| In Aron Salomon's time the law said that a company had to be started with at least seven members. (Today corporations can be started with a single member.) So in September 1892 Aron Salomon, his wife, and five of his adult children incorporated as Aron Salomon & Co., Ltd. with each member holding one share valued at £1.
Next, Aron Salomon sold his business to the new company for £39,000. In today's money this would be about $4,500,000. A senior judge would later say that the price was "a sum which represented the sanguine expectations of a fond owner rather than anything that can be called a businesslike or reasonable estimate of value."
Here's how Aron Salomon & Co. Ltd. paid Aron Salomon:
£20,000 in £1 shares
£10,000 in bonds
£9,000 in cash
Were the shares worth £20,000? Well, the company issued 20,000 of them at a par value of £1 each. Par value (nominal value) is simply the face value of a share when issued. In the United States par value is typically less than a penny, and California allows companies to issue stock with a par value of zero. The economic value of a share is whatever the market will bear. In this case, Aron Salomon agreed to take 20,000 shares with a par value £1 as partial payment of the company's debt to him. The transaction made him the controlling shareholder of the company with 20,001 shares versus the rest of his family's 6 shares. Since shares are votes, Aron Salomon would always win.
The £10,000 in bonds (also called debentures) made Aron Salomon the sole secured creditor of the company. In this instance, Aron Salomon's debentures were a floating charge over the company's assets. This meant that the debt was securitized (guaranteed) by the movable assets of the company, e.g., inventory, supplies, accounts receivable. If Aron Salomon & Co., Ltd. were to become insolvent, these assets would be liquidated, and the holder of the debentures would be the first person paid-off.
Viewed from the outside, in the world of things, nothing had changed. Venders and customers still interacted with the same employees, and the same army boots were made from the same hides by the same workers. Aron Salomon's name was still on the sign, and the old man was still in the front office telling other people what to do.
But in the world of words everything was different. Aron Salomon had gone from sole proprietor to: (i) controlling shareholder, (ii) managing director, and (iii) principal secured creditor of Aron Salomon & Co., Ltd. Further, the shoemaking business-Lock, stock, barrel, and floating charges-was now the property of Aron Salomon & Co., Ltd. and not Aron Salomon.
Almost immediately after the sale of the business things got worse. Worried about labor conflicts the British government arranged for a more reliable supply of army boots by making smaller contracts with more venders. This meant that Aron Salomon & Co., Ltd. lost a large and reliable chunk of its business. Worse, by early 1893 the international economy was sliding into a decade-long depression.
So Aron Salomon and Salomon & Co., Ltd. went looking for angel investors and found a financier named Edmund Broderip. A complex transaction followed in February, 1893. First, Aron Salomon returned his £10,000 in debentures to the company. Next, Broderip paid the company £5,000. Then the company issued Broderip a fresh £10,000 in debentures at 8% interest.
It was a prototypical junk bond deal. Aron Salomon remained the CEO and controlling shareholder of Aron Salomon & Co., Ltd. Aron Salomon, the company, got £5,000 in liquidity (money to pay operating expenses, e.g., payroll, venders), and Edmund Broderip got £10,000 in debentures paying 8% for half price.
But what had Broderip actually bought? The debentures were backed by a floating charge on the movable assets of the company, and Aron Salomon & Co., Ltd. was fighting for liquidity. Further, the Broderip's 8% interest on the bonds could only make a sick company sicker.
By September of 1893 Aron Salomon & Co. Ltd. could no longer make the interest payments on the bonds, and declared bankruptcy. (In the United States today companies typically choose between Chapter 7 and Chapter 11 bankruptcy. Under Chapter 11 the company is reorganized, its debts are renegotiated, and it continues doing business. For example, retired United Airlines employees lost a significant portion of their pensions in the airline's Chapter 11 reorganization. Under Chapter 7 the company is wound-up and its assets sold to pay off the creditors.) Aron Salomon & Co., Ltd. went into the 19th century English equivalent of Chapter 7.
When a company is wound-up the first creditors paid are the secured creditors, and so Broderip had the right to be the first snout in the trough. But by now Aron Salomon & Co., Ltd. was an empty trough. The £20,007 in shares were of nominal value only, and Aron Salomon had already taken £9,000 in cash out of the company the previuous fall when he incorporated. Worse, the £10,000 in debentures was a floating charge that had crystalized over whatever was left in the accounts of a company that had sought out Broderip precisely because it was desperately short of operating capital.
Once a company goes into bankruptcy it has to be run in the interests of its creditors rather than to increase shareholder value. Thus, Edmund Broderip, the sole secured creditor, was able to make Aron Salomon (the company) sue Aron Salomon (the human being)., presumably because that was where the money went. What Broderip ddsn't reckon on was the power of three letters at the end of the company's name: Ltd.
Initially, the courts said that Aron Salomon & Co., Ltd. was just a mask that Aron Salomon was hiding behind in order to swindle unwary financiers. In the Court of Appeal Lord Lindley, one of the great architects of the modern law of contracts said that the company was a mere device to enable a man to carry on trade with limited liability, to incur debts in the name of a registered company, and to sweep off the company's assets by means of debentures which he has caused to be issued to himself in order to defeat the claims of those who have been incautious enough to trade with the company without perceiving the trap which he has laid for them.
But the outcome was different once the case reached the highest court in Great Britain, the House of Lords. First, the Law Lords found that Aron Salomon had satisfied the requirements of the Companies Act 1862. The Act required seven incorporators, and Aron Salomon fathered five of them. Further, once the company was up and running it wasn't the court's place to instruct it on how to do business. If a company wanted to issue £20,000 in shares, for example, and somebody else want to accept them as partial satisfaction of a debt, then that was entirely the business of the parties to the transaction. It was a free market, after all.
The Law Lords' analysis was possible because once incorporated under the 1862 Act, the company was a separate juristic person from Aron Salomon. It's very important at this point to understand what judges and lawyers mean by the word "person." In law a juristic person is an entity capable of appearing in court, enforcing a right, or having an obligation. Thus, a legal person needn't be a natural person (viz., a human being). For example, a religious order like the Little Sisters of the Poor might have rights (e.g., property rights) that the individual nuns would not because of their vows of poverty. Similarly, nobody would find it particularly sinister if Asphalt Paving, Inc., a juristic person, were allowed to appear in court (through its attorneys) to collect on a debt owed by the City of Federal Heights, another juristic person (appearing through its attorneys). The key point is this: incorporation creates a right of appearance (a legal personality), and this right is granted by legislatures.
As Lord MacNaughten, one of the judges on the House of Lords panel that reviewed the Salomon case explained:
When the memorandum is duly signed and registered, though there be only seven shares taken, the subscribers are a body corporate 'capable forthwith,' to use the words of the enactment, 'of exercising all the functions of an incorporated company.' Those are strong words. The company attains maturity on its birth. There is no period of minority-no interval of incapacity. I cannot understand how a body corporate thus made 'capable' by statute can lose its individuality by issuing the bulk of its capital to one person, whether he be a subscriber to the memorandum or not. The company is at law a different person altogether from the subscribers to the memorandum; and, though it may be that after incorporation the business is precisely the same as it was before, and the same persons are managers, and the same hands receive the profits, the company is not in law the agent of the subscribers or trustee for them. Nor are the subscribers as members liable, in any shape or form, except to the extent and in the manner provided by the Act. That is, I think, the declared intention of the enactment.
Second, the Companies Act 1862 was a consolidating act that brought together: (i) the rules for incorporation and juristic personality of Joint Stock Companies Act 1844 and (ii) the Limited Liability Act 1855. Corporate personality and limited liability are separate concepts, but in practice they often occur together. (There is nothing in principle but only good sense that would prevent someone from forming an unlimited company.)
Limited liability (represented by the initials "Ltd.") means that by grant of a legislature the members of the company, in our case Mr. Salomon and his family, are only on the hook for the value of their shares. A creditor cannot reach through the company and into a shareholder's pocket. Thus, if one of Mr. Salomon's friends bought one of Mr. Salomon's 20,001 shares for £2, that friend would only lose £2 when it zeroed out once the company went into bankruptcy.
Eventually, Aron Salomon prevailed against Aron Salomon & Co., Ltd. Edmond Brodedrip was stuck with the worthless debentures, the assets of the company were liquidated, and the British army had to buy its boots elsewhere.
For our purposes, there are three lessons:
(1) Corporate personality and limited liability are created by legislative grant.
(2) Because legislatures say so, corporations are not the same things their founders, shareholders, or boards.
(3) Because legislatures say so, limited liability means that shareholders are not responsible for a company's debts.
Finally, a note about the United States Supreme Court decision in Santa Clara County v Southern Pacific Railroad (1886). Since Santa Clara US corporations enjoy the same Fourteenth Amendment protections as natural persons. Namely, the constitutional rule that "[No] State [shall] deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of the laws" now applies to both human beings and corporations equally.
However, how the corporate person is constituted and governed and the nature and scope of limited liability are still in the hands of state and federal legislatures. Much can be done by legislators to constitute the nature of the constitutionally-protected corporate person long before it appears before the bench to claim those protections.
Next: the corporate veil. |
