Discuss whether the concept of “limited liability” has long engaged the academic community, whilst arguably the concept of “entity shielding” deserves more attention from company law scholars.
The concept of limited liability (LL) operates to prevent firm creditors having recourse against assets of the firm owners. On the other hand, entity shielding (ES) prevents personal creditors of the firm owners from any claim to assets of the firm itself. Discussions surrounding LL has long engaged the academic community, indicated by the courts reluctant approach in ‘piercing the corporate veil’ where LL is at stake. Conversely, ES is underdiscussed, despite the concept being equally as significant as LL for firms and creditors. Therefore, more attention is needed to protect the concept of ES and prevent the application of the veil doctrine in these cases.
Limited liability has long engaged the academic community
LL is key in establishing the incorporation of a company as a distinct legal entity (Salomon). The concept denotes that a company’s shareholders are not personally liable for the company’s debts. This is evident in s.3(1) Companies Act 2006 (CA), where a limited company will limit the liability of the members under the company’s corporate constitution.
The concept has long engaged the academic community regarding its benefits and costs. It is clear that LL can be detrimental for corporate creditors as they can lack recourse against shareholders if a company cannot pay debts. Thus, creditors who have bargained for security are better placed to recover what they are owed, whilst unsecured creditors lose out. However, Arnold has highlighted how the costs of LL are usually outweighed by its benefits. He argues that creditors are able to adjust the terms of their bargain to reflect the risks they bear, therefore they are suited to take on these risks. Creditors can also self-protect by investigating the creditworthiness of the companies they deal with. This is most useful in the context of public companies. Nevertheless, La Forest J notes that in smaller companies, which may not contribute to the functioning of the securities market or facilitate efficient risk-bearing, LL may exacerbate the cost for creditors, rendering the concept less useful in these contexts.
As a result of the recognised importance of LL, the concept has stimulated considerable academic discussion in case law regarding the veil doctrine. Here, courts have rarely applied the doctrine where claimants have attempted to circumvent the LL rule, emphasising the importance of preserving LL. For instance, in Salomon, although it was decided that the veil could be lifted if a company is acting as an agent of another party, and will therefore be liable on behalf of the party, Gallagher and Ziegler note that the courts appear reluctant to determine that this agency relationship exists. Similarly, in Adams, though a parent company would be accountable for the debts of a subsidiary if they are an agent, it was held that there is no presumption of agency and the court should not lift the veil just because matters have been organised so liability falls on a particular member of a corporate group. Creasey is an exception to the veil doctrine in LL cases, but this was effectively overruled in Ord where the court held that the doctrine would not apply simply for justice purposes.
Thus, it is clear that the LL concept is firmly protected in the case law, arguably resulting from a large volume of academic engagement surrounding its importance.
Importance of entity shielding
ES protects a firm’s assets from the personal creditors from the firm’s owners. Hansmann, Kraakman and Squire (HKS) describe three types of ES. ‘Weak’ ES grants firm creditors priority over personal creditors in the division of firm assets. ‘Strong’ ES adds liquidation protection to this, which restricts firm owners and personal creditors to force a payout of an owner’s share of the firm’s assets. An example of this is capital maintenance rules. More significantly, ‘complete’ ES denies non-firm creditors any claim to firm assets at all. HKS argue that the latter is needed to allow an unpaid creditor to seize assets owned by a defaulting promisor. Rather than contractual principles in LL rules, rules of law are required for ES to avoid the large costs of waivers and moral hazard in contracts. Although this may disadvantage creditors, it can reduce their information costs and creditor monitoring costs for firms. Though LL can reduce monitoring costs as well, it does not protect a firm’s assets from non-firm creditors.
Moreover, managerial agency costs can be saved under ES. This is because creditors will know their risks so will be less likely to lend based on estimates. This reduces the risk that a firm agent will engage in excessive borrowing, reducing risks of default. ES also protects the firm’s going-concern value as the value of the company cannot be withdrawn by personal creditors, enhancing stability. This makes it easier for investors to invest in multiple firms and diversify risks, as well as facilitating a market for shares. Although Easterbrook and Fischel note that LL is equally able to achieve this, HKS argue that LL does not remove the risk of shareholders’ ability to threaten the firm’s going-concern value through personal withdrawals. However, ES may increase the cost of borrowing by attracting opportunistic behaviour which allows a borrower to subordinate their creditors without their consent. This may deter lenders whilst increasing enforcement costs to establish credibility. It can also reduce the diversification of assets secured by creditors, as they are only able to acquire assets from the entity they invested in.
Despite the costs, it is evident that ES is an equally important feature of incorporated companies and can be very useful in protecting firm assets.
Deserves more attention
Given the importance of ES, it is noteworthy that the veil doctrine has been used to justify the removal of this concept. Lonrho, The Tjaskemolen, and Raja are examples. This allows the personal creditors of shareholders to seize the assets of the company in a default. Other cases like Gilford and Jones provide personal creditors with security over the company’ assets. This is an indirect form of the doctrine in ES cases.
Cabarelli argues that this is an area which has been under-researched, unlike the application of the doctrine in LL situations. He argues that it needs to be understood that ES is not a consequence of separate legal personality, as it cannot be simulated by a nexus of contracts. Thus, applying the veil doctrine would be wrong. He compares the English cases to Scottish partnerships, where creditors can only take the shares of the partner without title. If a similar principle were applied to the English ES cases, the ES features would not have been removed to enable creditors to seize company assets. Therefore, applying the doctrine to ES cases means the English company is placed at a competitive disadvantage to other types of partnership in England and Scotland. It leads to an increase in corporate borrowing costs as the creditors of the company would need to offset the risk that other personal creditors would take priority. It also invites criticism that the law is incoherent in the commercial context, as the doctrine rarely applies in LL cases.
Therefore, more academic research in applying the doctrine in this area is duly needed. This is made clearer when considering existing alternative doctrines, such as protection in tort law based on the assumption of responsibility (Standard Chartered Bank, Chandler v Cape), and equitable principles like dishonest assistance (Tan). There are also other mechanisms in CA which deal with abuses, for instance s.767(3), s.563(2), as well as s.215-217 of the Insolvency Act 1986. These indicate that the veil doctrine should be kept very narrow, protecting the concept of ES and LL in companies.
To conclude, academic engagement in LL has meant the veil doctrine has protected this concept, highlighting the recognition of its importance. However, the ES concept is often conceded when the doctrine is applied, thus similar academic attention is required here to afford the concept the protection it deserves.
The writer, Simrhan Khetani, is a law graduate from the University of Cambridge and future trainee solicitor at Akin Gump LLP. She has a keen interest in Equity and Trust law and will be pursuing this interest in her work as a solicitor.
Law Tutors Online, UK Law Tutor, UK Law Notes, Manchester Law Tutor, Birmingham Law Tutor, Nottingham Law Tutor, Oxford Law Tutor, Cambridge Law Tutor, New York Law Tutor, Sydney Law Tutor, Singapore Law Tutor, Hong Kong Law Tutor, London Tutors, Top Tutors Online and London Law Tutor are trading names of London Law Tutor Ltd. which is a company registered in England and Wales. Company Registration Number: 08253481. VAT Registration Number: 160291824 Registered Data Controller: ZA236376 Registered office: Berkeley Square House, Berkeley Square, London, UK W1J 6BD. All Rights Reserved. Copyright © 2012-2024.
