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SAME BUT DIFFERENT

 

Chee Kheong revisits the landmark case of Salomon v Salomon

The appellant, Aron Salomon, had successfully carried on business as a leather merchant and boot manufacturer for more than 30 years. Sometime in 1892, the appellant formed A. Salomon and Company, Limited, the respondent, under the Companies Act 1862 ("Act").

To comply with the Act which required a company to be incorporated with at least seven shareholders, the appellant and six members of his family each subscribed for one share of £1 each in the respondent.

The respondent acquired the appellant's business from 1 June 1892 and issued to the appellant 20,000 shares of £1 each and £10,000 of debentures, the latter of which were secured against the assets of the respondent. The appellant obtained a £5,000 loan from a certain Mr Broderdip. The loan was secured against the debentures issued by the respondent.

The respondent encountered financial difficulties and defaulted in paying interest on the debentures. On 11 October 1893, Mr Broderdip commenced proceedings to enforce his security under the debentures against the assets of the respondent. Shortly thereafter, a winding up order was issued against the respondent on 26 October 1893 upon the application of its unsecured creditors.

The liquidator of the respondent sought, inter alia, to set aside the issue of the debentures and an indemnity from the appellant for the business liabilities of the respondent.

THE DECISION OF THE HIGH COURT

The High Court held that the respondent was merely a nominee for the appellant and was therefore entitled to be indemnified against its business liabilities by the appellant who was its principal. The court came to this decision notwithstanding that all the shares held by the appellant in the respondent were fully paid.

THE DECISION OF THE COURT OF APPEAL

The appellant's appeal to the Court of Appeal was dismissed.

According to Lindley LJ, the Act was intended to encourage trade by enabling a small number of persons, namely not less than seven, to carry on business with limited liability. It was not the legislature's intention to extend the principle of limited liability to sole traders or to a number fewer than seven persons.

The court held that it was manifest that the six shareholders who held one share each had practically no interest in the respondent and their names had been used by the appellant to enable him to form a company and screen himself from liability.

The learned judge was of the view that in this case, there was no doubt that an attempt had been made to use the machinery of the Act for a purpose for which it was never intended. His Lordship held that the formation of the respondent and the issue of debentures which enabled the appellant to obtain priority over the other creditors of the respondent were devices by the appellant to defraud creditors.

THE DECISION OF THE HOUSE OF LORDS

On further appeal, the House of Lords by a unanimous decision of six judges, allowed the appellant's appeal.

The Lordships proceeded to examine the effects of sections 6 and 8 of the Act. The former provided, inter alia, that any seven or more persons, associated for a lawful purpose, may form a company with limited liability by subscribing to the memorandum of association and complying with the other requirements of the Act, whilst the latter stipulated, inter alia, that no subscriber shall take less than one share.

According to their Lordships, section 6 did not prohibit the subscribers from being related to one another and section 8 made it clear that the holding of a single share was sufficient for a person to qualify as a shareholder. Their Lordships further stated that the Act did not, expressly or impliedly, impose any limit on the number of shares which a shareholder may subscribe for or take by allotment.

Their Lordships held that once a company has been legally incorporated, it had to be treated like any other independent person with rights and liabilities appropriate to itself.

According to Lord Macnaghten, when the memorandum of association is signed and registered, the subscribers become a body corporate which is capable forthwith of exercising all the functions of an incorporated company, even though only seven shares are taken.

His Lordship emphasised that a company is at law a different person altogether from the subscribers to the memorandum, and is not an agent of the subscribers or trustee for them, even though after incorporation, the business is precisely the same as it was before, and the same persons are managers, and the same persons receive the profits.

According to Lord Halsbury LC, the respondent was either a legal entity or it was not. If it was, the business belonged to it and not to the appellant. If it was not, there was nothing to be an agent of at all.

As it was not disputed by the parties that all the requirements of the Act in relation to the formation of the respondent had been complied with, the respondent could not be an agent of the appellant, but was a legal entity in its own right. Accordingly, the apex court held that the High Court had erred in its findings that the respondent was an agent of the appellant and that the latter was bound to indemnify the respondent.

With regards to the Court of Appeal's conclusion that the formation of the respondent and the issue of the debentures were schemes contrary to the true intent and meaning of the Act, Lord Herschell stated that there was no means of ascertaining the intent and meaning of the Act except by examining its provisions and finding what conditions had been imposed for trading with limited liability.

According to His Lordship, the Act required the memorandum to state the amount of the capital of the company and the number of shares into which it is to be divided and that no subscriber is to take less than one share. The shares may be of as small a nominal value as those who form the company determine: the statute prescribes no minimum; and although there must be seven shareholders, it is enough if each of them holds one share, however small its denomination. The legislature therefore, in His Lordship's opinion, clearly sanctions a scheme by which all the shares except six were owned by a single individual.

Lord Halsbury LC further opined that the motive of a person who becomes a shareholder or is made a shareholder was not a relevant consideration. The Lord Chancellor then ventured to opine per obiter dicta that even if six of the subscribers were trustees of the seventh, the statute would have made them all shareholders.

According to Lord Halsbury LC, the Court of Appeal judges had erred in that they "never allowed in their own minds the proposition that the company has a real existence. They had been struck by what they have considered the inexpediency of permitting one man to be in influence and authority (over) the whole company; and, assuming that such a thing could not have been intended by the Legislature, they sought various grounds upon which they might insert into the Act some prohibition of such a result."

His Lordship reiterated that if a company has been duly constituted by law, he could not insert into the Act limitations that were not found in the Act, regardless of the motives of the persons who constituted a company.

The contention that the issue of debentures was part of a scheme to defraud the creditors was rejected by Lord Herschell. Although His Lordship acknowledged that the issue of debentures to the vendor of a business as part of the purchase price may be subject to abuse, the learned judge held that there was nothing in the law which rendered the creation of the debentures unlawful.

For the reasons set out above, their Lordships ordered the decision of the Court of Appeal to be reversed.

CONCLUSION

In coming to their decision in Salomon v Salomon, the learned judges in the House of Lords adopted a literal interpretation of the relevant provisions of the Act. The case firmly establishes that a company is a separate legal entity from its shareholders and that a shareholder is not liable for the debts of the company except to the extent provided in the Act, that is, where a shareholder knowingly allows a company to continue trading for more than six months after the number of shareholders have been reduced below the minimum number prescribed by the Act, or in the case of a winding up of the company, where a shareholder is liable to the extent of the amount of capital which remains unpaid on the shares taken up by that shareholder.

Although the courts have declined to follow the House of Lords' decision in Salomon v Salomon in instances where a company has been used for an illegal or improper purpose, such instances are the exception rather than the rule. This decision remains a cornerstone of company law in common law jurisdictions to this day.

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