Advantages and Disadvantages of Incorporation of Companies

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This assignment will discuss the advantages and disadvantages of incorporation of companies. This will be discussed in relation to public and private companies and it will be concluded that the main advantageous of incorporation is and continues to be that of limited liability and separate legal personality. Other issues will discussed and the advantages and disadvantages discussed.

It is important first to point out the distinction between public and private companies, the former being those which are permitted to offer their securities to the public and the latter being those which are not so permitted. Often whether a company is public or private is taken more generally as an indication of the social and economic importance of the company, so that the public company is more tightly regulated than the private company in a number of ways, which fall outside the remit of this assignment. However, it is important to note that this difference does exist.

The fundamental attribute of corporate personality is that the corporation is a legal entity which is distinct from its members. At the end of the 19th Century following the case of Salomon v Salomon & CO[1] this concept was finally grasped by the courts and it was appreciated that companies have a separate legal entity, as Lord Macnaghten explained

“The company is at a law a different person altogether from the subscribers….; and, though it may be that after incorporation the business is precisely the same as it was before, and the same persons are managers, and the same hands receive the profits, the company is not in law the agent of the subscribers or trustee for them. Nor are the subscribers, as members, liable in any shape or form, except to the extent and in the manner provided by the Act[2]

As a corporation is a separate legal person its members are not personally liable for its debts[3]. This principle also applies to obligations other than debts such as the members of the company, although members who become involved in the management of the company’s business will find that this separate legal personality does not necessarily protect them from personal liability to third parties.

If a company enters insolvent liquidation, in theory the issue undergoes a considerable change, although in practice it does not. The question becomes whether the liquidator acting on behalf of the company can seek contributions from its members so as to bring its assets up to the level needed to meet the claims from the company’s creditors. The overall result of the broad recognition by the courts of the separate legal entity of the company and of the limited liability of its members and managers is to produce at a first sight a legal regime which is very unfavourable to potential creditors of companies. However lenders often “seek to leap over the barrier created by the law of limited liability by exacting the price of the loan to the company personal guarantees of its repayment from the managers or shareholders of the company, guarantees which may be secured on the personal assets of the individuals concerned”[4]. Legislation, whilst it has not overturned Salomon, contains an extensive list of publicity and disclosure obligations to priorities for certain classes of unsecured creditors on the winding-up of a company[5]. Recently added to these statutory weapons are the provisions relating to the wrongful trading and the expanded provisions on the disqualification of directors, especially on grounds of unfitness.

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One clear advantage of corporate personality is that it enables the property of the association to be more clearly distinguished from its members. In an unincorporated society, the property of the association is the joint property of the members. The rights of the members therein differ from their rights to their separate property since the joint property must be dealt with according to the rules of the society and no individual member can claim any particular asset. By virtue of the trust and the obvious complications can be minimised but not completely eradicated. And the complications cause particular difficulty in the case of a trading partnership both as regards the true nature of the interests of the partners and as regards claims of creditors.

On incorporation, the corporate property belongs to the company and members have no direct proprietary rights to it but merely to their “shares” in the undertaking. A change in the membership, which causes inevitable dislocation to a partnership firm, leaves the company unconcerned; the shares may be transferred but the company’s property will be untouched and no realisation or splitting up of its property will be necessary, as it will on a change in the constitution of a partnership firm. Similarly, the claims of the company’s creditors will be merely against the company’s property and the difficulties which can arise on bankruptcy of partners will not occur.

There are difficulties relating to legal actions in unincorporated associations. The problem is of practical importance with trading bodies but has been solved in the case of partnerships as they are now able to be sued or sue in the firm’s name[6], although there are still practical difficulties in enforcing the judgement. This question does not arise with incorporated companies as they can sue or be sued in their own right.

Another advantage of a limited company is that it cannot become incapacitated by illness, mental or physical, and it does not have to have an allotted life span[7]. This of course does not mean that the death or incapacity of its human members may not cause the company considerable embarrassment, however the vicissitudes of the flesh have no direct effect on the disembodied company, as Grcer LJ said “ a corporate body has no soul to be saved or body to be kicked.[8]” The death of a member leaves the company unmoved: members come and go but the company can go on forever.[9] The continuing existence of a company, irrespective of changes in its membership, is helpful in other direction also. When an individual sells his business to another, difficult questions may arise regarding the performance of existing contracts by the new proprietor[10], the assignment of rights of a personal nature[11], and the validity of agreements made with customers ignorant of the change of proprietorship[12]. Similar problems may arise on a change of the constitution of a partnership[13]. Where the business is incorporated and the sale is merely of the shares, none of these difficulties arise. The company remains the proprietor of the business, performs the existing contracts and retains the benefits of them, and enters into future agreements. The difficulties attending vicarious performance, assignments and mistaken identity do not arise.

Connected to this issue is the issue of the shares. Incorporation with the resulting separation of the business from its members greatly facilitates the transfer of the member’s interests. In the absence of limited liability the opportunity transfer is in practice very much restricted. With an incorporated company, freedom to transfer, both legally and practically, can be readily attained. The company can be incorporated with its liability limited by shares, and these shares constitute items of property which are freely transferable in the absence of express provision to the contrary, and in such a way that the transferor drops out and the transferee steps into his shoes. A partner has a proprietary interest which he can assign, but his assignment does not operate to divest him of his status or liability as a partner; it merely affords the assignee the right to receive whatever the firm distributes in respect of the assigning partners share[14]. The assignee can be admitted into the partnership in the pace of the assignor only if the other partners agree and the assignor will not be relieved of his existing liabilities as a partner unless the creditors agree, expressly or impliedly, to release him.

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Another important feature of an incorporated company is that a structure which allows for the separation of risk investment via the purchase of shares, in which many persons may participate, from the management of the company, which is delegated to a smaller and expert group of people who partly constitute and who are partly supervised by a board of directors. This concept was first explored in the United States by AA Berle and GC Means[15] and they drew attention to the revolutionary change thus brought about in traditional conceptions of the nature of property. Today, the great bulk of large enterprise is in the hands not of individual entrepreneurs but of large public companies in which many individuals have property rights as shareholders and to the capital of which they have indirectly or directly contributed. Direct or indirect investment in companies probably constitutes the most important single item of property for most people, but whether this property brings profit to its “owners” no longer depends on their energy initiative but on that of the management from which they are divorced.

Two further advantages which must be considered are that of borrowing and taxation. The ingenuity of equity practitioners has led to the evolution of an unusual but highly beneficial type of security known as the floating charge; i.e. a charge which floats like a cloud over the whole assets from time to time falling within a generic description, but without preventing the mortgagor from disposing of those assets in the usual course of business until something occurs to cause the charge to become crystallised or fixed. This is advantageous to incorporated companies because until recently such a charge could not really apply to partnerships or other unincorporated organisation -this is because of two pieces of legislation. The first was the “reputed ownership” provision in the bankruptcy legislation which relates to individuals[16]”. This, however under the reforms resulting from the report of the Cork Committee was repealed and not replaced in the Insolvency Act 1986. It never applied to the winding-up of companies. The second, which still remains, is that the charge, in so far as it related to chattels, would be a bill of sale within the meaning of the Bills of Sale Acts 1878 and 1882 which applies only to individuals and not to companies[17]. Hence it would need to be registered in the Bills of Sale Registry, and, what is more important, as a mortgage bill it would need to be in the statutory form which involves specifying the chattels in detail in a schedule. Compliance with the latter requirement is impossible since in a floating charge the chattels are indeterminate and fluctuating. Therefore it can be seen that use of this form of security is in practice restricted to bodies corporate. By virtue of it the lender can obtain an effective security on “all the undertaking and assets of the company both present and future” either alone or in conjunction with a fixed charge on its land. By so doing he can place himself in a far stronger position that if he merely had the personal security of the individual traders. It therefore happens not infrequently that a business is converted into a company solely in order to enable further capital to be raised by borrowing.

Once a company reaches a certain size, the attraction of limited liability is likely to outweigh all other considerations when business people are considering in what form to carry on their activities. Investors are unlikely to be willing to put money in a company where there liability is not limited if they are to have no or little control over the running of the company and for this reason incorporation is preferable. However with small businesses, which it is feasible to give all the investors a say in management, it is likely that tax considerations play a major part in determining whether the business shall be set up in corporate form or as a partnership. In the case of small companies the investors’ return on their capital may take the form of the payment of directors’ fees rather than dividends, so that participation in the management of the company may be the means for the investor both to safeguard the investment and to earn a return on it.

This assignment has discussed the advantages and disadvantages of incorporation of companies. It can be seen that the advantages of incorporation very much depend on one company to another. For larger firms the division between the board and shareholders, transferable shares and the conferment of limited liability on the shareholders are helpful for the raising of capital. Partnerships and unincorporated organisations do not lend themselves easily to this kind of need and therefore are more favourable in this respect. There are many other issues that make incorporation favourable but it can be seen that it is, and will continue to be the fact that these organisations have limited liability that will continue to make them attractive and more advantageous than unincorporated organisations.

Bibliography

Cases

Brace v Calder (1895) 2 QB 253

Boulton v Jones (1857) 2 H & N 564

British Waggon Co v Lea (1880) 5 QBD 149

Griffith v Tower Publishing Co [1897]1 Ch 21

Rayner (Mincing Lane) Ltd v Department of Trade [1989] Ch 72

Re Noel Tedman Holding Pty Ltd (1967) QD R 561

Robson v Drummond (1831) 2 B & AD 303

Salomon v Salomon & CO [1897] AC 22 HL

Slavenburg’s Bank v International Natural Resources Ltd [1980] 1 W L R 1076

Stepney Corporation v Osofsky [1937] 3 ALL ER 289

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Statutes

Bankruptcy Act 1914

Bills of Sale Acts 1878

Insolvency Act 1986

Partnership Act 1890

RSC ORD 81

Books

Berle A and Means G, (1993) “The Modern Corporation and Private Property” New York

Davies P, (2003) “Gower and Davies Principles of Modern Company Law”, Seventh Edition, Thomson Sweet and Maxwell

Dobson P, (2003) “Commercial Law”, Third Edition, London Cavendish

Morse G, (2005) “Charlesworth Company Law”, Seventeenth Edition, London Sweet and Maxwell

Smith and Kennan, (2005) “Smith and Keenans Company Law , Thirteenth Edition, Harlow Press/Longman

1

Footnotes

[1] [1897] AC 22 HL

[2] [1897] AC 22 HL at 51

[3] See for example Kerr LJ in Rayner (Mincing Lane) Ltd v Department of Trade [1989] Ch 72 at 176

[4] Davies P, (2003) “Gower and Davies Principles of Modern Company Law”, Seventh Edition, Thomson Sweet and Maxwell at page 32

[5] Insolvency Act 1986 Ss40 175 and 386-387

[6] RSC ORD 81

[7] S84 (1) (a) of the insolvency Act

[8] In Stepney Corporation v Osofsky [1937] 3 ALL ER 289 at 291

[9] See Re Noel Tedman Holding Pty Ltd (1967) QD R 561

[10] Robson v Drummond (1831) 2 B & AD 303 and British Waggon Co v Lea (1880) 5 QBD 149

[11] See Griffith v Tower Publishing Co [1897]1 Ch 21

[12] Boulton v Jones (1857) 2 H & N 564

[13] Brace v Calder (1895) 2 QB 253

[14] Partnership Act 1890

[15] The Modern Corporation and Private Property, New York 1933

[16] Bankruptcy Act 1914 S38 (1)(C)

[17] See Slavenburg’s Bank v International Natural Resources Ltd [1980] 1 W L R 1076

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