Company Law: Theories and the Registered Company
1. Does corporate theory assist our understanding of company law?
The fact the state had the dominant role in the formation of companies through charter or statute led to the view that the company was a concession or privilege from the state.
The concession theory (hereafter, concession) is also linked with the fiction theory (hereafter, fiction). Fiction theory similarly emphasises the law’s key role in the creation of the corporation. It views the corporation as a legal person rather than a natural one thus it is a fiction. Concession and fiction theories are therefore bound together because the corporation in a concession analysis is simply a legal creation of the state and therefore, according to fiction theory, a legal fiction. They are also bound together because they have the same essential observation to make about company law, that is, that the state’s role in the creation of corporations is central and therefore state intervention in corporate activity is more easily justified. The corporation, after all, is just a manifestation of the will of the state.
The weakness of concession and fiction theories is that they have little to say on the subject of the private individuals behind the corporation. Once registered companies arrived in the mid-19th century and incorporation became a simple matter of registration rather than requiring a charter or specific Act of Parliament, this weakness became very apparent. Other theories arose to challenge the dominance of concession and fiction theories which were better equipped to deal with the diminished role of the state in forming the company. These theories are known as the corporate realist and aggregate theories (hereafter, corporate realism and aggregate).
Aggregate theory drew on Roman law theory surrounding the Roman Societas (association) which had legal personality. The Societas was a particularly important influence in the evolution of the company as it directly influenced common law partnerships and the Continental European société en commandite. These entities were formed by individuals who agreed to associate with each other for a common purpose. From this, aggregate theory emphasised the real persons behind the corporation. The law was not central to the formation of the company, rather the company was an aggregate of the individuals who had contracted for its formation. Therefore, the private individuals behind the aggregate are the focus of the corporation’s rights and obligations. The corporation in an aggregate analysis has no independent existence and everything is explained by reference to the members of the corporation.
Aggregate theory had two significant claims to make about the operation of company law. First, as the company is formed by private contracting individuals state interference in what is viewed as essentially a private arrangement becomes very difficult to justify as it would be an interference with the individual’s freedom to contract. Second, and perhaps most significantly, as everything to do with the corporation was only relevant by reference to the contracting individuals behind it, the theory served to justify the primacy that company law gives to shareholders as the key contracting individuals behind the corporation.
However, with the arrival of the managerial company aggregate theory began to struggle for influence. First, as shares became increasingly transferable and shareholders behaved more like speculators than owners the idea that a legally binding contract was behind the corporation started to lose its legitimacy. Second, the separation of ownership from control itself raised questions about relating the company only to its shareholders. Identifying the shareholders from a fluctuating dispersed group was difficult and they seemed uninterested in exercising control. At the same time managers had also emerged as a significant force within the corporation who exerted more power than the shareholders. Accompanying this decline in the shareholders’ influence was the sense that the corporation was now a thing in itself which affected a much wider constituency than just its shareholders. In particular aggregate theory has great difficulty explaining corporate personality, specifically the fact that the company owns its own property and that fiduciary duties are owed to the company. Corporate realism emerged to offer an explanation better suited to the managerial company.
Corporate realism is the theory that probably seems the strangest to a 21st-century reader. It originated from 19th-century German theorists who considered the company to have a ‘real’ separate existence from its shareholders. Essentially it argued that once a collective is formed it takes on a life of its own which cannot be referenced back to its members. The sum of the individuals’ interests does not in any way equate to the interests of the collective. The collective has interests and objectives which may not change even though the members of the collective may change many times over. As in aggregate theory the state is irrelevant to the existence of the collective. Its legitimacy is established by the coming together of its original members but once the collective is formed it continues on its own independent way without reference to individual members.
The theory offers some important insights into the nature of the managerial company. As the corporation is a real person with its own interests it can in no sense be owned by the shareholders. The shareholders have no primacy within the realist model; rather the company’s interests and objectives as defined by its managers are paramount. This being so, corporate realism goes a long way to legitimising the manager-dominated companies that arose at the beginning of the 20th century. It did not however deal with the managerial accountability issue as it assumed a neutral disinterested management.
This is something that aggregate theory solves by emphasising the primacy of the shareholders, i.e. the managers are accountable to the shareholders. Thus, corporate realism left a key question unanswered, that is, what are the interests of this real person if they are not equated with the shareholders? Additionally, corporate realism is somewhat malleable as far as the state is concerned. Some proponents of corporate realism considered the corporate person subject to state regulation as any powerful person who could affect the community would be. Others considered the corporate person as a purely private person and thus free from state control.
These deficiencies in corporate realism went largely unchallenged until the Great Depression in the 1930s. The first major challenge to it was the work of Berle and Means, primarily their concern about unaccountable managers. However, while The Modern Corporation and Private Property was an important milestone in the corporate governance literature it was a debate between Adolf Berle and Merrick Dodd played out in the pages of the Harvard Law Review that was to shape the course of the corporate governance debate significantly.
Dodd (1932) sought to provide an answer to the key unanswered question of corporate realism: what are the interests of this real person if they are not equated with the shareholders? Dodd set out a corporate realist model where the company is a real person and not an aggregate of its members. Just as other real persons have citizenship responsibilities that require personal self-sacrifice a corporation has social responsibilities which may sometimes be contrary to its economic objectives. In turn, managers of this citizen corporation are expected to exercise their powers in a manner which recognises the company’s social responsibility to employees, consumers and the general public. In providing this pluralist formulation Dodd emphatically rejected the notion of shareholder primacy and provided a clear basis for the separation of ownership from control.
Berle (1932) in his response to Dodd’s article opposed Dodd’s solution. He believed that the Dodd answer was too vague. It would be practically unenforceable and lead to the furtherance of managerial dominance. Instead he sought to focus the company’s accountability mechanism on just the shareholders. He proposed an aggregate theory in which managers are trustees for the shareholders not the corporation. Thus, the managers are accountable to the shareholders and shareholder wealth maximisation is the sole corporate interest.
The two views broadly shaped the debate over the period up to the 1960s. However, the apparent and tangible success of managerial companies after the Second World War caused the Berle thesis great difficulty. Despite the lack of any legislative intervention in the USA to promote the Dodd pluralist approach, managerial companies did indeed appear to be able to act like corporate citizens and balance the needs of shareholders, employees and the general public. By 1959 just as evidence was emerging (see below) that supported Berle’s claims of a lack of managerial accountability in a pluralist model, Berle gave up and adopted a pluralist approach.
However, by the early 1970s changes in the global economy began to affect the managerial company’s ability to balance these different constituencies. In turn aggregate theories were redeveloped by economists and began to challenge corporate realism once again. In this section we deal largely with the economic theories that have influenced corporate legal scholarship.
Economic theory is concerned primarily with efficiency. Here we are talking about two types of efficiency, first, that resources are allocated efficiently, and second, that production is efficient, that is, output is maximised from a given input. Using these tools economic theory can test whether a company (firm) is operating efficiently or whether company law is promoting efficiency. While it may seem odd to company lawyers, traditional (neo-classical) economic theory did not recognise the firm in its analysis, viewing it purely as an individual capable of operating in a marketplace. The internal arrangements of the firm were irrelevant and so neo-classical economics had no real insight into the separation of ownership from control. The focus of neo-classical economics is instead on the market and its equilibrium mechanisms.
In studying markets, it makes four key suppositions. The first is that the laws of supply and demand will determine price. That is, if the price of a good is higher in one market than another, sellers will move to the higher market until the price difference is eliminated. It is in essence the market that establishes the price. As the market is the key mechanism for price setting any state interference with this mechanism is unwelcome as it causes inefficiency. Thus, neo-classical economics provides a justification for limiting the state’s role in regulating both markets and the firms operating in them.
The second assumption is that the market itself is perfectly competitive. That is, there are a large number of firms producing an identical product, with the same costs and no barriers to entering that market. The third assumption is that the firm has only one objective and that is profit maximisation in both the short and long term. Additionally, the firm pursues this goal without reference to the response of other firms in the marketplace. The fourth assumption is that the firm has perfect certainty about its activities. That is, it has complete information about all present and future events that would influence its activities. This allows the firm to act in perfect certainty and make a rational profit-maximising choice.
Therefore, in the neo-classical perfect marketplace the price is set by supply and demand and the rational firm operating in it in full knowledge of the present and future makes output decisions in order to maximise its profit without reference to the response of other firms. Critics of neo-classical economics have focused on the fact that it makes fundamental assumptions that may not bear any relation to reality. The following should give a flavour of those criticisms. ‘A neo-classical economist falls down a well. A passer-by rushes over to see if he is all right and looks down the well to see the economist standing at the bottom of the well looking up. The passer-by shouts down that he is going to get help but the neo-classical economist replies “No need, I’ll assume a ladder”.’
The managerial company in particular caused great difficulty for neo-classical theory as its very existence destroyed some of its key assumptions and therefore its predictive ability. First, the large size of these managerial companies meant they operated in markets with few other firms, in other words, an imperfectly competitive marketplace. Second, if management is purely responding to market stimulus in a rational profit-maximising way the separation of ownership from control has no significance.
Management of the firm either is neutral or is purely an agent for the market’s price mechanism—in this management has no discretion. An owner-controller will also be responding to market stimulus in a rational profit-maximising way. Therefore, the outcomes in a neo-classical market for a managerial company and an owner-managed firm are the same. As a result neo-classical theory had no way to explain the evident difference between owner-managed and manager-dominated companies.
2.Is company law user-friendly?
Is company law useful for small businesses?
Is company law useful for businesses?
While the registered company is designed for large organisations, it has not been particularly useful for small businesses.
The main three forms of business organisations are as follows:
-The sole trader
-The partnership
-The registered company
The sole trader s a one-person operation where someone just operates on their own. There are no legal filing requirements. Sole traders usually provide the capital with personal savings or a bank loan.
They contract in their own name and have personal liability for all the debts of the business. Legally there is no distinction between the sole trader’s personal and business assets. As the business is just one individual, there is no need for a formal organisational structure. The sole trader therefore is adequate for a single person with capital but is unsuitable for larger scale investment. The risk to the sole trader of doing business is large but there is no need for a formal organisational structure.
Another alternative is the partnership. The Partnership Act 1890, s 1 defines a partnership as “the relationship which subsists between persons carrying on a business in common with a view of profit”. This is a very broad definition. Therefore, a partnership can come about by oral agreement, it can be inferred by conduct or it can be a formal written agreement specifying the terms and conditions of the partnership. There is no formal process of becoming partners. The minimum membership required for a partnership is (obviously) two and the maximum is, since 2002, unlimited (prior to that it was 20 unless you were a professional firm (solicitors, accountants etc.) who could exceed the maximum number). The assets of the firm are also owned directly by the partners. This as we will see below is very different from a company where the shareholders do not own the company’s assets.
A partnership which does not expressly exclude the Partnership Act 1890 will be governed by it. This can sometimes be a problem for those who are unaware that they are partners, as under the Act each partner is entitled to: participate in management, an equal share of profit, an indemnity in respect of liabilities assumed in the course of the partnership business and not to be expelled by the other partners.
The last option is to form a registered company. As our entrepreneur is pursuing a commercial venture he/she would be forming a company limited by shares (that is a company where the liability of the shareholders for the debts of the company is limited to the amount unpaid on their shares.
Setting up a company is governed by the Companies Act 2006 (CA 2006), ss 7–15 and is a relatively simple process: it is required to provide the Registrar of Companies with the constitution of the company, a memorandum of association stating that the subscribers intend to form a company and become members and an application for registration containing the company name, its share capital, the address of its registered office, whether it’s a private or public company, that the liability of its members is limited, a statement of the company’s directors’ names and addresses and a statement of compliance with the CA 2006. The purpose of registering these documents is to provide certain key information that could be accessed by the general public or government agencies if necessary. This is still the case but in recent years fears that this public information could be abused have led to restrictions on its public availability.
Prior to 1992 at least two people had to subscribe to become shareholders in a private company (see below on public and private companies). As a result of the Twelfth EC Company Law Directive (89/667) implemented in 1992 private companies could be formed with a single member but public companies still needed at least two members. The CA 2006, s 7 now provides for single-person private and public companies.
The main advantages of the registered company may be as follows:
-Facilitating investment, minimising risk and providing an organisational structure the registered company seems to perform well. It is specifically designed as a capital-raising vehicle. The subdivision of shares allows for a very large number of investors to become members of the company. Those members have limited liability which minimises their risk. This in theory makes raising capital easier as individuals may feel more secure in their investment.
-Limited liability is also said to increase the entrepreneurial spirit of the directors, encouraging them to take risks in the knowledge the shareholders will not lose their houses or cars if the business venture fails. A company is also impervious to death, and shares are also in theory transferable and so particularly in public companies easily convertible into cash. The company is designed to potentially have a large number of participants and so has a formal constitution outlining its basic organisational and power structure. Technically, the people who control the company are the shareholders. They buy shares in the company which entitle them to certain control rights exercised through the shareholder organ, the general meeting. However, the running of the company cannot be effected by a large number of members as such control would be cumbersome and so they elect people to do it, the directors. The directors operate through the second organ of the company, the board of directors. The shareholders appoint or remove directors by simple majority vote (more than 50 per cent of the votes actually voted) at the general meeting.
However, the registered company may also have several disadvantages for small businesses:
-The statutory model has historically assumed a separation of ownership and control. That is, it assumes that the shareholders are residual controllers exercising control once a year at the annual general meeting (AGM) and that the day-to-day management of the business is carried out by professional managers (directors). For large companies this is the case but for the vast majority of companies in the UK this separation of ownership from control does not exist.
-Additionally, Freedman found that 90 per cent of all companies were small private concerns. She also suggested that for small businesses the corporate form and the regulatory requirements that went with it were burdensome. It was also costly, as they had to employ professional advice to deal with these requirements. One assumed advantage to the small business, that of limited liability, was also negated by the practice of banks requiring the shareholders to provide guarantees for bank loans. Thus any debts owed to the banks could be reclaimed from the personal assets of the shareholders. In Freedman’s study one of the major reasons that business people incorporated was the perceived benefits of having the word ‘Ltd’ after the company’s name, namely, that it conferred prestige, legitimacy and credibility on the venture.
-Private companies present another problem. In a nutshell private companies, because there is often a close relationship between the participants, have more potential for those participants to have disagreements. In these cases company law and the constitution of the company can be problematic for a minority shareholder who has fallen out with the majority. Company law presumes that the company operates through its constitutional organs. In order for the company to operate, either the board of directors makes a decision or if it cannot then the general meeting can do so. It can, however, happen that a majority of shareholders holding 51 per cent (simple majority voting power) of the shares in the company could act to the detriment of the other 49 per cent. A 51 per cent majority would allow those members to elect only those who support their policies to the board. Thus the 49 per cent shareholder would be unrepresented on the board and powerless in the general meeting.
In this sense, it is important to take into account that the same company law model applies to a small company but with significant differences in effect:
The shareholders and directors will often completely overlap. The same people will also be the only employees of the company. To take the example of a two-person company, the two shareholders will also be the two directors and the two employees. There is no separation of ownership from control, the shareholders are the managers, and therefore most of the historical statutory assumptions about the company’s organisational structure will not hold. Given that one can also form one-person companies the statutory assumption had begun to take on farcical proportions. However, the elective regime, as we explained above, had historically attempted to address this problem by allowing a ‘quasipartnership’ or ‘close company’ (a company with few participants who know each other well) like this to do away with some of the more onerous aspects of the statutory model and the CA 2006 has significantly improved the difficulties close companies faced in using the company. The courts have also tried where possible to recognise and make allowances for these ‘quasi-partnership’ type companies (see Ebrahimi v Westbourne Galleries Ltd (1973)).
The differences in the types of business that use the statutory model featured heavily in the CLRSG’s Final Report (2001. The CLRSG recommended that the statutory requirements for decision making, accounts and audit, constitutional structure and dispute resolution be simplified. They also recommended that legislation on private companies should be made easier to understand. In particular there should be a clear statement of the duties of directors. The White Paper (Modernising Company Law (2002)) that followed the Final Report, the Consultative Document, March 2005 (Company Law Reform (2005)) and the CA 2006 all carried through this focus on the ‘quasi-partnership’ company with a ‘think small first’ emphasis. However, it’s still not clear if this focus has been entirely successful.
In conclusion, while the company is designed as an investment vehicle, with limited liability for its shareholders and a clear organisational structure, it is designed for ventures where there is an effective separation of ownership from control and thus has been largely unsuitable for the majority of its users who are small businesses. Even given the reforms in the CA 2006 which focus more on small business needs, in many ways the partnership would be more suitable for our entrepreneur and less onerous for small businesses generally, especially given that limited liability is rarely a reality for these types of business. The removal in 2002 of the 20-partner limit will help as it enhances the capital-raising ability of the general partnership. However, the continued use of the corporate form by small companies seems secure given the prestige attached to the tag ‘Ltd’.