The concept of separate legal entity is widely used in the business scenario. Human beings are generally legal person but humanity is a state of nature and legal personality is an artificial construct, which may or may not be conferred. The origin of corporation lies in a logical extension of this separation of humanity from legal personality as the group of humans who are engaged in a common activity could attempt to simplify their joint activity by gaining legal personality from the venture.
A very common query made by students and even qualified professionals is that if there is separate legal entity prevailing as per Companies Act, then why Subrata Roy or Vijay Mallya are booked by the law for their company’s offences.
Here, bear in mind that in case of Mallya, he gave his personal guarantee as Promoter while taking loan. Similarly Subrata Roy was booked because of fraudulent act done by the company, where all the related parties are held responsible.
Now, we will discuss the famous case “Saloman vs Saloman”. Probably this is the one case, which every commerce or legal student must have read sometime in his or her academics and all over the world. It is the foundational case on Separate Legal Entity.
Case Facts:
Aron Salomon was a successful leather merchant who specialized in manufacturing leather boots. For many years he ran his business as a sole proprietor. By 1892, his sons had become interested in taking part in the business. Salomon decided to incorporate his business as a Limited company, Salomon & Co. Ltd.
At the time the legal requirement for incorporation was that at least seven persons subscribe as shareholders of a company. Mr. Salomon himself was managing director with an ownership of 20,001 shares out of company’s total 20,007 shares – the remaining six were shared individually between the other six shareholders (wife, daughter and four sons). Mr. Salomon sold his business to the new corporation for almost £39,000, of which £10,000 was a debt to him.
He was thus simultaneously the company’s principal shareholder and its principal creditor. He asked the company to issue debenture of £10,000 to him.
However, a sudden slow down in business occurred and the company could no longer pay interests to Salomon. Even the wife puts money, but the company still cannot pay. Finally, Salomon transfers the debenture to one B, but still the company could not pay. B is here a secured creditor, in relation to the company, as he holds in respect of his a security over property of the company in term of the debenture. B called for a receiver and therefore, sold the factory to cover his debts. That led to the end of the business.
This left the debts of the general creditors. The company had to be hence liquidated and the assets were to be sold to pay them. As a liquidator of a company, the official receiver’s general functions were to investigate any wrong doing in the company, to secure the assets, realise them and distribute the proceeds to the company’s creditors, and, if there is a surplus, to the persons entitled to it.
When the company went into liquidation, the liquidator argued that the debentures used by Mr. Salomon as security for the debt were invalid, on the grounds of fraud; Salomon was not a genuine incorporator.
High Court:
Deciding on case, High Court judge, Vaughan Williams J. accepted this argument of Liquidator, ruled that since Mr. Salomon had created the company solely to transfer his business to it, prima facea, the company and Salomon were one unit; the company was in reality his agent and he as principal was liable for debts to unsecured creditors.
The Court of Appeal also ruled against Mr. Salomon, on the grounds that Mr. Salomon had abused the privileges of incorporation and limited liability, which the Legislature had intended only to confer on “independent bona fide shareholders, who had a mind and will of their own and were not mere puppets”. The lord justices of appeal variously described the company as a myth and a fiction and said that the incorporation of the business by Mr. Salomon had been a mere scheme to enable him to carry on as before but with limited liability.
The Lords:
The House of Lords unanimously overturned this decision, rejecting the arguments from agency and fraud.
Salomon followed the required procedures to the set the company; shares and debentures were issued. The House of Lords held that the company has been validly formed since the Act merely required 7 members holding at least one share each.
It was irrelevant that the bulk of shares were issued to one shareholder. Statute did not mention that each share holder should have X amount of shares. It said nothing about their being independent, or that they should take a substantial interest in the undertaking, or that they should have a mind and will of their own, or that there should be anything like a balance of power in the constitution of the company.
There was no fraud as the company was a genuine creature of the Companies Act as there was compliance and it was in line with the requirements of the Registrar of Companies.
The wordings of House were:
“The company is at law a different person altogether from the shareholders …; and, though 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 received the profits, the company is not in law the agent of the shareholders or trustee for them. Nor are the shareholders, as members, liable in any shape or form, except to the extent and in the manner provided for by the Act.”
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