Saturday, May 17, 2008

Basics of Investing – Part IV

The Legal Aspects

Before investing, I believe it is important to have a good grounding of the legal aspects on investing in companies. Most of the time, people gloss over the fundamentals and assume they know the full legal repercussions of investing in companies.

When you assume – you are making an ASS out of yoU and ME, so don’t do it. Find out, by reading the facts below. By the way, I have a law degree, so you can have a measure of confidence in the matters below. However, if in doubt, you can always check with your lawyers.

What is a Company?
A Company can be described as an artificial person recognized by law as having legal rights and liabilities, (i.e. a company is a separate legal entity). In the case of Salamon v Salamon & Co, Lord Macnaghten judgment in the House of Lords decided that:

“The company is at a law a different person altogether from the subscribers…; and though it may be that after the incorporation the business is precisely the same as it was before, and the same persons are managers, and the same hands receive the profits, the company is not in law, the agent of the subscribers or trustee for them. Nor are the subscribers, as members, liable in shape of form except to the extent and in the manner provided by the [Companies] Act”

What are the consequences?
The major consequences of a company being recognized as a separate legal entity, for you as an investor are as follows:

(a) Limited Liability
As a company is a separate legal personality, any and all debts assumed by the company will be borne by the company itself. Its' shareholders will be completely free of any personal liability.

In Malaysia, all incorporated companies will either have the word “Sdn Bhd” or “Bhd” after their names. The acronym “Bhd” stands for “Berhad”, i.e. Limited. What this means is that the company is a separate legal entity. The shareholders liability is limited to the extent of the share capital contributed to the Company. As an investor, this is a very important concept to grasp. This means, if the company you invested in fails, your loss is limited to the amount that you bought the shares for.

Compare this to a situation where you are invited and become a partner in an trading firm. This trading firm is not incorporated as a company but is a partnership. Currently under Malaysian Laws, all partners are jointly and severally liable for any and all liabilities of the partnership. In other words, if the partnership fails and still owes money to the banks and creditors, you as a partner will be PERSONALLY liable to pay for this liability. The separate legal entity concept DOES NOT apply to partnerships.

Assuming your trading firm suffered huge losses and you have decided to end the partnership. You have a 10% voting right and your other partner has a 90% voting right in the partnership. Currently, your partner has been declared a bankrupt by the Courts. The total amount to settle the liabilities of the partnership is RM100K. How much do you have to fork out of your PERSONAL assets to settle the debt?

Some of you may think, 10% * RM100K = RM10K :)

Well, generally that may be true. However, since there are only two partners and your other partner is bankrupt, you are SEVERALLY liable. What does this mean?

ANSWER [highlight this line]:

YOU PAY RM100K!!! [you are liable for the entire debt]

If you and your partner set up a company instead of a partnership, what would the answer? [Highlight the area below]:


(b) Separation of Ownership and Management
In large companies such as those listed on the Main Board in the Bursa Malaysia, ownership and management are usually separated. This merely means that the people running the companies’ [management] are paid salaries and are not owners of the company. The owners of these companies are the people who hold shares in the companies, called shareholders.

This is an important fact as it means that you must have the utmost confidence in the management of the companies (usually Chief Executive Officer and his management team) you invest in. At times, top management may have ulterior motives and act in their own interest instead of the interest of the shareholders.

In companies such as Enron, it is clear the management acted in their own interests and profited at the expense of the shareholders. Shares of Enron were trading at a high of USD80 per share in Jan 2001 but were worthless one year later. The faith of investors in the top management including Kenneth Lay and Jeffrey Skilling were clearly misplaced and many investors suffered huge losses. However, these top management would not have suffered any major financial losses are they are NOT owners of the companies [and probably would have sold their shares in Enron earlier on].

Conversely, companies that are well managed such as Berkshire Hathaway means that by investing in their companies, you will profit from their sound management and astute decisions. Consider the fact that USD10K invested in Berkshire Hathaway in 1965 would be worth USD51 million in December 31, 1998, compared to USD132,990 for the S&P (analyst report by Paine Webber).

A sound understanding of the Malaysian Law is fundamental before you begin to decide in any investment vehicle. We have covered two important concepts today. For those of you that are interested in furthering your understanding of company law, I suggest that you visit


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