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A New Rule for Company Groups? Knowingly Allowing a Subsidiary to Act Illegally

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About The Author

Freddy Simpson (Guest Contributor)

Freddy graduated with a degree in Philosophy from Christ's College, Cambridge. After spending seven years as an Army officer, he is currently studying the BPTC in London and will begin pupillage in October 2018. His main interests are in company, contract and tort law. Outside the law, he enjoys art and the outdoors.

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The status of corporate groups in English law is well established; the constituent companies are legal persons in their own right, and their individual personality is by and large not affected by being part of a group. This is a coherent approach, and one which maintains a desirable simplicity in the law.

However, the consequences of separate legal personality – particularly when played out across multiple jurisdictions – currently enable large modern groups to limit more of their liability than is appropriate. A new rule is needed to avoid abuses of the privilege of limited liability.

In this respect, after examining the various options that the law could take, this article concludes that it is clear that the most appropriate way forward is the creation of a new offence of ‘knowingly allowing a subsidiary to act illegally.’

The Group in English Company Law

The purpose of the company form is to encourage business in a way that brings economic benefit; limited liability reassures entrepreneurs and investors that their personal assets will not be vulnerable should the company fail. Tradeable shares, meanwhile, increase the liquidity of any investment. The most effective way of providing these benefits is by respecting the doctrine established in Salomon v Salomon & Co Ltd [1896], that once properly incorporated a company has a separate legal personality and can do business and enter into contracts in its own name.

But limited liability and separate personality also reduce the ability of creditors to pursue their debts in the event of the company’s failure. As a result, the law is a balancing act in which greater business advantage attracts greater regulation in the interests of protecting those dealing with the company.    

Just as natural persons can limit their liability by organising their business affairs through a company, a company too may itself structure its liabilities and assets in an advantageous way through the use of various subsidiary companies. Again, the rationale for permitting this is the business benefit it brings: it permits entrepreneurs and investors to manage risk when investing wealth, which should ultimately accrue to the country in which they are operating.

For this reason, English company law has resisted various calls to contain the great economic power of large groups of companies. It has rejected the use of separate schemes of regulation that would treat them as – to some extent – unitary, preferring instead to deal with them analogously to groups of natural persons.

From the perspective of the judiciary, the most comprehensive modern overview of English courts’ attitude to groups of companies was provided by Adams v Cape Industries plc [1990] Ch 433. Here, the Court of Appeal came down firmly on the side of respect for separate legal personality, with Slade LJ declaring that:

[T]he court is not free to disregard the principle in Salomon… merely because it considers that justice so requires. Our law, for better or worse, recognises the creation of subsidiary companies [that] fall to be treated as separate legal entities with all the rights and liabilities which would normally attach to separate legal entities.

This approach to corporate groups was roundly supported by a seven-strong Supreme Court in Prest v Petrodel Resources Ltd [2013]. It authoritatively concluded that – subject to some exceptions, such as the requirement contained in Section 155(1) of the Companies Act 2006 (CA 2006) that a company must have at least one director who is a natural person – the position remains that the companies in a group are as legally individual as natural persons.

The rationale for this approach is sound, for there are – at least – three good reasons to permit company groups. Firstly, the ability to limit liability for loss is just as useful to a company as to a natural person, with economic benefits flowing in the same way. Secondly, maintaining the separate legal personality of subsidiary companies provides clarity in insolvency. And thirdly, it maintains the simplicity of the law because it means that only one set of rules for dealing with companies is required.

The Problem with Company Groups

The English approach to company law was reviewed by the Department of Trade and Industry in the lead-up to the CA 2006. This was explicitly aimed to ‘think small first’, treating large and group companies as an exception. It is therefore not inappropriate over a decade later to consider whether the situation as regards the largest groups of companies is as it should be. Groups do exist and do play a significant role in modern economic life; the law must not allow itself to be blind to this.

However, the law must also not overlook the consequences of itself. Indeed, while it is fair to say that the ultimate rationale for the separate legal personality of a company is to preserve the principle of limited liability and set out the boundaries of the rights of creditors, it must not be forgotten that the device of separate legal personality limits all forms of risk, not merely those associated with creditors.

So while the economic benefits which justify the limited company form flow from controlling business risks, questions can be raised about whether this is true in relation to the other potential costs which companies face; in particular, those connected with negligence and other tortious wrongdoing. Whilst business partners deal willingly with the company and can price in the risk of default, those exposed to tortious wrongdoing are generally involuntary creditors. Is it right that their ability to seek redress is limited in the same way as a business creditor?

Arguably not; it is one thing for creditors to deal with a company in the knowledge that its liability is ultimately limited, but quite another for a subsistence farmer to find a pipeline or factory next to their field, which one day fails with disastrous results only for him to discover that they cannot obtain meaningful compensation because the infrastructure is the property of the underfunded subsidiary of a corporation which has merrily absorbed the profits whilst walling off the risk. This is doubly egregious where the parent company is incorporated in a separate jurisdiction: in these circumstances, the parent company is protected both by the limited liability of its subsidiary and by not being present in the jurisdiction of the subsidiary to be party to any proceedings.

The doctrinaire may suggest that, correctly analysed, this is another unwelcome cost which is part of the trade-off inherent in company law – it therefore gives no grounds to invent a relationship between legally independent entities. However, this argument overlooks that these are not the risks that the limited company form is intended to allow members to limit. The purpose of legal reform is precisely to ‘invent’ new laws where appropriate; given the real existence of corporate groups, and the undesirability of exposing involuntary creditors to unnecessary risk, this is just such a case.

Providing protection for involuntary creditors against the enormous power of large corporate groups is greatly to be desired. There is a moral duty on the UK not to unleash on the world business forms which enable the exploitation of the weak and the poor, whether in its own jurisdiction or abroad. As one of the crucibles of company law and a world leader in the provision of legal services, it is appropriate that the UK leads the way in ensuring that company law is structured so as to protect the weak whilst not unfairly penalising the strong. Indeed, as it repositions itself globally post-Brexit, being able to display (not describe) a strong image of its values and what it stands for will be vital.

Options for Reform

Option One: Vicarious Tortious Liability?

One way of correcting this issue would be to make parent companies vicariously liable for the torts of their subsidiaries. Business risks are generally contractual: as such, the economic benefits of allowing companies to structure these risks would be maintained, while simultaneously ensuring that involuntary creditors are not denied the ability to seek fair redress.

The law would not be without inspiration from which to draw when implementing this reform. After all, vicarious liability for employees’ torts is a long-established concept. Vicarious liability for the torts of a subsidiary could therefore be equally coherent and need not threaten the separate legal personality of the companies involved.

A recent overview of the position regarding the liability of parents for the torts of their subsidiaries was given by Fraser J in Okpabi v Royal Dutch Shell plc [2017]. This case concerned a class action against the Shell Group for a breach of a common law duty of care in respect of oil pollution. The essential complaint, a representative case of involuntary creditors suffering at the hands of a group, was:

[T]hat the oil companies that profit handsomely from their operations in the Niger Delta do so without making adequate safeguards for the population… whose livelihoods and daily activities are damaged considerably.

Legally, it was agreed that primary liability lay with the Nigerian subsidiary but the claimants sought to have the senior holding company – Royal Dutch Shell plc (RDS) – included as a defendant in order to pursue the action in the English courts.

The claimants failed, with Fraser J concluding that RDS plc was able to avoid liability for five reasons. Firstly, it was held that RDS had no direct responsibility for the tort as it conducted no operations in Nigeria itself. Secondly, it was held that liability could not be implied by membership of a group of companies, because all the companies therein are separate legal entities. Thirdly, an argument that RDS’s public statements gave rise to a duty of care were rejected. Fourthly, Fraser J that the oft-cited test for determining whether was sufficient proximity between a tortfeasor and a claimant for direct tortious liability outlined in Caparo Industries plc v Dickman [1990] was not satisfied.

And fifthly, it was concluded that the circumstances did not meet the test for the attribution of vicarious liability articulated by Arden LJ in Chandler v Cape plc [2012], which states that vicarious liability arises not by the simple fact that a company is a parent company. Instead, Arden LJ explained, there must be substantial practical involvement on the part of the parent company in the subsidiary’s affairs:

[T]he law may impose on a parent company responsibility for the health and safety of its subsidiary's employees… where… (1) the businesses of the parent and subsidiary are in a relevant respect the same; (2) the parent has, or ought to have, superior knowledge on some relevant aspect of health and safety in the particular industry; (3) the subsidiary's system of work is unsafe as the parent company knew, or ought to have known; and (4) the parent knew or ought to have foreseen that the subsidiary or its employees would rely on its using that superior knowledge for the employees' protection.

Fraser J in Okpabi v Royal Dutch Shell plc [2017] found that RDS satisfied none of these conditions: he placed emphasis on the fact that, as a holding company, they carried on no business of their own and so had no relevant knowledge or any supervisory function as anticipated by Arden LJ. Whilst this considered liability for health and safety specifically, the idea that liability rests on practical involvement is applicable to most torts.

The decision in Okpabi v Royal Dutch Shell plc [2017] represents a sound application of the law as it stands, but that does not make it right. What is particularly egregious is that the decision rested largely on a characterisation of RDS as being of little consequence, not operating any business other than holding shares’, and possessing no expertise. Yet the Financial Times reports that RDS had revenues of US$233bn in the 2016 fiscal year, and is the parent company of a group which shares a corporate brand, refers to itself collectively as the Shell Group, operates in a coherent manner and directs its profits towards RDS plc as the ultimate holding company.

Making RDS vicariously liable for the torts of the companies in the Shell Group would recognise this economic unity and the fact that RDS ultimately gains from the same activities which harm the claimants. Such a policy would also ensure that adequate funds were available to meet any sizeable actions which may otherwise overwhelm the assets of the subsidiary. Furthermore, it would be in accordance with modern notions of corporate social responsibility, thereby increasing public confidence in the legal structures underlying modern business.

However, there remains flaws in the proposal. For one thing, it must not be overlooked that the distinction between contractual and tortious wrongdoing is imperfect. After all, some torts are business-related, such as professional negligence, and it is appropriate to limit liability for them just as for contractual risk. Hence, a blanket imposition of vicarious tortious liability would go too far in restricting the business advantage offered by the company form.

A modified suggestion advanced by Peter Muchlinski is to allow parent companies to exclude tortious liability except in cases where this causes death or personal injury. However, this goes too far in the opposite direction, and would exclude many forms of wrongdoing for which it is desirable to make groups liable, such as actions and omissions which cause serious environmental damage but fall short of harm to humans.

Furthermore, vicarious tortious liability presents difficulties for groups with overseas subsidiaries: it would effectively allow overseas claimants to skip their home courts in favour of English law. While this may be attractive to claimants in jurisdictions with less developed legal systems, the ability of countries to set their own laws is fundamental to sovereignty and – where business laws are concerned – key to economic policy. Encroaching on this would have serious and undesirable diplomatic ramifications, as well as retarding the development of overseas courts.

Recognising this issue, Peter Muchlinski has suggested the introduction of an international standard for corporate behaviour amongst multinational groups which would provide a universal safeguard without disadvantaging developing jurisdictions. However, it is difficult to see how this would work in practice; if the standard were meaningfully high, there would be little incentive for any country to tighten its own regulations further in a way that would grant space for developing legal systems to compete. Furthermore, it would be a significantly more substantial undertaking than reforming English law alone. This option therefore also fails to deal satisfactorily with the issue of groups of companies being able to limit too many forms of liability.

For these reasons it appears that vicarious liability for a subsidiary’s torts would both fail to accurately capture what is wrong with limited liability as it stands, and have unwelcome practical consequences. It should therefore be rejected.

Option Two: A New Offence

A better option would be the retention of blanket limited liability, but combined with the introduction a new civil offence of ‘knowingly allowing a subsidiary to act illegally’ that would operate using a presumption that companies are aware of the actions of their subsidiaries. This would respect the independence of other legal systems whilst ensuring groups were held accountable.

Individuals in foreign jurisdictions would have no cause of action against the parent company, thus removing the issue of sidelining foreign courts; instead, cases would be brought by a national supervisory body in the UK following judgment against an overseas subsidiary. Remedies in the form of fines could both punish the parent and compensate for any inability of the overseas subsidiary to meet its liabilities, as well as funding the supervisory body.

This in turn would potentially encourage less-developed foreign jurisdictions to robustly enforce their laws as they would have the confidence of knowing that their judgments would have real effect however ephemeral the local subsidiary, and could work well in concert with a diplomatic effort to promote the development of local legal systems.

Such an approach would be eminently practical; it retains the benefits of the current system in terms of economic encouragement and a simple regulatory approach, and fits in without disturbing the current provisions, sitting neatly on top with no re-write required. In that sense, it embodies the best of English pragmatism.

Furthermore, it is usefully precise in targeting those aspects of corporate behaviour which need to be controlled whilst not encroaching on those which do not. No doubt this would spark protest from some quarters; but from the abolition of the slave trade to the repeal of the Corn Laws the UK has a proud history of doing what is right in the face of established interests, and it is appropriate to continue that tradition.

Conclusion

English law has long and rightly held that group companies are independent legal entities; this view is both philosophically coherent and attractive to business. However, companies must not be allowed to limit too much; the law must be adjusted to limit business risk alone to ensure the proper balance of economic benefit and protection for the individual.

Whilst it may seem simple to import the concept of vicarious liability from the employer and employee relationship, a detailed examination of the merits of doing so shows that such an approach would have undesirable consequences. The introduction of a new offence – of ‘knowingly allowing a subsidiary to act illegally’ – is therefore to be preferred.

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Tagged: Commercial Law, Company Law, Environmental Law, Justice, Law and Development

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