Ajai, Sneha
Mid-Term Essay 2012 LSE ID: 201132532
Introductions
In Broderip v. Salomon1
, the Court of Appeal upheld the trial court judgment and supported the
interest of creditors on the grounds that Salomon had abused the Companies Act, 1862 for his
own benefit and for cheating honest creditors, but this was overruled by the House of Lords
where Lord McNaughton stated “Every member of the company.., is as much entitled to take and
hold the company’s debentures as any outside creditor”. This essay deals with the position of the
given scenario in the understanding of the relevant laws in the United Kingdom.
Limited liability sole purpose for incorporation
The principle of limited liability tends to unfairly shift the risk of business loss from a company’s
shareholders onto its creditors. The Salomon case has allowed shareholders to legitimately shield
themselves from extended damage. By such a decision, the creditors have to deal with a large
percentage of risks in dealing with the Company. One must however also consider how unless
such a concept of separate legal entity to support limited liability of shareholders was introduced;
the chances of persons, especially amateurs entering entrepreneurial activities would be
significantly lesser.
According to Salomon’s Case 2
the Company is a separate legal entity from its shareholders, but
when flexibly applied to cases where the law to be complied with has been open to wide
interpretation, it can shield shareholders unfairly, to the detriment of the creditors such as in the
DHN Food distributors case.3
By laying excessive reliance on the entity doctrine according to
Salomon’s case the moral obligations of the law to provide equal protection is lost. Shareholders
will see limited liability as a major purpose of incorporating a Company, thus throwing the big
picture of community, creditors, employees etc. out of focus.
Should minority shareholders be responsible for creditor indemnification?
In a large corporation there will be hundreds of shareholders some holding a top 20% of the
shares in the Corporation while others might hold less than 2% shares in the Corporation. All the
major decision making in the corporation will usually be done at the instance of the majority
shareholders such decisions will include inter alia the decision to avail debts. Since the minority
shareholders have no power in the day to day management of the company and usually merely
1
[1895] 2 Ch 323
2
[1897] AC 223
3
(1976) 1 WLR 852
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Ajai, Sneha
Mid-Term Essay 2012 LSE ID: 201132532
enjoy the dividends they receive it will not be equitable to impose a liability on the minority
shareholders for actions they were not privy to.
It would however be just to impose the liability to indemnify the creditors on the majority
shareholders or such persons who are in charge of the day to day affairs of the Corporation or
have decision making power in the Corporation. It has also been a practice in business to get a
personal guarantee from the directors or such shareholder at whose instance the debt is availed so
that the interest of the creditor is secured or some property movable or immovable including
shares of the Corporation are pledged by such director/shareholder at whose instance the debt is
availed. Unless otherwise agreed to by the director/shareholder’s and the corporation when
availing a debt, the liability of shareholders is usually in proportion to the number of shares held
by them
Can rationally apathetic shareholders who have no bearing in the management be asked to
repay debts to creditors?
Unless pro rata unlimited liability is applied, minority shareholders would be unduly affected by
such a scenario. The concept of shifting debt liability to creditors is usually to transfer it from the
shareholder to someone who is in a better position to repay the debt. This equation however also
involves involuntary creditors such as customers, small suppliers etc.
Weak position of tort creditors
The entity doctrine was meant to protect shareholders from corporate contract liability and
claims brought by voluntary creditors, but not from tort liability and involuntary creditors.
According to Mr. Warsch “Tort claimants’ ability to obtain compensation is constrained by a
multitude of factors: time, expense, informational asymmetries and the corporate form, itself,
among them.” For this reason, while shareholders personal assets at the least are protected,
creditors of these sorts have no such shielding.
Further, in the event of the Company being wound up, liquidated or being held insolvent, the
creditors have priority over the shareholders. However, if the debts exceed its remaining assets,
creditors with weak negotiating power will have face loss. For this reason, corporate debt is
never risk free because any company, no matter how successful it may appear to be, can fail to
repay its creditors. Therefore, the law should make way for shareholders to be held liable to
repay the debts in the creditors’ better interest, irrespective of whether they are majority or
minority shareholders
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Ajai, Sneha
Mid-Term Essay 2012 LSE ID: 201132532
Conclusion
In light of the aforementioned discussions, I would like to conclude on the grounds that, the law
in the United Kingdom, provides excess grounds of protection in the form of limited liability to
shareholders while involuntary creditors have little scope for protection. Though voluntary
creditors are in a position to regain the status quo after a crisis, those creditors who are not
spoken for must be given a fair chance at regaining their losses and shareholder liability to this
extent must be acknowledged by the law. The decision of the House of Lords in Salomon case
might have laid precedent and foundation to the law on a Corporation's separate legal entity, but,
is the said decision applicable in this 21st Century is a question worth pondering. The decision of
the Judges of the Court of appeal is proving true today. Corporations are being incorporated as a
gamble. If the business does well then the shareholders reap all the profits but if the business
turns out to be a failure then the shareholders usually the promoters in the company only stand to
lose their initial investment into the company, several others who impose their faith in the
shareholders and support the business by either providing debt or purchasing the goods or
availing the services of the business are at a loss as there is no mechanism to protect their
interest.
Also, by allowing a sole shareholder to hold debentures and have priority over other unsecured
creditors in the present scenario, the chances of misusing the flexible interpretation of the
doctrine and the relevant laws, becomes wider.
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