Topic 6 - The Company as a Corporate Entity

7/30/2019 Topic 6 - The Company as a Corporate Entity

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TOPIC 6

A COMPANY AS A CORPORATE ENTITY COMPANY AS A CORPORATEENTITY

EFFECT OF REGISTRATION OF THE COMPANY

Why incorporate or form a company?

The reasons for and against the incorporation of a business into a companyare varied. Section 112 of the Corporations Act lists the types ofcompanies that can be registered under that Act. Those companies are asfollows:

proprietary companies - limited by shares or unlimited with sharecapital;

public companies - limited by shares; limited by guarantee; unlimitedwith share capital; or no liability companies. With respect to noliability companies, note section 112(2), (3) and (4) and the need forthe relevant constitution requiring that the sole object of thecompany be for mining purposes (defined in section 9).

With respect to proprietary companies, note section 113 of theCorporations Act.

One of the most important prohibitions contained in the Corporations Actinthis regardis set out in section 115. That section precludes a person fromparticipating in the formation of a partnership or association that has anobject gain for itself or for any of its members; and has more than 20members unless the partnership or association is incorporated under anAustralian law.

Note the prohibition in section 116 of the Corporations Act.

Steps in registering a company

You should note Part 2A.2 of the Corporations Actbeginning at section 117.Once an application is lodged under section 117 ASIC may give thecompany an ACN and register the company and issue a certificate settingout the matters contained in section 118(1)(c). ASIC must keep a record ofthe registration.


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In relation to names note Part 2B.6 of the Corporations Actbeginning atsection 147. However, note the need for a company to exhibit its name:section 144. In particular, note the need to have Limited, No liability orProprietary as part of the name: (section 156) unless sections 150 or 151apply. In relation to change its name to see section 157 and 157A.

A company comes into existence on registration: section 119.

With respective jurisdiction of registration note section 119A.

A company must have at least one member: section 114. A personbecomes a member, director or company secretary on registration if theperson is specified in the application with their consent: section 120. Notealso sections 121 and 122 dealing with registered office and expenses inpromoting and setting up the company. Finally, a company may have acommon seal (section 123) and this aspect is important when dealing with

the application of sections 127 and 129 which is covered in Topic 8 in thiscourse.

Advantages of registration

Registration of a company brings with it a number of advantages. Some ofthese are:

(a) Separate legal personality

Upon incorporation the company becomes a new and independent legalentity. It is completely separate from the subscribers who formed it andfrom those who manage it. A creditor can generally only sue the company,not its members, to recover damages. However exceptions exist to thislatter point and these are outlined later in this Topic.

(b) Limited liability

If the company is one limited by shares (defined in section 1070A), then

section 516 of the Corporations Act provides that a member's liability islimited to the amount unpaid, if any, on these shares. This can becontrasted with a partnership where there is, except for limited liabilitypartnerships, unlimited liability and therefore all the assets of a partner arevulnerable in the event of default by another partner. The extent of amember's liability depends on the type of company as provided in section112 of the Corporations Act.

It should be noted that limited liability applies only to members. Acompany does not enjoy limited liability in its dealings with outsiders.


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(c) Flexibility

When drafting up the company's constitutional documents1, it is possible to

give directors and shareholders various combinations of rights. Forexample, it is possible to have differing voting rights and variedentitlements to dividends and the division of powers between membersand shareholders can be established. It should be noted that a privatecompany, known as a proprietary company, has some restraints imposedon its flexible structure. Some of these restraints are set out in sections113(1) and (3) of the Corporations Act.

(d) Perpetual succession

A company will continue as a legal entity regardless of the death orchanging circumstances of its members. It does not exist for a specificperiod of time.

(e) Transferability and transmissibility of shares

Shareholders in companies often have flexibility in being able to transfer orassign their shares to other parties. In such cases a transfer will occurwhen the ownership of the share passes from one shareholder to another

resulting in the transferee becoming a member of the company afterregistration of the transfer. However, companies can impose restrictionson the ability to transfer shares and this is common with respect toproprietary companies. In this regard section 1072G provides for areplaceable rule that directors may refuse to register a transfer of shares inthe company for any reason.

Similarly transmission of shares is possible where a shareholder dies,becomes incapable through incapacity or becomes bankrupt. In such casesthe shares vest in the deceased shareholder's personal representative orthe Official Trustee in bankruptcy.

(f) Imputation of taxation

Companies are able to impute the tax they have paid back to shareholders.This ability means that the same revenue is not taxed twice and that anindividual can receive dividends which may not attract any further tax.

1 "Constitution" is defined in sec 9.


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(g) Power to acquire, hold and dispose of property

A company being a separate legal entity can own property. This propertyis not owned by the members as they only own shares in the company. In

Macaura v Northern Assurance Co Ltd [1925] AC 619, Macaura owned atimber yard. He had an effective insurance policy to cover the destructionof any timber by fire. He subsequently formed a limited company in whichhe was a substantial shareholder and assigned the timber to the company,the purchase money for the timber remaining owing to him. He did notassign the insurance policy to the company, nor did the company take outits own policy. A fire destroyed the timber.

The insurance company's refusal to pay the claim made by Macaura wasupheld by the court. The limited company, considered by law to be a legalentity separate to its shareholders, had an insurable interest in the timber

but had no policy. Macaura had a policy, but he had no insurable interest inthe timber: all he had was a debt owing to him by the company2.

Also changes in membership of the company have no effect on theownership of the company's assets.

(h) Capability of suing and being sued

As a company is a separate legal entity it may sue to enforce rights and it

may be sued by others. Importantly, members in some instances may sueon behalf of the company. This latter aspect will be dealt with in Topic 7under the headings, Members Remedies and Derivative Actions.

(i) Privilege against self-incrimination

Historically courts have preceded on the basis that a corporation couldclaim privilege against self-incrimination. This was clearly an advantage.However since the recent decision in Environment Protection Authority vCaltex Refining Co Pty Ltd (1994) 68 ALJR 127 this position is no longer

clear. In this case Caltex was the holder of a licence under the StatePollution Control Commission Act1970 (NSW) to discharge waste into theocean. The Environmental Protection Authority prosecuted Caltex for

2 Now sections 16 and 17 of the Insurance Contracts Act 1984 (Cth)require only that the claimant suffer a "pecuniary or financial loss" throughthe destruction of, or damage to, the insured property. So long as thisinterest exists as at the date of the loss, the claimant is not barred fromclaiming on the policy by reason only of not having a legal or equitableinterest in the property. It thus seems that if the circumstances ofMacaura's case were repeated today, the claimant would be successful.


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discharging oil and grease into the ocean in breach of its licence. TheAuthority subsequently served Caltex with a notice under the Clean Waters

Act 1970 (NSW), sec 29(2)(a) requiring it to produce certain documentsrelating to its discharge of waste. Caltex objected to the validity of thenotice and the Authority then issued a notice to produce under the Land

and Environment Court Rules 1980 (NSW).

Caltex sought to have the notices set aside on the basis that a productioncould incriminate them. The trial judge held that the privilege against selfincrimination did not apply to corporations but the New South Wales Courtof appeal allowed the appeal. The High Court held however, by majority,that the privilege was not available to corporations.

1. Disadvantages of registration

As opposed to these advantages in incorporating a company, there are acertain number of disadvantages. For example:-

(a) Limitations on shareholders bringing proceedings on behalfof the company

There are procedural difficulties for shareholders to bring a court action ontheir own behalf and on behalf of their company. Historically, the so-calledrule in Foss v Harbottle [1843] 2 Hare 461 was illustrative of such a

problem. In that case two shareholders brought an action on behalf ofthemselves and all other shareholders against the directors, solicitor andarchitect of their company. They alleged that the defendants hadfraudulently misapplied company property and that the board was notproperly constituted. The defendant's argued that the plaintiff's plea, evenif proved, did not entitle them to succeed.

The Court held that the injury of which the plaintiff's complained of was notan injury to themselves but to the company. Therefore the companyshould sue in its own name. According to Wigram VC:

"It was not, nor could it successfully be, argued that it was a matterof course for any individual members of a corporation thus to assumeto themselves the right of suing in the name of the corporation. Inlaw the corporation and the aggregate members of the corporationare not the same thing for purposes like this; and the only questioncan be whether the facts alleged in this case justify a departure fromthe rule which, prima facie, would require that the corporation shouldsue in its own name and in its corporate character, or in the name ofsomeone whom the law has appointed to be its representative."


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Now this area is governed by section 236 242 of the Corporations Actwhich is covered in Topic 7 under the headings, Members Remedies andDerivative Actions.

(b) Limited role that shareholders have in management

A company often has a separation of powers between management andshareholders. According to Samuels JA., in Winthrop Investments Ltd vWinns Ltd [1975] 2 NSWLR 666 at 683:

"...[T]he shareholders may have, ultimate control, because they canalter the articles or remove the directors: but they cannot interfere inthe conduct of the company business where management, as here, isvested in the board ... they have no general power to transact thecompany's business, or to give effective directions about its

management."

The main decision in this area is Automatic Self-Cleansing Filter SyndicateCo. Ltd v Cunninghame [1906] 2 Ch 34. In this case an article gave powerof management to directors "...subject to such regulations as may fromtime to time be made by extraordinary resolutions." A further article gavethe board power to sell property owned by the company on terms itthought fit. Shareholders at a meeting purported by ordinary resolution todirect the board to sell property and the board refused and relied on thearticles. The Court held that unless an extraordinary resolution was

passed, as provided for in the articles, the shareholders could not ignorethe articles and give directions3.

(c) The ever-increasing penalty provisions applying to thedefaulting officer and director

(d) Fees and paperwork associated with compliance

Under the Corporations Actthere are a number of returns to be completedand some of these require filing fees, for example, filing of the Annual

Return. There is also paperwork associated with meetings, accounts, andregisters and there may be a need for auditors or at least accountants.

These bureaucratic requirements may be seen as disadvantages toproprietors of businesses.

THE COMPANY AS A SEPARATE LEGAL ENTITY

3 See also NRMA v Parker(1986) 4 ACLC 609.


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A company is an artificial legal entity which enjoys rights and is subject toduties and obligations. It comprises a number of members, both naturaland non natural persons. The company is also a separate legal entity andcan have limited liability. Separate legal personality was firmly establishedin Salomon v A. Salomon & Co Ltd [1897] AC 22.

Salomon had traded on his own as a leather merchant and shoemanufacturer for over thirty years. While his business was solvent heformed a company called "Aron Salomon and Company Limited" and soldhis business to this company. The Companies Act 1862 (UK) requiredseven subscribers and Salomon, his wife and five children each subscribedone share to satisfy the statute.

Salomon valued his business at 39,000 pounds which appeared to be aninflated figure. However instead of taking cash for the sale of the business,Salomon took 20,000 fully paid one pound shares in addition to debenturesto the value of 10,000 pounds. These debentures were secured by a

floating charge. The balance of the purchase price remained as anunsecured debt.

Soon after the company came into financial difficulties and needed aninjection of funds. In response, Salomon borrowed 5000 pounds fromBroderip which he advanced to the company. To obtain this loan, Salomonhad his debentures cancelled and reissued to Broderip, but on terms thathe should obtain a residual benefit after the debt was discharged.

Payments to Broderip fell into arrears and Broderip enforced his security.

The company's liquidation followed. After Broderip was paid, thereremained a balance of indebtedness secured by the debentures. Salomonclaimed his reversionary entitlement. However if this claim was satisfiedthere would be no funds left to pay out the other unsecured creditors. Theliquidator attempted to resist the claim by arguing that the debentureswere invalid on the ground of fraud.

At first instance, Vaughan Williams J4, held that the company was merelyacting as Salomon's nominee and agent and therefore Salomon as principalhad to indemnify the company's creditors personally. On appeal, the Courtof Appeal in rejecting Salomon's appeal, held that Salomon was a trustee

for the company which was his mere shadow.

Salomon appealed to the House of Lords which rejected the lower courts'rulings. According to Lord MacNaghten5:

"The company is at law a different person altogether from thesubscribers to the Memorandum and, although it may be that after

4 [1895] 2 Ch 323.

5 [1897] AC 22 at 51.


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incorporation the business is precisely the same as it was before, andthe same persons are managers, and the same hands receive the

profits, the company is not in law the agent of the subscribers ortrustee for them. Nor are subscribers as members liable, in anyshape or form, except to the extent and in the manner provided by

the Act. That is, I think, the declared intention of the enactment".

Lord Watson emphasised6 that the creditors of the company could havesearched the Companies Register to ascertain the names of theshareholders and the number of shares which they held. However thefailure to do this should not impute a charge of fraud against Salomon.

Lord Herschell7 looked at the intention of the statute in that it sought toprotect shareholders by limiting their liability.

Lord Halsbury LC had a similar view. According to his Lordship there was

no right to add to the requirements of the statute, nor to take from therequirements which had been enacted. "The sole guide must be thestatute itself." Once a person was a shareholder they were shareholdersfor all purposes and the statute was silent as to the extent or degree ofinterest which had to be held by the individual corporators.

Importantly Lord Halsbury added an important qualifier to the immutabilityof the separate legal entity doctrine. His Lordship said;

"I am simply here dealing with the provisions of the statute, and it

seems to me to be essential to the artificial creation that the lawshould recognise only that artificial existence - quite apart from themotives or conduct of individual corporators. In saying this, I do notat all mean to suggest that if it could be established that this

provision of the statute to which I am adverting had not beencomplied with, you could not go behind the certificate ofincorporation to show that a fraud had been committed upon theofficer entrusted with the duty of giving the certificate and that bysome proceeding in the nature of scire facias you could not prove thefact that the company had no legal existence. But short of such

proof it seems to me impossible to dispute that once the company is

legally incorporated it must be treated like any other independentperson with its rights and liabilities appropriate to itself and that themotives of those who took part in the promotion of the company areabsolutely irrelevant in discussing what those rights and liabilitiesare..."

From this judgment by the House of Lords the concept of "a company" was

6 [1897] AC 22 at 40.

7[1897] AC 22 at 45.


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seen as a legal entity in its own right. The very heart of separation andindependence from those involved in the company's management andstructure was established as a result of Salomon's case. If creditors dealtwith the company it was to the latter to which recourse had to be made,not to those who were behind the entity. Over time this traditional

perception would be severely eroded. Recent illustrations of the principlein Salomon's case appear in Lee v Lee's Air Farming [1961] AC 12 andIndustrial Equity Ltd v Blackburn (1977) 52 ALJR 89.

In Lee v Lee's Air Farming (1961) AC 12, Lee formed a company, Lee's AirFarming Ltd, to carry on the business of aerial top-dressing. Lee held allthe shares except for one which was held by his solicitor. Lee wasgoverning director of the company and employed as its chief pilot. Lee waskilled while working for the company when an aeroplane crashed. Hiswidow sued under the company's workers' compensation insurance. TheNew Zealand Court of Appeal rejected the claim on the basis that since Lee

was the governing director of the company, he could not also be itsemployee. His widow appealed to the Privy Council.

The Court held that the company was a separate legal entity. According toLord Morris:

"A contractual relationship could only exist on the basis that therewas consensus between two contracting parties. It was neversuggested (nor in their Lordships' view could it reasonably have beensuggested) that the company was a sham or a mere simulacrum. It

is well established that the mere fact someone is a director of acompany is no impediment to his entering into a contract to servethe company. If, then, it be accepted that the respondent companywas a legal entity their Lordships see no reason to challenge thevalidity of any contractual obligations which were created betweenthe company and the deceased."

Lord Morris also said:

"Always assuming that the company was not a sham then thecapacity of the company to make a contract with the deceased could

not be impugned merely because the deceased was the agent of thecompany in its negotiation. The deceased might have made a firmcontract to serve the company for a fixed period of years. If withinsuch period he had retired from the office of governing director andother directors had been appointed his contract would not have beenaffected. The circumstance that in his capacity as a shareholder hecould control the course of events would not in itself affect thevalidity of his contractual relationship with the company. When,therefore, it is said that `one of his first acts was to appoint himselfthe only pilot of the company', it must be recognised that the


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appointment was made by the company, and that it was none theless a valid appointment because it was the deceased himself whoacted as the agent of the company in arranging it. In their Lordships'view it is a logical consequence of the decision in Salomon's casethat one person may function in dual capacities."

In Industrial Equity v Blackburn (1977) 52 ALJR 89, the High Court refusedto treat a subsidiary company as merely part of its holding company for thepurposes of determining the profits of the holding company because of theseparate legal entity concept. In this case the question arose "whether inascertaining the amount of profits available for distribution by a holdingcompany by way of dividend, it is correct to look at the profit of the holdingcompany itself or to the group profit as disclosed by the consolidatedaccounts." The court held that it was correct to do this. According toMason J:

"However, it can scarcely be contended that the provisions of the Actoperate to deny the separate legal personality of each company in agroup. Thus, in the absence of contract creating some additionalright, the creditors of company A, a subsidiary company within agroup, can look only to that company for payment of their debts.They cannot look to company B, the holding company, for payment."

It should be noted that the provisions contained in sec 588V-588X of theCorporations Law allows a liquidator to recover compensation from aholding company where its subsidiary has been involved in insolvent

trading. This is discussed later in this Topic.

MITIGATING THE RIGOUR OF THE SEPARATE LEGAL ENTITYDOCTRINE

Once it was acknowledged that a company enjoyed a separate and legalexistence apart from its members, another consideration needed to bedealt with, namely the rights of creditors. The fact that many companieswere incorporated with limited liability further entrenched the notion thatcreditor's rights were limited. If creditors dealt with this separate legal

entity in which members had limited liability, then any recourse which theymay have had would be to the company itself. Thus the separate legalentity doctrine was a two-edged sword. On the one side the rights ofmembers were limited and on the other side, a creditor practical ability toseek redress was limited. Courts and the legislature then had to balancethese respective rights to prevent abuse. A starting point to analysing thequest for a balance can be found by examining the chequered history oflimited liability in the corporation confine.

Limited liability found its inception with regards to companies in 1854 in


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the Limited Liability Act8. The justification for its inception can be found inarguments conveniently summarised by Farrar9 as follows:

limited liability allowed small capital to be turned to profitableemployment;

it was a question of free trade against monopoly;

unlimited liability was impracticable and impeded work such asrailways, canals and docks;

unlimited liability prevented prudent men from becoming membersof companies which were consequently being formed by the rash andreckless.

Interestingly, there were a number of arguments against the introductionof limited liability10. Some of these arguments were:

limited liability was not a privilege to be given to partners but it wasa right to be taken from creditors;

it encouraged people to trade beyond their means;

it led to speculation and fraud;

there was adequate capital available without it.

Up until the passing of the Limited Liability Act 1854, a form of limitedliability existed in a practical sense in particular circumstances. Forinstance, it was common for clauses to be included in deeds of settlementand prospectuses11 which limited the liability of those behind the scheme.According to Gower12:

..."[U]nlimited liability, though a danger to the risk taker, was often asnare and a delusion rather than a protection to the public and no

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18 & 19 Vict. c133. This Act was repealed soon after and laterincorporated in theJoint Stock Companies Act1856.

9 Farrar, J.H., Company Law, Butterworths 1985 ed. London, at 18.

10 Farrar, J.H., Company Law, Butterworths 1985 ed. London, at 18.

11 Such limiting clauses were held to be ineffective from 1854.

12 Gower LCB, Gower's Principles of Modern Company Law 4th ed. 1979,Stevens & Sons London at 36.


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handicap at all to the dishonest promoter. The difficulties of suing afluctuating body and the even greater difficulties of levyingexecution made the personal liability of the members largely illusory.Moreover, the investor was supposed to become a member bysigning the deed of settlement and until he did so his identity would

not be known by the creditors. But in fact `stags' would deal inallotment letters or scrip certificates to bearer without signing thedeed and often before any formal deed was in existence, anddishonest promoters, who alone might be under any legal liability,might disappear with the subscription moneys."

Despite these convenient ways of introducing limited liability and thearguments against it, Government intervention was not far away and theintroduction of statutory limited liability was a by-product of suchintervention. The form of this limited liability introduced by the LimitedLiability Act 1854 was, however, subject to certain qualifications and it

could be argued that right from the beginning, limited liability as it appliedto companies was not going to be absolute.

The qualifications to enjoying limited liability were built into this initiallegislation. For example:

the company needed to have at least 25 members holding 10 poundshares of which 20% had been paid up;

three-quarters of the company's capital needed to have been

subscribed;

the word "limited" was to have been included as part of thecompany's name;

directors of such limited liability companies were personally liablewhen they paid a dividend knowing the company to be insolvent ormade loans to the members;

the company had to wind up if three-quarters of the capital was lost.

The Limited Liability Act1854 was soon repealed and later its provisionswere incorporated in the Joint Stock Companies Act1856. This latter Actallowed incorporation with limited liability with minimal restrictions and itremoved most of the qualifications contained under the 1854 Actmentioned above, although directors were still to be liable for payment ofdividends when the company was insolvent. In fact, all that was necessaryto incorporate was for a minimum of seven persons to sign and register amemorandum of association. According to Gower13:

13 Gower LCB, Gower's Principles of Modern Company Law 4th ed. 1979,


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..."[T]he legislature had adopted Lord Bramwell's recommendationsand accepted his view that those who dealt with companies knowingthem to be limited had only themselves to blame if they burnt theirfingers. The mystic word `Limited' was intended to act as a red flag

warning the public of the perils which they faced if they had dealingswith the dangerous new invention." [bold added]

The question which can be asked is whether the colour of this `red flag' hasfaded? Historically, creditors have been precluded from recovering fromshareholders or directors an amount in excess of the unpaid amounts ontheir shares, yet both the courts and the legislature have widened the gapsin the corporate veil. As mentioned at the beginning of this Chapter anumber of situations now exist whereby directors and others who take partin management of a corporation will be personally liable for debts incurredby the company. This liability may be exclusive personal liability or

concurrent liability with the company. Whatever the liability, the distinctlegal personality pronounced in Salomon's case14 by the House of Lords hasbeen shown, on occasions, not to be an immutable principle. Both thelegislators and the courts lift the corporate veil and seek out the realities ofthe situation. They may deny the usual legal consequences ofincorporation and of the red flag. Further legislation directly imposespersonal liability upon management. Limited liability is not sacrosanct andthe principle in Salomon's case no longer rules.

Since the decision in Salomon's case there has been a steady stream of

common law decisions and legislative enactments which have eroded theimmutability of the separate legal entity doctrine and have thus exposedofficers to personal liability to a company's creditors. These decisions andenactments are conveniently seen as ways to `lift or pierce the corporateveil'15.

Stevens & Sons London at 48.

14 [1897] AC 22.

15 In Qintex Australia finance Ltd v Schroders Australia Ltd (1991) 9

ACLC 109, Rogers CJ suggested that the whole issue of the separateness ofthe corporate legal entity be re-examined in the light of the so-calledtension between the realities of commercial life and the applicable law.Although his Honour in the case at hand had to determine which company inthe Qintex group of companies should be able to claim the benefit of thecontract entered into, a number of more general remarks were madeconcerning the separate legal entity doctrine. According to his Honour, (at p111) it may be desirable "for Parliament to consider whether this distinctionbetween the law and commercial practice should be maintained. This isespecially the case today when the many corporate collapses ofconglomerates occasion many disputes."


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According to Easterbrook and Fischel, "piercing seems to happen freakishly... like lightning, it is rare, severe and unprincipled."16 But this so calledfreakish happening has occurred on a number of grounds. Farrar notesthat17:

"... [I]t is difficult to rationalise the cases except under the broad,rather question-begging heading of policy and by describing themain categories under which they fall. These are:

agency;

fraud;

group enterprises;

trusts;

enemy;

tax;

the Companies Act itself."

We will now analyse some of these grounds under the convenient headingsof "common law" and "statute".

(1) Common Law

(a) Fraudulent use of the corporate form

Lord Halsbury in Salomon's case acknowledged that the corporate veil willnot protect a fraudulent person hiding behind the corporate structure.Illustrative of this is the decision in Gilford Motors Co Ltd v Horne [1933] 1Ch D 935.

In this case the defendant was employed under a service contract as

managing director of the plaintiff company. As part of this contract he wasforbidden, when ceasing his employment with the company, from takingaway the plaintiff's customers. The defendant left the plaintiff company,formed a competitive business and a company in which he was one of

16 Easterbrook FH and Fischel DR., Limited Liability and theCorporation, (1985) Uni of Chicago Law Review 7 at 89.

17 Farrar JH., Company Law, 1985 ed, Butterworths, London at 57. Thiscategorisation was accepted by Young J, in Pioneer Concrete Services Ltd vYelnah Pty Ltd (1987) 5 ACLC 467 at 474.


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three shareholders. The new company solicited the plaintiff's customersand the plaintiff sought an injunction restraining this conduct. Thedefendant argued that he was not soliciting customers of the plaintiff andthat if there was any solicitation, it was from a separate legal entity,namely the new company which had no contract with the plaintiff. This

argument was rejected by the Court.

According to Lord Hanworth MR18, the new company was a "mere cloak orsham" for the defendant, its purpose was to enable the defendant toengage in a business in breach of the covenant contained in his contractwith the plaintiff.

In Re FG (Films) Ltd [1953] 1 WLR 483, an American company owned mostof the shares in an English company and exercised control over it. TheAmerican company financed and produced a film in India and then causedthe English company to apply for a subsidy under the Cinematograph Films

Act1938 (UK). A subsidy would have been paid if the film was made by aBritish film maker. It was held that no subsidy should be paid as the Britishcompany had acted as a mere nominee and agent of the Americancompany. According to Vaisey J19:

"[T]he British company's intervention in the matter was purelycolourable. They were brought into existence for the sole purpose ofbeing put forward as having undertaken the very elaboratearrangements necessary for the making of this film and of enabling itto qualify as a British film."

Similarly inJones v Lipman [1962] 1 WLR 832, Lipman agreed to sell land toJones. Before completion of the contract, Lipman transferred the land to acompany of which he and a clerk employed by his solicitors were the onlyshareholders and directors. Jones brought an action for specificperformance of the contract against both Lipman and the company.

The Court held that the company was a sham and ordered specificperformance of the contract. According to Russell J:

"The defendant company is the creature of the first defendant, a

device and a sham, a mask which he holds before his face in anattempt to avoid recognition by the eye of equity."

In Creasey v Breachwood Motors Ltd (1992) 10 ACLC 3052, Creasey workedfor Breachwood Welwyn Ltd as its general manager pursuant to a writtencontract. This company carried on the business of a garage trading in carsfrom premises owned by Breachwood Motors Ltd. F and S were the

18 [1933] 1 Ch D 935 at 956.

19 [1953] 1 WLR 483 at p 486.


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shareholders and directors of both these companies. In 1988, Creasey wasdismissed by Breachwood Welwyn Ltd and he claimed damages forwrongful dismissal against this company.

In November 1988, Breachwood Welwyn Ltd ceased trading and in

December 1988 Breachwood Motors Ltd took over its business andcontinued its operations under the same trading name. This takeover wascarried out without regard to the separate entity of Breachwood WelwynLtd and the interests of its creditors, especially Creasey, if his claim forwrongful dismissal were to succeed.

As a result of the actions of F, S and Breachwood Motors Ltd, Creasey foundhimself with a judgement against Breachwood Welwyn Ltd, an insolventcompany, the assets of which had been removed to Breachwood MotorsLtd. Breachwood Motors Ltd refused to meet any part of the judgement.One of the questions which had to be decided was whether the corporate

veil could be pierced?

The Court held that the corporate veil could be pierced. Nothing couldjustify F and S's conduct in deliberately shifting Breachwood Welwyn Ltd'sassets and business into Breachwood Motors Ltd in total disregard of theirduties as directors and shareholders. This meant that Breachwood MotorsLtd were liable for the liability of Breachwood Welwyn.

(b) Agency

In some circumstances a company may act as an agent for others, forexample, shipping agents or investment brokers. Moreover, it is possiblefor a company to act as the agent for its own shareholders. This may bedone by express contract or impliedly.

In Smith, Stone & Knight Ltd v Birmingham Corp [1939] 4 All ER 116,Birmingham Corporation, a local council, compulsorily acquired premisesowned by the Birmingham Waste Co. Ltd. This company was awholly-owned subsidiary of Smith, Stone & Knight Ltd. Indeed, of the 502issued shares in the waste company, 497 were held by Smith, Stone &

Knight and the other 5 were held on its behalf. The Waste Company hadno staff, no separate books of account and on the evidence it was treatedlike one of Smith, Stone & Knight's departments. Accordingly a claim forcompensation for loss of business was made by Smith, Stone & Knight Ltd.Birmingham Corporation argued that Smith, Stone & Knight Ltd. could notsucceed because the loss had been sustained by the waste company - aseparate legal entity.

The Court held that compensation was payable as the Waste Company wascarrying on no business of its own but was in fact carrying on the Smith,


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Stone & Knight business as agent for them.

Atkinson J held that the following six factors must be proven in order toshow the requisite agency relationship and thus be able to lift thecorporate veil:

Profits of the subsidiary must be treated as profits of the holdingcompany;

Those conducting the subsidiary's business must be appointed by theholding company;

The holding company must be the head and brain of the tradingventure;

The holding company must be in control of the venture and mustdecide what capital should be spent and what should be done;

The profits made by the subsidiary's business must be made by theholding company's skill and direction; and

The holding company must be in constant and effective control.

This decision was adopted in Pioneer Concrete Services Ltd v Yelnah PtyLtd & ors (1987) 5 ACLC 467. In this case a dispute occurred betweenmajor competitors in a concreting industry. Hi-Quality Concrete (Holdings)Pty Ltd was the holding company for a large group of companies, known asthe Hi-Quality group. This group was under the control of MessrsHargreaves, Ward and Armstrong. Hi-Quality Concrete (NSW) was part ofthis group and was a fully-owned subsidiary of the holding company.

In 1982 Hargreaves, Ward and Armstrong together with Hi-Quality Concrete(NSW) Pty Ltd and Hi-Quality Concrete (Holdings) Pty Ltd entered into adeed with the plaintiff. In the deed "Hi-Quality" was defined as Hi-QualityConcrete (NSW) Pty Ltd. In 1985 the holding company entered intotransactions which were alleged to be in breach of this deed. The other

members of the group denied any breach of the agreement on the basisthat they were not parties to the 1985 transactions and that the holdingcompany was not a party to the 1982 deed.

The Supreme Court of New South Wales held that the specific provisiondefining "Hi-Quality" meant that the holding company was specificallyexcluded from the promises in the 1982 deed and therefore could not be inbreach of the deed. Young J acknowledged the separateness of the legalentities involved and held that on the facts there could be no imputation ofthe promise by the subsidiary to the holding company. In other words the


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corporate veil could not be lifted. Importantly the court could not infer anagency agreement, nor could they find a partnership between thecompanies in the group or a sham or a facade 20. Further there was "noquestion of a corporation being formed for the sole purpose or for thedominant purpose of evading ... a contractual or fiduciary obligation." 21

According to Young J22, the corporate veil would not be lifted when itappears that "there was a good commercial purpose for having separatecompanies in the group performing different functions even though theultimate controllers would very naturally lapse into speaking of the wholegroup as `us'."

This issue was also examined in Briggs v James Hardie & Co Pty Ltd (1987)7 ACLC 841. In this case Briggs suffered from a medical condition allegedlycaused by negligence of his employer. His employer was a subsidiary ofthe defendant. In an action against both his employer and its holding

company, one argument which had to be addressed was whether thecorporate veil could be lifted so as to find the holding company liable.

The New South Wales Court of Appeal admitted to the possibility of the veilbeing lifted and remitted the case back for determination.

(c) Groups of companies

Companies may form part of a group of companies where for example,

they operate with a holding company and subsidiaries. On occasion, courtswill regard the entities as one. In DHN Food Distributors Ltd v TowerHamlets London Borough Council [1976] 1 WLR 852, three companies in agroup of food distributors were treated by the court as one 23. In this caseone company, D.H.N. Food Distributors [DHN], owned and controlled abusiness of importing and distributing groceries. It operated out of awarehouse which was owned by a subsidiary, called Bronze InvestmentsLtd. Vehicles which were used in the business were owned by anothersubsidiary, D.H.N. Food Transport Ltd. DHN held all the shares in both thesubsidiaries and the companies had common directors.

In 1969 the local council, known as Tower Hamlets London Borough

20 (1987) 5 ACLC 467 at 476.

21(1987) 5 ACLC 467 at 477.

22 (1987) 5 ACLC 467 at 476.

23 Indeed Lord Denning described the case as the "three in one". Threecompanies in one or alternatively as the "one in three". One group of threecompanies. See [1976] 1 WLR 852 at 857.


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Council, made a compulsory purchase order so as to acquire the land onwhich was built the warehouse. DHN was unable to relocate and thebusiness subsequently closed down. On the issue of compensation, therewere two factors to consider. First, the value of the land and secondlycompensation for disturbance in having the business closed down. On the

first issue, the council offered and paid an agreed sum to BronzeInvestments Ltd. However with regards to the "disturbance value", thecouncil argued that none was payable as Bronze Investments were notdisturbed. The council admitted that both DHN and DHN Food DistributorsLtd were disturbed, however they argued that those two companies werenot entitled to any compensation at all because they had no interest in theland. The council argued that DHN was only a licensee of BronzeInvestments Ltd. Under the Compulsory Purchase Act1965 (UK) if a personhas no greater interest than a tenant from year to year in the land, then heis only entitled to compensation for that lesser interest. As a licensee canbe evicted on short notice, the compensation payable to DHN would be

negligible.

The English Court of Appeal treated the companies as one economic entityand following from this, DHN could be treated as owner of the property andwas thus entitled to compensation for disturbance to its business24.According to Lord Denning25:

"We all know that in many respects a group of companies are treatedtogether for the purpose of general accounts, balance sheet, and

profit and loss account. They are treated as one concern. Professor

Gower in Modern Company Law (3rd ed., 1969), p 216 says: ... `thereis evidence of a general tendency to ignore the separate legalentities of various companies within a group, and to look instead atthe economic entity of the whole group.' This is especially the casewhen a parent company owns all the shares of the subsidiaries - somuch so that it can control every movement of the subsidiaries.These subsidiaries are bound hand and foot to the parent companyand must do just what the parent says ... They should not be treatedseparately so as to be defeated on a technical point. They shouldnot be deprived of the compensation which should justly be payablefor disturbance. The three companies should, for present purposes,

be treated as one, and the parent company DHN should be treatedas that one26."

24 For a discussion on this point see Re Securitbank Ltd [1978] 1 NZLR97 at 133 and Industrial Equity Ltd v Blackburn (1977) 137 CLR 567.

25 [1976] 1 WLR 852 at 860.

26 The decision in DHN was approved in Amalgamated Investment &Property Co Ltd (in liq) v Texas Commerce International Bank Ltd [1983] QB84. However the case was distinguished in Woolfson v Strathclyde Regional


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Lord Goff also believed that this was a case in which one was entitled tolook at the realities of the situation and to pierce the corporate veil. In hisLordship's opinion27:

"I would not at this juncture accept that in every case where one hasa group of companies one is entitled to pierce the veil, but in thiscase the two subsidiaries were both wholly-owned; further they hadno separate business operations whatsoever; third, in my judgment,the nature of the question involved is highly relevant, namely,whether the owners of this business have been disturbed in their

possession and enjoyment of it."

An Australian illustration of this "group enterprise" circumstance occurredin Hobart Bridge Co Ltd (in liq) v Commissioner of Taxation (1951-52) 25ALJ 225. In this case the appellant was granted a franchise to build a

bridge across the Derwent river in Tasmania. The company's source ofrevenue was to include profit from the subdivision and sale of land adjacentto the bridge. The promoter had secured options over the land and asubsidiary company was formed to purchase it. The appellant heldapproximately nine-tenths of the shares in the subsidiary. No sales of landwere made by the subsidiary, however some preparatory work was done.An Act was passed whereby the government acquired all the undertakingof the appellant and later they acquired all of the shares in the subsidiarycompany. By the share transactions the appellant made a substantialprofit.

The respondent treated this profit as assessable income earned pursuant toa profit-making scheme of which the subsidiary was the "collectingmedium".

The High Court rejected this and held that the subsidiary was not to bedeemed the medium or machinery for a scheme. There was to be nolifting of the corporate veil simply because the formation of the subsidiaryreduces tax liability. The subsidiary had a real existence and a valid reasonfor its incorporation.

Kitto J referred28

to the judgment of Lord Sumner in Gas Light Improvement

Council (1978) 38 P & CR 521. Lord Keith of Kinkel at 526 expressed doubtas to whether the decision in DHN correctly applied the principle that it isappropriate to pierce the corporate veil only where special circumstancesexist indicating that it is a mere facade concealing the true facts.

27 [1976] 1 WLR 852 at 861.

28 (1951-52) 25 ALJR 225 at 228.


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Co v Inland Revenue Commissioners29 where his Lordship stated:

"It is said that all this was `Machinery' but that is true of allparticipations in limited liability companies. They and theiroperations are simply the machinery, in an economic sense, by which

natural persons, who desire to limit their liability, participate inundertakings which they cannot manage to carry on themselves,either alone or in partnership, but, legally speaking, this machinery isnot impersonal though it is inanimate. Between the investor, who

participates as a shareholder, and the undertaking carried on, thelaw interposes another person, real though artificial, the companyitself, and the business carried on is the business of that company,and the capital employed is its capital and not in either case thebusiness or the capital of the shareholders. Assuming, of course,that the company is duly formed and is not a sham (of which there isno suggestion here), the idea that it is mere machinery for effecting

the purposes of the shareholders is a layman's fallacy. It is a figureof speech, which cannot alter the legal aspects of the facts."

In Qintex Australia Finance Ltd v Schroders Australia Ltd (1991) 9 ACLC109, Rogers CJ suggested that the whole issue of the separateness of thecorporate legal entity be re-examined in the light of the so-called tensionbetween the realities of commercial life and the applicable law. Althoughthe court in the case at hand had to determine which company in theQintex group of companies should be able to claim the benefit of thecontract entered into, a number of more general remarks were made

concerning the separate legal entity doctrine. According to Rogers CJ itmay be desirable30:

"... [F]or Parliament to consider whether this distinction between thelaw and commercial practice should be maintained. This is especiallythe case today when the many corporate collapses of conglomeratesoccasion many disputes."

In Briggs v James Hardie Co Pty Ltd (1989) 7 ACLC 841 Rogers AJA notedthat complete domination or control over a subsidiary may not by itselflead to the corporate veil being lifted. Further the judge suggested31 that

different considerations should apply when this veil is to be lifted in tortioussituation as compared with actions based in contract and taxation.

29 [1923] AC 723 at 740-741.

30 (1991) 9 ACLC 109 at 111.

31 (1989) 7 ACLC 841 at 863. This was also the view of Lord Goff inDHN Food distributorsv Tower Hamlets London Borough Council [1976] 1WLR 852.


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2. Statute - Corporations Act

Under the Corporations Act there are numerous illustrations of personal

liability attaching to management despite the company structure being inexistence and perhaps being the entity which contractually dealt with athird party.

(a) Section 183

Promoters who enter pre-registration contacts32 may incur personal liabilityto those with whom they dealt on behalf of a non-existent entity, irrespec-tive of any contractual intention. This is due to the operation of section131of the Corporations Act. Bay v Illawong Stationery Pty Ltd (1986) 4

ACLC 429. See also sections 711, 728 and 729.

(b) Section 153

This section requires a company to set out its name on all its publicdocuments and negotiable instruments. It is a strict liability offence forbreach. In an English case, Jenice Pty Ltd v Dan (1994) 12 ACLC 3209 acompany's cheques bore the name "Primkeen Limited" when its name was"Primekeen Ltd". A cheque which was later dishonoured was issued and

signed by a director and the payee attempted to make the director liable.The Court held that the director was not liable. The company's name wasmentioned notwithstanding the typographical error. This was differentfrom omitting the whole name.

(c) Sections 588G-588Z and 592-593 (Insolvent Trading)

Introduction to sections 588G-588Z

When a company has a liquidity crisis its directors and officers need to take

special care in their dealings with those outside the company. Directorsneed to consider their company's ability to pay all its debts as and whenthey become due. This is particularly so when the company is in financialdifficulty and some form of financial management structure is in place. If areasonably competent director would conclude that the company lacks thatcapacity or would lack that capacity after incurring the debt, they shouldnot cause the company to incur further debts.

32 Courtney, W., Failed Pre-registration Contracts and the StatutoryRemedy, (2007) 25 C & SLJ 226.


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The relevant provisions of the Corporations Act regulating insolventtrading are contained in sections 588G-Z. Those provisions contain acomplete code for the regulation of such trading. Sections 588G-588Z ofthe Corporations Act are provisions which commenced operation on and

from the 23 June 1993. These sections were designed to replace theinsolvent trading provisions contained in sections 592-593 of theCorporations Law33. However these latter provisions will continue to applyto debts incurred prior to 23 June 1993 in circumstances amounting toinsolvent trading.

The duty

Section 588G(1) imposes a duty upon directors to prevent a company fromengaging in insolvent trading. The heading to Division 3 of theCorporations Actrefers to this duty and this heading is regarded as part of

the Corporations Actbecause of the operation of sec 109D.

Section 588G(1) applies if:

(a) the director was a director of the company at the time when thecompany incurs a debt; and

(b) the company is insolvent at the time of the incurring the debt orbecomes insolvent by incurring that debt or by incurring at that timedebts including that debt; and

(c) at the time there are reasonable grounds for suspecting thecompany was insolvent or would become insolvent as a result of thetransaction; and

(d) that time is at or after the commencement of this Part, that is 23 June1993.

Section 588G(3) provides that by failing to prevent the company fromincurring the debt, the person will contravene the section if they wereaware at the time that there are such grounds for so suspecting or a

33 It should be noted that sections 592(6) and 593(2) of theCorporations Act also deals with conduct known as fraudulent trading.

These provisions have not been replaced and this means that these parts ofsections 592 and 593 are still operative in regards to fraudulent tradingnotwithstanding that the debts were incurred after the 23 June 1993.However with regards to insolvent trading, a preliminary issue ofascertaining the date the debt was incurred must be made. If debts wereincurred after 23 June 1993 in these circumstances sections 588G-588Z willapply. For debts incurred prior to this date in similar circumstances,sections 592(1)-(5),(7),(8), 593(1) and (4)-(8) apply.
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reasonable person in a like position in a company in the companycircumstances would be so aware.

Further, section 588G(3) provides that a person commits an offence if:

(a) the company incurs a debt at a particular time; and

(b) at that time, the person is a director of the company; and

(c) the company is insolvent at that time, or becomes insolventby incurring that debt, or by incurring at that time debtsincluding that debt; and

(d) the person suspected at the time when the company incurredthe debt that the company was insolvent or would becomeinsolvent as a result of incurring that debt or other debts; and

(e) the persons failure to prevent the company incurring thedebt was dishonest.

(a) If either section 588G(2) or (3) is satisfied, then section 588Mcan be used to enable a creditor to recover compensation forloss resulting from insolvent trading as long as section 588Ror section 588S are satisfied.

It should be noted that both those who contravene the section and those

"involved in the contravention" (section 79) can be caught.

Relevantly, section 588M provides that if:

(a) a person (director) has contravened section 588G(2) or (3) inrelation to the incurring of a debt by a company; and

(b) the person (creditor) to whom the debt is owed has sufferedloss or damage in relation to the debt because of thecompanys insolvency; and

(c) the debt was wholly or partly unsecured when the loss ordamage was suffered; and

(d) the company is being wound up,

then a creditor may, if they have satisfied either section 588R or section588S, recover from the director, as a debt due to the creditor, an amountequal to the amount of the loss or damage.

Section 588R enables a creditor to commence proceedings with the
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written consent of the companys liquidator.

Section 588S enables a creditor to sue for compensation without theliquidators consent but only after giving notice to the liquidator.

Section 588M(4) provides that proceedings under section 588M may onlybegun within six years after the beginning of the winding up. Further,section 588M has the effect in addition to, and not in derogation of, anyrule of law about the duty or liability of a person because of the personsoffice or employment in relation to the company and does not preventproceedings from being instituted in respect of a breach of such a duty orin respect of such a liability (section 588P).

According to para 1229 of the Explanatory Memorandum whichaccompanied these provisions:

"[A] court would be expected to look at two separate issues whenconsidering whether the duty had been breached. The first matterwould be what circumstances that particular company was in,including the size of the company, the type of the company, thenature of its enterprise, the provisions of its articles, the compositionof its board and the distribution of work between the board and other

officers. The second matter that a court would be expected to lookat would be, in the light of the circumstances referred to, what woulda reasonable person in the position of director normally be expectedto do to ensure that he or she would be aware of any insolvency

problem. In particular a court might expect the following:

that directors of a large company would ensure that amongtheir number there should be one or more who are talented inthe field of corporate financial management;

that directors of a large company should read, be able to

understand and seek any necessary clarification of the keyfinancial information put before the board, such as a balancesheet and a profit and loss statement;

that the board ensure that appropriately skilled people areengaged to carry out the company's accounting functions;

that the board would require relevant accounting informationto be supplied ahead of regular board meetings at which key
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financial decisions are to be made, and that, where asignificant borrowing is to be undertaken, the managementshould supply the board with a statement of the company'scurrent financial position as well as the particulars of the wayin which the principle, interest and other charges are to be

serviced over the anticipated term of the loan;

that the board make arrangements for monitoring the use ofany authorisation granted in relation to the use of the companyseal, the entering into contracts with financiers or the signingof cheques and bills of exchange; and

where the nature of the business may expose the company toa high risk of sudden liquidity restriction, or the company isknown by the director to be in a delicate financial position, that

extra care and more rigorous safeguards may be adopted."

Importantly, there is nothing in section 588G which necessitates thewinding up of the company as a precondition to activating the section,however it can be argued that the heading to Part 5.7 (including Part 5.7Bin which sections 588G-588Z is located) of the Corporations Actmakes itclear that section 588G is part of particular legislation concerned with therecovery of property or compensation after a winding up has begun.Furthermore some of the sections related to section 588G, such as sections588M and 588R, reinforce the view that they operate only where thecompany is being wound up. In contrast, other related sections such as

sections 588J and 588K, are not expressed to be contingent upon windingup occurring and it is arguable that these particular sections are notconfined to winding up situations.

Taking each of the elements in section 588G(1) in turn, the following canbe stated:

(1) Directors

With respect to `directors', section 9 of the Corporations Actprovides that a"director" would include any person occupying or acting in the position of

director by whatever name called and whether or not validly appointed orauthorised and any person in accordance with whose directions or instruc-tions the directors are accustomed to act - so called "defacto" directors.See Taylormaid Marine Industries Pty Ltd v Beaurepaire & Ors (1987) 5ACLC 253. Further persons dealing with a company can assume that aperson is a director in certain situations [sec 129].

The definition may also include alternate directors if called upon to act.See Playcorp Pty Ltd v Shaw & ors (1993) 11 ACLC 641.
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(2) Incurring of a debt

Another requirement to found a cause of action under section 588G(1) isproof that "the company incurred a debt." This involves an examination of

two requirements. First, what qualifies as a `debt' for the purposes of thesection and secondly, what is involved in the `incurring' of a debt.

(a) The meaning of debt'

The meaning of the word debt is not defined in the legislation.However it has been interpreted to bear its ordinary technical meaning assomething recoverable by an action for debt and thus must beascertained or capable of being ascertained: Ogdens Ltd v Weinberg(1906) 95 LT 567; Hussein v Good (1990) 1 ACSR 710. Therefore, a

debt refers to an obligation for the payment of money or moneysworth and there is authority to suggest that the obligation must be for anascertained liquidated sum: 3M Australia Pty Ltd v Watt (1984) 9 ACLR503;Jelin v Johnson (1987) 5 ACLC 463.

In CAC v Shapowloff (1974) CLC 27,964, the defendant, by telephone,allegedly ordered 5,000 shares from a broker on behalf of his company.

The terms were that the company would pay for them only when thebroker received the scrip. In other words, the liability remained contingentuntil the scrip was received. The broker obtained these shares in 29

transactions and 29 contract notes were forwarded to the company. Theshares were not paid for and the company was wound up. The defendantwas charged with knowingly being a party to contracting a debt provable inthe winding up of that company having, at the time the debt wascontracted, no reasonable or probable ground of expectation of thecompany being able to pay.

A declaration was sought from the Supreme Court. Before any evidencewas taken, as to the meaning of the word `debt' in the section, Jacobs P inthe Court of Appeal (1974) CLC 27,974 declared at 27,977:

"[T]hat for the purposes of sec 303(3) of the Companies Act where aseries of contracts is made from time to time which result in aliability on behalf of the company to pay in respect of each of them,then each such liability constitutes a debt; and the time when eachsuch debt is contracted is the time when each respective liabilityarises, and not the time or times when the balance is declared orcomputed."

The Magistrate, believed that contingent debts should be included withinthe meaning of the word "debt". Here liability arose when the contract


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notes were delivered to the company. This view was affirmed by Cantor Jin the Supreme Court and by Mahoney JA in the Court of Appeal.

Notwithstanding these comments on contingent debts, it appears thatsome divergence of opinion has developed because of the lack of clarity in

the section as to whether these debts are "debts" within the meaning ofsec 592 Corporations Law. The section does not expressly state whether"debt" includes a contingent debt and this omission could lead tounsatisfactory results. Illustrative of these concerns is the VictorianSupreme Court decision in Hussein vGood (1990) 8 ACLC 390. In this casethe defendant, a director of a clothing retail company ordered a range ofclothing from the plaintiff, a manufacturer. The date of delivery wasoriginally to be March 1988 but this, by agreement, was changed to 3 May1988. Payment was to be made upon delivery.

Part of the total goods were delivered on 3 May 1988 but no payment was

made. A few days later money was collected by the plaintiff, however oneof the cheques used for payment was dishonoured. Before notice ofdishonour was given, the remainder of the goods were delivered. Nofurther payment was made.

On 16 May 1988 the defendant's accountant advised the defendant to putthe company into voluntary liquidation. The company was placed underthe control of a liquidator. The company was placed under the control of aliquidator. The plaintiff claimed against the defendant pursuant to section556 of the Companies Code (now section 588G Corporations Act).

The Court held that the date to determine whether there were reasonablegrounds to expect that the company could not pay all its debts as andwhen they became due was in May 1988 and that at that date thedefendant did not expect the debt would be paid. A debt it was held,34

meant "what is owed, state of owing something". Here nothing was oweduntil the delivery of the manufactured garments.

According to Southwell J, Shapowloffwas distinguishable from the presentcase:

"I see some difficulty in drawing an analogy between the particularcircumstances surrounding transaction between a purchaser ofshares and his agent, the broker, where the creation of a contingentliability can usually be expected to become a present indebtednessvery quickly, perhaps upon the same day, and a case where, as inthe present case, a trader in goods places an order with amanufacturer in circumstances where any contingent liability, if therewas one, would not become a present indebtedness until some

34 (1990) 8 ACLC 390 at 397.


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months thereafter."

The defendant unsuccessfully argued that the date on which the debt wasincurred was November 1987, when the goods were ordered.

In Standard Chartered Bank v Antico (1995) 131 ALR 1 at 57 Hodgson Jstated that:

a company incurs a debt when, by its choice, it does or omitsomething which, as a matter of substance and commercial reality,renders it liable for a debt which it otherwise would not have beenliable.

Further, in ASIC v Plymin (No 1) (2003) 46 ACSR 126 Mandie J noted at247:

the weight of authority shows that a debt can be incurred whenthe contract giving rise to the debt is entered into, even ifcontingencies affect the debt or the debt is a future debt. In thecase of a future debt, it may be incurred at the time of entering thecontract if it is then an ascertained or an ascertainable amount. Bythe same token, a debt may in appropriate circumstances beincurred within the meaning of the section at a time later than theentry of the contract under which the debt arises or may arise.

Although it is necessary to consider the terms of the relevantcontract, the question when the debt is incurred within the meaning

of this section does not depend on strict legal analysis but turns onwhen, in substance and commercial reality, the company isexposed to the relevant liability.

In Australian Securities and Investments Commission v Edwards (2005)220 ALR 148; 54 ACSR 583; [2005] NSWSC 831 Barrett J stated thatincurring, a debt involves any "act, omission or other circumstancewhich causes the company to owe the debt.

In Hawkins & ors v Bank of China (1992) 10 ACLC 588, it was held that"debts" can include a contingent liability35. According to Gleeson CJ:

"`Debt' is capable of including a contingent liability. The word wasused in that sense in sec 291 of the Companies Act 1961, whichreferred to `debts payable on a contingency'. That expression didnot involve a contradiction in terms. Dictionaries define `debt' as aliability or obligation to pay or render something. Such a liabilitymay be conditional as well as present and absolute.

35 (1992) 10 ACLC 588 at 595. Kirby P also agreed at 599 with thisconclusion.


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Likewise a contractual obligation to supply goods even after theyhave been paid for, will not constitute a debt for the purposes of thesection. This is because as at the time of the contract all that couldbe claimed if the goods were not supplied would be an action for

damages. "A potential liability for damages does not constitute theincurring of a debt for the purposes of sec 592."36

In Deputy Commissioner for Corporate Affairs v Abbott & Anor (1980) CLC34,428 it was held that37:

"The word `debts' means something recoverable by an action fordebt and nothing can be recovered in an action for debts except thatwhich is ascertained or can be ascertained.; see Ogden's Ltd vWeinberg (1906) 95 L.T. per Lord Davey at p.567".

This view was accepted and followed by Master Seaman in Jelin Pty Ltd vJohnstone & Anor(1987) 5 ACLC 463 and it appears that the word is usedin its ordinary sense38 and therefore claims for unliquidated damages39 andoutstanding interest would be excluded40. In addition taxes which are dueand payable and which may even be deemed to be debts owing to thecrown are not `debts' for the purposes of section 588G41. However, claimsfor outstanding workers compensation premiums are debts within themeaning of the section.42 Finally, the fact that a company's liability to paya debt has been extinguished (subject to proofs of debt) upon a winding up,does not mean that directors and management will avoid liability43 as

creditors have a vested right to sue the officer.

(b) The meaning of incurring a debt

Section 588G(1A) contains a debt table which is designed to assistascertain the point in time when a debt was incurred. It is non-exhaustive.

Predecessor legislation covered situations where the defendant wasknowingly a party to the contracting of a debt by the company. For

36 Reed International Books Australia v King (1993) 11 ACLC 935 at 938.37 (1980) CLC 34,428 at p 34,430.38 See 3M Australia Pty Ltd v Watt & Anor; NEC Home Electronics

Australia Pty Ltd v White & Anor(1984) 2 ACLC 621.39 SeeJelin Pty Ltd v Johnstone & Anor(1987) 5 ACLC 463.40 See BL Lange & Co v Bird (1991) 9 ACLC 1015.41 See Castrisios v McManus; McManus v Castrisios (1991) 9 ACLC 287.42 State Government Insurance Corp v. Pollock(1993) 11 ACLC 839.43 See Ross McConnel Kitchen & Co. Pty Ltd (in liq) v Ross & Ors (1985)

5 ACLC 326 at 329.


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example, the purchase of shares via a telephone order 44; purchase of goodsand services45; entering into contracts to help build project homes46;arranging for advances to be made to the company. The question is, issection 588G of the Corporations Actrestricted to debts which have beencontracted47?

InJelin Pty Ltd v Johnson & Anor(1987) 5 ACLC 463, the plaintiff sought torecover damages from the defendant because it had been deprived of a

judgment debt. This judgment debt was given by the Federal Court inrelation to misleading statements made by servants of the company. Theplaintiff submitted that the relevant debt was incurred either when theplaintiff introduced funds into the business on the faith of the misleadingstatements of the servants or agents or when the Federal Court gave its

judgment. Master Seaman QC said that neither on the day on which themisrepresentations were made, nor on the day when judgment was givenby the court awarding damages, nor on any day between these two days,

did the company ìncur a debt'48.

"The incurring of a liability in damages is not the same as ìncurringa debt' under the section".

A similar conclusion was reached in relation to a liability to pay taxation 49.

In Hawkins & ors v Bank of China (1992) 10 ACLC 588 it was held that thegiving of guarantee constituted the incurring of a debt. The liabilityincurred under the guarantee was to pay an already-accrued sum which

was a liquidated amount. Even though it was unusual to say that thecompany may not have incurred a debt at the time when it had given theguarantee, nevertheless according to Gleeson CJ and Sheller JA it wasproper to say that the company incurred a debt to the bank at some stage.

Their Honours noted:

"[T]hat the words ìncurs' and `debt' are not words of precise andinflexible denotation. Where they appear in sec 556 they are to beapplied in a practical and commonsense fashion, consistent with thecontext and with the statutory purposes."

44

Shapowloff v Dunn (1981) ACLC 33,127.45 Deputy Commissioner for Corporate Affairs v Abbott & anor (1980)CLC 34,428 and DeRossi v Hamilton (1982) 7 ACLR 40 and Flavel v Day(1985) 3 ACLC 320.

46 Southern Highlands Building Co. Pty Ltd (in liq) and the CompaniesAct(1979) ACLC 32,074.

47 Metal Component Industries Pty Ltd (in liq) v Clark & Anor (1980)ACLR 862.

48 (1987) 5 ACLC 463 at 465.49 See Castrisios v McManus; McManus v Castrisios (1991) 9 ACLC 287

at 296.


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According to Gleeson CJ50:

"the word ìncurs' takes its meaning from its context and is apt todescribe, in an appropriate case, the undertaking of an engagement

to pay a sum of money at a future time, even if the engagement isconditional and the amount involved is uncertain. Once it isaccepted that `debt' may include a contingent debt then there is noobstacle to the conclusion that, in the present context, a debt mayhave been taken to have been incurred when a company entered acontract by which it subjected itself to a conditional but unavoidableobligation to pay a sum of money at a future time ."

Kirby P adopted a similar view and held51 that:

"The act of ìncurring' happens when the corporation so acts as to

expose itself contractually to an obligation to make a future paymentof a sum of money as a debt. The mere fact that such a sum ofmoney will only be paid upon a future contingency does not makethe assumption of the obligation any less ìncurring' a `debt'."

Associated with ascertaining whether a company has incurred a debt is theconcomitant task of being able to specify the particular time when the debtwas incurred.

In Russell Halpern Nominees Pty Ltd v Martin & Anor52, the plaintiff

company agreed to lease premises to two other companies. Rent was notreceived and it was found that immediately before and at the time ofentering into the agreement for lease, both tenants were unable to paytheir debts as and when they fell due. A writ based upon sec 556 wasstruck out on the basis that it did not disclose a reasonable cause of action.

The Supreme Court by majority, dismissed the appeal.

According to Burt CJ.53:

"[W]hatever the expression ìncurs a debt' might mean, it is clearlydescriptive of an act which when done by the company in the stated

circumstances exposes a director of the company and a person whotook part in the management of the company when the debt wasincurred, [sic] when the act was done, to a criminal liability. Theincurring of the debt by the company in the stated circumstances isthe act which constitutes the offence created by the subsection and

50 (1992) 10 ACLC 588 at 595.51 (1992) 10 ACLC 588 at 598.52 (1986) 4 ACLC 393.53 (1986) 4 ACLC 393 at 396.


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that act is done at a particular and identifiable point of time, [sic]`when the debt was incurred.' ... To hold otherwise would be to saythat if a company when in all respects financially sound were to enterinto a lease for a term of years and at some time thereafter and forreasons which could not be anticipated it were to fall on bad times

and be unable to pay its debts, the directors would thereafter and onevery rent day within the remainder of the term be guilty of anoffence for the reason that on the rent day the company `incurs adebt'. I am unable to accept that".

(3) Insolvent at the time of the incurring the debt orbecomes insolvent

The definition of insolvency is central to the operation of the insolventtrading provisions. Liability is not triggered under the insolvent trading

provisions unless the company was insolvent at the time the particulardebt was incurred, or became insolvent by incurring that debt or otherdebts: section 588G(1)(b).

Prior to 23 June 1993, no statutory definition of insolvency existed.However the Corporations Act now contains section 95A which providesdefinitions of both solvency and insolvency. Those definitions have beenargued54 as representing:

a particularly important reform in relation to Part 5.7B

because it refines and partly codifies the complex lawsurrounding the situation which arises when a company isinsolvent.

Under section 95A(1) a person is deemed solvent, if and only if, theperson is able to pay all the persons debts as and when they becomedue and payable.

Under section 95A(2) a person who is not solvent is insolvent.

It has been held that the definition contained in section 95A suggests

that a cash flow test is intended rather than a simple balance of assetsover liabilities: Leslie v Howship Holdings Pty Ltd (1997) 15 ACLC 459.

This was reinforced by Prior J in Powell v Fryer (2000) 18 ACLC 480 at482 where his Honour stated that the primary cash flow test ofinsolvency was as follows:

The commercial solvency of the company is not proved by merely

54 Pollard SM., Fear and Loathing in the Boardroom: DirectorsConfront New Insolvent Trading Provisions (1994) 22 ABLR 392.
http://www.austlii.edu.au/au/legis/cth/consol_act/ca2001172/s95a.htmlhttp://www.austlii.edu.au/au/legis/cth/consol_act/ca2001172/s95a.html


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looking at its accounts and making a mechanical comparison of itsassets and liabilities. Insolvency is a question of fact falling to bedecided as a matter of commercial reality in the light of all thecircumstances with things being viewed as it would by someoneoperating in a practical business environment. The statutory focus

is on solvency, not liquidity. Thus it is appropriate to consider theterms of credit or financial support available to the company withwhich to defray any debts owed to creditors. The question is not tobe answered merely by looking at the financial statements.

Similar views were expressed by Palmer J in Hall v Poolman (2008) 65ACSR 123 and in Lewis v Doran (2004) 50 ACSR 175.

The definition of insolvency contained in section 95A differs from the pre-existing law which had developed around its predecessors in insolvencylegislation as those predecessor provisions defined insolvency as an

ability to pay the debtors debts from his own monies: see, forexample, section 122 of the Bankruptcy Act1966 (Cth) and section 451 ofthe Companies (NSW) Code 1981. However, those sections have hadsome influence over what is required to be satisfied to prove solvency.Cases such as Sandell v Porter (1966) 115 CLR 666 held that a debtorsability to pay from his own monies, as required by section 95 of theBankruptcy Act1966 (Cth), included an ability to raise money by its sale,pledge or mortgage of his assets. However, money obtained byunsecured borrowings was not treated by the Courts as the debtors ownmoney: see Armour; Ex parte Official Receiver v Commonwealth

Trading Bank (1956) 18 ABC 69 at 74; Kyra Nominees Pty Ltd (in liq) vNational Australia Bank Ltd (1986) 4 ACLC 400 at 405; Norfolk PlumbingSupplies Pty Ltd v Commonwealth Bank of Australia (1992) 6 ACSR 61 at615.

It appears to be the case that the Courts, prior to the enactment ofsection 95A of the Corporations Actwere heavily in support of the viewthat the requirement that a debtor be able to pay from his own moneyin order to demonstrate solvency excluded from consideration thedebtors ability to obtain unsecured loans.

The Exposure Draft Bill of the Corporate Law Reform Bill (Cth) publishedin February 1992, in the clause that ultimately became section 95A,defined insolvency as a debtors inability to pay his or her debts as theybecame due and payable from his or her own money. In the light ofthat, Palmer J noted in Lewis v Doran (2004) 50 ACSR 175 at 193-194, itis legitimate to assume that the inclusion of those words was intended toconvey that the case law which had developed around those words in

prior insolvency legislation was to continue to be applicable. However,when the Bill became law, the words from his or her own money weredropped and no explanation of why those words were omitted from


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v) in assessing solvency, the Court acts upon the basis that acontract debt is payable at the time stipulated for payment inthe contract unless there is evidence, proving to the Courtssatisfaction, that:

there has been an express or implied agreementbetween the company and the creditor for an extensionof the time stipulated for payment; or

there is a course of conduct between the company andthe creditor sufficient to give rise to an estoppel

preventing the creditor from relying upon the stipulatedtime for payment; or

there has been a well established and recognised

course of conduct in the industry in which the companyoperates, or as between the company and its creditorsas a body, whereby debts are payable at a time otherthan that stipulated in the creditors terms of trade orare payable only on demand:

vi) it is for the party asserting that a companys contract debtsare not payable at the times contractually stipulated to makegood that assertion by satisfactory evidence: Powell v Fryer(supra) at 600; Melbase (supra); Cuthbertson & Richards

Sawmills Pty Ltd v Thomas (supra).

In Lewis v Doran (2004) 50 ACSR 175 Palmer J reiterated the above viewsby stating at 198:

I think that I must approach the application of s.95A [of theCorporations Act] with two considerations in mind. First, the wordsof s.95A must be construed as they stand, without addition orsubtraction. Second, the law both before and after the enactmentof s.95A is unequivocally and emphatically clear that insolvency is,first and last, a question of fact to be ascertained from a

consideration of the companys financial position taken as a whole.In considering the companys financial position as a whole, theCourt must have regard to commercial realities. Commercialrealities will be relevant in considering what resources are availableto the company to meet its liabilities as they fall due, whetherresources other than cash are realisable by sale or borrowing uponsecurity, and when such realisations are achievable.

His Honour added at 199:


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In my opinion, the omission of the words from its own moniesfrom the definition of insolvency in s.95A now leaves the Court freeto determine the question of retrospective insolvency free of aqualification which might well be appropriate to determine only

prospective insolvency. The omission leaves the Court free to

determine insolvency, whether retrospective or prospective, as aquestion of commercial reality having regard to the particular factsof the case.

Later in his judgment Palmer J stated (at 200)56:

I conclude that section 95A of the Corporations Act has changedthe pre-existing law as to the definition of insolvency as stated incases such as Sandell v Porter, and that it is no longer necessary inorder to assess solvency to ascertain whether the company is ableto pay all of its debts from its own monies, in the sense discussed

in those cases. In my opinion, section 95A requires the Court todecide whether the company is able, as at the alleged date ofinsolvency, to pay all of its debts as they become payable byreference to the commercial realities. If the Court is satisfied thatas a matter of commercial reality the company has a resourceavailable to pay all its debts as they become payable that it will notmatter that the resource is an unsecured borrowing or a voluntaryextension of credit by another party.

Therefore it is the case that all cash resources available to a company

including credit resources are to be taken into account when assessingsolvency: See Metropolitan Fire Systems Pty Ltd v Miller(1997) 23 ACSR699. This would include promises of financial support: see Dunn vShapowloff [1978] 2 NSWLR 235

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Topic 6 - The Company as a Corporate Entity

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