Business or businessman: Who to sue when things go wrong

When can a third party claim against company members directly?

In law, a company is separate from its company’s members. It stands to reason — but in some circumstances a company member’s conduct is so bad that he or she could bear the brunt of a third party legal challenge.

Every registered company has a corporate personality, meaning that it has separate legal status from its members. If you work for a company, you won’t be liable for the company’s debts.

This key principle is called separate legal personality and the authority for it is the well known case of Salomon v Salomon & Co Ltd. The Court of Appeal judges focused on the company as a legal entity in itself, stating that “any company formed in compliance with regulations of Companies Act is a separate legal person”, and this means that members will have limited liability towards its debts.

As a result of Salomon, the general rule is that every company will be treated as a separate legal person and all of its members will have limited liability. However, the judiciary may well decide that this separation of personalities should not be maintained, so the veil of incorporation can be lifted.

The lifting of this metaphorical veil is designed to prevent the protection of limited liability being used for fraud and will only apply to members who created the situation, such as shareholders or directors.

One example of the court being prepared to lift the veil is when it is deemed that the company has been used as a ‘sham’ or ‘façade’ to hide a dishonest purpose. Take the case of Trustor SB v Smallbone, where it was ruled that it was appropriate to lift the veil because the company was a sham used for concealing money. As a result of the veil being lifted, the members of the company won’t be able to use their privilege of limited liability, and shareholder or director will be liable for any debts or dishonest actions of the company.

The second exception to the Salomon principle is an agency. In the case of Rainham Chemical Works v Belvedere, the contract for an agency relationship goes with the grain of Salomon. However, in the case of Smith, Stone and Knight Ltd v Birmingham Corp it was argued that the proper claimant was the subsidiary company, which was a separate legal entity. The court held that possession by a separate legal entity was not conclusive. The subsidiary company was not operating on its own behalf but rather on behalf of the parent company. Therefore, the parent company was able to claim compensation. The closer the parent and subsidiary company are to each other — in terms of operating in the same manner or place — the more likely that they will not be considered as separate legal entities.

However, contrary to the Smith case, Adam v Cape Industries established that the law recognises subsidiary companies and, even though they are under control of the parent companies, they will be treated as separate legal entities with rights and liabilities of their own.

These two decisions vary so much in their judgments, and on the face look irreconcilable. It seems that the courts will simply lift the veil and ignore the separate personality of incorporation doctrine as and when justice requires them to do so.

The third category of exceptions to the Salomon rule is born out of the statute book. There are a number of exceptions found in legislation, most notably the Companies Act 2006. S399, which allows the courts to lift the veil and look behind it to see company’s accounts, being a key example.

Another is contained in s993 — an offence of fraudulent trading — and also confirmed in s213 of the Insolvency Act 1986. Fraudulent trading is when, in the course of winding up, business is carried on with the intent to defraud creditors. In the 1933 case of Re Patrick & Lyon Ltd (Unreported), a director of a company delayed liquidation for six months, in order to deprive the unsecured creditors of the right to challenge his debentures under s266 of the Companies Act. The veil was lifted, and the defendant was held liable for the debts of the company.

Courts may also be prepared to lift the veil of incorporation when there is an issue of tortious liability. Take the case of Lubbe v Cape PLC. Here, a claimant suffered injuries after being exposed to asbestos. He worked for a South African subsidiary of Cape (a company). The claimant wanted to sue Cape in London rather than in the South African subsidiary. UK courts accepted jurisdiction, given that the South African courts did not have the resources to hear the case. The matter was eventually settled, and it was held that the company owed a duty of care towards its employees. The case of Chandler v Cape PLC also confirmed that a parent company owes a duty of care to its subsidiary’s employees, therefore extending the situation in which company can be held liable for group operations.

Business is a complex game, and in certain circumstances the strict application of the separate entity principle could lead to an unfair result. So that’s why the courts have chosen to ignore the principle of legal corporate personality in some circumstances. It must, however, be remembered that the Salomon case remains the general principle and other circumstances are merely exceptions.

Lord Sumption summed this up pretty succinctly in Petrodel v Prest, when he stated that there was limited power to pierce the veil and it will only be used to prevent abuse of the legal system in cases where people are under a legal obligation, which is evaded on purpose. All of the above exceptions to Salomon’s rule prove his lordship’s point, that any exploitation of legal rights, corporate personality in this case, must be prevented.

Aleksandra Jarosz is a law student at BPP University.