Business organisations

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1 Types of business organisation

1.1 Introduction

The common legal structures are:

• Sole traders

• Partnerships

• Limited companies (incorporated entities)

1.2 Sole traders

Most businesses start life with a sole trader structure. This means that a person simply begins to trade with very little formality. There is no legal distinction between what the business owns or owes and what its owner owns or owes. This means that the owner has unlimited liability for the debts of the business. If the business fails, people owed money by it can pursue the owner’s personal assets.

The owner puts capital into the business, the business trades and the owner can take out profits as drawings. The owner pays income tax on the profits made by the business.

The business assets, including goodwill can be sold to a new owner but, strictly, this means that the original business has ceased and a new one starts with the new owner. A sole trader business automatically comes to an end if the sole trader dies. The business may still have a value – stock, buildings, equipment and goodwill, but the business itself will legally cease. The business assets will form part of the sole trader’s estate and pass on to beneficiaries under the terms of the will.

1.3 Partnerships

If two or more people trade together with a view to profit, then a partnership is formed. Each partner will contribute agreed amounts of capital and profits are shared according to whatever agreement has been made between them. Each partner has unlimited liability for the debts of the business.

As with sole traders, tax on partnership profits is paid by the business owners through their income tax.

Unless provision is made in the partnership agreement, the partnership will cease on the death of a partner and the deceased partner’s estate becomes entitled to their share of the business. The remaining partners will have to pay the deceased partner’s estate the value of the deceased’s share.

Many countries now allow the formation of limited liability partnerships which operate like partnerships, but which also offer the partners limited liability for the business’s debts.

A limited liability partnership (LLP) is a separate legal person that is taxed like a partnership but gives its members limited liability. It is the usual structure for professional firms.

1.4 Limited companies

Limited companies require more formality to establish. They have to be registered with the relevant government organisations (in the UK, The Registrar of Companies). The most common type of company is one limited by shares. This means that shareholders’ liability is limited to the value of their shares. Note that the liability of a limited company for its debts is unlimited: it is the liability of the shareholders that is limited.

Limited companies (or incorporated bodies) are known as ‘legal persons’ (or ‘persona at law’). They have a legal existence that is separate from their owners. In particular they can:

• Own property in their own name

• Be liable for their own debts

• Sue and be sued

• Face criminal charges (eg if an employee were injured)

• Pay their own tax (corporation tax).

Many large limited companies are listed (or quoted) on stock exchanges where their shares can be freely bought and sold by investors. A listed company’s shares have a share price that depends on supply and demand for those shares. Typically, these prices vary frequently and the latest prices can be seen in the financial press or on the internet. This lets investors see immediately what their shares are worth.

Shareholders can receive a share of the company’s profits if the company directors decide that the company should pay a dividend. Dividends are defined as a payment per share owned. The shareholders will also benefit if the value of their shares increase so that they make a profit when the shares are sold.

Usually limited companies are profit-seeking, but don’t have to be. For example, a charity or school could use this legal structure.

1.5 The four forms compared

2 Advantages and disadvantages of the limited company format

2.1 Advantages of the limited company

• Tax: From time to time there are tax benefits. The corporation tax rate is often lower than income tax rates to attract businesses into the economy. Shareholders are taxed only on dividends paid out. Many shareholder-directors pay themselves a small salary and large dividends and this arrangement can save tax.

• Limited liability: the personal wealth of investors is protected because their liability is limited.

• Succession: because companies have a separate legal existence they can continue in perpetuity even as shareholders change or die.

• Easy transfer of shares: ownership is represented by shares and these can be bought and sold in small quantities allowing very wide ownership.

• Professional: some people claim that limited companies project a more professional impression than a sole trader can. It can look as though they have more substance.

• Raising finance: if a limited company does well it can be listed on a stock exchange and it then has potential access to a huge amount of funding from a wide range of investors.

2.2 Disadvantages of the limited company

• Formalities. A company has to be registered before it can trade, and the documentation has to be right. §6 sets out what registration involves and the off-the-shelf shortcut that removes most of the effort.

  Thereafter, financial statements (accounts) and returns have to be filed annually with the appropriate government department. Once a company becomes large enough it will have to have an annual audit by an independent auditor who hopes to be able to state that the company’s financial statements show a ‘true and fair view’ ie that the accounts are ‘OK’. Audits can be costly.

• Separate tax calculations: corporation tax has to be calculated according to corporation tax legislation.

• Publicity: because the financial statements have to be filed with the appropriate government department they can be inspected by the public, so profits and other information cannot be kept confidential.

3 The company’s constitution

3.1 What the constitution is

The Companies Act 2006, s.17 defines it: “Unless the context otherwise requires, references in the Companies Acts to a company’s constitution include (a) the company’s articles, and (b) any resolutions and agreements to which Chapter 3 [of Part 3 of the Act] applies.”

So the constitution is:

• the articles of association — the company’s own rulebook (§3.2); and

• certain resolutions and agreements — chiefly special resolutions of the members, and agreements binding a class of shareholders, which have to be filed with the registrar so that the public register shows the current rules.

The memorandum is not in that list. Its role has shrunk to a single formation document, and §3.4 explains what is left of it.

3.2 The articles of association: purpose and contents

The articles are the company’s internal rulebook. Their purpose is to regulate the relationship between the company, its members and its directors: who may decide what, how decisions are taken, and what rights attach to the shares.

Most companies do not draft their own. Parliament prescribes model articles for each type of company and, under the Companies Act 2006, s.20, these apply by default — if no articles are registered, or so far as the articles that are registered do not exclude or modify them, the relevant model articles form part of the company’s articles. A company that wants something unusual has to say so.

The contents of a typical set of articles cover:

• Directors’ powers, responsibilities, decision making (eg how many have to be present at a meeting to make decisions), appointment and removal.

• Shares: types of share, transfer of shares, rights to dividends, procedures for declaring dividends.

• Power to capitalise profits

• Decision making by shareholders: attendance, speaking and voting at general meetings; proxy votes.

• Administrative matters: means of communication to be used, director’s indemnity and insurance.

What the articles cannot do is override the Act. Where the Companies Act 2006 gives the members a right — to remove a director by ordinary resolution, for example — the articles cannot take it away.

3.3 The legal effect of the constitution

This is the half of the syllabus outcome that “what is in the articles” does not answer. Under the Companies Act 2006, s.33(1): “The provisions of a company’s constitution bind the company and its members to the same extent as if there were covenants on the part of the company and of each member to observe those provisions.”

In other words the constitution takes effect as a statutory contract. Three consequences follow:

• it binds the company to each member — a member can enforce the articles against the company;

• it binds each member to the company, and the members to one another, in their capacity as members. Money payable by a member to the company under the constitution is a debt due from them (s.33(2));

• it binds them only in the capacity of member. A provision in the articles appointing someone the company’s solicitor for life is not enforceable by them as solicitor, because that is not a membership right. This is the point most often tested.

The articles can be altered by special resolution — a 75% majority of those voting. The alteration must be made in good faith for the benefit of the company as a whole, and the amended articles must be filed.

3.4 What is left of the memorandum of association

The memorandum survives, but only as a short historic formation document. The Companies Act 2006, s.8(1) states it in full: “A memorandum of association is a memorandum stating that the subscribers (a) wish to form a company under this Act, and (b) agree to become members of the company and, in the case of a company that is to have a share capital, to take at least one share each.” It must be in the prescribed form and authenticated by each subscriber (s.8(2)).

It is delivered to the registrar on incorporation (§6.1) and then never changes. It cannot be amended, and nothing is added to it later.

The information that the pre-2006 memorandum carried — the company’s name, its registered office, its objects, the liability clause and the authorised share capital — has not disappeared; it has moved. The name and registered office are now matters for the application for registration and the public register; the objects, if a company wants any, go in the articles; limited liability follows from the type of company registered. If you meet the old description in older material, that is what it is describing.

Anyone who adds their name to the memorandum on formation becomes a member (shareholder) of the company immediately, and the register of members is available for public inspection.

4 Public and private companies

A private company cannot offer shares to the public. It has no minimum capital requirement and might have only one director. In the UK they are designated by having ‘Ltd’ (meaning limited liability) after their names.

A public company can offer shares to the public. There are minimum capital requirements and there must be at least two directors and a company secretary (who cannot also be the sole director). In the UK they are designated by having ‘Plc’ (Public Limited Company) after their names. If they meet the stock exchange listing requirements, public limited companies can be listed (quoted) on a stock exchange.

Note that the term ‘public’ is often, wrongly used to mean ‘listed’. Listed companies have to be public companies, but public companies do not have to be listed.

5 The corporate veil

5.1 Separate legal personality and limited liability

It was explained above that limited companies have a separate legal existence and that their actions and liabilities are separate from those of the shareholders and directors. A company might be sued if it causes damage, but the shareholders won’t be because the company is the guilty party. The company might be pursued by creditors, but the creditors cannot chase the shareholders or directors for amounts owed by the company.

Case: Salomon v Salomon (1897)

Salomon formed a limited company to take over his business. He was the majority shareholder but also lent money to the company as a secured creditor. The company failed. Salomon’s debt was safe because it was secured on company assets but there was nothing left for the unsecured creditors who then attempted to claim their money from Salomon, asserting that Salomon and the company were one.

Held: Salomon and his company were separate. The unsecured creditors could claim from the company but not from Salomon personally.

Case: Macaura v Northern Life Assurance (1925)

Macaura owned a forestry company. He insured the timber against fire, but in his own name. The forest was destroyed by fire and the insurance company refused to pay out.

Held: To insure an asset you must have an insurable interest in the asset (eg ownership). Macaura owned shares in the forestry company; the forestry company owned the trees. Macaura therefore did not have an insurable interest in the trees because he did not own them, so the insurance company did not have to pay out.

5.2 Lifting the veil at common law

The distinction between the company and its owners is sometimes called the ‘veil of incorporation’. However, the veil of incorporation can be lifted (or pierced) in some situations. This means disregarding the separate personality of a company and occurs when the court applies an exception to the rule in Salomon v. Salomon.

For example:

Case: Gilford Motor Co v Horne (1933)

Horne was an employee who, in his employment contract, had agreed not to compete with his employer, Gilford Motor Co. Horne left and formed a company and caused his company to compete. He claimed that he had not broken his agreement because it was the company (a separate legal entity) not him who was competing.

Held: An injunction to stop the competition was granted because incorporation should not be used to evade legal responsibilities.

The veil of incorporation is to be lifted only in circumstances where incorporation is being used to give protection from improper behaviour and so the company is being used as a front.

5.3 Lifting the veil by statute: fraudulent and wrongful trading

Parliament has also provided for the veil to be lifted, and the two provisions the syllabus needs are in the Insolvency Act 1986. Both bite only when a company is being wound up — that is, when a liquidator has been appointed to realise the assets, pay the creditors as far as the money goes and dissolve the company. Both claims are brought by that liquidator, and both make individuals contribute their own money to a company whose debts they would otherwise be shielded from.

6 Company registration and off-the-shelf companies

6.1 Registering a company

A company comes into existence only when the registrar of companies says so. In the UK the registry is Companies House and the process is set out in Part 2 of the Companies Act 2006. Under s.9 the memorandum of association (§3.4) is delivered to the registrar together with an application for registration, the other required documents and a statement of compliance. The application must state:

• the company’s proposed name;

• whether the registered office is to be in England and Wales (or in Wales), in Scotland or in Northern Ireland;

• whether the members’ liability is to be limited, and if so whether limited by shares or by guarantee; and

• whether the company is to be private or public.

It is accompanied by a statement of capital and initial shareholdings, a statement of the proposed officers, a statement of the intended registered office address, and the articles — unless the company is content to rely on the model articles, which apply by default under s.20 (§3.2).

If the registrar is satisfied, a certificate of incorporation is issued. Under s.15 it states the company’s name and registered number, the date of incorporation, whether the company is limited and if so how, whether it is private or public, and where the registered office is situated. The certificate is conclusive evidence that the company exists. From that moment the company is a separate legal person and everything in §5 applies to it.

6.2 Buying a company off the shelf

Company formation agents keep stocks of companies that have already been registered and have never traded. Buying one — an off-the-shelf company — means taking over an existing shell: the buyers are appointed as directors, the existing subscriber shares are transferred to them, the name is changed, capital is paid in and trading starts.

7 Check your understanding

Five short questions on the chapter, with the answers under each. Work through them before you move on.

8 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.