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Modern Law Review - July 1994 - Freedman - Small Businesses and The Corporate Form Burden or Privilege
Modern Law Review - July 1994 - Freedman - Small Businesses and The Corporate Form Burden or Privilege
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
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. l 3
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. ’ I 6
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
< I .
communitv as well as that of lobbv mourn and oolicv makers. See the discussion in Freedman and
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.
II Department of Trade (DOT) (now DTI), A New Form of Incorporation for Small Firms (1981) Cmnd
8171.
12 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.
13 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.
14 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.
15 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).
16 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.
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.
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.l 8 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
~~ ~ ~~ ~
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.
23 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.
24 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.
25 See Farrar et al, op cit n I , at p 536.
26 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).
27 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.
28 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).
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.
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
Blackburn (eds), Paths of Enterprise (London: Routledge, 1991).
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.
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 L a w Reform (London: IOD, 1994).
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.52In this sense a minimum capital requirement could save business
owners from inappropriate incorporation and therefore be ‘deregulatory’ in
practice.
create incentives for owners to exploit a moral hazard and transfer uncompensated business
risks to ~ r e d i t o r s . ~ ~
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
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.
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. Various 17*
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.
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
r e s u l t ~ . ”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.83A 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
~~
7 9 Gower, op cir n I , p 12. The definition takes up sevcn pages of the 1959 Palmer’s Company h w
(London: Stevens & Sons Ltd, 20th ed, 1959).
80 Jenkins Committee (1962) Cmnd 1794, paras 55-63, and see discussion in Magnus and Estrin, The
Compunies Acr I967 (London: Butterworths, 1967).
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.
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 ~100,000net 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 f 1 . 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
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 o f a 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.
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.Io3The 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.
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
( 4 s ) . 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.
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
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
W 160. Cheffins reviews the US literature thoroughly.
128 American Bar Association, Revised Model Business Corporation Act Annotated (New York: Harcourt
Brace Jovanovich, 3rd ed, 1985).
129 ibid.
130 It should be noted that neither the SARL nor the GmbH give all shareholders the right to participate in
management: Maitland-Walker, op cit n 109.
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.135Nevertheless, 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.137Thus, 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:
NZLC, 1989) para 237.
132 International Business Lawyer 9, January 1994.
133 Cheffins, op cit n 127; Dickerson, Howard and Getz, Proposalsfor a New Business Corporations Law
for Canada (Ottawa: Information Canada, 1971) p 11.
134 Hamilton.. Cormrations
. (St Paul. Minn: West Publishing Co, 3rd ed, 1986) D 516. For a critical
analysis, see Karjala, 'A Second Look at Special Close Corporation Legislation'~l981)58 Tex L Rev
1207.
135 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.
136 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).
I37 Delport and Pretorius, ibid.
138 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.
139 The perception that the new form offers tax advantages may still linger despite their removal. This is a
common phenomenon.
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 F o r m 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).
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).
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.154It 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,155this 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.156A 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.
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.158This 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
Corporation Supplement discussed at p 577.
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
of the Companies Act 1985 governing removal of directors.
162 See n 116 and n 145 above, and also Carsberg, Page, Sindall and Waring, Small Company Financial
Reporting (London: Prentice Hall, 1985).
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.
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 h c u l Business Services in the 1990s (London: LSE Department of Geography, 1990).