Facts of the case :
Mr. Aron Salomon, originally a sole proprietor of a leather boot and shoe business, transformed his venture into a limited liability company to involve his sons as business partners. The newly formed company purchased Salomon’s business at an inflated price, with his wife and five elder children becoming subscribers, and his two sons taking up director roles. Salomon himself took 20,001 of the company’s 20,007 shares, as payment from A. Salomon & Co. Limited for his old business (each share valued at £1). The business transfer occurred on June 1, 1892, and the company also issued Salomon £10,000 in debentures, using which Salomon secured a £5,000 advance from Edmund Broderip.
Shortly after incorporation, the business experienced a decline in boot sales and eventually failed, leading to a default on debenture interest payments, half of which were held by Broderip. Broderip sued to enforce his security, and the company went into liquidation. After Broderip was repaid his £5,000, £1,055 remained in company assets, which Salomon claimed under his retained debentures. If successful, Salomon’s claim would leave nothing for the unsecured creditors.
Issues:
The liquidator, representing the company, counter-claimed, seeking to have the amounts paid to Salomon returned and his debentures cancelled. He argued that Salomon had breached his fiduciary duty to the newly formed company by selling his business at an inflated price. Additionally, he contended that the company’s formation was intended as a fraud against its potential unsecured creditors in the future.
Judgement of Trial Court:
In the initial ruling of Broderip v Salomon, Judge Vaughan Williams found Mr. Broderip’s claim to be valid, confirming that the 200 shares were fully paid. The judge stated that the company held a right of indemnity against Mr. Salomon, considering the signatories of the memorandum of incorporation as mere “dummies.” He asserted that the company was essentially an alias or agent of Mr. Salomon. Consequently, it was entitled to indemnity from Salomon, the principal. The liquidator amended the counterclaim, leading to an award for indemnity based on this agency argument.
Judgement of Court of Appeal:
The Court of Appeal confirmed Judge Vaughan Williams’ decision against Mr. Salomon, stating that he had abused the privileges of incorporating a limited liability company—privileges intended for “independent, not counterfeit shareholders with their own minds and will, not mere puppets.” Lindley LJ, an expert on partnership law, viewed the company as a trustee for Mr. Salomon, making him liable to indemnify the company’s debts.
The incorporation of the company itself was undisputed under section 18 of the Companies Act 1862. Lindley LJ suggested that the company, though recognized as a corporation, was created for an illegitimate purpose. Despite having seven members, six holding only one £1 share each, the company was essentially controlled by Salomon, who used it to shield himself from liability. This perspective was consistent with previous case law, such as In re George Newman & Co.
While legally the business might be regarded as the company’s, any reasonable person would see it as Aron Salomon’s, who benefitted from it. Although the creditors could only pursue Salomon through the company, his liability arose from forming the company to achieve a legally prohibited outcome, not just from owning nearly all the shares.
Lopes LJ and Kay LJ described the company as a myth and a fiction, a scheme by Salomon to continue his business with limited liability while evading debts. They emphasized that such abuses pervert the intended use of limited liability and harm honest creditors. The Court criticized the notion that creditors are protected by section 43 of the Companies Act 1862, noting that creditors rarely check mortgage registers before engaging with companies. They highlighted that until the law changes, such deceptive schemes should be defeated to protect the integrity of corporate laws.
Judgement of House of Lords:
The House of Lords unanimously overturned the decision, dismissing the agency arguments. They held that the Act did not specify whether the subscribers (shareholders) needed to be independent of the majority shareholder. The company was legally constituted, and it was not the judges’ role to impose additional limitations. Lord Halsbury LC stated that the statute did not dictate the extent of interest held by each of the seven shareholders or the influence one or the majority had over the others.
He emphasized that it was not within his rights to add or subtract from the statute’s requirements. A limited company was either a legal entity or it was not. If it was, the business belonged to the company and not to Salomon. It would be contradictory to claim that a company exists and does not exist simultaneously.
Lindley LJ acknowledged that the company had seven members but noted that six were essentially there to enable the seventh (Salomon) to conduct business with limited liability, which the Legislature did not intend. He questioned where this supposed intention was manifested in the statute and highlighted the difficulty of defining the exact intention imputed to the Legislature.
Lord Herschell highlighted the potential far-reaching implications of the Court of Appeal’s logic, noting that many companies had been formed with some shareholders being “disinterested persons” who had no influence over the company’s management. Anyone dealing with such a company could consult the shareholder register to understand the distribution of shares.
Lord Macnaghten questioned what was wrong with Mr. Salomon taking advantage of the statute’s provisions, as he was perfectly entitled to do. He asserted that it wasn’t the role of judges to impose their personal views on statutory limitations. Referring to a similar precedent overturned by the House of Lords in In Re Baglan Hall Colliery Co., he explained that once a memorandum is duly signed and registered, even with just seven shares, the subscribers form a corporate body capable of exercising all functions of an incorporated company. The company, thus created, does not lose its individuality even if one person holds the majority of its capital.
According to Lord Macnaghten, the company at law is a distinct entity from its subscribers. Even if the business remains the same post-incorporation, and the same individuals manage it and receive profits, the company is not the subscribers’ agent or trustee. Subscribers’ liability is limited to the extent provided by the Act.
He pointed out that the primary reasons people form private companies, such as avoiding bankruptcy risks and facilitating borrowing, are legitimate. A company member, acting in good faith, is entitled to hold debentures like any outside creditor.
If the Court of Appeal implied that Mr. Salomon acted fraudulently, Macnaghten saw no evidence to support such a claim. Salomon’s actions were lawful, and his £5,000 raised for the company on debentures showed good faith and confidence. Unsecured creditors trusted the company, knowing they were no longer dealing with an individual. The law allowing floating charges, although controversial, was necessary.
Lord Macnaghten dismissed the term “one-man companies” as misleading, stating that a company controlled by one person but legally incorporated under the Act of 1862 was valid. He also dismissed the argument that the business transfer agreement should be invalidated due to no independent board of directors and overvaluation, noting the directors were authorized by the memorandum of association and there was no fraud or deception.
Reforms after the case:
In response to the decision, the Preferential Payments in Bankruptcy Amendment Act 1897 was enacted. This law ensured that certain classes of preferred creditors would have priority over secured creditors under a floating charge. However, the act’s effectiveness was limited because a floating charge typically crystallizes into a fixed charge before enforcement. It wasn’t until the Insolvency Act 1986 that this provision was modified. The 1986 Act stipulated that a floating charge would include any charge initially created as a floating charge, regardless of subsequent crystallization, thereby giving preferred creditors priority over floating charge holders.
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