The Relationship between Incorporation and Limited Liability - Term Paper Example

The relationship between incorporation and limited liability is often misunderstood and at best confused. These concepts are distinct even though in some contexts they may in practice be closely connected. Critically evaluate. Arguably one of the most attractive features of a company incorporated under UK law as a business vehicle is the principle of distinct corporate personality as enshrined in the Salomon case1. Directly intertwined with this is the concept of limited liability whereby individual members will not be liable for the acts of the company subject to limited exceptions2. In order for a company to avail itself of the limited liability principle it must be incorporated in accordance with procedures stipulated by the Companies Act 20063. However, there is sometimes confusion as to the correlation between incorporation and limited liability and the objective of this paper is to critically evaluate the interrelationship between the two concepts. It is submitted at the outset that the process of incorporation specifically deals with the legal formalities for trading as a corporate body and applies to various trading mediums including limited and unlimited companies4. If a body is incorporated as a limited liability company, compliance with the requirements of incorporation enables a limited company to use the limited liability principle. Therefore, limited liability is enabled as a consequence of incorporation5. Accordingly, whilst the two concepts are closely linked, they are distinctly separate, particularly as limited liability is only one of many potential legal consequences as a result of incorporation. Arguably, part of the misconceptions regarding the definitions of incorporation and limited liability are the assumptions surrounding the definition of a company. It is well documented that a properly incorporated company will have a separate legal status6 and a consequence of this is limited liability. However, the mere process of incorporation does not lead to limited liability per se as it ultimately depends on the type of company that is created by virtue of incorporation7. For example, a ‘company’ is a form of corporate body which is registered under the Companies Act 2006. The main regulatory framework in United Kingdom for companies is the Companies Act 1985 and the Companies Act 2006, which codifies previous legislation regulating company law8. Furthermore, the Companies Act 2006 regulates the various types of corporate structures that fall within the “company” umbrella” and under, English law, a company is a form of corporation generally registered under the Companies Act or similar legislation.9. Therefore, the English legal system under the Companies Act 2006 includes a number of types of business organisation, which highlights the point that incorporation regulates the formalities for creation of a corporate structure. For example, a first classification is between limited and unlimited companies10. Limited companies exist in their own right as a separate legal personality and as a result, the Company’s finances are independent of any personal finances of their owners11. As a consequence, shareholders are not responsible for the debts of the company12. An unlimited company on the other hand, has no limit on the liability of its members13. These two types of companies are defined by section 3 of the Companies Act 2006, which provides: “(1) a company is a “limited company” if the liability of its members is limited by its constitution..... (4) If there is no limit on the liability of its members, the company is an “unlimited company” 14 The process of incorporation requires those setting up the company to provide the Registrar of Companies with the constitution of the company, which contains the internal rules of the company; namely the articles of association and any objects clause limiting the power the company may have, a memorandum of association including an application for registration containing the company name, its share capital, whether it is a private or public company, that the liability of its members is limited, a statement of the company’s directors’ names and addresses and finally a statement of compliance with the Companies Act 2006. Lastly, the purpose of registering these documents is to provide certain key information that could be accessed by the general public or government agencies if necessary.15 Furthermore, there are two types of limited companies; namely companies limited by shares and companies limited by guarantee. A company may be limited by share or by guarantee by an appropriate limiting provision in the company’s constitution16. Where there is no such limiting provision on the liability of the company’s member, a company is an ‘unlimited company’17. In the former, the liability of shareholders is limited to the amount of contributions to the capital, which is represented by shares18. Moreover, a member is not liable for the company’s debts beyond the amount remaining unpaid on his or her shares19. In a company limited by guarantee the liability of its members is limited to the amount of their guarantee, therefore a member is only liable to make a contribution to the assets of the company in the event of its being wound up, and the amount of this contribution is fixed at the outset by the company’s constitution20. Additionally, this type of company does not have a share capital or shareholders and is used mainly for non-profit-making purposes such as charities, clubs and associations21. Furthermore, under section 4 of the CA 2006, there is a distinction between ‘private’ and ‘public’ companies. A private company is a company whose ownership is private and a public company which is permitted to offer its shares to the public so only a company limited by shares may be a public company22. The main difference between private and public companies is that, the investment in private companies is largely provided by the founding members either through their personal savings or from bank loans23. Each type of corporate body regulated by the CA requires incorporation and reinforces the distinction between incorporation and limited liability. In order to incorporate a company under the CA24, two essential conditions are necessary: the memorandum and the article of association25. The memorandum is a simple document providing certain basic information and key declarations to the public. The company’s constitution or articles of association are a set of rules governing the running of the company. They form the core of the organizational structure of the company-the board of directors and the general meeting-and generally allocate the powers of each organ26. To this end, Hicks comments that “a certificate of incorporation is issued as the ‘birth’ certificate of the company, showing the date of incorporation, the company name and registered number”.27 The effects of incorporation are formed according to the provision of CA 2006 s 16, including that the body corporate is capable of exercising all the functions of an incorporated company28. Once more, the certificate of incorporation is conclusive evidence that the requirements of the Act have been complied with and that the company is duly registered29. Therefore, it is the process of incorporation as a limited company that results in the consequence of separate legal personality of the company and the limited liability.30 This in turn highlights the fundamental point regarding the interrelationship between incorporation and limited liability. The process of incorporation does not lead to automatic limited liability; it is the incorporation of a company as a limited liability company and compliance with the formalities pertaining to incorporation which enables limited liability. Additionally, as highlighted by the case law where courts pierce the corporate veil; the sole fact of incorporation will not protect against abuse of the limited liability principle31. This is further highlighted if we consider the judicial approach to limited liability in practice. For example, incorporation confers status on a company as a legal person plays a major role to the whole structure of company law32. The consequence of separate legal personality means that a company can guarantees its own property, can directly enter into contracts with third parties, and create legitimate responsibilities to its members.33 In turn, this leads to the consequence that the company’s business assets and liabilities are separate from that of the company’s members and directors. It is this separate legal status that increases the attractiveness of companies as “commercial vehicles”. The fundamental principle that a company is a separate legal identity is well established from the Salomon case.34 The assets of the company do not belong to its members but merely to the company as a ‘person’ as it mentioned above. To this end, it is essential to refer to Macaura v Northern Assurance Co case.35 In that case, the property of the company belonged to the company and not to its members. Lord Sumner held that “he owned almost all the shares in the company and the company owed him a good deal of money but, neither as creditor nor as shareholder, could he insure the company’s assets36”. Similarly in JJ Harrison Ltd v Harrison case37, the court stated that “there is no rule of company law which constitutes a company the trustee of its property and its members or shareholders as beneficiaries of that trust”38. Therefore, incorporation enables the creation of the vehicle through which the company is conferred separate legal status and the principle of limited liability operates. However, as highlighted above the very fact of incorporation will not prevent courts looking behind the corporate veil. For example, the character of the principle of identification and the difference between this principle and the doctrine of vicarious liability was illustrated in Tesco Supermarkets Ltd v Nattrass39 case by Lord Reid who held that: “a corporation must act through living persons.... Then the person who acts ... is acting as the company and his mind which directs his acts is the mind of the company....if it is a guilty mind then that guilt is the guilt of the company40”. Moreover, in the case of H.L. Bolton Co Ltd v T.J. Graham and sons Ltd case41 Denning L.J. asserted that: “A company may in many ways be linked to a human body. It has a brain and nerve which controls what it does....some of the people in the company are mere servants and agents....others are directors and managers.... The state of mind of these managers is the state of mind of the company and is treated by the law as such42.” Furthermore, members of a limited liability cannot find an asylum behind the corporation if their behaviour is not the appropriate. 43 Therefore, it the judicial approach to determining the corporate mind in liability cases also highlights the distinction between the legal formalities of incorporation and the legal principle of limited liability. This is reinforced by the judicial approach to piercing the corporate veil, which considers whether there has been fraud or a sham transaction44. On the other side of the spectrum the misconceptions surrounding the distinction between incorporation and limited liability have resulted in a presumption in favour of incorporation as a limited liability when setting up businesses45. In particular, Hicks highlights the point that small businesses are often attracted by the limited liability principle, which is often the main trigger for incorporation without considering the other legal consequences of incorporation46. As a result, Hicks highlights that often businesses focus on the limited liability angle when considering trading as a company without considering all of the potential ramifications of incorporation as a limited liability company47. This is further reinforced if we compare the legal position for limited liability companies and limited liability partnerships. For example, setting up as a limited liability company can have numerous advantages, with the main reason being limited liability, whereby any liabilities are in the name of the company and not individual shareholders or directors48. Additionally, the tax rates and reliefs are more favourable. Nevertheless, there are numerous administrative requirements in order to commence trading and companies are subject to strict financial reporting requirements, which can be cumbersome. Alternatively, limited liability partnerships under the Limited Liability Partnerships Act 2000 (LLPA) has certain similarities to limited companies and section 1(2) of the LLPA states that an LLP is a separate corporate entity with legal personality separate to its members. Accordingly, the distinct advantage compared to a general partnership is that an LLP can hold land and other assets in its own name, enter into contracts with its own name and goes further in protecting partners from wrongful acts of other partners49. However, in contrast to a limited liability company, as an LLP does not have any share capital, it is not bound by the rules on capital management and in the event of insolvency all assets and funds will be used to repay creditors50. Additionally, tax treatment under an LLP is similar to that of a general partnership and members are taxed individually with no imposition of corporation tax.51 Additionally, there is no requirement for annual meetings and there is greater flexibility on internal governance and member’s agreements can override the default provisions in the Limited Liability Partnership Regulations 2001 (the Regulations)52. Accordingly, the inherent advantage is that LLPs grant wide scope for a partnership to define its own rules on management and relationship between its members, which contrasts with the detailed requirements of limited companies as a result of incorporation.53 This in turn correlates to Hicks’ point that the many businesses starting out focus on the limited liability principle as a basis for incorporating as a company. However this ignores the other consequences of incorporation, which can impact the interests of the business in the long term. Additionally, the comparative analysis of limited liability partnerships and limited liability companies highlights the pitfalls of failing to acknowledge the distinction between limited liability as a legal principle on the one hand, and the consequences of incorporation on the other; which are different depending on the trading medium chosen to be incorporated. Furthermore, the above analysis highlights that the principles of incorporation and limited liability are undoubtedly correlated however they are not the same. Incorporation refers to the formal process of creating a valid corporate body under UK law. Additionally, the process of incorporation applies to numerous corporate structures and the limited liability principle will only be applicable if a company is set up as a limited liability company. Finally, it is submitted that the process of incorporation as a limited liability company facilitates the consequence of limited liability, which again reinforces the distinction between the two principles. BIBLIOGRAPHY N. Bourne, Bourne on Company Law (Routledge, 5th Edition 2010) Dignam & J. Lowry, Company Law (6th edition Oxford University Press, 2010) J. Dine & C. Ervine, Company Law and Core Statutes 2010-2011, (Palgrave Macmillan, 2010). B. Hannigan, Company Law (2nd Edition, Oxford University Press, 2009). A Hicks & S. H. Goo, Cases and Materials on Company law (6th Edition, Oxford University Press, 2008) A Hicks, “Alternative Company Structures for the Small Business” (1995), ACCA Research Report Hodgson & Zabrosky, “LLPs in Great Britain. Consulting to Management”, (2002) Volume 13 Issue 2. G. Morse, Palmer’s Company Law: Annotated Guide to the Companies Act 2006, (Sweet & Maxwell, 2nd Revised Edition, 2009). C. Wild, Smith & Keenan’s Company Law, (14th revised edition Pearson Longman, 2009) Legislation Partnership Act 1890 Limited Liability Partnerships Act 2000 Limited Liability Partnership Regulations 2001 Companies Act 2006 All available at www.opsi.gov.uk accessed December 2010. Read More