Understanding Company Law

Alastair Hudson

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351655552
• Edition: 2
• Topic: Law
• Subtopic: Law Theory & Practice
• Index: Law

Understanding Company Law is a lively introduction to the key principles of the Companies Act 2006 and modern company law. It takes a unique approach to the subject, which also encompasses the important and growing fields of securities regulation, corporate governance and corporate social responsibility.

This book covers all of the key topics that a student reader will encounter in any company law course. The discussion presents the key principles simply, before guiding the reader through the more complex issues that are often the focus of examinations in this subject. It also offers pathways into further reading, while injecting enjoyment back into the topic.

In Understanding Company Law, Professor Hudson provides a straightforward guide to the law, while providing context, detailed analyses of the leading cases, and no little humour.

The second edition covers key recent changes and developments in company law, both case law and statutory, including: two recent Supreme Court decisions on piercing the corporate veil, VTB Capital plc v Nutritek International Corp and others and Prest v Petrodel Resources Limited & Others, and an analysis of the Conservative government's Green Paper on Corporate Governance.

Online support
Visit the author's website at www.alastairhudson.com to find podcasts of specially recorded lectures covering the basic principles and an audiobook version of this text.

Chapter 1
The birth of modern company law

Introduction

This book analyses the foundational principles of company law in detail. It is only possible to understand many of those principles if we understand their historical and jurisprudential bases. For example, it is only possible to understand the nature of the duties of directors if one understands how the law conceived of directors in their earliest incarnations as trustees. Much of the modern law will make more sense if we understand its roots. Similarly, it is only possible to unpick many of the problems with modern company law if the history of the company is understood. So, in this chapter we begin, as all good stories do, at the beginning.

The meaning of a ‘company’

The word ‘company’ is derived from a combination of the Latin words ‘com’ and ‘panio’ (meaning ‘with’ and ‘bread’ respectively) so as to form the word ‘companio’ (from which we also derive the English word ‘companion’) meaning literally ‘someone with whom you break bread’. Therefore, in its earliest usage, a ‘company’ was a group of people who ate together. If you mix in polite society you might occasionally belong to a ‘company’ of people going to the theatre, or you may form part of a ‘company’ having dinner together. A good friend is someone we might think of as being ‘good company’. These are the older definitions of the word ‘company’. Therefore, the concept of a company began as an agreeable collection of people joining together for some social or joint purpose. A company was simply an association of people in its earliest form.

The birth of the joint stock company

In time companies also came to represent people who banded together specifically to trade. Literally, the traders formed a ‘company’ of people with interests in common with one another. It is from this root that our legal conception of the company grew. The earliest companies of that sort can be identified most clearly in England in the mediaeval town corporations and, more familiar to our commercial understanding of the company today, in the Elizabethan era when the trading nations of Europe were seeking new lands that they could colonise, where they thought they could collect treasure and with whose people they could trade. In truth, Europeans had been doing this for centuries, just as Christopher Columbus had done in 1492 when he reached America.

It was in the sixteenth and seventeenth centuries that the idea of the joint stock company can be understood as having begun. In the simplest example, a number of rich English merchants and traders would acquire the use of a ship, which they filled with their different items of stock. In that sense the boat contained their ‘joint stock’. Someone was appointed to act as captain of the ship. The captain’s job was to sail the ship to whichever destination had been chosen and to trade the joint stock for the fabulous wealth that was believed to exist in faraway lands. The ‘South Seas’ were a popular destination at the time – what we now call South America – because it was believed that gold lay on the ground there, once one had sailed past sea serpents and dragons, and that this plentiful gold could be acquired in exchange for the stock on the ship. (In effect, somewhat optimistically perhaps, it was hoped that a few sheepskins could be exchanged for huge quantities of gold.)

In legal terms, the traders formed a contract between themselves, which we would analyse today as being a partnership. That means that the traders agreed to share the profits and losses of this venture between them in accordance with the terms of their partnership contract. The ship’s captain was understood as being a person who had legal powers to deal with the stock held on board the ship just like a trustee, and who also owed the fiduciary duties of a trustee to the traders to sell their goods for the best price and to bring the profits home. The captain owed fiduciary duties to act fairly and even-handedly between all of the traders just as any trustee would. The traders were therefore not only partners in contract law but they were also beneficiaries of this trust arrangement under trusts law. The trust property was the stock held on board ship, and any property or money for which it was exchanged on arrival in the South Seas. Therefore, the joint stock company was an imaginative use of the centuries-old ideas of contract, partnership and trust to achieve a very particular relationship that permitted trade to be conducted overseas. This was how the commercially useful idea of the joint stock company developed.

From illegality to necessity

The earliest companies were, however, beset by fraud. Knowing a little about this early history will help to explain a large amount of company law, from the general duties of directors to the detailed rules governing the maintenance of a company’s share capital. In the early eighteenth century, a man called John Law had the exceptionally clever idea of encouraging people to exchange their gold and silver coins for paper money so that the French king could control the amount of money in circulation in France. This also created the possibility that money could be raised from the public more easily to wage wars or expand French trade. A company was formed in Paris to trade in America, called the Mississippi Company. In 1719 in Paris, speculative fever was at its height as people fought to give their money over to the Mississippi Company to acquire a ‘share’ in the riches, which everyone agreed was sure to be earned by members (or shareholders) of the company from the company’s prospective trading activities in America.

In 1720 in England a man called John Blunt had a similar idea. A century of waging war had left the English monarchy in debt. Money had to be borrowed from the public and those investors had to be paid interest on their loans as well as being paid their money back. When the new king, George I, had acceded to the throne, he was a stranger in the country he ruled because he was a German import needed to succeed to the thin Protestant bloodline of English royalty. Saddled with a huge national debt and few friends, the new king and his government fell into Blunt’s thrall. At that time the state borrowed money by issuing bonds, in return for which the bondholders were entitled to receive interest. Blunt’s idea was to encourage people to give up their bond rights in exchange for shares in the South Sea Company. The South Sea Company purported to trade in the South Seas and promised to generate unimaginable wealth for those fortunate enough to hold shares in it. A speculative fever spread in London just as it had spread in Paris. Everyone, from members of the royal family down to the petit bourgeoisie wanted to own shares in these new companies. It was a common belief that their investments could not fail. Indeed, in London each new issue of shares was greeted with tremendous public excitement.

Trading in these shares in the London coffee houses around Exchange Alley was feverishly excited. Huge fortunes were made in the short term in buying and selling shares in the South Sea Company. But, in truth, John Blunt was operating a sham. He had loaned money to well-placed individuals from the company’s funds to buy shares in the company so that it appeared that the company’s shares were much sought after. This is known today as ‘making a market’ in shares and is a criminal offence (‘market manipulation’, see Chapter 11). In fact the company had no business and all of this share speculation went on before a single ship had sailed. People willingly exchanged their bonds against the government, which entitled them to be paid money by the State, for shares in an illusory company. When the fraud became public knowledge, many people were ruined, including members of the royal family and Cabinet ministers. As a result, companies were made illegal for about a century because they were associated with fraud and immoral speculation. (The South Sea Bubble is discussed brilliantly by Balen, 2002.)

By the nineteenth century and the Industrial Revolution, however, there was a need for more investment capital to fund and fuel economic expansion. The construction of the railways and the infrastructure of modern English towns (for our sewers and so on still rest on Victorian ingenuity, muscle and skill) needed to be funded. To do this, companies were legalised again in 1824 so that investment capital could be raised from the public, instead of relying on ordinary bank borrowing, which could not meet the pace of growth.

It is important to note, however, that companies have a heritage and a root in English law as being based both on commercial expediency and the possibility of systematic fraud. Much of modern company law is concerned to encourage the former while avoiding the latter. This explains a large number of the rules underpinning company law today because they were created in the light of fraudulent schemes. Cases like Gluckstein v Barnes (1900) illustrated the sort of fraud with which early companies were associated. It was a commonplace of Victorian fiction that companies and commercial people were often engaged in fraud: examples are the Anglo-Bengali Disinterested Life Assurance Company in Charles Dickens’s Martin Chuzzlewit, Melmotte’s specious railway company in Thackeray’s The Way We Live Now and financial skulduggery in the City of London in Frederick Wicks’s The Veiled Hand.

In Gluckstein v Barnes, four men promoted a company that bought the Olympia exhibition premises in London. They raised investments from the public on the basis of the plausible-looking prospectus that they issued. The prospectus suggested that all of the investors had paid in full for their shares, when in fact the promoters had not paid all the required money into the company at that stage. Typically in cases of this sort, the promoters also raised more money from investors than the property was worth. Their intention was to abscond with the money, without having invested very much money of their own. When the investors had paid for their shares, the company was allowed to fold once the promoters had redeemed their shares for their full face value. Lord Macnaghten explained both how well established this sort of fraud had become and how exactly this sort of transaction worked:

It is the old story. It has been done over and over again.

These gentlemen set about forming a company to pay them a handsome sum for taking off their hands a property which they had contracted to buy with that end in view. They bring the company into existence by means of the usual machinery. They appoint themselves sole guardians and protectors of this creature of theirs, half-fledged and just struggling into life, bound hand and foot while yet unborn by contracts tending to their private advantage, and so fashioned by its makers that it could only act by their hands and only see through their eyes. They issue a prospectus representing that they had agreed to purchase the property for a sum largely in excess of the amount which they had, in fact, to pay. On the faith of this prospectus they collect subscriptions from a confiding and credulous public. And then comes the last act. Secretly, and therefore dishonestly, they put into their own pockets the difference between the real and the pretended price. After a brief career the company is ordered to be wound up. In the course of the liquidation the trick is discovered.

Interestingly, this sort of skulduggery was considered to be an old story even in 1900. The investing public is conned by means of being fed false information. Nevertheless, the pace of economic growth in the Victorian era meant that companies were encouraged to proliferate as a means of raising money from the public, and so company law had simply to develop rules that tried to prevent fraud while allowing companies to grow. One particularly significant development was the advent of limited liability, which is considered next.

Limited liability

One of the key developments in the growth of the company was the development of limited liability. An investor in an early company faced the risk that she would be personally liable for all of the company’s debts in the event that the company went into insolvency or that it failed to make enough profit to pay off its creditors. Under partnership law, for example, unless the arrangements had been very cleverly organised, each partner would be personally liable for all of the debts of the business. So, partners and therefore all investors in companies ran the risk of losing all their property if the business failed. This was a huge disincentive to investors. So, in 1844 a statute was passed that permitted companies to award limited liability to their shareholders. This meant that a company could be created by investors paying an amount of money agreed between them and set out in the company’s constitution as an initial investment, which would form the company’s capital.

That the investor has limited liability means two things. First, the investor as shareholder is not personally liable for the company’s debts (unless she agreed separately to guarantee the company’s debts). Second, the investor is only risking the loss of her original investment in the company (i.e. the purchase price of the shares), but is not risking an open-ended exposure to the company’s future losses. On the upside, the investor could receive a share in the company’s profits proportionate to her shareholding. This encouraged more investors to invest in companies, particularly given the pace of economic growth in Victorian England as not only did the companies build railways, bridges and viaducts that were the engineering wonders of their time, but the British also established one of the largest empires ever known across every continent, which created further trade and ever greater wealth (whatever one may think of that). Consequently, the combination of limited liability and the conspicuous generation of great wealth through the marvels of the Victorian age encouraged more and more people to invest in companies.

The joint stock company became a different animal. Professional managers operated the companies not simply as servants of rich aristocratic patrons and traders, but rather as a growing bourgeois class in their own right. The new age changed the British class system irrevocably, as people who had formerly been serfs in the fields moved into the dangerous, dirty new factories in the new towns effectively as slave labour and, if they were lucky or clever, as part of a new petit bourgeoisie that could earn a living with its brains instead of its brawn. The empire offered prospects for imaginative men (mainly) to make their fortune. The company was an important part of spreading the fruits of this activity by spreading the possibility of investment gain among the bourgeoisie. It also created a larger class of bourgeois professionals who worked in the banks, around the Stock Exchange, and in law and accountancy offices.

All of this discussion of breathless growth and of limitations on investor liability has catapulted us to the centre of the modern company as a means of effecting trade, but it has overlooked two important dimensions in the development of the concepts of company law: the roots of companies in the law on associations and the development of the idea of corporate bodies in the corporations formed by royal charter.

Associations, and their links with modern companies

Modern companies, as understood by English jurisprudence, began in the law of unincorporated associations. Anyone who has studied property law at an English or Welsh university should be aware of the law on unincorporated associations. Associations are clubs or societies or groups of people that are not organised as companies. In that sense they are said to be ‘unincorporated’, whereas a company is a body that has been incorporated (see Chapter 6). When companies were unlawful, people still wanted to group together. They did so lawfully in the form of associations, which had long been a part of English law. An association is a contract between a group of people who want to carry on an activity in common. A good example of such an association is a student law society at university. A well-organised association will have a constitution that sets out its rules in contractual form. Typically, members will pay a subscription to join the association (just as an investor in a company buys shares at the outset so as to become a shareholder in that company). This contribution stands for the contractual ‘consideration’ that is necessary to make an English contract valid. The constitution will deal with questions such as the powers of the various officers of the association, the election and dismissal of those officers, what happens to property that people give to the association (such as subscriptions or legacies), the members’ rights to vote so as to control the activities of the association democratically, the rights of the members to receive accounts as to the association’s property and activities, the circumstances in which the association will be wound up, and the rights of the various members to take property rights in the association’s property after it has been wound up.

The joint stock company and the modern company are built on these foundations. Modern companies have members. They are more colloquially known as ‘shareholders’ in limited liability companies, although they are commonly described as ‘members’ in the companies legislation, just like members of an association. Company law sets out the rights of shareholders if something goes awry, and company law specifies which matters need to be decided by a voting procedure, as discussed in Chapter 6. However, while company law presents a default setting for companies with inadequate constitutions and deals with many types of abuse within companies, it is the company’s own constitution that specifies the company’s objectives, the powers of the directors, the rights of shareholders, and many, many other points of detail concerning the operation of the company, as discussed in later chapters. A company’s constitution is known formally as its articles of association today. There was once another constitutional document, known as the memorandum of association, which set out the company’s objects, but the memorandum of association is no longer required after the enactment of the Companies Act 2006 (CA 2006), although some companies still have them. These various constitutional documents are discussed in Chapter 6.

What is important to understand at this stage is that the somewhat peculiar-looking articles of association purport by s 33 of the CA 2006 to create a contract between the shareholders when those shareholders may never have met. However, this contract makes complete sense when we understand it as being simply a modern evolution of the old contract between the members of an unincorporated association as contained in its constitution, as has been the practice of the law of associations for centuries, which has remained in our company law. Company law still uses the expression ‘constitution’ to this day.

Let us think of a university student law society as a clear example of an unincorporated association. Members join and leave a student law society all the time, and the constitution binds ...