 1892 and cancel the allotted debentures of the appellant.

The trial court refused to grant relief to the company and observed that although the company was duly incorporated as a limited company, it acted as an agent of the appellant as the company undertook the appellant's business. Since the company acted as a mere agent of the appellant, therefore, he was bound to indemnify the company to the extent of the creditor's claim. Given the decision of the trial court, both parties filed an appeal.

On 28 May 1895, the 3 judge bench of the appellate court consisting of judges Lindley LJ, Lopes LJ, Kay LJ held that the establishment of the company was a myth or fiction and that the actual business belonged to Aron Salomon. The other six members, who were shareholders of the Company acted as mere dummies of the appellant. The entire scheme of formation of the company, the agreement dated 20 July, and the consequent issue of debentures to the appellant was a mere scheme to enable him to operate the business under the cover of limited liability, contrary to the true meaning and intention of the Companies Act 1862.

Such move of the appellant to own the debentures was to enable him to obtain preference upon the claims of other creditors by creating a first charge on the assets. Thus, the unsecured creditors were liable to be paid by the appellant.

Aggrieved by the decision of the appellate court, the appellant filed the present case.

Issues Stated

1. Whether there was a valid constitution of a joint stock company?
2. Whether the company was defrauded by the appellant?
3. Whether the unsecured creditors were defrauded by the appellant?

Appellants Contention

1. The appellant contended that the company should be treated like a separate legal entity company if it fulfilled all the requirements of the legislature. The constitution of the joint stock company was valid as all the requisites of the Companies Act have obediently complied during the formation of the company and thereafter. The purpose of the formation of the company was lawful too.
2. If the incorporation of the Company was lawful, therefore the transactions of the company were valid too including the debenture allotment of the appellant was lawful too. As regards to the holding of debentures by the appellant via the agreement dated 20 July, it was contended it made no actual difference whether the debentures were held by the appellant or any other creditor for that matter. All that mattered was a preference in payment over the other creditors.
3. The Companies Act 1862 prescribed that holding of one share each was sufficient and that the relation among the shareholders was not focal, in order to categorize them as a valid shareholder. In such a backdrop, the appellate court did not have the right to impose conditions that were in contradiction to the above rule and declare the incorporation of the company invalid.
4. The sale of the business was not done to shoulder off the mounting losses of the appellant to the third parties but was done with a bona fide intention to mitigate unlimited liability. The business was flourishing, solvent, and genuine at the time of its sale. Hence, the company was not defrauded by the appellant.
5. Further, the consent of the family members to act as shareholders was genuine and lawful, they gave their approval after being well versed with all the terms and conditions.
6. As regards the conversion of the appellant's business into a limited company, it was contended that there was nothing wrong in converting a private business with unlimited liability into a joint stock company with limited liability, for such practice was also undertaken by the banks and other firms every day.
7. It was further contended that there was no misrepresentation of fact to the creditors nor they were defrauded. The creditors were free to enquire about the shareholders and debenture holders of the company and find out their proportion of shares and debentures respectively.

Respondent Contention

1. The respondent contended that the company was invalidly incorporated as it never had any independent existence, in spite of its incorporation under the Companies Act. The appellant exercised total control over the company by acting as its managing director. His family members merely acted as dummies and facilitated the objectives of the appellant. They didn't have minds and will of their own and the appellant acted as their absolute master. Thus, the company acted as an alias of the respondent and was a sham, contrary to the actual meaning of the Companies Act.
2. The chief motive of the appellant was to mount off the losses of the business upon the third parties as the business was in a decaying state at the time of its sale to the Company. The Appellant intended to shift the business risk upon the creditors so that he could carry it out without any impediment and peril and thus, defraud the company and creditors
3. Further, in order to escape the liability of the business and shelf off the losses, the appellant cunningly employed the debentures. The fact that the appellant held the debentures was further, willingly concealed from the creditors.
4. The company was defrauded as the terms of sale of the business were solely dictated by the vendor which was exploitative per se as the business was overvalued by the appellant in order to obtain the exorbitant amount of purchase money.

Decision

1. The judgment of the appellate court was reversed and the court held that the company was not an agent of the appellant. It was held by the House of Lords that the establishment of the Company was valid and real as per the requisites of the Companies Act. Given the legitimate institution of the company, therefore the transactions of the company were valid, including the debenture allotment of the appellant and the agreement dated 20 July 1892. Since the company was a separate legal entity (SLP) and therefore, in the present case of liquidation, the shareholders shall not be personally liable for the creditor's claims, given their limited liability. They would only be liable to the extent of their subscribed shares.
2. The court held the sale of the boot and the leather business of the appellant to the limited liability company as valid and the consequent price paid for its sale as not exorbitant since the shareholders were cognizant of the price and other terms and conditions of sale. The sale transaction was concluded after the due ratification of all the shareholders. And hence, no case of fraud can be established against the appellant.
3. The fact that the shareholders of the company consisted of the appellant and his six other family members who held one share each, did not affect the validity of the company under the Companies Act as in order to constitute a shareholder, it was sufficient to hold one share and that the relation among the shareholders was irrelevant. Moreover, the Act did not prescribe the quantum of interest or influence, to be exercised by each shareholder proportionate to one's shareholding. So, there was nothing wrong if the appellant acted as the MD of the Company and exercised influence more than other members of his family who were shareholders in this case.
4. Held that even if Aron Salomon chose to employ a company in order to carry out his business, there was nothing wrong in doing so if analyzed on the anvil of true intention and meaning of the Companies Act. In the given case where the company was duly incorporated, the motive or conduct of the promoters was absolutely irrelevant. The company hence created should be treated like an independent person, with its own rights and liabilities.
5. The Act contemplated the association of seven or more independent bona fide members with the mind and will of their own to form a company so as to limit their liability. In the given case, the shareholders collaborated out of their free will to secure their collective interests, and all the terms and conditions of the sale were known and approved by them. The shareholders acted bona fide and consequently, transferred their solvent business to a limited liability company in order to cap their liabilities. Hence, no case of fraud could be established against the appellant. While coming to this proposition, reliance was placed on the case of Erlanger v. New Sombrero Phosphate Co.[1]
6. The unsecured creditors were not defrauded as they had been given full freedom under the Companies Act to inspect and analyze the share and debenture holding pattern of the company. It was not the duty of the law to warn the creditors of the risk of not being paid due to the ill performance of the company. They failed to exercise their rights and inform themselves of the terms of purchase by the company, and thereby acted negligently.

Ratio Decidendi

The company was a separate and distinct legal entity after it was legally incorporated. Hence, the corporate veil should not be pierced. Hence, in such cases, the shareholders cannot be made liable to pay any sum beyond their portion of subscribed shares. In other words, they cannot be made personally liable for the unlimited liabilities since the Companies Act limits the liability.

As per the Companies Act 1862, it was sufficient to hold one share only, in order to constitute a shareholder.[2] Neither the relation between the shareholders nor the authority or influence exercised by them played any role whatsoever in order to determine their position as shareholders. Since the six other members of the appellant's family held one share each, they constituted valid shareholders, which was irrelevant to the fact that they acted as mere dummies. Thus, once a company was duly incorporated, all the transactions that it undertook became valid and legal per se.

Conclusion

This landmark case changed the landscape of corporate undertakings. It firmly established and underscored the artificial personality of the Joint Stock Companies. It affirmed that the corporate veil cannot be dissolved easily so as to endanger the rights of the shareholders. Once incorporated, the company had a separate legal identity apart from its promoters and shareholders. This paved way for a new revolution as regards shareholder right in the corporate environment.

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References

[1] Erlanger v. New Sombrero Phosphate Co.,(1878) 3 App. Cas. 1218

[2] Companies Act 1862(UK), Available Here

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