A Two-Edged Sword: Salomon and the

Separate Legal Entity Doctrine

Introduction
1. The decision of the House of Lords in Salomon v Salomon & Co Ltd [1]
evinces the accuracy of Gooley's observation that the searate le!al entity
doctrine "as a #t"o$ed!ed s"ord#.[%] &t a !eneral level' it "as a !ood decision.
(y establishin! that cororations are searate le!al entities' Salomon's case
endo"ed the comany "ith all the re)uisite attributes "ith "hich to become the
o"erhouse of caitalism. &t a articular level' ho"ever' it "as a bad decision.
(y e*tendin! the benefits of incororation to small rivate enterrises' Salomon's
case has romoted fraud and the evasion of le!al obli!ations. +onetheless' this
article "ill ar!ue that the overall balance is ositive.
Salomon v Salomon
%. &t its most !eneral level' the decision of the House of Lords in Salomon v
Salomon & Co Ltd "as a !ood decision. Salomon's case is universally reco!nised
as authority for the rincile that a cororation is a searate le!al entity.[,]
,. The case firmly established that uon incororation' a ne" and searate artificial
entity comes into e*istence. &t la"' a cororation is a distinct erson "ith its o"n
ersonality searate from and indeendent of the ersons "ho formed it' "ho
invest money in it' and "ho direct and mana!e its oerations.[-] .t follo"s that
the ri!hts and duties of a cororation are not the ri!hts and duties of its directors
or members "ho are' most of the time' obscured by a cororate veil surroundin!
the comany.[/]
-. The reco!nition that a cororation is a searate le!al entity in its o"n ri!ht is the
foundation of modern cororate la"0 1acLaine 2atson & Co Ltd v 3eartment
of Trade and .ndustry.[4] .ndeed #[e]very system of la" that has attained a certain
de!ree of maturity seems comelled by the ever increasin! comle*ity of human
affairs to create ersons "ho are not men...#.[5] Consistent "ith this observation'
&rnold states that #[o]ne of the essential and central notions "hich !ive our
industrial feudalism lo!ical symmetry is the ersonification of !reat industrial
enterrise.#[6]
/. Suort for the rincile of the searateness of le!al ersonality' shared amon!st
academic commentators' has been unbro7en in le!islative and 8udicial circles.
+otably' this rincile is enshrined in section 1%- of the Cororations &ct.
Similarly' the 8udiciary has' "ith minor e*cetions' consistently reaffirmed the
need to treat this le!al doctrine seriously.[9] Subse)uent :n!lish and &ustralian
8udicial decisions have uheld the Salomon rincile.[1;] .n other "ords' since
the decision in Salomon's case' the comlete searation of the comany and its
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members has never been doubted.[11] The rulin! has' "ith fe" e*cetions' stood
the test of time.[1%] (ut' "hy<
4. =rom a theoretical ersective' the ans"er is strai!htfor"ard. &ll theories of the
cororate entity a!ree on the ractical need for the artificial ersonality "ith
"hich the le!al system invests cororations. Concession theorists' for e*amle'
re!ard cororate ersonality as a rivile!e !ranted by the state #for le!al and
business convenience#.[1,] Similarly' the contractarian school ar!ues that
#[c]ororation la" reduces transaction costs by imlyin! in every cororate
charter the normal ri!hts on "hich shareholders could be e*ected to insist#' such
as searate le!al status.[1-] This rincile' the essence of cororate la"' is said to
oerate as a default rovision that facilitates cororate activity.[1/] .n many "ays'
this is the vie" ta7en by a!!re!ate theorists "ho raise the role of the Salomon
rincile in assistin! the formation of contractual relationshis that constitute the
bac7bone of voluntary a!!re!ations of individuals that the la" other"ise
identifies as cororations.[14] +atural entity theorists' claims are not much
different0 advocates e*lain that the searate le!al entity rincile is imortant in
!ivin! le!al effect to the natural fact that the cororation' as a conse)uence of
human interaction and initiative' has its o"n "ill and caacity for action.[15]
There "ould then aear to be theoretical unanimity on the ractical need for the
rincile that a cororation is a le!al entity entirely searate from its members. &t
issue' ho"ever' is "hat this entails and "hy the Salomon rincile has roven so
robust.
5. =rom a ractical ersective' the ans"er to the )uestion above demands a close
attention to detail. The searate le!al ersonality of a cororation is often the
reason "hy a cororation has been favoured for the conduct of commercial
enterrise or social or!anisation.[16] .t is ar!ued that0
Comanies "ill be desirable or necessary "hen the arran!ements that are
to ivot on them are not conveniently or realistically to be erected directly
around individual human bein!s... The individual human bein! is fic7le'
short$lived' and difficult to or!anise into lar!er$scale economic and
olitical associations on a ermanent basis.[19]
6. Thus' many commercial enterrises must be o"ned and mana!ed by a body
cororate rather than by its human o"ners directly' in erson.[%;] This is ossibly
due to the reco!nition in Salomon's case that incororation achieves the
interosition of a le!al erson bet"een the natural ersons "ho o"n and control
it' and the business activity to be underta7en.[%1] .n essence' a cororation is #...
an artificial erson comosed of natural ersons#.[%%] (ein! a le!al artifice'
ho"ever' the comany is metahysical in form rather than hysical.[%,] &ny
difficulties this imlies are overcome by virtue of subsection 1%->1? of the
Cororations &ct "hich states that a cororation has the le!al caacity of a
natural erson.
9. .n line "ith the decision in Salomon's case' a re!istered comany #is caable of
erformin! all the functions of a body cororate# >see subsection 1%->1??. .n other
"ords' the cororation is a le!al entity distinct from its members. This is the
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fundamental attribute of cororate ersonality' from "hich all the other ractical
conse)uences flo".[%-]
1;. =irst' as a searate le!al erson' a re!istered comany is caable of suin! and
bein! sued0 =oss v Harbottle.[%/] Second' a cororation has eretual succession0
@e!al >Hastin!s? Ltd v Gulliver.[%4] Third' a cororation can enter into contracts
in its o"n name. =ourth' a cororation has o"er to ac)uire' hold and disose of
roerty0 1acaura v +orthern &ssurance Co Ltd. Ho"ever' this statutory list of
attributes is not e*haustive. There are others.[%5]
11. & cororation' for e*amle' can contract "ith its controllin! member >Lee v Lee's
&ir =armin! Ltd? and can be the debtor' creditor or surety of a member
>Salomon's case?. Similarly' shares are transferable and transmissible. Li7e"ise'
cororations benefit from ta* minimisin! throu!h income slittin! >encoura!ed
by dividend imutation?0 Hobart (rid!e Co Ltd v =CT.[%6] 1oreover' a
cororation can enter into fle*ible financin! arran!ements by creatin! a floatin!
char!e. =inally' and #althou!h it is not erhas a lo!ically necessary attribute of
searate le!al ersonality in modern la"#'[%9] the liability of a limited comany
is limited0 Salomon's case. & comany is e*clusively liable for obli!ations
incurred on its behalf. Commercial enterrises "ith limited liability characterise
almost all develoed le!al systems.[,;]
[S]ome form of limited liability is essential if the maintenance and
continuation of the system of rivate enterrise as is ractised in advanced
industrial caitalist societies is to continue.[,1]
1%. @elyin! on :asterbroo7 and =ischel' =arrar oints out0
Limited liability ar!uably reduces the costs involved in the searation of
o"nershi and control... =irst' limited liability reduces the need to monitor
mana!ement and other shareholders. Secondly' limited liability and free
transfer of shares "ith "hich it is ar!uably lin7ed facilitate the mar7et for
control. This acts as an incentive to mana!ement to erform efficiently.
Thirdly' limited liability' in addin! to the mar7etability of shares imroves
the information fed to the mar7et lace by the increased volume of
transactions. =ourthly' limited liability allo"s shareholders to diversify
their holdin!s. =ifthly' it facilitates otimal investment decisions since a
ositive attitude to ris7 ta7in! "ill ensue.[,%]
Discussion
1,. The Salomon rincile has stood the test of time because it has meant that
cororations do have ractical utility. &s a searate le!al entity sub8ect to limited
liability and defined by share transferability' eretual e*istence' fle*ible
financin! methods' secialised mana!ement' ma8ority rule [,,] and the other
attributes or conse)uences of incororation' the cororation has many
economically and socially beneficial functions.[,-]
,
1-. Arimarily' a cororation enables the investin! ublic to share in the rofits of an
enterrise "ithout bein! involved in mana!ement. .t also enables a sin!le trader
or a small artnershi to carry on a business. Similarly' a cororation rovides a
structure for 8oint ventureB holdin! family assetsB continuin! trusteeshiB fund
mana!ementB cororatised !overnment enterriseB and' the co$en8oyment of
roerty. 1arshallin! articiants in lar!e commercial enterrises and actin! as a
nominee to hold the le!al title to assets are t"o other imortant functions.
1/. &t its most articular level' ho"ever' the decision of the House of Lords in
Salomon v Salomon & Co Ltd "as not a !ood decision. Arofessor Cahn$=reund
"ent so far as to describe it as #calamitous#.[,/] Salomon's case established the
indeendent cororate e*istence of a re!istered comany' a rincile of the
!reatest imortance in comany la".[,4] (ut if alied infle*ibly' as "as the case
in Salomon' it can shield arties unreasonably' to the detriment of ersons dealin!
"ith comanies.[,5]
Cororate ersonality is essentially a metahorical use of lan!ua!e
clothin! the formal !rou "ith a sin!le le!al identity by analo!y "ith a
natural erson... [(ut] &s CardoDo E said in the &merican case of (er7ey v
Third &venue @ly [>19%4? %-- +F 6- at 9-$/]0 #metahors in la" are to
be narro"ly "atched' for startin! as devices to liberate thou!ht' they often
end by enslavin! it.#[,6]
14. .n stressin! the indeendent nature of cororate ersonality' the House of Lords
le!itimised the usa!e of the cororate form by individual traders and small
artnershis0 rivate enterrises "hich do not see7 to raise caital from the ublic
but are an*ious to interose an entity bet"een themselves and their creditors.[,9]
The La" Lords concluded that once re!istered in a manner re)uired by the &ct' a
comany forms a ne" le!al entity searate from the shareholders' even "here
there is only a bare comliance "ith the rovisions of the &ct and "here all' or
nearly all' of the comany's issued shares are held by one erson.[-;]
=urthermore' the Court held that it "as ossible for traders not merely to limit
their liability to the caital "hich they invested in the enterrise but even to elude
any serious ris7 to the ma8or art of that by subscribin! for debentures rather than
shares.[-1]
15. &s noted in The La" Guarterly @evie"' Salomon's case "as not about #a dry
oint of construction#.[-%] The House of Lords had sanctioned a chan!e in ideas
about "hat the comany "as and about the uses to "hich it could be ut.[-,] .t
!ave riority to the searate identity of the le!al form and essentially i!nored the
economic reality of a one$erson comany.[--] (asically' Gouldin! e*lains' the
reason for criticism of Salomon's case is t"o$fold.[-/] =irst' the decision !ives
even aarently honest incororators the benefit of limited liability in
circumstances in "hich it is not necessary in order to encoura!e them to initiate or
carry on their trade or business. Second' the oortunities that the decision affords
to unscruulous romoters of rivate comanies to abuse the advanta!es that the
Cororations &ct !ives them by achievin! a #"afer$thin# incororation of an
undercaitalised comany.
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16. =irst' limited liability attracts small traders to the cororate form not because it
reresents an effective device "ith "hich to raise caital' but because it !ives
them access to an avenue via "hich to escae the #tyranny of unlimited liability#.
[-4] Criticisms of limited liability are addressed at its imact on creditors and on
society at lar!e.[-5]
19. The rincile is that a limited comany's creditors must loo7 at the caital' the
limited fund' and that only. Limited liability discoura!es shareholders from
monitorin! and controllin! their comany's commercial ventures. The comany's
creditors bear the burden of the ris7s inherent in dealin! "ith limited liability
comanies. &t issue is "hether it is ri!ht that limited liability should oerate to
restrict the siDe of the comany's caital. 3ifferent tyes of creditors have
different caacities to rotect themselves a!ainst these ris7s. 2hile ban7s and
similar financial creditors easily overcome such ris7s' the same cannot be said of
trade creditors' emloyees and tort creditors. (ecause trade creditors rarely insist
on security before they suly !oods on credit' they bear a considerable art of
the ris7 of cororate insolvency. :mloyees are in an even more recarious
osition. .n star7 contrast to finance and trade creditors' emloyees have no
oortunity to obtain security or diversify the ris7 of their cororate emloyer's
insolvency. 1oreover' the ma8ority of emloyees has minimal information about
their emloyer's financial standin! >but see the Cororations &ct?. 2hile contract
creditors bear a de!ree of ris7 "hen they deal "ith a limited liability comany'
they at least enter into the contract by their o"n "ill. This is not so for a
comany's tort creditors. Hictims of torts committed by a comany bear an
uncomensated ris7 in case of the comany's insolvency.
%;. =rom a more technical ersective' the economic benefits brou!ht about by
limited liability are absent "ith resect to closely held or rivate comanies. The
reduction in monitorin! costs' for e*amle' is irrelevant because o"ners and
mana!ers are one and the same. 1oreover' the benefit of fosterin! an efficient
mar7et for shares throu!h limited liability does not aly as there is no mar7et for
the shares of closely held comanies. =urthermore' limited liability encoura!es
such comanies to ta7e e*cessive ris7s because the directors of closely held
comanies have more to !ain ersonally by shiftin! the ris7 of commercial
collase to cororate creditors than is the case "ith ublic comanies' directors.
%1. Second' ever since the House of Lords handed do"n its decision in Salomon's
case' le!al doctrine re!ards each cororation as a searate le!al entity. 2hen
couled "ith the conse)uent attribute of limited liability' the Salomon rincile
rovides an ideal vehicle for fraud.[-6] (ecause of its malleability and facility for
rotectin! directors and members a!ainst the claims of creditors' the cororate
form has been resonsible for the develoment of many different forms of
fraudulent or anti$social activity. =raud' in this conte*t' cannot be recisely
defined' but t"o tan!ible illustrations may elucidate the concet.
%%. 2hat is collo)uially 7no"n as the #I% comany# is one notable e*amle of
cororate fraud.[-9] This involves the situation "here a small !rou of ersons
set u a limited liability comany that is undercaitalised. The o"ners then cause
the cororation to incur lar!e debts in its o"n name' "ith little rosect of bein!
able to reay the loans. 2hen the comany's creditors see7 reayment of the
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debts' the o"ners ar!ue that because the comany as a searate le!al erson o"es
the debt' then neither the directors nor the members are liable.
%,. &nother instance of cororate fraud involves #bottom of the harbour# schemes.
[/;] Here' all of the assets of one cororation that is about to incur a lar!e income
ta* liability are transferred to a ne" cororation incororated for this urose.
This transfer is channelled throu!h a confusin! series of transactions involvin!
other cororations and overseas cororate havens in an attemt to conceal the real
desi!n of the scheme. The ori!inal cororation mi!ht also chan!e its name and
address' and create false documentation so as to defeat the efforts of re!ulatory
investi!ators. .f investi!ators trace this shell of a cororation' they often find that
stra" men have been aointed in lace of the ori!inal directors. The ne"
cororation' no" asset rich' is oerated merely to fund further schemes for the
eole "ho have formed it' includin! activities as varied as the !rantin! of
unsecured interest$free loans by the cororation to the directors or to comanies in
"hich they have an interestB the use of cororate caital for the ersonal livin!
e*enses of directors or ma8or shareholdersB the ayment of astronomical fees and
other ayments for mana!ement servicesB and' further ta* minimisation by
methods such as unrealistic asset valuations. Jften' such schemes involve
undercaitalised cororations carryin! on a business as trustee for other ersons
as beneficiaries. (y combinin! the cororate form "ith the malleability of the
trust structure' creditors mi!ht be 7et at even !reater distance from those "ho
mana!e the enterrise.
Conclusion
%-. The )uestion of "hether the ne!ative asects of the decision in Salomon's case
out"ei!h the !ood ones is best left unans"ered for it is far too broad. Jne is
inclined to"ards the vie" that the rincile of searate le!al entity established in
Salomon's case has been instrumental in the develoment of modern caitalism
and the immense social and economic "ealth "hich it has !enerated. The House
of Lords e*tended the rincile so far as to cover small rivate enterrises. This
move has had several ne!ative conse)uences over time. Ho"ever' it is also true
that these have been lar!ely neutralised by 8oint le!islative and 8udicial action.
%/. .ndeed' #the le!islature can for!e a sled!ehammer caable of crac7in! oen the
cororate shell.#[/1] &nd' even "ithout statutory assistance' the courts have often
been ready to dra" aside the veil and imose le!al liability on members and
directors "here to aly the Salomon rincile strictly "ould lead to in8ustice'
inconvenience or dama!e to !overnment finances.[/%]
%4. Similarly' it should be ointed out that' follo"in! Salomon's case' all &ustralian
8urisdictions' in a desire to ameliorate le!al facilities for small commercial
enterrises'[/,] introduced rovisions for rivate comanies into their cororate
la".[/-] :*erience since Salomon's case demonstrated that there "as no reason
"hy the benefit of limited liability should aly only to !rous of business
entrereneurs. The Cororations &ct ta7es this to its lo!ical conclusion and
sanctions the re!istration of one$erson comanies. .n 199/' the =irst Cororate
La" Simlification &ct amended the Cororations &ct to ermit a rorietary
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comany to be set u "ith one or more shareholders. Knder another amendment'
the minimum number of directors needed to be desi!nated in a rorietary
comany "as cut from t"o to one. 1oreover' the Cororations &ct states that any
sort of comany' not 8ust a rorietary comany' may be established "ith only
one member and may continue to e*ist "ith only one member >section 11-?. .t
"ould aear then that the overall balance is ositive and that the decision of the
House of Lords in Salomon v Salomon & Co Ltd "as a !ood decision.

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