Small Businesses and the Corporate Form: Burden or Privilege?
| Author | Judith Freedman |
| Date | 01 July 1994 |
| DOI | http://doi.org/10.1111/j.1468-2230.1994.tb01959.x |
| Published date | 01 July 1994 |
Small Businesses and the Corporate Form: Burden or
Privilege?
Judith
Freedman
*
A
Introduction
There is a strong intuitive case for the creation
of
a new legal form through which
small businesses in the United Kingdom could operate. The view is widely held
that our companies legislation, fashioned with the public, quoted company in
mind, is of a length and complexity which is wholly inappropriate to the small,
private company.’ The development of the theory of the company as a nexus of
contracts2 has strengthened the analysis of the limited liability company as a
device for raising capital and reducing agency and monitoring costs. This is a
corporate model which forces its supporters to distinguish the unquoted owner-
managed company from the public listed corporation and depict them as altogether
different
creature^.^
The dichotomy revealed by this analysis has come
to
dominate our understanding of company law.
The weight placed by economists and politicians on the small business as a
vehicle for entrepreneurship, economic growth and job creation in recent years4
has also drawn attention to the apparent inadequacy of the legal packages available
to small firm
owner^.^
The fashion for deregulation6 emphasises the facilitative
role of company law, which leads to proposals for simplification and removal of
burdens from small firms. At the same time, legislation and other forms of binding
*Judith Freedman, Senior Lecturer
in
Law, London School of Economics.
1
should like to thank Michael Godwin, Research Officer on the empirical project referred to in this article
and co-author of the articles based on it, who supplied the methodological know-how and without whom the
project could not have been completed. My thanks are due also to a number of student research assistants
who have helped with this project and to Vanessa Finch. The usual disclaimer applies.
1
Gower,
Principles
ofModern
Company
Law
(London: Sweet
&
Maxwell, 5th
ed,
1992) pp
106-
107;
Farrar, Furey and Hannigan,
Company
Law
(London: Butterworths, 3rd ed, 1991) ch 31; Hadden,
Company
Law
and Capitalism
(London: Weidenfeld and Nicolson, 2nd ed, 1977) pp 222-230; Sealy,
Company
Law
and Commercial Reality
(London: Sweet
&
Maxwell, 1984).
2
Jensen and Meckling, ‘Theory
of
the Firm: Managerial Behaviour, Agency Costs and Ownership
Structure’ (1976) 3
J
Fin Econ 305; Fama and Jensen, ‘Separation of Ownership and Control’ (1983)
26 JL and Econ 301; Posner,
Economic Analysis
ofhw
(Boston: Little, Brown
Cyr
Co, 3rd
ed,
1986).
The limits of this analysis are explored
in
Brudney, ‘Corporate Governance, Agency Costs and the
Rhetoric of Contract’ (1985)
85
Columbia L Rev 1403, but its influence on our understanding of the
function of company law remains pervasive and the criticisms of the theory do not undermine the use
made of it here in relation to the small private company.
3 Manne, ‘Our Two Corporation Systems: Law and Economics’ (1967) 53 Virginia L Rev 259;
Easterbrook and Fischel, ‘Close Corporations and Agency Costs’ (1986) 38 Stanford
L
Rev 265;
Halpern. Trebilcock and Turnbull, ‘An Economic Analysis of Limited Liability in Corporation Law’
(1980) 30 Univ of Toronto L Rev 117.
4
Bolton Committee
of
Inquiry
on
Small
Fim
(197
1)
Cmnd 481
I
(hereinafter ‘the Bolton Report’); ‘An
Economic Survey, 1971
-
1991’ in Stanworth and Gray (eds),
Bolton
20
Years
On
(London: Paul
Chapman Publishing Ltd, 1991); Atkinson and Storey, ‘Small Firms and Employment’ in Atkinson
and Storey (eds),
Employment,
the
Small
Firm and
the
Labour
Market
(London: Routledge, 1994).
5
See Chesterman,
Small
Businesses
(London: Sweet
&
Maxwell, 2nd ed, 1982) p
58.
6 The ongoing review of company law announced by DTI Press Notice on
I8
November 1992 is largely
driven by the philosophy of deregulation. See DTI,
Deregulation
-
Cutting Red Tape
(London: DTI,
1994);
Deregulation Task Forces Proposals for Reform
(London: DTI, January 1994); Deregulation
and Contracting Out Bill 1994; Patfield, ‘The Reform of Company Law,’
Palmer’s
In
Company
(October 1993).
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108
Cowley Road, Oxford
OX4
IJF
and
238
Main Street, Cambridge, MA
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USA.
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standard are being produced at a great pace at both national and international
levels, driven by pressure for harmonisation as well as by financial scandals and
fears about investor protection. Blanket application
of
new corporate governance
provisions, investor protection rules and accounting standards increases the
unsuitability of the applicable rules for small companies.’
Furthermore, harmonisation initiatives in the European Union direct attention to
variations
in
the laws and institutions of Member States. Divergences and
omissions call at the least for explanation. It follows that the availability of a
greater variety of legal forms in one country than another leads to questions as to
the sufficiency of provision in the latter Member State.8
This is the broad background to the current debate on the legal regulation of
small firms. On the one hand, it is widely argued that corporate law is burdensome
for small companie~.~ On the other, in a climate in which incorporation is often
associated with entrepreneurship,’O there is no will to cut down access to the
limited liability company by business owners. Therefore, the logic seems to point
to amendments to corporate law, either generally or in relation to small firms only.
One possibility is a tailor-made legal form for such
firms.
In
1981,
the Department of Trade and Industry (DTI) published proposals by
Professor Gower for a new form of incorporation for small firms.” These met
with very little support
in
the United Kingdom, although they were taken up
in
South Africa12 and similar proposals came near to implementation in Australia.
l3
Curiously, despite the apparently cool reception
to
Gower’s proposals,I4 the
pressure for reforms targeted at small business has, far from diminishing,
increased in recent years.I5 In
1993,
the DTI announced the establishment of a
Working Group on the law on private companies to examine whether ‘it can be
simplified and separately presented.
’I6
7
For example, Accounting Standards, despite increasing in number and sophistication, currently apply
equally to audits of small companies as to all other audits (Auditing Practices Committee exposure
draft of auditing guideline, March
1991).
This was undoubtedly one reason for the support by the
Institute of Chartered Accountants
of
England and Wales for the removal
of
the requirement for a
statutory audit in respect of very small companies, discussed at p
572
below. It is understood that the
policy
of
applying the same accounting standards to all companies may now be under review.
8
Hadden,
op
cit
n
1,
at p
230.
9
See Institute of Directors
(IOD),
Company
Law
Reform
(London: IOD,
1994)
and materials at n
I
above.
10
This association can
be
found in the literature
of
economists, lawyers and the small business
communitv as well as that of lobbv
mourn
and oolicv makers.
See
the discussion in Freedman and
II
12
13
14
15
16
.
Godwin, ‘Incorporating the Micro Business: Pe;cept:ons and Misperceptions’ in Hughes and Storey
(eds),
Finance and the
Small
Firm
(London: Routledge,
1994)
and p
564
below.
Department of Trade (DOT) (now DTI),
A
New
Form
of
Incorporation
for
Small
Firms
(1981)
Cmnd
8171.
The South African Close Corporations Act
1984
came into operation on
1
January
1985
on the
recommendation of the South African Standing Committee on Company Law. This is discussed further
below at p
578.
The Australian Close Corporations Act
1989
was not proclaimed due to constitutional deficiencies.
The approach taken in this Act has now been rejected by the Joint Parliamentary Committee on
Corporations and Securities (Canberra: Commonwealth of Australia,
1992)
and alternative proposals
to simplify the law on proprietary companies are now under discussion
-
see p
580
below.
See Wooldridge, ‘A New Form of Incorporation
-
Responding
to
the
Gower Proposals,’
3
77w
Company
Lawyer
58;
Milman and Flanagan,
Modern
Partnership
Law
(London: Croom Helm,
1983)
ch
10.
See, for example. Institute of Directors,
Deregulation
for
Small
P
rivate Companies
(London: IOD,
1986);
Manchester Business School,
Business Legal
Structures
(Cheshire: Forum of Private Business,
1991).
DTI Press Notice,
18
November
1992.
This was part of a more general review of company law. The
author was a member of this Working Group and benefited from its discussions. However, the views
expressed here are her own and do not represent those of other Working Group members
or
the DTI.
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In April of this year, the Government announced that, following completion of a
preliminary paper by the Working Group, the matter would be passed to the Law
Commission ‘to carry out a feasibility study to see what is likely to be the best way
forward.’” The Press Release stated that the Working Group had identified two
main possible approaches. The more radical would be:
a completely new corporate form more like an incorporated partnership which would
dispense with some of the existing concepts
of
company law (eg the distinction between
shareholders and directors) while retaining other key features such as separate legal
personality and limited liability.
The alternative would be the simplification of the Companies Act
1985:
either by amending and dropping some of the existing requirements and if appropriate
drawing the remaining provisions together
in
a self-contained statute
or
by allowing
companies to opt out of some provisions by extending the elective regime introduced in the
Companies Act 1989.
However, the Law Commission has not been limited to these options and could,
indeed, recommend that no reform
is
desirable. If the Commission does favour
change, then no doubt a formal reference
will
be made and a full programme of
work embarked upon. This article does not purport to answer the detailed
questions which will need to be examined as part of the reform process. Rather, it
addresses some of the underlying issues which, it is suggested, are fundamental to
the matters the Law Commission has been asked to consider.
‘Internal’ and ‘External’ Provisions
An important distinction must be made from the outset. There are two elements to
the criticism of the corporate legal form as a vehicle for small companies. One is
that the regulation of such firms
in
the interests of outsiders is burdensome.
Examples of this type of regulation are disclosure and filing requirements. Here,
the argument is that the public interest requires a lesser degree of protection in the
case of small companies than for larger enterprises. These burdens are regressive,
that is they weigh most heavily on the smallest firms, and are not cost effective. In
this article, provisions of this type are described as regulatory, or ‘external.’ The
second element is that the provisions of the Companies Acts are said to be too
detailed and complex for small firms. In particular, it
is
argued that the provisions
designed to protect shareholders where ownership and control are separated are
unnecessary in cases where there is no such separation. It would follow from this
that, in a small company, lengthy provisions about meetings and class rights would
not be needed. Furthermore, some provisions, such as the statutory right to
remove directors by ordinary resolution in section
303
of the Companies Act
1985,
seem inappropriate where the basis of the organisation is an identity between
managers and shareholders. Such provisions, which will be described here as
facilitative, or ‘internal,
’
affect the shareholders between themselves. Arguably,
they are suitable matters to be left to agreement by those shareholders.
These two types of problem require very different responses. Relaxing
regulatory provisions could bring real benefits to companies
if
consistent with
investor and creditor protection, but removal of too much third party protection
17
DTI
Press
Notice,
Low
Commission
to
Look
at
Company
Law
Reform
(6
April
1994).
There
is
no
formal reference from the
Lord
Chancellor at this
stage.
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will not only be undesirable for reasons of public interest but will also destroy the
credibility of the small company sector which is very important to those choosing
incorporation.
l8
In
relation to regulatory provisions, therefore, the emphasis must
be on definition and cost-benefit analysis. Reliefs affecting third parties
will
need
to be targeted carefully at specific groups of companies to avoid abuse, and work is
needed to define these sub-groups for specific purposes. More than one set of
definitions may be needed for different purposes, although, where possible,
proliferation of thresholds should be avoided since such thresholds can generate
confusion and actually result
in
the
creution
of barriers to the growth of firms.I9
Ultimately, it must be accepted that regulatory provisions
will
be essential for
any legal form offering the benefits of limited liability. Firms considering them too
burdensome might do
so
because they are unable to take advantage of the
full
benefits of limited liability. For those firms, unlimited liability might be preferable
and
it
might even be helpful to set up barriers to incorporation as a warning to such
firms. This article therefore questions the true value of giving (or apparently
giving)20 free access to limited liability and suggests that there are strong
arguments for making incorporation less rather than more attractive. These
arguments should not be excluded from the current debate purely because they are
not deregulatory in appearance: a danger in the present climate. First, deregulation
should be only one amongst a number of guiding factors. Secondly, in practice,
discouraging firms from entering into an inappropriate regime may be the most
deregulatory step possible.
In respect of internal
or
facilitative requirements, what may be needed is not a
reduction of the legislation applicable to small firms but a change in its terms to
make it more appropriate. If corporate law is seen as providing participants
in
the
company with a standard form contract,*’ small firms require a suitable set of
terms but, if these are to save transaction costs, they must be comprehensive.
Despite the raising of ‘simplicity’ to the status of an objective in much of the
literature, it is not an end
in
itself. An apparently simple legislative solution, where
the underlying situation is complex, could create ambiguity and uncertainty and
have the ultimate effect of increasing costs. It is a mistake to imagine that because
the financial assets of the company are low, the situation is a simple one. Small
companies can give rise to difficult disputes, more so because they are frequently
associated with breakdown of personal relationships in the family or between
erstwhile friends.22 Neither is it necessarily true that there will be complete
identity between ownership and management in small firms. The familiar
~~ ~ ~~ ~
18 See the empirical evidence presented at pp 560-566 below.
19 The concern of the small business community with barriers
to
growth
is
reflected in the first
recommendation of the Government’s own Deregulation Task Forces which states ‘Do not create
exemptions, barriers and thresholds
for
small business regulation. Regulate only where essential
-
and then universally’
(Deregulation Task Forces Proposals for Reform, op cit
n
6).
20 Limited liability is often stated
to
be illusory in the case
of
small
companies due
to
the need
for
directors
to
give personal guarantees
in
many cases. The author’s empirical data support this view but
many small company owners, even those who had given personal guarantees, appeared
to
believe that
limited liability was of value
to
them. See p 561 below.
21 Easterbrook and Fischel,
The Economic Stnccfure of Corporare
Law
(Cambridge, Mass: Harvard
University Press, 1991).
22 A reading
of
the cases
on
s
459
of
the Companies Act 1985 and
s
122(
I)(@
of
the Insolvency Act 1986
and their predecessors supports this. See, for example,
Re Harmer
[
19581 3 All ER 689;
Ebrahimi
v
Westbourne Galleries
[I9731 AC
360;
Re a Company
[I9831 Ch 178;
Re
a
Company
1986
(Re
XYZ
Ltd)
[I9871 BCLC 94;
Re D.R. Chemicals Ltd
(19891
5
BCC 39;
Virdi
v
Abbey Leisure Lrd
119901
BCLC 34;
Jesner
v
Jarrad Properties Ltd
[
19921 BCC 807.
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dichotomy drawn between the owner-managed company and the public, quoted
company may be unhelpful in that it masks the
full
range of companies in
existence. In practice, there is a continuum from the one person firm, through the
husband and wife company, the family company, the private company which
brings in outside finance, the unlisted public company and the quoted company to
the multinational group. Even this list understates the variety of firms for which
the law of business organisations must cater and fails to recognise their changing
character: some firms will transmute through a number of these categories over
their life cycles.
As
soon as a firm ceases to be a one person concern, some minority protection
may become necessary. Protective provisions may be more necessary for some
small firms than for quoted public companies where the market exerts some
control. For these reasons, simplicity may not be an attainable or even a desirable
objective for structures governing small firms. However, the precise balance
desired within the structure can be left to those engaged
in
the venture and need not
be the concern of outsiders, provided there are default provisions for cases where
the internal relationship breaks down and no provision has been made by the
parties. Flexibility seems a more appropriate objective than simplicity.
A
New
Legal Form for Small Firms
It is not obvious that creation of an entirely new legal form would result either
in
simplification or in provision of a more appropriate vehicle for small business. It
has been demonstrated above that the relaxation of external regulations may have a
different focus from that of internal provisions. Once it has been accepted that
these are separate issues, it follows that there is no need to attempt to formulate a
single definition of small firms requiring a specially tailored package which will
cover both areas: indeed, this would be unlikely to prove helpful. Furthermore,
given the rejection above of a simple dichotomy between large and small
companies, the existence of a legal package entirely distinct from the partnership
and the private limited company could
create
complexity and barriers to growth.
What would be appropriate at one stage of the lifecycle would not be at another.
A
firm which had been operating under a legal form designed specifically for small
firms would have to transform itself into a private limited company if it outgrew
the small firm vehicle.
A
transition from one legal form to another would be bound
to involve formalities and would set up a psychological and practical barrier to
change. In contrast, a small firm using a flexible private limited company structure
could evolve gradually, within this structure, to meet changes in its situation.
A
structure which allows shareholders to formulate a suitable set
of
internal
provisions for themselves may result in the most appropriate legal organisation not
only for small firms but for all private firms. Only
in
the case of reliefs from
external provisions is it necessary to formulate thresholds to protect the public
interest and these do not need to be associated with a new legal form.
It
is these relationships between removal of burdens, simplification and
facilitation and the central problem of definition which
will
now be further
examined, drawing on historical and comparative material as well as empirical
data. This examination will lead to the conclusion that the creation of a new legal
form for small businesses is not desirable, but that modification of general private
company law is the best approach to take when dealing with internal provisions. In
relation to external provisions, the targeting of reliefs is seen to be an essential
requirement.
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B
Consulting Small Firm Owners
Throughout the following discussion, the author
will
draw on the results of a
survey of small business owners and their accountants conducted during
1990
and
1991.23
This exercise was prompted by the fact that the lack of enthusiasm for
Gower’s
1981
proposals24 seemed to be at odds with both the continuing pressure
for reform and the theoretical mismatch between the legal forms available to small
businesses and the actual needs
of
those businesses. Some commentators had
suggested that one reason for this was that the consultation process
in
1981
might
not have reached those very small business owners most likely to benefit from any
change.25 It is the case that the professions and business lobby groups, even those
focused on small business, tend to reflect the views of the larger firm more
effectively than those
of
sole traders and one person companies.
26
For these reasons, a survey which consulted small business owners directly
seemed to be needed. For present purposes it suffices to give a brief summary of
the main findings since the objective of this article is to build upon an analysis of
the results already undertaken2’ and to examine its relevance in the context of the
wider debate on the legal packages available to small firms.
It must be stressed that the majority of small firm owners are not particularly
interested in the question of legal form.
An
unreal preoccupation with legal matters
could mislead our thinking. Despite careful structuring of interviews and
questionnaires emphasising the question of legal form, the responses showed
greater interest
in
other concerns.2s The mixed initial reaction to the reference of
this topic to the Law Commission,
with
some small business groups saying that it
23
24
25
26
27
28
This survey was undertaken by the author and Michael Godwin at the Institute of Advanced Legal
Studies as part of the ESRC Small Business Programme funded by the ESRC, Barclays Bank, the EC
Commission (DG
XXIII),
DOE, the Rural Development Commission and the DTI. The views
expressed do not necessarily reflect those of the sponsoring organisations. Postal questionnaires were
sent
to
small business owners backed up by telephone interviews, company searches and face-to-face
personal follow-up interviews with selected business owners and auditors experienced in small
business work. Information was obtained from
429
firms
in four geographical areas.
125
usable
completed postal questionnaires were received from limited companies and
146
from unincorporated
firms
(82
sole traders and
64
partnerships). Of the telephone respondents,
50
were
sole
traders,
37
partnerships and
65
had limited companies. Five operated in both forms.
Of all the respondents
to
these proposals (DOT,
op
cit
n
I
I),
only the National Chamber of Trade, the
National Farmers’ Union and the Institute of Chartered Secretaries and Administrators were in favour
of the new form of incorporation: see Wooldridge,
op
cir
n
14.
See Farrar
et al,
op
cit
n
I,
at p
536.
Small business owners characteristically have a commitment to the values
of
independence and
autonomy. In addition, time and other resource restraints mean that they operate with a restricted
range
of
contacts with the wider environment and are difficult to reach through any existing economic
or social network: see Curran. Jarvis, Blackburn and Black,
Small
Firms andNetworks,
published in
the Proceedings of the 14th National Small Firms Policy and Research Conference (Blackpool: UK
Enterprise Management and Research Association,
1991).
See Freedman and Godwin,
Legal
Form,
Tar
and rhe Micro Business,
Institute of Advanced Legal
Studies Working Paper, May
1991;
Freedman and Godwin, ‘Legal
Form,
Tax and the Micro
Business’ in Caley, Chell, Chittenden and Mason (eds),
Small
Enterprise Development
(London: Paul
Chapman Publishing Ltd,
1992);
Freedman and Godwin
(1994).
op
cit
n
10.
The methodology
adopted is described in more detail and the findings
fully
analysed in these papers.
Our questionnaires were circulated as the recession took grip of the economy. Prime amongst
respondents’ concerns were problems
of
late payment of debts, VAT penalties and the perceived
behaviour of banks. All these issues are or have been the subject of governmental review and are not
for discussion here. They affect
small
business whatever its legal form. There was a similar reaction
to
the Government’s own survey in
1984
into burdens on business. Responsas of
firms
to questions on
burdens were ranked on a seriousness index. Company law was classified with the least frequent
burdens, ranking after,
inter alia,
VAT, PAYE, local authority planning requirements and health and
safety regulation: see DTI,
Burdens
on
Business
(London: HMSO,
1985).
560
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Small
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is ‘an example of government tendency to focus on the wrong issues,’29 bears out
the need to be wary of over-emphasising legal problems. However, within the
framework
of
the survey, there were some matters which were clearly of more
moment than others, notably the cost of the statutory audit, which, like the other
concerns of small business owners, actually make a direct impact on their
pockets
.30
(a) Unincorporated Firms
Most of the main reasons given by unincorporated firms for non-incorporation
were unsurprising; for example, simple accounting requirements (mentioned as
important by
76
per cent of respondents) and ease of operation
(67
per cent) but,
less predictably, the most often mentioned reason was to retain personal control
over the business
(83
per ~ent).~’ Although
46
per cent of the unincorporated
firms agreed that lack
of
limited liability was a disadvantage, only
5
per cent
thought that the disadvantages of remaining unincorporated outweighed the
advantage^.^^
The next most highly rated disadvantage was that the firm cannot
survive the owners
(28
per cent) with only
23
per cent giving difficulties in raising
finance (expressly stated to include the non-availability of floating charges) as
a
disadvantage.
(b)
Limited Companies
The company directodowner respondents agreed that they incorporated in order to
obtain limited liability, although the
66
per cent giving this as a reason was lower
than might have been expected.
54
per cent of the respondents stated that directors
and/or their spouses currently provided personal guarantees (in almost all cases to
banks), yet half
of
these
54
per cent gave limited liability to banks and financiers as
an important reason for incorporation. This objective was, at best, only partly
fulfilled.
The most often mentioned reason for incorporation after obtaining limited
liability was prestige and credibility
(50
per cent), well ahead of tax reasons
(38
per cent) and ownership of property in the firm’s name
(26
per cent). Other
textbook factors for preferring incorporation were even less enthusiastically
supported: for example, ease of raising finance was stated to be important by only
24
per cent
of
these very small company respondents and ease of transferring
shares by only
18
per cent. Clearly there is a great deal
of
incorporation for
reasons which do not fit the usual economic or legal analyses. Those companies
which were dissatisfied with their legal form33 were
less
likely to have
29
Gourlay, ‘Inventing a Hybrid,’
Financial Times,
19
April
1994.
On
the other hand, the Federation of
Small Businesses welcomed the move, commenting that
it
would address ‘a serious weakness in
Britain’s industrial structure’
-
Mason, ‘Small Businesses Set to Benefit in Wide Review
of
Company
Law,’
Financiul Times,
7
April
1994.
30
This is also consistent with
the
findings reported in
Burdens on Business,
op
cit,
n
28.
The
Government has now reacted to this concern about the statutory audit, as discussed at p
572.
31
Analysis
of
small business literature and further questioning suggested this was not merely a general
comment but was related to prevailing perceptions
of
incorporation. For example, in
1991
the Barclays
Bank booklet,
Serring
Up
Your
Business,
stated ‘If
you
are a sole trader
you
have complete control of
your business’ but,
of
limited companies, ‘[they] can exist without you.’
32
This is not surprising since
it
is relatively easy to move from unincorporated to incorporated form,
so
dissatisfied owners would
be
likely to do this.
33
Defined as those who considered the disadvantages of incorporation outweighed the advantages:
22
per
cent of the total
of
incorporated respondents.
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incorporated to obtain limited liability
(59
per cent) or because of ease of obtaining
finance
(15
per cent), but
more
likely to have incorporated for tax reasons
(52
per
cent).
34
The responses from incorporated firms on the disadvantages
of
the corporate
form were striking.
72
per cent agreed that the cost of the statutory audit was too
high.3s Other administrative burdens were also seen as a disadvantage by a
majority
(52
per cent) as was lack of confidentiality
(52
per cent), but the
difference between these dissatisfaction levels and the
72
per cent figure on the
statutory audit is significant. When asked about other administrative burdens,
personal interviewees almost invariably referred
to
bookwork, which was accounts
related,
or
the annual return which must be delivered to the Registrar
of
Companies with an accompanying fee. Many also referred
to
VAT and other tax
burdens which would be experienced without incorporation. The message was
clear: work which involved form filling and fees was not only expensive in money
terms but, more important, time. Such costs are regressive, hitting hardest at the
smallest firms with the least administrative back-up, and are seen as a distraction
from the true business
of
running the firm.36 Internal requirements, relating to
meetings for example, are another matter. These are not monitored and
so,
whilst
all the shareholders are in agreement at least, can simply be ignored. About
30
per
cent of our respondents seldom
or
never held shareholders’ meetings. Fewer than
half
(46
per cent) thought that the provisions in the
1989
Companies Act enabling
them to dispense with annual general meetings would be helpful, compared with
74
per cent who thought that the introduction of the shuttle annual return, which
simplifies the form filling requirements on the company, was helpful.
34
per cent
of limited companies thought that companies were expensive and complicated
to
set up: not an insignificant figure, but low when compared with the number
complaining of the audit.
(c)
Capital
One problem identified in the literature with permitting very small firms to obtain
limited liability is that this may create incentives for owners to exploit a moral
hazard and transfer uncompensated risks to
creditor^.^'
The data collected support
the view that incorporation, far from being a capital raising device in relation to
these very small companies, may actually result in
less
capital being invested in a
business than will be the case with an unincorporated business. Since there is no
minimum capital requirement for private companies in the United Kingdom and
putting in capital by way of equity is riskier than lending to the company, it was not
surprising to find that few
(22
per cent) of our incorporated sample considered
share capital to be an important source of finance on incorporation. However,
long-term loans were important to only
19
per cent and debentures to
10
per cent,
34 The tax advantages of incorporation have diminished in recent years as income tax rates have reduced.
Finns which incorporated for tax reasons may
be
at a tax disadvantage now but not be aware of this
or
may feel ‘trapped’ in corporate
form,
given that disincorporation itself can have adverse tax
consequences. Some companies are incorporated by freelance workers wishing
to
avoid being
classified as employees
of
their clients
for
tax purposes,
or
being caught under special rules for agency
workers, both of which result in tax being deducted under PAYE
-
for a fuller discussion, see
Freedman and Godwin (1994).
op
cit
n
10.
35 See Freedman and Godwin, ‘The Statutory Audit and the Micro Company
-
An Empirical
Investigation’ (1993) JBL 105, for a full account.
36 Sandford, Godwin and Hardwick,
Adminisrrurive
and
Compliunce
Cosrs
of
Tararion
(Bath: Fiscal
Publications, 1989).
37 Halpern
er
ul,
op
cir
n 3; Easterbrook and Fischel,
op
cir
n 3.
562
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The Modern law Review Limited
1994
July
19941
Smull
Businesses
and
the Corporate
Fom
and these categories overlapped considerably. By contrast, bank borrowing was
important to nearly
60
per cent of the companies at commencement.
As
described
above, this will often have been secured by personal guarantees or mortgages
so
that the company owners are in fact providing financial backing, but indirectly. By
contrast,
70
per cent of unincorporated firms stated that capital contributed by
owners was an important source of capital at start up; a much more visible
investment and risk sharing was taking place here.
Corporate respondents were asked questions about the company’s constitution.
Only
8
per cent reported that the articles were tailored to their own requirements
and most of these also had a written shareholders’ agreement. About
25
per cent of
the companies had standard form documentation with a
few
changes and the rest
believed they had an off-the-shelf standard form (although these may have been
amended by the company formation agents). Checks against company searches
revealed a worrying divergence between the actual position and the perception of
directors as to the contents of this documentation, for example on the question of
whether shareholders had pre-emption rights under the articles, on which up to
half our respondents appeared to misunderstand the position. Since other responses
generally appeared to have been careful and correct, this seems to reveal a real
failure of knowledge or understanding.
Some
Conclusions
from
the
Survey
The responses of small business owners taking part in this survey do not suggest a
great clamour for the advantages normally claimed for incorporation. What is
suggested by these results is that many small firms are content with their
unincorporated form, although it is possible that this is for want of an alternative.
The fact that limited liability would be an attraction to a substantial minority if
available at no cost is natural. However, it is not clear that this group would be
prepared to forgo
any
of their existing freedom from formalities for this privilege.
A
new legal form without limited liability would have little attraction, given that
lack of limited liability is the main perceived disadvantage of non-incorporation.
The problem for any new form with limited liability is that some disclosure
requirements and
loss
of confidentiality are inevitable, in the interests of third
parties and the stability of the structure within the economy. The question which
then arises is whether a new structure would save sufficient costs to be worthwhile.
Despite the importance attached to limited liability, it is incomplete
in
many
cases. It was clear from comments that protection of the family home was a major
reason for requiring limited liability and yet this will frequently be subject to a
charge, being the main asset available. Some firms may be incorporating in order
to obtain the unattainable. However, many firms incorporated for reasons other
than limited liability. There appears to be a perception amongst some sectors of the
business community that incorporation bestows prestige and credibility. Any new
form would need to carry similar status
in
order to be attractive. This perception
seems odd to lawyers familiar with the true import of limited liability38 and may
38 The limited company was greeted with great suspicion when first introduced. During the debates
on
the introduction of the Limited Liability Act 1855,
it
was suggested that a limited liability company
would be ‘in a situation
to
do incalculable mischief
to
the fair trader.’ The reply given was that ‘The
right hon. Gentleman would have the British public
to
believe that the people were such idiots that they
would
not
know what the credit of these Companies was, when every name, every note and every
letter would have marked
on
it
limited liability’
(Hunsurd,
3rd series, vol 139, col 1712). Strangely,
this word ‘limited,’ intended to act as a warning, has become a symbol of creditworthiness: see also
Gower.
op
cir
n
1,
p
46.
(c)
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1994
563
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[Vol.
57
be unwarranted in many cases but cannot be ignored by those considering reform
if
it is a major motivating factor. It is worth noting that the great majority of
uninco orated firms considered that their legal status made no difference to third
parties3 However, this does not remove the importance of prestige and
credibility as a reason for incorporating by the limited companies. The belief
amongst incorporated firm owners that banks, suppliers and customers prefer
dealing with limited companies‘’’’ may have some root in the simple fact of
registration and increased visibility and disclosure. Again, any comfort given by
this apparent transparency may be based on a misperception of its value, but this
does not remove the importance of the belief as a motivating factor amongst those
who incorporate. Both incorporated and unincorporated questionnaire respondents
and interviewees suggested that any form of registration, including a VAT number
or
membership of a trade organisation, assisted them in obtaining credence.
A
number expressed regret at the disappearance of the Register of Business Names
for this reason.4’
The ‘enterprise culture’42 has encouraged this view of the limited liability
company as an important vehicle for entrepreneurship. The Institute of Directors
claims, for example, that:
The limited liability company is the unsung hero of all free enterprise economies. Its
structure provides a unique, flexible, efficient means of bringing together capital and
expertise, raising finance, limiting risk, stimulating investment and channelling economic
activity. In Britain, the competitive market has streamlined time-consuming registration
procedures
so
that an entrepreneur can acquire and begin to trade with a private limited
company, ready made,
in
five minutes for a payment
of
E100.43
Incorporation in the United Kingdom is cheap and presents few obstacles on
commencement; the majority of company owners did not consider that setting up a
company was complex or expensive. Government has now responded to
complaints about the greatest perceived burden, the statutory audit.44 Other
attempts to remove requirements monitored by outside agencies may be welcome,
but deregulation of internal requirements such as meetings could create more
verbiage and complexity than it saves if elaborate safeguards need to be built
in.45
Such requirements are often avoided by agreement amongst the parties (sometimes
in accordance with provisions in the articles but sometimes
in
contravention of
39 Some unincorporated
firms
thought that third parties preferred them to limited liability companies as
follows: 18.5 per cent believed this in relation to suppliers;
15
per cent in respect of customers,
12
per
cent banks and
7.5
per cent employees. A few thought that third parties preferred companies:
5.5
per
cent in respect of suppliers, 3.4 per cent customers and 9.6 per cent banks.
40 Around half of the incorporated respondents believed that third parties preferred to do business with
them rather than unincorporated
firms.
41 Abolished by the Companies Act 1981.
42 Burrows, ‘The Discourse of the Enterprise Culture and the Restructuring of Britain’ in Curran and
43
IOD
(1986),
op cir
n
15.
44 It is proposed
to
introduce legislation by regulations under the Companies Act as part
of
the
deregulation initiative.
DTI
Press Notice,
Small
Companies
to
be
Freed from
Audit
Requirement,
7
April 1994
-
discussed further at p
572.
45 As in the case of the Companies Act 1985 procedure
(ss
381A-C, inserted by Companies Act 1989)
whereby private companies may adopt resolutions in writing without having
to
hold a general meeting
provided they are signed by all the members of the company and copied to the company’s auditors.
Since this could be achieved under the articles without the need to involve the auditors, the new
provision, which was intended
to
be deregulatory, actually complicated matters and cast doubt on the
ability to rely
on
the simpler procedure under the articles. The Companies Act 1985 is
to
be amended
under the deregulation initiative
to
drop thc requirement
to
involve the auditors:
DTI,
Deregulation.
op
cit
n
6, para
B7.
Blackburn (eds),
Paths
of Enterprise
(London: Routledge, 1991).
564
0
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Modern
Law
Revicw
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1994
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19941
Small
Businesses and the Corporate
Form
strict procedural requirements) whilst remaining in place as a default provision
should the need arise.
Firms which incorporate for reasons not associated with capital raising or other
theoretical advantages of the limited liability company, such as taxation, are more
likely to be dissatisfied than those which genuinely need limitea liability or the
ability to raise capital from outsiders.46 This points to the importance of a tax
system which is as neutral as possible between legal forms: taxation is not a good
reason for choice of business organisation. Introduction of a new legal form could
complicate the tax position, especially
if
there was pressure for special tax
treatment for one or other form.47 The level of dissatisfaction expressed may be
much reduced by the removal of the statutory audit from the very smallest firms.
For those for whom incorporation still seems burdensome, it may be that little is
being gained by incorporation and that disincorp~ration~~ should be eased and
unincorporated status made more attractive, perhaps with some registration
provision being reintroduced along the lines of the Business Names Registry to add
prestige.
The lack of understanding of what is obtained by incorporating and, indeed,
what rights and obligations are created by the particular incorporation documents
of
the firm, suggests that business owners are not interested in this documentation
prior to problems arising. If this is
so,
there are two main consequences. First, it is
not at all clear that shorter companies legislation, say
50
pages instead
of
the
current
480
pages, would be any more likely to appeal. If company owners do not
read their own memorandum and articles, they will not read the legislation. They
will, probably correctly, feel that they have more important things to do when
setting up a business. Commentators such as Professor Sealy have railed against
the excessive length of our companies legislation and praised the model Canadian
statute, for example, of which Sealy comments:
The English text
fits
comfortably into
100
pages and can be read as bedtime reading.49
This is no doubt meant to be taken with a pinch of salt. However, the point is that
there is no evidence that business owners would wish
to
look at any legislation at
all, even a one-page pamphlet, until the need arises. Shorter, simpler legislation
will assist those advising business owners in due course and therefore reduce costs
eventually, but only if it covers the points that need to be dealt with. Otherwise,
even greater costs will be incurred in trying to plug the gaps, either on setting up
46
15
per cent
of
the company respondents which reported that share capital was an important source of
finance at the start thought the disadvantages
of
incorporation outweighed the advantages, compared
with 24 per cent of those for whom share capital was not important.
47 The Bolton Report
(op
cir
n
4,
at para 13.58) recommended that close companies should be allowed to
elect, by unanimous decision
of
the shareholders. to be taxed as partnerships to prevent taxation from
deterring businessmen from incorporation and obtaining the benefits of limited liability. This follows
the
US
sub-chapter
S
treatment. To the Inland Revenue's argument that higher taxation was a price
of
limited liability, Bolton responded that this was
to
'elevate a purely incidental differential into a point
of principle.
'
Sce
also
Conclusions and Recommendations of the Commirree of Independent Experts
on
Company Taxation
(Brussels:
EC,
1992) which recommend that partnerships and sole traders should
be able to opt to be taxed as companies, a more difficult and less attractive option under current
conditions.
48
There is a DTI Working Group on disincorporation but no proposals have been published. Previous
attempts to provide disincorporation relief foundered due
to
taxation complications (DTUInland
Revenue,
Disincorporation,
1987;
Tiley,
UK
Tax
Guide Policy Supplement
1993- 94
(London:
Butterworths, 1993) p 70).
49 Scaly, 'Company Law and the Small Business' in
Company
Law
Reform
(London: IOD, 1994).
0
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Limited
IVY4
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The
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[Vol.
57
the business or, worse, after a problem has arisen.
To
put physical brevity at the
top of our list of objectives would be a mistake.
The second consequence is that it would be foolish to expect too much of the
ability of individual business owners to come to their own agreements to cover
future problems since this is not their focus of attention. The low level of
shareholders’ agreements in existence supports this view. This argues for
legislative standard forms which offer provisions for the problems most likely to
arise. However, such standard forms could also have an educative function. If it is
believed that business owners should understand the relationships they are
creating, then a series of options or elections which they must consider before
forming their company could be a very helpful way of ensuring that they have
given these some The majority
(65
per cent) of the company owners
responding to our survey took external advice before setting up a company. For
those who do not currently consult advisers, the posing of these questions might
enable owners to come to a sensible conclusion on their own or lead them to seek
advice. This might increase initial cost but could save problems at a later stage.
Where limited liability and outside finance are real objectives, a minimum
capital requirement might assist the intending entrepreneur. If he incorporates with
no capital he is likely to find that he will not obtain limited liability because
security will be demanded of him by lenders and
other^.^'
In addition, prospective
outside investors will probably demand some sign of commitment,
so
that he may
find the supposed benefits of incorporation elude him. Worse still, he may then be
‘trapped’ in corporate form, since disincorporation can be costly in administrative
and tax terms.52 In this sense a minimum capital requirement could save business
owners from inappropriate incorporation and therefore be ‘deregulatory
’
in
practice.
C
Incorporation
of
‘Small’ Businesses: Problems
of
Objectives
and Definition
The debate on the role of the limited company in relation to small firms is as old as
the creation of this legal form.
It
is a debate which raises fundamental questions
about the nature of the limited liability company. If the corporation is seen as
‘primarily a method of solving problems encountered in raising substantial
amounts of capital’s3 (problems such as monitoring costs and control of
managers),s4 then there is little place for the firm in which ownership and control
are not separated and capital is not to be raised from outsiders. On this analysis,
problems will result for the small corporation ‘because of the insistence by the
various participants on some role
in
managing.’s5 Moreover, allowing small firms
access to such a form
will
50
38
per cent
of
the partnership respondents agreed that it
was
a problem that no legislative detailed
standard form partnership agreements were available.
Our
personal interviews suggested that
accountants will refer clients requiring a partnership agreement to a solicitor but will form a company
themselves, often making incorporation appear cheaper
to
the client than a partnership.
51
In other words, third parties will contract around the regime, being an unsuitable standard form: see
Halpern
er
al,
op
cir
n
3.
52
The provision in the Deregulation and Contracting Out Bill
1994
which would permit voluntary
striking-off
of
private companies which are no longer trading will not meet these problems.
53
Posner,
Economic Analysis
ofhw
(Boston: Little, Brown
&
Co,
3rd
ed,
1986).
54
Easterbrook and Fischel, ‘Limited Liability and the Corporation’
(1985)
52
Univ
of
Chicago L Rev
55
See Manne,
op
cir
n
3.
89.
566
CJ
The
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Rcview
Limited
19Y4
July
19941
Small Businesses and the Corporate Form
create incentives
for
owners to exploit a moral hazard and transfer uncompensated business
risks
to ~reditors.~~
An analysis of the company as a concession from the State, on the other hand, will
adapt more easily to the small company, limited liability being seen as a privilege
to which all should have equal access, subject
to
suitable safeguards, to encourage
entreprene~rship.~~
There has been a failure to articulate a clear philosophy regarding the
functions of company law in relation
to
incorporation by small firms in the
United Kingdom. This is abundantly clear from an examination of the history of
our company legislation, which has alternated between attempts to exclude
incorporation by very small firms and the introduction of provisions especially
designed to facilitate such use. The lessons for current reformers in past debates
and experiences are also clear when we turn to the central question of defining
‘small’ firms.
In the context of legal form, ‘small’ is generally used as shorthand for owner-
managed, in contrast with the public, widely held company. However, a
qualitative definition is not easy
to
draft or enforce. Numerical thresholds also
have their drawbacks. Measures such as turnover, balance sheet total and number
of employees have differing significance depending
on
the type of business being
carried These problems have resulted in the absence of any agreed definition
in past debates. Yet the needs of a one person company and one with, say,
10
shareholders and
200
employees may differ enormously. Without a clear definition
of the firms aimed at, sensible reform will be impossible.
Writing in
1944,
Kahn-Freund assumed that the limited company was originally
a capital raising device which was wrongly appropriated by small firms. He
suggested that:
Instead of,
or
in
addition to, altering the
legal
consequences
of
company formation,
one
might
make
the formation
of
companies
more
difficult and
more
expensive, and thus reduce
the number of companies and especially
of
small
companies.
By
doing
so,
Parliament might
go
some
way towards restoring to
the
limited
company
its original function, and to
the
partnership its
proper
place
in
business
life.’9
According to Kahn-Freund, the limited company, a form originally created for
major capitalists embarking upon risky adventures, was distorted by the
‘calamitous decision in
Sulomon
v
Sulomon
&
Co
Lid’@’
so
that, in his famous
phrase, ‘company law has come to annex the functions of the law of partnership.’6’
56
Halpern
er
al,
op
cir
n
3.
57
This is the tenor of the statement of the Institute of Directors, cited above. Sce also the European
Commission’s explanatory memorandum on the
1988
draft Twelfth Company Law Directive on the
Single Person Company which stresses the importance
of
promoting the ‘access of individual
entrepreneurs
to
the status of company, which represents the best framework for business development
in the internal market.’
58
For this reason, the Bolton Report,
op
cit
n
4,
adopts varying definitions depending on the sector. The
Committee’s qualitative criteria were that of owner-management, small market share and
independence but it recognised this was unsuitable as a basis for its detailed studies. For
manufacturing,
it
adopted an upper limit of
200
employees. For a detailed discussion of the problems,
see Hertz,
In
Search
ofa
Small
Business Definition
(Washington, DC: University Press of America,
1982).
59
Kahn-Freund, ‘Some Reflections on Company Law Reform’
(1944)
MLR
54.
60
[1897]
AC
22.
61
In
his introduction to Renner, Schwarzschild and Kahn-Freund,
The Institutions
of
Private
hw
and
567
their
Social
Funcrions
(London: Routledge and Kegan Paul,
1976).
0
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19Y4
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The Problems
in
Historical Context
Whilst it is clear that the impetus for the Limited Liability Bill in
1855
was the
need to provide for the capitalists Kahn-Freund had in mind, the objectives of
company law were not crystal clear even at this early stage. There were those who,
from the beginning, believed that the limited liability company should be available
equally to the small entrepreneur. The House of Commons voted by a large
majority to remove the minimum capital requirement originally inserted into the
1855
Bill by the Government. The express purpose of this amendment was to avoid
creating a monopoly in favour of large and wealthy companies.62 It is true that the
House of Lords countered by requiring a minimum of twenty-five shareholders,
but even
so
the debates in the House of Lords envisaged that the limited company
might be used by small businesses. Lord Redesdale suggested that:
some protection should be inserted, as a protection
to
poor
persons,
preventing very small
Companies being set up under the Bill, for, otherwise petty Companies
of
all kinds would be
set
afloat by lawyers
for
the purpose
of
getting long bills paid to them
for
their services.h3
Lord Stanley of Alderley agreed that it would be absurd for very small firms to
use this form, but ‘the expense would be too great to admit of their being
formed.’64 This burden was seen as a useful deterrent. However, Lord Stanley did
not reckon with the ingenuity of the company formation agents who have now
reduced that expense to a minimum. Similarly, when Robert Lowe, then Vice-
President of the Board of Trade, introduced the
1856
Companies Act which
reduced the number of shareholders required to seven, he did not intend this
to
apply
to
small concerns, but others were aware of this possibility and very quickly
developed it.
65
Thus, even if the originators of the limited liability company were not aware that
it would apply to small traders, this very soon became clear and by the end of the
nineteenth century there was no doubting it. In the light of this,
it
cannot be said
that the legislators and policy makers who have been instrumental in the great
increase in length and complexity of the Companies Acts have acted in ignorance
of the fact that this statute would be used by small companies. Indeed, many of the
‘complexities’ introduced over the years are expressly directed at private
companies, providing specific relief or special provisions to assist them.& As
Sealy has pointed out, these include some very complex provisions indeed,67
although whether this is the result of an inherently complex situation or of the
method of drafting is a matter for debate. It is clearly the case that merely drawing
the provisions relevant to small private companies together in a self-contained
statute68 offers little reduction of complexity without radical changes to the
substantive law.
62 Formoy,
Foundations
of
Modern Company
Law
(London: Sweet
&
Maxwell, 1923).
63
Hansard
(1855). 3rd Series, vol 139, col 2042.
64
ibid
at col 2 102.
65 Paddy Ireland has traced the history of the development of the company
as
a vehicle for the small
firm
in fascinating detail in ‘The Triumph of the Company Legal Form, 1856- 1914’ in Adams
(ed),
Essays for Clive SchmirthofS
(London: Professional Books, 1983). Ireland writes that Lowe’s
‘objection was not
to
giving small traders limited liability, but to incorporating them, which would
render their acts
open
to “constant ambiguity”.’
66 For example, Companies Act 1985,
ss
155- 158 (relaxation of
s
151 on financial assistance for
private companies);
s
91 (excluding provisions
on
share allotment);
ss
17
I
-
177 (purchase of own
shares).
67
Company
Law
and Commercial Reality, op cir
n
1,
at p
8.
68 One of the possibilities identified by the DTI Working Group: see p 557 above.
568
(9
The
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1994
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19941
Small
Businesses and
the
Corporate
Form
Just as legislators have been aware of the presence of the small private company
since the introduction
of
company law,
so
the various reports on company law
reform produced over the years show an awareness
of
the legal forms available in
other jurisdictions. One
of
the first calls for limited liability, from Professor John
Austin in 1825
,69
put forward a proposal for a limited partnership modelled on the
French partnership
en
commandite.
However, this was not a proposition intended
for small firms: limited companies did not exist at this stage and the express
intention was to provide for ‘the establishment
of
large trading associations.’ The
Ker Report rejected this approach in 183770: again it was seen as a substitute for
and not an addition to a company law.” Limited Partnership Bills in 1855 and
1856 were clearly intended for the smaller firm, but both lapsed, opposed in
particular by Archibald Hastie who was convinced that they would ‘increase fraud
and bankruptcy and destroy the credit of the English merchant.
17*
Various
attempts to improve partnership law followed but did not provide the protection
that was intended.73
When the Limited Partnership Act was introduced in 1907, as a last ditch
attempt to provide a suitable form for small business away from the corporate
ambit, it had no chance of success. By then the small trader had already been
granted the full benefits of incorporation and was not about to settle for anything
less.
74
Limited partnerships require registration, a fully liable general partner and
involve risks for limited partners. Indeed, once relatively simple incorporation
became available in France, the limited partnership lost its popularity there also.75
Paradoxically, the introduction of the 1907 Limited Partnership Act coincided
with the commencement of a rather different legislative approach to the problem of
small companies using the corporate form. The Companies Acts
1900
and 1907
created special exemptions from disclosure for ‘private companies’
-
positive
legislative encouragement for use by small traders.76 Although this might have
been the end
of
one chapter, it was the beginning of another. There followed a
history of abuse of the privileges of the private company by public companies
running their business through private companies and thereby maintaining secrecy
in relation to aspects of their dealings.77 The attempt by the Cohen Committee78
to tackle this by the introduction of the exempt private company in the Companies
Act 1947 was not a success and highlights the difficulties inherent in distinguishing
between different types of private company for the purpose of creating
exemptions: difficulties with which we continue to struggle and which are at the
heart of the reforms now being discussed.
69
(1825)
Parliamentary History and Review 709.
71
There was no simple form of incorporation in France at this time
-
see Haddeli,
op
cit
n
I,
p 168.
72
Hansard, op cit
n 63, col 638.
73 See Gower,
op
cir
n
1,
p 48.
74 The Limited Partnership Act 1907 continues in force. At the end of 1993 there were 3,634 on the
register (DTI,
Companies
in
1992-
93,
London: HMSO, 1993). They are sometimes used for tax
planning purposes and joint ventures between corporate partners but rarely by small traders, although
it
is interesting to note that they have increased by 76
per
cent from 2,064 since 1989.
70
PP 1837 (530) XLIV 19-23.
75 Hadden,
op cir
n
I;
DOT,
op
cit
n
11,
Annexe
B.
76 This was on the recommendation of the 1906 Loreburn Committee (Cd 3052). The impact of the
formal creation of the private company, with publicity exemptions, on company registrations is shown
by Ireland,
op
cir
n 65, pp 42-43.
77 Schmitthoff,
Palmer’s Company
Law,
Vol
1
(London: Stevens
&
Sons Ltd, 24th ed, 1984) p 48.
78 (1945) Cmnd 6659.
0
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1994
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57
Under the 1908 legislation, a private company was one with membership limited
to
50,
restrictions on the right to transfer shares and a prohibition on any invitation
to the public to participate
in
shareholding. The exempt private company was
designed to give exemption from balance sheet disclosure only to a sub-group of
such companies. Broadly, the definition aimed to eliminate companies which were
owned or controlled by other corporations which were not exempt private
companies themselves, but this is a considerable oversimplification of the
conditions. The categorisation produced ‘hideous
*
complications and capricious
result~.”~ It was abandoned by the Companies Act 1967, following the evidence
of the Board of Trade to the Jenkins Committee that many of those claiming this
status were ‘not very small in membership or in capital or in the extent of their
undertakings.
’‘O
After this, all companies were required to
file
accounts.
With 403,000 companies on the register at the end of 1961 and only 16,000 of
those public companies,81 the Jenkins Committee was far more concerned with
the irresponsible multiplication of small companies and the dangers of abuse by
undercapitalised companies than with facilitating incorporation for such
businesses. It even favoured a minimum capital requirement but allowed itself to
be persuaded against recommending this by witnesses who
suggested that it would be difficult, if not impossible,
to
prevent
a
company, once formed
with
a
statutory minimum of cash, from returning the cash
to
the promoters.n2
This important proposal was therefore summarily dismissed without further
consideration of ways of making
it
operate effectively, despite the fact that the
Committee favoured it in principle. The idea that a minimum capital requirement
might encourage more serious consideration of incorporation, as a type of
‘deposit,’ even if it were not possible to ensure long-term retention of the cash,
was not discussed. The White Paper,
Company
Law
Reform,
produced in July
1973, gave weight to the argument that a minimum share capital would deter
frivolous incorporations and the 1973 Companies Act included such a provision
but was lost with the defeat of the Conservative Government in the February 1974
General Election.
Despite the very clear emphasis
on
policing small companies in the Jenkins
Report, by the time the Companies Bill 1967 was debated the Committee was
already being criticised for not dealing with the small private company left exposed
by its abolition of the exempt private company. By this time a form of incorporated
partnership, drafted by Professor Gower, had been introduced in Ghana. Surprise
was expressed that although Professor Gower was on the Jenkins Committee this
area was ‘very poorly and weakly argued’ in their report.83
A
draft definition of a
family or ‘proprietary’ company was introduced in Committee when discussing the
1967 Bill,*4 but it met with the same problem as all other definitions of small
companies
-
there was no real agreement about the type of company to be
targeted. The draft would have limited the new status to,
inter
alia,
companies
~~
79 Gower,
op
cir
n
I,
p 12.
The
definition takes up sevcn pages
of
the
1959
Palmer’s
Company
hw
80
Jenkins Committee (1962) Cmnd 1794, paras 55-63, and
see
discussion in Magnus and Estrin,
The
81
Of
the private companies, 70 per cent claimed exempt status: Magnus and Estrin,
ibid.
82 Jenkins Committee,
op
cir
n
80,
at para 27.
83 Parliamentary Debates, Commons Standing Committee E, Session 1966-67,
Vol
IX,
cols
9
and 73.
84
ibid
at col 4.
(London: Stevens
&
Sons Ltd, 20th
ed,
1959).
Compunies
Acr
I967
(London: Butterworths, 1967).
570
0
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Review
Limited 1994
July
19941
Small
Businesses and the Corporate Form
inter
uliu,
companies where no person other than a director or the spouse or infant
child of a director held shares or debentures. But this describes one kind of small
company in one particular state: infant children grow up and spouses, all too
frequently, are divorced. Should such
life
events result in a transformation of the
status of the company? And why should a company owned by two brothers be
subject to a different regime from that owned by a husband and wife? The scheme
was patently unworkable and was dropped. Neither could agreement be achieved
on a definition based on numbers of members or asset size. One amendment would
have used a limit of
~100,000
net assets, but many, including the Government,
thought this much too high. A number of speakers in the debate clearly had only
firms the size of their local grocer’s shop in mind.R5
Subsequent reforms have been based on European Community Directives and
have taken a different tack. Since
1980
United Kingdom company law has defined
public companies, which have a minimum capital requirement, and all others are
private.86 ‘Small companies’ are defined by reference to turnover (not more than
f2.8
million), balance sheet total (not more than
f1.4
million) and number
of
employees (not more than
50).
They must fall below at least two of these
thresholds to be ‘small’ and therefore eligible for certain accounting and disclosure
exemption^.^'
As can be seen from the description of these companies, they cover
a wide range and are a long way from the ‘proprietary company’ definitions which
were in the minds of reformers in
1967.88
The Problems Unresolved
There were
960,600
companies on the register in March
1993
and only
11,700
(1.2
per cent) of these were public companies.89 There are no official figures on
the number which are within the Companies Act definition of ‘small,’ but
Government estimatesw that around
90
per cent of all companies are ‘small’
appear to be s~pportable..~~ If anything, this proportion will rise in future since
the Ecofin Council has recently decided to increase the relevant thresholds by
25
per cent to keep up with inflation and improve conditions for small companies.’2
Any serious reduction of protection for creditors and third parties (‘external’ or
‘regulatory’ provisions) is unlikely to be targeted on ‘small’ companies as a whole:
85
ihid
eg at cols
23, 34, 39
and
63.
86
s
1
of the Companies Act
1985.
87
Companies Act
1985
(Accounts of Small and Medium-Sized Enterprises and Publication
of
Accounts
in ECUs) Regulations
1992,
amending Companies Act
1985.
s
247(3).
88
Another reform arising from a European Community Directive is the formal recognition of the one
person company (Twelfth Directive on Single Member Private Companies
(I
19891 OJ L395/40),
implemented in the United Kingdom by
The
Companies (Single
Member
Privure Limited Compunies)
Regulutions
1992,
S1
1992,
No
1699).
This was not used as an opportunity for substantive change in
the United Kingdom and therefore makes very little practical impact on our company law.
89
DTI,
op cir
n
74.
YO
(1985)
Cmnd
9749,
para
8.5.
91
For a detailed statistical survey, see Freedman and Godwin
(1994).
op cir
n
10.
The Freedman/
Godwin survey imposed a
fl
million turnover limit on companies where possible, but since this
sample was drawn from the Companies Register, this information was not always available due
to
the
provisions permitting abbreviated accounts, discussed below note
94.
Those tiling abbreviated
accounts or no accounts were included in
our
sample since exclusion would have introduced
a
number
of distortions. The unincorporated firms were picked from the Yellow Pages
so
that there was no way
of
imposing size limits. Nevertheless, almost
YO
per cent
of
our total sample had an annual turnover of
less than
f
I
million.
92
Agence Europe, Brussels.
23/3/1994.
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ivoi.
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the definition is much too wide for this purpose. The difficulty is then to create
sub-groups. The 1967 Commons Committee debates and attempts at proprietary
company definition were based on pure anecdote as to the make up of the corporate
population. This has continued to be a problem. There are figures available
on
the
size of businesses drawn from employment statistics and VAT
registration^,^^
but those produced by the Companies Registry are based on legal distinctions such
as public and private and the amount of nominal and issued share capital rather
than by turnover and balance sheet total or number of employees. Of course,
because of the relaxations for small and medium companies, +his more qualitative
information will not always be available.94
Attempts at qualitative definition have also foundered on lack of information and
disagreement about the nature of the ‘small’ company. When abolition of the
statutory audit was discussed in 1985, one option was to abolish the audit
requirement for small companies all of whose members are
director^.^^
In 1993,
when the Government decided to take action on removing the audit requirement
from some companies, attempts at a qualitative approach were abandoned in
favour of size thresholds.96 Full exemption from audit is to be given to private
companies with an annual turnover of less than €90,000 (said by Government to be
40
per cent of
all
companies). For companies with a turnover above €90,000 but
below €350,000, a compilation report will be permitted instead of an audit.97
f350,000 is also the VAT cash accounting threshold but it is not clear whether the
link will be a formal one. The original Government proposals were for much lower
limits: a turnover linked
to
the VAT registration threshold (currently
€45,000)
and
a balance sheet total not exceeding
€100,000.98
The April 1994 Press Release
states that ‘the overwhelming majority of respondents
.
.
.
thought the proposed
exemption thresholds were too low.’ Even the new thresholds are the subject of
current criticism.99 A major problem is that the rationale behind them has not
been made clear. The €90,000 limit introduces another new threshold for small
business owners to assimilate. The methodology used seems
to
be
one
of
trial and
error. The Press Notice states that:
Once implemented
we
will
see
how the
measures
work
in
practice and consider, in due
course,
whether
any further
changes
might be appropriate.
93
Even thesc are not as comprehensive
as
researchers would wish
-
see
CE,
Enterprises
in
the
European Community
(1,uxembourg: EC,
1990):
‘Considerable estimations have been necessary to
dcvelop the UK enterprisc database.’
94
Under Schcd
8
of
the
1985
Companics Act as amended, small companies may file an abbreviated
balance sheet and no profit and
loss
account, in which case turnover and number
of
employees will not
be apparent from the file.
95
DTI,
Accounting and Audit Requirements for
Small
Firms
(DTI,
1985).
96
HM
Treasury Press Release,
A Budger for Enterprise,
30
November
1993;
DTI Press Notice,
7
April
1994.
up
cir
n
44.
See also Freedman and Godwin,
JBL,
op
cir
n
35.
Shareholders with
a
holding
of
I0
per cent or more will be able
to
veto use
of
the exemption. The original DTI consultative document
suggested that unanimous agreement would be required.
No
explanation
has
been given
of
this change.
There
is
one qualitative element rcmaining in the definition of eligible companies. They must not be
‘part ofa group structure
or
subject
to
a
statute-based regulatory regime.’ It remains
to
be seen how
this will be dealt with
in
the Regulations.
97
It
appears from the DTI Press Release that this relief will be more limited than had been hoped by some
since the compilation report will be required to be from an independent accountant holding a practising
certificate from one
of
the accountancy bodies, or registered
as
an auditor confirming that the annual
accounts have bcen prepared from the company’s accounting records in accordance with the relevant
format and disclosure requirements
of
the Companies Act
1985.
98
DTI,
Audit and Accounting Requirements for Very Small Companies
(London: DTI,
1993).
99
Scc
JOD,
op
cif
n
9;
Dercgdatim Task Forces Proposals. op cit
n
6,
prQposal
416.
572
(C,
Thc
Modern
Law Rcview Limited
I994
July
19941
Small
Businesses
and
the
Corporate Form
It is surely the case that a prerequisite for further reforms which are aimed at a sub-
group of small or private companies based on size is a thorough census of the
registered company stock
so
that thresholds can be formulated based on real needs
and not anecdotal evidence.
loo
Frequent shifts in policies and threshold levels are
most disruptive to the small business community. Throughout the debates
described above there has been lack of agreement and knowledge as to the types of
business actually incorporating, with policy swaying between attempts to facilitate
the use of the company by small traders and attempts to control them. Any serious
work programme on the reform of legal regulation of small firms should certainly
commence with some fact finding.
It has been reported that ministers see the issues to be considered by the Law
Commission as:
a means
to
removing obstacles to the growth
of
small businesses into medium-sized
companies better able to compete, particularly in the European single market, and
to
provide
increased employment.
This is a very different objective from that of easing the burdens on the smallest
businesses, many of which have no desire to grow.lo2 This reflects the major
problem of unclear definition and objectives in this area. There is a tendency for
reforms initially intended for the very smallest firms to be ‘hijacked’ by those
supporting larger firms and ‘growth’ firms, in relation to which different
considerations may very well apply.Io3 The nature of the relief can change as
thresholds rise and more safeguards are required.Io4 To ensure that reliefs are
effectively targeted, statistical and economic information is essential.
D
New Corporate Form
or
Modification
-
Overseas Experience
As
outlined above, one option which the Law Commission has been asked to
consider
is
a completely new corporate form. The position in other European
countries, such as France and Germany, is often,cited in support of such a
proposal, since those jurisdictions have more than one corporate form. However,
it can hardly be argued that our lack of a specialist corporate form for small firms
is deterring incorporation which, if anything, is more frequent in the United
Kingdom than in other European countries. This may
in
part be ascribed
to
the
absence of a minimum share capital requirement in the United Kingdom, whereas
all the other members of the European Union (except Ireland) have such
a
100
For
an exercise
of
this nature in the
US,
see
Conard, ‘The Corporate Census: A Preliminary
Exploration’ (1975)
63
Cal
L
Rev 440.
101
Mason,
Small Businesses Set
to
Benejit
in
Wide Review
of
Company
LAW,
Financial Times,
7
April
1994. This is not an objective set out in the Press Release.
102
‘It
has already been established that the majority of Britain’s small firms do not want or
do
not have the
ability
to
grow, but now it seems that even the growth-oriented firms may have rather limited
objectives.
’
Gray, ‘Growth-Orientation and the Small Firm’
in
Caley, Chell, Chittenden and Mason
(4s).
Small
Enterprise Development
(London: Paul Chapman Publishin& Ltd, 1992).
103
This occurred in Australia: see pp 579-580. The author’s survey did not seek
to
explore the
relationship, if any, between legal form and growth. this not being the major preoccupation of the lcgal
arguments being tested. For a further discussion of this, see Freedman and Godwin (1994),
op
cit
n
10.
The terms
of
the current debate suggest that this should now be explored further.
104
As
in the case
of
the abolition of the statutory audit. Extension beyond the originally proposed
thresholds has resulted in the introduction
of
the compilation report for firms at the upper end of the
range to be relieved. This complication could have been avoided by keeping the threshold low.
CD
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requirement applying to their private company form as well as to public
companies.
Io5
About
34
per cent of United Kingdom firms are incorporated.Io6 In France, in
1983, 14
per cent of firms were incorporated as
Sociktds
d
Responsibilite' Limitke
(SARLs), the incorporated form for small firms, and
6
per cent used the large
corporate
form
(Sociktks Anonyme
or SAs).
lo'
The minimum capital requirement
of
the SARL is currently
50,000
francs
(€6,000).
In Germany, the small company
form (the GmbH) has a minimum capital requirement of
50,000
DM
(about
€20,000).
In
1980,
only about
6
per cent of firms used this form with very tiny
numbers using the
AktiengesellschuB
(AG) or stock corporation designed for the
large corporation.Io8
80
per cent
of
all German firms were individual
proprietorships. The most popular limited partnership form in Germany is the
GmbH
&
Co
KG, which is a limited partnership whose general partner is a
GmbH.Iw What evidence is available, therefore, does not suggest that the
absence of a range of legal forms in the United Kingdom leads to a lower level of
incorporated trading here than in other European countries.
Ilo
Although France and Germany have these specialist corporate forms for small
companies, they do not appear to be much more flexible or free of formalities than
the general private company in the United Kingdom, particularly now that the
United Kingdom elective regime permits private companies to avoid holding
meetings and most resolutions will be effective in writing without a meeting.
The true comparison is between the GmbH and the SARL on the one hand and the
much more rigid AG and SA
on
the other. For example, all AGs must have a
supervisory board whereas GmbHs with fewer than
500
employees need not do
so.
As this reference to GmbHs with
500
employees shows, the form
is
in fact used by
many large firms and the vast majority of German subsidiaries
of
foreign
corporations are GmbHs. Although designed for small firms, the GmbH has, in
Kahn-Freund's term, been annexed by large In this sense, the GmbH is
little more tailored to small firms than is the United Kingdom private company.
105
106
I07
108
I09
I10
111
I12
The author learned during discussions at the European Commission in July
1993
that this was a matter
of
concern to some Member States, particularly Germany, and consideration was being given to an
extension
of
the Second Directive to private companies partly for this reason. A report (unpublished)
has been prepared for the Commission by Boden de Bandt de Brauw Jeantet
&
Uria (Brussels, July
1992).
Of all registered VAT units,
38
per cent are sole proprietors,
26
per cent partnerships and
34
per cent
companies
(1989190
figures). Since this does not include firms below the threshold for registration
(€23,600
in
1989/90
and now
€45,000)
unless they register voluntarily,
it
omits some very small firms
which are more likely to
be
unincorporated than incorporated and
so
may slightly overestimate the
percentage of companies.
Vickery,
Small
Business in Europe,
Burns and Dewhurst (eds) (London: Macmillan,
1986).
Other
forms used by small business in France account for fewer than
5
per cent of firms each. For example,
the
Socidrd
en
Nom
Collectif
accounts for less then
1
per cent
of
businesses.
Buxbaum and Hopt,
hgal
Harmonisation and the Business Enrerprise
(European University Institute,
Walter de Gruyter,
1988)
p
171.
Maitland-Walker,
Guide
to
European
Company
Laws
(London: Sweet
&
Maxwell,
1993).
It should be noted that the comparisons are made between figures for different years and some of the
data is old. The German figures are,
of
course, pre-unification and
so
must be treated with caution.
The difficulties
of
collecting data on small enterprises in the European Union are discussed in
Enterprises
in
the European
Community,
op
cit
n
93.
Most Member States have deliberately avoided
building up systematic statistical inquiries at the
very
small firm level to avoid imposing burdens: see
also Buxbaum and Hopt, n
108,
p
169.
Companies Act
1985,
ss
379A
and
381A
inserted by the Companies Act
1989.
Wooldridge,
op
cit
n
14;
Drury, 'Legal Structures
of
Small Businesses in France and England
Compared'
(1978)
ICLQ
510,
at p
527
describes a similar position in relation to the SARL. The
French have now introduced a simplified form of
Socikfd
Anonyme,
but only for joint ventures
(Financial Times World Accounting Report
May
1994).
574
(r)
The
Modern
Law
Review
Limited
1994
July
19941
Small
Businesses
and
the Corporate Form
In formulating his proposed new form of incorporation in
1981,
Professor
Cower decided that none of the Continental legal systems provided a wholly
suitable model. The incorporated limited partnership which he put forward
suffered from much the same difficulty as the Limited Partnership Act in
1907
in
that it offered the business owner something less than the
full
limited liability
company to which he had become accustomed to having access. Any chance of
success would have been dependent on a minimum capital requirement being
introduced for full limited liability companies,
so
giving the new form an
advantage by deterring use of the existing one. The consultative document which
contained Gower’s proposals listed a number of objections to this: it would be
difficult to enforce maintenance of the capital; the level at which it would be set
would be arbitrary since different types of business have different needs and the
requirement could be applied to new companies only and
so
would take a long time
to become truly effective.’15 When the new form
of
incorporation was not
acclaimed, consideration of a minimum capital requirement was quietly dropped.
Cower’s model would have been limited to entities with no more than
10
members (not a figure based on any empirical evidenceII6), would have
simplified registration, applied partnership rules to internal relations and given
members an entitlement
to
a fraction of the firm’s net worth, not a share. One
important feature would have been that each member would have been entitled to
take part in the management
of
the busines and any provision precluding this would
have been void. Similarly, it would not have been possible to contract out of a
provision that unanimity would be required for a change in the nature of the
business.”’ These provisions were based on section
24
of the Partnership Act
1890,
with the significant difference that under the Partnership Act the equivalent
provisions can be varied by express or implied agreement.
Under Cower’s scheme, on death or retirement there would have been buyout
provisions, failing which the firm would have been wound up unless the existing
participants wished to admit an outside purchaser or legatee. External relations
would have operated along the lines of partnership rules, with no
ultra
vires
rule.
Floating charges would have been available and debts due to partners would have
been deferred to creditors. There would have been personal liability for
withdrawals during two years prior to winding up unless it could be shown that the
firm was solvent at the time
of
withdrawal; otherwise withdrawal would not have
been restricted. There would have been no statutory audit requirement; only an
auditor’s certificate of insolvency would have been required.
Adopting the ‘internal’ and ‘external’ divide proposed above,l18 it is hard
to
see
that the ‘external’ or ‘regulatory’ benefits offered by Cower have much relevance
in the current debate. The statutory audit is now being abolished or lessened in
113
DOT,
op
cit
n
11.
p
28.
I14
‘It
is difficult
to
see what would make any novel corporate form sufficiently attractive in itself to lure
people away from the limited company’
-
Sealy, ‘The New Form of Incorporation: A Personal
View,’
The
Compuny
Lawyer,
Vol
2,
No
3,
128.
115
DOT,
op
cit
n
11.
s
7.
I16
See Wooldridge,
op cit
n
14.
Some American states use this figure as did the original
US
Internal
Revenue Sub-chapter
S
corporation.
96
per
cent of the company respondents to the author’s
questionnaire had five
or
fewer shareholders and 68
per
cent had only two shareholders. This was a
sample biased towards the small end of the corporate population but the figures are striking and show
the need for more information before formulating such proposals.
117
DOT,opcitnII,p29.
I18 At
pp
557-559.
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impact for many small firms,’19 the cost
of
start up is not a major problem for
companies in any event, and
ultra vires
problems are much diminished following
the 1989 Companies Act.120
The ‘internal’ or ‘facilitative’ rules proposed by Gower might be more
attractive. However, it is not clear that a new legal form is needed
to
achieve them.
To some extent they can be achieved already by a combination of carefully drafted
articles and shareholders’ agreements, including voting agreements. The case of
Russell
v
Northern
Bunk
Corp
Ltd’2’
has highlighted the pitfalls for those drafting
such agreements, whilst confirming the basic efficacy of the device. It was held in
this case that although the company’s exercise of its statutory powers could not be
fettered, a severable shareholders’ agreement was enforceable
inter
se
as a
personal agreement. By careful drafting this can be backed up by creating special
voting rights
to
prevent the passing of a resolution to exercise a statutory power.122
Voting agreements may be used to prevent a shareholder from voting in
contravention of an agreement or compelling him to vote as agreed.’23
There are problems with leaving these matters to shareholders’ agreements.
Easterbrook and Fischel argue persuasively that:
corporate law is a set
of
terms available off-the-rack
so
that participarts in corporate ventures
can
save the cost
of
transacting.’24
On this analysis, corporate codes and case law provide, free
of
charge (as ‘public
goods’), accumulated knowledge and experience built up over the years. It is
arguable that small company participants without easy access to expert advice,
little experience of the pitfalls of running a business and no interest in what they
would see as pure mechanics, prior
to
a problem actually arising, need such
standard terms as much
or
more than large firms. This is supported by the
empirical evidence on the low level of shareholders’ agreements and tailored
articles and the lack of understanding of such articles.
However, this does not necessitate a special legal form with all its associated
problems, such as defining firms eligible to use the form and providing for
transition from one form to another. It would be sufficient to clarify the law on
shareholders’ agreements and to provide a range
of
options and elections from
which shareholders could choose.
125
These would relate to such matters as the
right to participate in management, the holding of meetings, rights to transfer
shares and rights of parties to be bought out on retirement, death or in the event of
disagreement. Possibly these could be gathered together for convenience in one
chapter of the Companies Act, but not in a separate Act, since the latter would
merely necessitate repetition of provisions applicable to
all
companies. This
1
I9
120
121
122
123
124
I25
See
n
96
and text thereto.
Despite the problems with this legislation, in practical terms for very small companies the problems
are much reduced.
[I9921
3
All
ER
161
(HL). For an argument that the decision in
Russell
does not protect members
sufficiently and that the right to enforce such contracts should
be
restricted, see Riley, ‘Vetoes and
Voting Agreements: Some Problems of Consent and Knowledge’
(1993)
NILQ
34.
Bushell
v
Fuith
[1969]
I
All
ER
1002
and see Griffiths, ‘The Need for More Flexible Corporate
Structures,’
Palmer’s In Company,
January
1993.
Greenwell
v
Purfer
119021
1
Ch
530;
Pddephart
v
hifh
[I9161
1
Ch
200.
See generally Stedman and
Jones,
Shareholders
’
Agreements
(London: Longman, 2nd ed,
1990).
Easterbrook and Fischel.
op
cit
n
2
1.
This proposal
is
for a wide range
of
options covering matters sometimes dealt with currently in the
articles or in shareholders’ agreements. In addition, the elective regime introduced in the Companies
Act
1989,
which relaxes formalities such as the need
to
hold meetings, could be extended: one of the
options put forward by the DTI Working Group.
576
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approach could be achieved by some amendments and additions to substantive
company law, coupled with an expanded range of standard articles of association.
There is no reason why the flexibility offered by this combination should not be
available to all private companies, provided unanimity was required for the
elections and any change to them. The legislation would continue to provide
default provisions and could also continue to offer a remedy in the case of unfair
prejudice, although the extent to which this jurisdiction should be subject to the
contract of the parties would require consideration.
126
In the United States of America, where many States have either a separate Close
Corporations Act or Chapter, the general corporation law was originally much
more rigid and restrictive than in the United Kingdom and this accounts for the
perceived need for special legislation.
12'
However, the Revised Model Business
Corporation Act of
1984
is considerably more flexible.'28 Thus, according to the
introductory comment to the
1984
Model Statutory Close Corporation
S~pplement,'~~ it is
usually possible to achieve any desired legal result within a closely held corporation without
recourse to the Close Corporation Supplement by the use
of
sophisticated contracts among
the shareholders and special provisions in the articles.
The advantage of using the Supplement is said to be that it can achieve the same
results with less drafting and a lower probability that some factor has been
overlooked. What it does not do is simplify the legislation applicable: the
Supplement commences by applying the Model Business Corporation Act to
statutory close corporations to the extent not inconsistent with the provisions of the
Supplement and then goes on to provide for special arrangements, many of which
require further authorisation in the articles to come into force. The Board may be
eliminated
so
that management powers are vested in the shareholders and
shareholders may be given partnership style rights to dissolve the corporation.
Shareholder agreements relating to the regulation of the business of the
corporation are authorised; great flexibility is permitted, but unanimity is required
for adoption and amendment. There are provisions for judicial supervision in cases
of oppression, unfair prejudice or deadlock.
Many of the provisions of the Supplement are optional and depend on the
articles. This is a very important difference from the new legal form proposed by
Gower which would have made it mandatory for all participants to have the right to
manage, for example.13o A flexible approach such as is adopted by the Model
Close Corporation Supplement is preferable to a mandatory, simplified package
because the latter is unlikely to encompass the range of needs experienced by small
companies. It is a false economy to provide a cut price statute for a complex
situation.
For this reason, the New Zealand Law Commission, which considered this issue
recently, decided in favour of making its general company law as flexible as
126 See Riley, 'Contracting Out of the Company Law: Section 459 of the Companies Act 1985 and the
Role
of the Courts' (1992) 55 MLR 782.
127 Cheftins,
'US
Close Corporation Legislation: A Model Canada Should Not Follow' (1989)
35
McGill
128 American Bar Association,
Revised Model Business Corporation Act Annotated
(New York: Harcourt
129
ibid.
130
It
should be noted that neither the SARL nor the GmbH give all shareholders the right
to
participate in
577
W
160.
Cheffins reviews the
US
literature thoroughly.
Brace Jovanovich, 3rd ed, 1985).
management: Maitland-Walker,
op
cit
n
109.
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possible but not to have a special small company statute. In its report, the
Commission states:
It is, moreover, a feature of closely-held corporations in other jurisdictions that they are
extremely diverse. The flexibility required
of
statutes catering for them means that tailor-
made constitutions may generally be necessary
in
any event.I3'
The New Zealand Companies Act
1993
provides for companies to have a
constitution which allows them to vary many of the statutory rules.
132
Likewise,
in Canada, the Canada Business Corporations Act of
1975
is sufficiently flexible
to
make a special close corporations statute unneces~ary.'~~ In the United States,
despite the existence of Close Corporation Statutes in many States, it is reported
that they are not much used.'34 It is interesting to note that Delaware, that most
deregulatory of States, has a very short Close Corporations Chapter rather than a
special statute, presumably because much of the flexibility desired can be achieved
under the general law in any event.135 Nevertheless, the status of the company as
a close corporation must be acknowledged on the certificate of incorporation,
so
to
this extent it is a different type of entity.
One country which did follow Gower's proposals and create a new legal form is
South Africa.'36 On the face of
it
this has been a great success story. The Close
Corporations Act, consisting of only
83
sections, prescribes no share capital and
thus contains no capital maintenance rules, and requires no prescribed meetings
and no statutory audit. The internal relations of the members (a maximum of
10,
who must be natural persons) are governed by partnership-type rules which are
subject to variation by agreement.137 Thus, the provision that all members may
take part
in
the management of the company may be varied, a clear improvement
on Gower's proposals which, by insisting on this provision as mandatory, could
have prevented growth and change: a company may start out being jointly
managed by its shareholders but
will
want the flexibility for this
to
change should
one shareholder become
ill
or die, for example.
Between
1985
and
1993, 288,020
Close Corporations were registered in South
Africa as compared with
61,559
private companies.
138
In part, the popularity of
the new form may be ascribed to tax advantages deliberately bestowed on it: when
131 New Zealand Law Commission, Report
No
9,
Company
Law
Reform
and
Restatement
(Wellington:
132
International Business Lawyer
9, January 1994.
133 Cheffins,
op cit
n 127; Dickerson, Howard and Getz,
Proposals for
a
New Business Corporations Law
134 Hamilton.
Cormrations
(St Paul. Minn: West Publishing
Co,
3rd ed, 1986)
D
516. For a critical
NZLC, 1989) para 237.
for Canada
(Ottawa: Information Canada, 1971) p
11.
135
136
I37
138
..
analysis, see Karjala, 'A Second Look at Special Close Corporation Legislation'~l981) 58 Tex L Rev
1207.
Balotti and Finkelstein,
The
Delaware
Law
of Corporations
and
Business Organizations
(Prentice
Hall, 1993). The recent development in the United States
of
the Limited Liability Company, a
company with some partnership characteristics, appears to be almost entirely tax driven and therefore
not
of
great interest in this context. See, for example, Kalinka, 'The Lirnitcd Liability Company and
Subchapter
S:
Classification Issues Revisited' (1992)
60
Cincinnati L Rev 1083.
I
am grateful
to
Caroline Bradley for her assistance on this point.
See Naude, 'The Need
for
a New Legal Form
for
Small Business' (1982) 4
Modern Business Law
5:
for a general description, see Delport and Pretorius,
Introduction
ro
the
Close
Corporations Act
(Cape
Town: Juta
&
Co, 1989).
Delport and Pretorius,
ibid.
For
these figures and further information on the South African position,
1
am indebted to Professor
J Henning
of
the University
of
the Orange Free State with whom
I
had conversations and whose
lectures
I
attended whilst he was Visiting Fellow at the Institute
of
Advawed Legal Studies. These
figures include conversions from one to the other.
578
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1994
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these advantages were removed in
1989,
new registrations began to fall.139
Again, the particular economic and political climate in South Africa must surely
account for some of the development, with the Government actively encouraging
use of this form by groups which had not previously been engaged in the formal
business economy. There are then good reasons for caution in following the South
African example in the United Kingdom. Moreover, it should be noted that the
original intention in South Africa was to phase out the private company
completely." The Close Corporation was to be the usual form for non-public
companies. However, this has not occurred. Instead there are now three forms in
existence, yet the Close Corporation, despite the limitation on number of
members, is actually being used by companies which are large in terms of assets.
There are consequent worries that this could give rise to abuse of the simplified
legal form: the membership test seems inadequate to determine which companies
should benefit from the removal of external requirements associated with this new
legal form. The linkage of the internal and external provisions inherent in the
creation of a specialist legal form creates problems as the relevant limits may not
be the same for each case. The South African experience will need
to
be monitored
carefully by reformers in the United Kingd~m.'~'
Attempts in Australia to follow a similar route to that in South Africa were not
successful.
142
Few tears were shed when the Australian Close Corporations Act
1989
was lost as a result of constitutional pr0b1ems.I~~ The concept behind the
Australian Act may have been similar to that in South Africa, but the execution
was very different. The Australian Act had
170
clauses and still incorporated much
of the general law
by
reference.IM Thus it remained relatively complex, and also
offered fewer advantages to users than the proprietary company, a category which
already existed. Under the Close Corporations Act provisions, limited liability
could be lost relatively easily, for example, if the number of members exceeded
10.
This led to arguments that this limit on members was
too
low and comparisons
were made with the United States where the limit for close corporations provisions
is normally
50
members. This objection ignored the fact that the United States
provisions generally deal only with the internal issues of company law, whereas
the Australian Act would have dealt with external or regulatory provisions also.'45
Another major criticism was that the Act assumed that all members would
139 The perception that the new form offers tax advantages may still linger despite their removal. This is a
140
Naude,
op
cir
n
136.
141
In
The Company
Luwyer
(1993)
Vol
14,
No
11,
at p 229,
J
Du Plessis comments:
'I
am convinced
that a comprehensive investigation of the South African company law will in fact accentuate the
various spheres in which the company and the close corporation ought
to
operate respectively.
In
so
doing, the conclusion may well
be
that such differentiation is unnecessary, as was the case in New
Zealand.
'
142 Companies and Securities Law Review Committee,
Report
ro
the
Ministerial Council
on
Form
of
Legal Organisation
for
Small
Business Enterprises
(Sydney: September 1985), discussed in Hill,
'Close Corporations in Australia
-
The Close Corporations Bill 1988' (1989) 15 Can Bus
W
43;
Greenwood, 'The Close Corporations Act 1989
-
Where Did Parliament
Go
Wrong?'
(1989)
Burterworths Company
Law
Bulletin
(Australia).
common phenomenon.
143
New
South
Wales
v
The Commonwealth
(1990) 169 CLR 482.
144
Hill,
op
cir
n
142, p
44.
145 Subsequent research showed that
99.1
per cent of existing exempt proprietary companies in Australia
have ten members
or
less,
so
that this objection seems unfounded. Joint Statutory Committee
on
Corporations and Securities,
Close Corporarions
Act
1989
(Canberra: Commonwealth of Australia,
1992).
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be involved
in
management and
so
could not accommodate the passive
investor.
When the Act failed for constitutional reasons, the opportunity was used to argue
for modifications of the close corporation concept. It became apparent that if the
changes being urged on the Government were adopted, there would be little
distinction between the new form proposed and other proprietary companies,
Therefore, the Attorney-General's Department published new proposals to
simplify the existing general law on proprietary companies.
14'
These concentrate
on relaxing external requirements and simplifying internal requirements on
meetings. They do not appear to deal with the more complex issue of formulating
appropriate provisions for the internal operation of the business. However,
existing Australian law has the flexibility to allow much to be achieved without
new provisions.
148
The new proposals divide proprietary companies between
small and large for the purposes of some of the regulatory reliefs, and have moved
from a definition based on number of members to one similar to that used
in
the
United Kingdom, based on two out of three size criteria being ~atisfied.'~~
The Australian experience illustrates the impossibility of formulating a simple
statute that will cater for small business generally. Aimed at the owner-managed
enterprise, the Close Corporations Act was attacked because it did not cover those
firms where the identity between owners and managers was not complete.
Targeted at the smallest firms, it nevertheless covered potentially large ones, the
test of
10
members being at once too wide to exclude sizeable firms and too narrow
for many critics. There was no simple process for converting a close corporation
into a proprietary company: thus the creation of the new form was seen as a barrier
to growth. History and logic suggest that a similar exercise in the United Kingdom
is likely to develop into a comparably contentious task.
I5O
A final salutary example can be found in the Swiss experience.I5l The Swiss
AG was fairly liberali5* and was widely used by small firms. However, in
1936
it
was decided to import a new form modelled on the German GmbH to allow
freedom of internal structure for small undertakings. Yet the Swiss GmbH is not
widely used. Various reasons are given for this,i53 amongst them the fact that
there is a presumption that all partners may and shall jointly manage and represent
the partnership. This is seen as a disadvantage. Here, as elsewhere, a presumption
based on the oversimplistic dichotomy between the owner-managed firm and all
others has proved to be unhelpful. The fact that small firms were already familiar
with use of the AG by the time the GmbH was introduced is another obvious
factor. In addition, members do not have
full
limited liability, although their
liability is restricted to the registered capital.
146
ibid
p 24.
147 Corporations Law Simplification Program,
Proposal
to
Simplify Proprietary Companies
(Barton:
148
Hill,
op
cit
n 142.
149
The criteria are based on gross operating revenues,
gross
assets and number of employees: for the
United Kingdom criteria, see text
to
n 87.
150
The political and economic situation in the United Kingdom being nearer
to
that in Australia than that
in South Africa,
it
is submitted that the Australian experience is that which should guide us.
15
I
I
am grateful
to
Benedikt Suter, LLM student at the LSE, who is writing a dissertation comparing the
law on private companies in Switzerland and the United Kingdom and who has supplied information
and valuable comment on Switzerland.
152
The Swiss Federal Court interpreted company legislation in a way appropriate for small firms where
necessary.
153
Including the cultural and emotional reason that this form was unpopular due
to
its provenance.
5
80
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Due to the pressure on the Swiss to bring their company law into line with that
of
their neighbours in the European Union and therefore to increase the amount of
regulation governing the
AG,
further consideration has recently been given to the
needs of small companies. The idea
of
dividing the
AG
into two parts has not found
favour for reasons which reflect the analysis here: the difficulty of formulating a
suitable definition and the need for growing firms to change form being two main
objections.154 It has also been pointed out that such a division would increase the
total length of the Swiss commercial code by necessitating considerable repetition.
Development of other existing forms to cater for small firms is now under
consideration.
What is instructive is that, despite the existence of a wider range of legal forms
in Switzerland than in the United Kingdom, the main corporate form has still been
the choice of many small firms. Though they may complain of the consequent
burdens, it appears that the type of business owner who wishes to incorporate will
tend towards a legal form which gives him full limited liability and prestige. He
will also favour a form which is capable of use where there is not total identity of
ownership and management.
E
Conclusion
The dichotomy between the owner-managed firm and those in which ownership
and control are separated is an unhelpful starting point for an examination of the
legal structure suitable for small firms. It oversimplifies by suggesting that a
single, short, new legal form could cater for small firms generally. If we view
company law as providing a standard form contract,155 this merely amounts to an
argument that two standard forms are better than one.
However, converting two standard forms into two entirely different legal
structures, with formalities required for movement from one to the other, would
introduce elements of rigidity. One set definition would be needed to describe the
characteristics of those firms which could use the more relaxed regime.
A
choice
would need to be made between the two packages on offer, although it might be
that neither was entirely appropriate. For example, the legal form applicable for
small companies might be designed for firms where all shareholders participate in
management. The retirement from management of one shareholder would then
necessitate not just an adjustment of an agreement but a complete re-registration.
This hardly suggests a reduction in complexity and cost for small business owners.
Such a requirement could also stultify growth. Small business research has shown
clearly that one of the major barriers to growth of small firms is the desire for
independence and the unwillingness to part with control, particularly by the
alienation of equity in a company.156
A
structure which enforced this reluctance
by requiring all members to be involved in management could have a negative
impact on the small business community.
If the belief that every type
of
firm requires its own legal form is combined with
a recognition that there are not just two types, but a range
of
firms across a
~
154
Groupe de Reflexion, 'Droit des Socidrds,' Rapport Final
(Berne: Office Fkdkral de la Justice,
September
1993).
155 Easterbrook and Fischel,
op cir
n
21.
156 Curran,
Bolton Fifreen Years
On:
A
Review und Analysis
of
Small
Business Research in Britain,
1971-1986
(London: Small Business Research
Trust,
1986); Gray, in Caley
et al
(eds),
op
cir
n
102.
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continuum, this would suggest that only a myriad of separate legal forms could
provide entirely for the requirements of business associations. This is as
unnecessary as it is impractical. One flexible structure, coupled with a wide range
of statutory selections from which shareholders or their advisers could 'pick and
mix,' would reduce the need for rigid choices at each stage of development and
allow for the natural development of the company. Such a scheme would not be
simple, but there is a trade-off to be made between simplicity and comprehensive
provision for most eventualities. The choice could be presented in such a way as to
drive home the significance of the elections being made,
so
that small business
owners would better understand the legal relationships they were creating.
Where there was truly complete identity of ownership and control (and this is
only inevitably the case in a one person company), many formal burdens could be
avoided informally and without any need for safeguards. In those cases, the more
complex options
-
which might involve the formulation of agreements on
management and voting
-
could simply be ignored, but they would be available in
the statute to be called upon should the situation change. By making these
selections subject to unanimous agreement, and in some cases, periodic review,
this scheme would be self-limiting, avoiding the problem of definition, and new
entrants could be protected.
Another way to deal with problems which might arise in small firms, such as
exclusion from management and determination of exit price for a minority
shareholder, is to leave them to judicial decision. This is, in effect, the method
evolving under section
459
of the Companies Act
1985,15'
which provides for the
court to have a wide discretion as to remedies where there is unfair prejudice to a
minority shareholder. Such an approach is helpful to minorities but requires costly
judicial intervention. Attempts by some judges, notably Hoffmann
LJ,
to
use
companies legislation to hold shareholders to contractual bargains in the articles in
such cases have been curbed by the Court of Appeal, which has asserted an
unfettered jurisdiction to impose its own terms in these situations.158 This has the
advantage of avoiding arbitrary and unfair agreements but may be abused by
unscrupulous minority shareholders to extract a higher price from the majority
under threat of costly court action. It has been argued by Riley that judicial
interference in private contracting within small companies is inevitable and
legitimate due to the inadequacy of such contracting and its potential for
unfairness.
15y
However, if a statutory standard form exit clause embodying those
factors considered important by the courts could be developed, and enforced in all
but extreme and unusual cases, a great deal of cost and uncertainty could be
avoided. The advantage of making this a statutory standard form rather than
leaving the problem to be catered for by the market (that is, formulated by lawyers
and company formation agents) is that, where the form does not offer a complete
solution to an unforeseen problem, the courts can supply an answer which will then
be incorporated into the general law.
160
None of this requires a new legal form, but
only
new options16' and standard
form articles within the existing structure. The options could be collected together
157 And note that there is a similar jurisdiction under the American Bar Associa!ion Model Statutory Close
158
Virdi
v
Abbey
Leisure Ltd,
op
cit
n 22.
159 Riley,
op
cit
n 126.
160
Easterbrook and Fischel,
op
cit
n
21,
p 35.
161
This might necessitate some substantive changes in the general law; for example, amendment of
s
303
Corporation Supplement discussed at p 577.
of
the Companies Act
1985
governing removal
of
directors.
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conveniently in a special chapter as in some of the American states. However, it
would be desirable to avoid a completely new statute not amounting to a new legal
form but merely collecting together material relevant to the private company. This
would require a great deal of material to be repeated or incorporated by reference.
As discovered in Australia, it would become a lengthy piece of legislation
in
itself.
Little purpose would be served by such an exercise.
One problem with past proposals for new legal forms has been their failure to
draw a distinction between what have been described here as internal and external
provisions. Gower’s new form, for example, and the Australian Close Corporation
attempted to deal with both problems. This resulted in confusion of objectives and
discontent with the definitions chosen. Definition by reference to the number of
members is not appropriate where the issue is the public interest: it may bear little
relation to the level of corporate assets and, being qualitative, is much more
relevant
to
methods of management and decision making than to eligibility for
relief from external burdens. There is no hard information available concerning
the size of firms in existence in the United Kingdom in terms of numbers of
members, but it seems likely that the vast majority of existing private companies
have fewer than
10
members.’62 It seems, therefore, that any internal relaxations
designed to assist companies with small numbers of shareholders should be
available to all private companies, leaving the parties to decide if such a regime is
appropriate for them. Once the internal and external provisions are uncoupled in
this way, it
is
much easier to formulate sensible and well-targeted definitions of
those firms to which relaxed external provisions might apply. These limits can be
kept fairly tight to avoid abuse, whilst removing the need for any limit on those
who may take advantage of options and elections within a liberal internal regime,
since this may be decided upon by the parties.
What is required, therefore, is
a
flexible, general corporate form for those for
whom incorporation makes sense because there is some prospect of genuine
limited liability being created or capital being raised from outside investors. For
such business owners, the availability of options and a selection of standard form
articles would be a real advantage. Where corporate form would be a burden,
because its privileges would be withheld by third parties in view of the nature
of
the firm, or because these privileges are not really needed or expected, a minimum
capital requirement would be a valuable barrier against some of the
‘misincorporation’ currently taking place. This view is supported by the data on
the relevance of capital presented above. Regardless of whether capital
maintenance could be assured or the level was sufficient to provide protection to
creditors, it could be a symbol of intent and could drive home to the business
owner the import of the liabilities and burdens he would have to take on in return
for the privilege of limited liability. In a similar way, the need to consider various
alternative standard form agreements on offer could be used to persuade potential
shareholders to consider the relationships into which they were about to enter.
IM
Disincorporation relief for those already incorporated and wishing to escape the
162 See n
116
and n 145 above, and also Carsberg, Page, Sindall and Waring,
Small
Company Financial
163 See p 562 above.
164
Presentation is important here.
A
booklet explaining these issues and also setting out some questions
for potential business owners to consider before deciding on their business form and the special
provisions for which they might elect if choosing incorporation could be produced by Government.
If
presented as valuable advice rather than pure form filling,
it
might not be seen
to
be
burdensome. One
firm
of auditors interviewed provided a service of this kind to their clients and found
it
to
be popular.
583
Reporting
(London: Prentice Hall, 1985).
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consequent burdens would also assist. Firms which might otherwise incorporate to
gain prestige and credibility could be assisted by
a
simple registration
procedure.
165
A
statutory standard form partnership agreement could also save
unincorporated firms setting up costs in much the same way as incorporation is
seen to do currently.
This would not be the simplification of company law currently being demanded.
However, simplification may have more relevance
in
the case of external
requirements which must
be
observed on a regular basis, and where observance is
enforced, than in the case of internal requirements. Such internal requirements
may provide a useful backstop should problems arise without creating great cost
once they are in place. The fact that they do not make for good bedtime reading
does not destroy their value.
An
increase in barriers to incorporation at the outset, as opposed to an increase
in
recurrent running costs, should result in fewer dissatisfied businesses in the long
run. This could be a long-term saving for business owners and the wider business
community. The corporate form brings burdens and privileges to the small
business. For those who cannot utilise the privileges, the burdens will always be
too great. But a flexible general company law can serve a wide range of firms and
be moulded to facilitate the operation of their businesses. The real challenge is to
produce clearly drafted general company law based on coherent principles. The
value
of
the corporate form would then be enhanced for all firms using it, whatever
their size.
165
The Chambers
of
Commerce are keen to set up a registration system
-
see Bennett,
Attaining
Quuliry:
77w
Agenda
for
hcul
Business
Services
in
the
1990s
(London: LSE Department
of
Geography,
1990).
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