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Rights to Recover Their Debts

Michael and Claire Smith are the shareholders and directors of Woodcraft Pty Ltd which is the trustee of the Smith Family Trust. The share capital of Woodcraft Pty Ltd is $2.00 divided into two shares of $1.00 each. Michael and Claire each own one share in the company, which has no other assets. The company runs a furniture business on behalf of the trust. According to the trust deed, the trustee is authorized to engage in wholesale and retail trade in furniture of all types, kinds, and nature.

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The furniture business is a great success. As a result, Michael and Claire decide to expand. The company orders timber worth $20,000 from Forest Products Pty Ltd. Further, on the advice of their solicitor, a decision is taken to diversify into the horse breeding and real estate businesses. To this end, Michael and Claire, as directors of Woodcraft Pty Ltd, cause it to borrow $500,000 from Eastpak Bank Ltd with which it purchases a stud. The company also borrows a further $2,500,000 from National Finance Ltd and purchases a commercial property.

The horse breeding business proves unsuccessful. Also, the companies hopes of deriving rental income are frustrated when it fails to attract suitable tenants for its property. As the result, the company is unable to pay its debts. The trust has assets worth $5,000 but Michael and Claire have substantial assets. Before approving the loan, Eastpak was advised that Woodcraft was acting as trustee and a copy of the trust deed was duly supplied to the bank.

The personal assets of Micheal and Claire Smith may be used to answer for the debts of Woodcraft Pty Ltd. with respect to the $2,500,000 loan from National Finance Ltd but not the loan from East Pac.

In order to justify this, the character of Woodcraft Pty Ltd. and the Smith Family Trust must first be looked into. Woodcraft Pty Ltd. is a proprietary company as defined in Section 45A(1) of the Corporations Act. This is a form of corporation that has a separate juridical personality from its stockholders or members. Smith Family Trust is trusted as defined by the Trustee Act of 1925. It is an arrangement where the trustees, can exercise legal title over the trusts’ property for the benefit of the beneficiary. It appears that the Smith Family Trust exists to benefit the Smith Family. Woodcraft Pty Ltd is the trustee of the Smith Family Trust. Woodcraft Pty Ltd. has a fiduciary relationship with the Smith Family Trust which is the true owner as well as beneficial owners of Woodcraft Pty Ltd’s assets.

Woodcraft Pty Ltd is a form of corporation. One of the most important attributes of a corporation is that it has a separate juridical personality. Even in this case where Micheal and Claire own the entire asset base of Woodcraft both directly, as owners of its only shares, and indirectly, as the beneficiaries of the Smith Family Trust, Woodcraft Pty Ltd retains an entirely separate identity from the Smiths. In the leading case of Salomon vs. Salomon & Co Ltd no less than the House of Lords confirmed that a company’s acts were it’s own and not those of its corporators (Salomon vs. Salomon & Co Ltd [1897] AC 22). This belief of separation is so strong that in the latter case of Bank of Tokyo vs. Karoon that the corporate structure was entirely distinct from the economic realities of its corporators. Hence the general rule is that the Smiths will not incur any liability for the actions of Woodcraft Pty Ltd beyond the amount of their investment, $1 each.

However, it is worth noting that in the Salomon case the court acknowledged that there would be situations where the separate juridical personality could be ignored and the veil of corporate protection can be lifted. Piercing the corporate veil is a recognized doctrine whereby the rights and duties of a corporation are treated as the rights and liabilities of its shareholders. When lifting the corporate veil the court decides to do away with the legal fiction of separate personality and treat the actions of the corporation as if they were the actions of the shareholders or directors. Lifting the corporate veil is not done arbitrarily. It is only when the concept of the separate juridical personality of the corporation is used to defeat public convenience, justify wrong, protect fraud or defend crime will the law regard the corporation as a mere association of persons and lift the so-called corporate veil. In the present case, it appears that Woodcraft Pty Ltd is being used to commit fraud. The trust deed specifically empowers Woodcraft Pty Ltd to engage in the wholesale and retail trade of furniture of all types, kinds, and natures. It is not authorized by the trust deed to diversify into the horse breeding or real estate business. However, since Woodcraft Pty Ltd, as trustee, is not expressly forbidden by the trust instrument it may invest in any form of investment and vary its investment at any time. Since horse breeding and real estate are not the normal business of Woodcraft Pty Ltd it is only required to exercise the care, diligence, and skill that a prudent person would exercise in managing the affairs of other persons (Trustee Act).

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This minimal level of diligence is lacking in this case. Woodcraft Pty Ltd is only a modest corporation Woodcraft Pty Ltd has a total capital of only $2 completely owned by the spouses, Micheal and Claire. All the assets and equipment being used are owned by the Smith Family Trust, Woodcraft Pty Ltd is operating these assets as a trustee. There is no way that Woodcraft Pty Ltd could have collateralized the loans totaling $3,000.000 that was made for the expansion into the fields of real estate and horse breeding.

It is apparent that Micheal and Claire are trying to take advantage of the proprietary company character of Woodcraft Pty Ltd to escape liability for the considerable loans they made. There is cause to pierce the veil of corporate protection as there is a patent effort to commit fraud by using a proprietary company with no means of actually repaying the massive loans. While the mere ownership of all or nearly all the capital stock of a company does not necessarily mean it is a mere business conduit of the stockholder, that conclusion is amply justified where it is shown, as in the present case, that the operations of the corporation were tantamount to the operations of the Smith Family Trust. As there is no true separation between Woodcraft Pty Ltd and the Smiths, Micheal and Claire can be made directly liable for the $2,500.000 loan from National Finance Ltd. The couple can not be held liable for the $500,000 loaned by East Pac because in that situation East Pac was well aware that Woodcraft Pty Ltd had no assets to collateralize the loan and since they were provided with records of the Smith Family Trust. They also knew that the Trustor of Woodcraft Pty Ltd had no capability to repay the loan. Hence East Pac’s contributory fault denies them the benefits of piercing the corporate veil. Instead, it must content itself with the assets of Woodcraft Pty Ltd and the Smith Family Trust.

References

Laws

Australia (1925) Trustee Act of 1925-14 Sydney, HMSO.

Australia (2006) Companies Act 2006 Sydney, HMSO.

Australia (1963) Partnership Act of 1963 Sydney, HMSO.

Old Chief v. U.S., 117 S. Ct., 644 (1997).

Cases

Salomon vs. Salomon & Co Ltd [1897] AC 22.

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Bank of Tokyo vs. Karoon [1986] 3 All ER 468.

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