Legal Building Blocks: Salomon v Salomon- the case which built the modern world
Most academics agree that the foundations of company law were set out in the seminal case of Salomon v Salomon. This case impacts every single person in the modern world, yet only company law lawyers seem to know of it. In this article, we will explain why this case represents the foundation of our corporate-dominated society.
Mr Salomon was a business owner in the late 19th Century in London. He decided to incorporate a company with the name of Salomon Ltd. He went through the right procedure and satisfied all the required formalities for the incorporation. The law at the time required that a company must have 7 shareholders, so he issued 1 share to each of his 6 children and kept 20,000 shares for himself. The company was then incorporated with Mr Salomon as its director, as well as its majority shareholder. The act of incorporation created, in the eyes of the law, a new legal personality, separate to that of its directors or its shareholders. As Mr Salomon was a different person to Salomon Ltd, he was able to sell his pre-existing business to the new company and, in doing so, he also became a secured creditor of it.
As is often for many court cases, things did not go as planned for Mr Salomon. Business dried up and, as a result of the company’s financial issues, Salomon Ltd declared bankruptcy. To the dismay of the company’s other creditors, Mr Salomon argued he had priority as regards repayment of his debt to the company. This was due to the fact that Mr Salomon was a secure creditor and, thus, the company had to prioritise the repayment of his debts.
The other creditors of Salomon Ltd argued that the principle of separate legal personality should not be applied in cases in which a sole trader takes advantage of the company form to avoid liability. They claimed that applying the principle of separate legal personality here would result in an injustice. Through his position as the director and the majority shareholder of the company, Mr Salomon was essentially controlling the company by himself; a company in which he was the secured creditor with the highest priority.
The judges disagreed with the arguments of the company’s other creditors. The court ruled that the principles of separate legal personality and limited liability should not be disregarded if the necessary formalities for the company’s incorporation were met. As Salomon Ltd had been validly incorporated, the effects of the incorporation could not be ignored merely due to the fact that Mr Salomon had used the company form to his advantage. It was for this reason, after all, that companies were invented; to allow businesspeople to expand their businesses and take more risks without the fear of being personally liable if the business fails.
Mr Salomon could and did perform multiple roles simultaneously, one of which was that of a secured creditor. His legal right as a secured creditor could not be ignored just because he also held the position of a shareholder and director of Salomon Ltd. Mr Salomon and the company Salomon Ltd were, in the eyes of the law, two separate and distinct legal entities and Mr Salomon’s almost total control of the company did not alter this. The court concluded that the effect of incorporation could not be disregarded merely because it would seem just for the other creditors.
The separate legal personality principle has led to both positive and negative consequences. A risk created by this principle was illustrated in the Salomon case. It clearly clarified that the principle of separate legal personality of a company will be upheld, even in instances where an individual exerts obvious control over a company and simply uses the company form to limit his liability, to the detriment of the company’s creditors who can’t sue that individual for the company’s debts.
More pertinently, this principle enabled the creation of corporate groups, where each company in the group is understood as a distinct entity despite the fact that their control and beneficial ownership rested with the same people. Such groups are often used for tax avoidance. The parent company can be incorporated in a tax haven, whilst subsidiaries operate in other countries. The subsidiaries can avoid taxation in their local jurisdiction by paying the parent company various fees and royalties to artificially reduce their profitability. Thus, profits are artificially transferred to the parent company, which benefits from lower taxer due to the favourable tax regiment in its jurisdiction. This keeps the tax liability for the whole group to a minimum, to the detriment of the ordinary taxpayer who pays more to make up the shortfall.
The separate legal personality principle also allows companies belonging to the same group to engage in complex asset transfers between them that facilitate and enable money laundering, criminal acts, and corruption. Assets representing the proceeds of crime are constantly transferred between companies with separate legal personalities until the origin of those assets is concealed alongside the legitimate activities of the companies in the chain.
Despite these negative consequences, the principle of the Salomon case has produced some very significant positive effects. The judgment incentivised investment in companies, as it reduced the risks to individual shareholder by reaffirming that they would not be held personally liable for the debts of their companies. This enabled the creation of large companies, as more people could now invest in a company, even if they had little control over it, as they would incur no additional liability as a result of the company’s activities. These large companies enjoyed more funding and could utilise economies of scale to grow further and increase their offering, enabling the creation of the mega-corporations we are now so accustomed to seeing.
By reaffirming the separate legal personality principle, the case incentivised entrepreneurship. Corporations embarked on new and risky endeavours with minimal risks by incorporating subsidiaries. If the subsidiary defaulted, the rest of the corporate group would not be held liable. The principle allowed corporations to adopt risky strategies and limit their own exposure, whilst also encouraging investment in the uncertain research and development programmes that have brought about most of the technologies around us.
The Salomon case is of undoubted significance. Its main principle, that of the separate legal personality of a company, precipitated in the widespread adoption of the company form. Despite the criticisms of the current application of the separate legal personality principle, completely disregarding this principle is unwanted and unwarranted, as it would create chaos and disorder. The use of the company form has been extensive to the degree that corporations are essential to modern economies. Disregarding the separate legal personality of a company would increase risks for entrepreneurs and would discourage investing. Yet, the problems it has generated must be acknowledged and some amendments to the current robustness of the principle might be required. Public discontent with the current obvious exploitation of the company form is on the rise and one must ask, what will a potential amendment to this principle look like?