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Lifting of Corporate Veil with reference to Leading Cases


COMPANY LAW

LIFTING OF CORPORATE VEIL WITH REFERENCE TO LEADING CASE

Shagun Singh

15.04.2013

 NATIONAL UNIVERSITY OF RESEARCH AND STUDY IN LAW

2013


INTRODUCTION

Corporate personality has been described as the ‘most pervading of the fundamental principles of company law”. It constitutes the bedrock principle upon which company is regarded as an entity distinct from the shareholders constituting it. When a company is incorporated it is treated as a separate legal entity distinct from its promoters, directors, members, and employees; and hence the concept of the corporate veil, separating those parties from the corporate body, has arisen. The issue of “lifting the corporate veil” has been considered by courts and commentators for many years and there are instances in which the courts have negated from the strict application of this doctrine. This doctrine has been established for business efficacy, necessity and as a matter of convenience.

In the doctrine of ‘Lifting the Corporate Veil’, the law goes behind the mask or veil of incorporation in order to determine the real person behind the mask for the purpose of holding them liable.

But for clarity as to ‘Lifting of the Corporate Veil’, an understanding of the corporate personality of a company is required, along with study of the provisions of Indian law that pave the way for courts to pierce the corporate veil. Various grounds for piercing of the corporate veil and elements of lifting of corporate veil analyzed through the lens of leading case laws and judgements form the crux of this project report.

COMPANY AS SEPARATE LEGAL ENTITY

The company as a separate entity was firmly established in the landmark decision in Salomon v. Salomon & Co. Ltd. Salomon, a sole trader, sold his manufacturing business to Salomon & Co. Ltd. (a company he incorporated) in consideration for all but six shares in the company, and received debentures worth 10 thousand pounds. The other subscribers to the memorandum were his wife and five children who each took up one share. The business subsequently collapsed, and Salomon made a claim, on the basis of the debentures held, as a secured creditor. The liquidator argued that Salomon could not rank ahead of other creditors because, in fact, the company and Mr. Salomon were one and the same–or alternatively, that the company carried on business on Salomon’s behalf.

On appeal, the House of Lords held that Salomon & Co. Ltd. was not a sham; that the debts of the corporation were not the debts of Mr. Salomon because they were two separate legal entities; and that once the artificial person has been created, “it must be treated like any other independent person with its rights and liabilities appropriate to itself.”

In Macaura v. Northern Assurance Co. Ltd. the House of Lords decided that insurers were not liable under a contract of insurance on property that was insured by the plaintiff but owned by a company in which the plaintiff held all the fully-paid shares. The House of Lords held that only the company as the separate legal owner of the property, and not the plaintiff, had the required insurable interest. The plaintiff, being a shareholder, did not have any legal or beneficial interest in that property merely because of his shareholding. In Lee v. Lee’s Air Farming, the Privy Council held that Lee, as a separate and distinct entity from the company which he controlled, could be an employee of that company so that Lee’s wife could claim workers’ compensation following her husband’s death.

In Hobart Bridge Co. Ltd. v. FCT  relying on the judgment by Lord Sumner in Gas Lighting Improvement Co. Ltd. v. IRC, Kitto .J summarizes the position in the following manner:

“Between the investor, who participates as a shareholder, and the undertaking carried on, the law imposes another person, real though artificial, the company itself, and the business carried on is the business of that company, and the capital employed is its capital and not in either case the business or the capital of the shareholders. Assuming, of course, that the company is duly formed and is not a sham …”

More recently, the High Court in Industrial Equity v. Blackburn has held that the principle operates to prevent a holding company from treating a wholly-owned subsidiary’s profits as its own. Therefore, it can be seen that there has been, and still is, the highest authority for the separate entity concept.

However, consideration has to be given to the limitations of the separate entity principle which completely denies the efficacy of the corporate entity as a legal person separate from its founders, shareholders or management. Judgements as early as the Salomon case have indicated the recognition of exceptions to the principle of separate entity by the courts. Recognition of the separate entity is possible provided there is “no fraud and no agency and if the company was a real one and not a fiction or myth.” According to Lord Denning in Littlewoods Mail Order Stores Ltd. v. IRC, incorporation does not fully “cast a veil over the personality of a limited company through which the courts cannot see. The courts can, and often do, pull off the mask. They look to see what really lies behind.” “A corporation will be looked upon as a legal entity as a general rule but when the notion of legal entity is used to defeat public convenience, justify wrong, protect fraud or defend crime the law will regard the corporation as an association of persons.”

The two significant reasons as to why exceptions to the separate entity principle exist is that firstly, although a corporation is a legal person, it cannot always “be treated like any other independent person.” For example, a corporation is not capable of committing a tort or a crime requiring proof of mens rea unless courts disregard the separate entity and determine the intention held by the directors and/or shareholders of the corporation. Secondly, strict recognition of the principle may lead to an unjust or misleading outcome if interested parties can “hide” behind the shield of limited liability. Judicial discretion and also legislative action allows the separate entity principle to be disregarded where some injustice is intended, or would result, to a third party (either internal or external to the company) with whom the company is dealing.

LIFTING OF THE CORPORATE VEIL

Lifting or piercing the veil is corporate law’s most widely used doctrine to decide when a shareholder or shareholders will be held liable for obligations of the corporation. Lifting the veil doctrine exists as a check on the principle that, in general, investor shareholders should not be held liable for the debts of their corporation beyond the value of their investment. The corporate evil is said to be lifted when the court ignores the company and concerns itself directly with the members or the managers. “It is impossible to ascertain the factors which operate to break down the corporate insulation.” The matter is largely in the discretion of the courts and will depend upon “the underlying social, economic and moral factors as they operate in and through the corporation.” It can be said “that adherence to the Solomon principle will not be doggedly followed where this would cause an unjust result”. One of the grounds for lifting of the corporate veil is fraud. The courts have pierced the corporate veil when it feels that fraud is or could be perpetrated behind the veil. The courts will not allow the Solomon principal to be used as an engine of fraud. The two classic cases of the fraud exception are Gilford Motor Company Ltd v. Horne in which Mr. Horne was an ex-employee of The Gilford motor company and his employment contract provided that he could not solicit the customers of the company. In order to defeat this he incorporated a limited company in his wife’s name and solicited the customers of the company. The company brought an action against him. The Court of appeal was of the view that “the company was formed as a device, a stratagem, in order to mask the effective carrying on of business of Mr. Horne. “In this case it was clear that the main purpose of incorporating the new company was to perpetrate fraud.” Thus the court of appeal regarded it as a mere sham to cloak his wrongdoings.

In the second case of Jones v. Lipman a man contracted to sell his land and thereafter changed his mind in order to avoid an order of specific performance he transferred his property to a company. Russel J specifically referred to the judgments in Gilford v. Horne and held that the company here was “a mask which (Mr. Lipman) holds before his face in an attempt to avoid recognition by the eye of equity” he awarded specific performance both against Mr. Lipman and the company. Under no circumstances will the court allow any form of abuse of the corporate form and when such abuse occurs the courts will step in.

The second ground for piercing of corporate veil covers group enterprises. Sometimes in the case of group of enterprises the Solomon principal may not be adhered to and the court may lift the veil in order to look at the economic realities of the group itself. In the case of D.H.N. Food products Ltd. v. Tower Hamlets London Borough Council it has been said that the courts may disregard Solomon’s case whenever it is just and equitable to do so. The court of appeal thought that the present case where it was one suitable for lifting the corporate veil. Here the three subsidiary companies were treated as a part of the same economic entity or group and were entitled to compensation. Lord Denning has remarked that we know that in “many respects a group of companies are treated together for the purpose of accounts, balance sheet, and profit and loss accounts”. The nature of shareholding and control would be indicators whether the court would pierce the corporate veil. In the case of Woolfsan the House of Lords held that there was “no basis consonant with the principle upon which on the facts of this case the corporate veil can be pierced to the effect of holding Woolfson to be the true owner of Campbell’s business or the assets of Solfred, “the two subsidiary companies that were jointly claiming compensation for the value of the land and disturbance of business. The House of Lords in the above mentioned case had remarked “properly applied the principle that it is appropriate to pierce the corporate veil only where special circumstances exist indicating that it is a mere facade concealing the true facts” In the figurative sense facade denotes outward appearance especially one that is false or deceptive and imports pretence and concealment. That the corporator has complete control of the company is not enough to constitute the company as a mere facade rather that term suggests in the context the deliberate concealment of the identity and activities of the corporator. The separate legal personality of the company, although a “technical point” is not a matter of form it is a matter of substance and reality and the corporator ought not, on every occasion, to be relieved of the disadvantageous consequences of an arrangement voluntarily entered into by the corporator for reasons considered by the corporator to be of advantage to him. In particular “the group enterprise” concept must obviously be carefully limited so that companies who seek the advantages of separate corporate personality must generally accept the corresponding burdens and limitations.

The third ground for piercing the corporate veil is agency. In the case of Solomon v. Solomon Justice Vaughan Williams expressed that the company was nothing but an agent of Solomon. “That this business was Mr. Solomon’s business and no one else’s; that he chose to employ as agent a limited company; that he is bound to indemnify that agent the company and that this agent, the company has lien on the assets………” However on appeal to the House of Lords it was held that a company did not automatically become an agent of the shareholder even if it was a one man company and the other shareholders were dummies.

A company having power to act as an agent may do so as an agent for its parent company or indeed for all or any of the individual members if it or they authorize it to do so. If so the parent company or the members will be bound by the acts of its agent so long as those acts are within actual or apparent scope of the authority. But there is no presumption of any such relationship in the absence of an express agreement between the parties it will be difficult to establish one. In Cape case attempt to do so failed. In cases where the agency agreement holds good and the parties concerned have expressly agreed to such an agreement them the corporate veil shall be lifted and the principal shall be liable for the acts of the agent.

The courts may pierce the corporate veil to look at the characteristics of the shareholders. In the case of Abbey and Planning the court lifted the corporate veil. In this case a school was run like a company but the shares were held by trustees on educational charitable trusts. They pierced the veil in order to look into the terms on which the trustee held the shares.

Sometimes tax legislations warrant the lifting of the corporate veil. The courts are prepared to disregard the separate legal personality of companies in case of tax evasions or liberal schemes of tax avoidance without any necessary legislative authority.

There are three components that the complainant must prove in order to pierce the corporate veil. Those elements are as follows

1.      Control and domination: Control and determination part of the test determines the relationship between the shareholder and the corporation. Generally, mere majority stock ownership will be insufficient to satisfy this element. Instead, one must show “complete domination, not only of finances, but of policy and business practice in respect to the transaction attacked so that the corporate entity as to this transaction has no separate mind, will or existence of its own.” To determine the existence of “complete domination”, courts usually require the plaintiff to produce evidence of inadequate capitalization or undercapitalization, failure to follow corporate formalities, commingling of funds, diversion of funds or assets for non-corporate purposes, etc.

2.       Improper purpose or use: This test requires the plaintiff to show that the control exercised by the parent company or dominant stockholder was “used by the defendant to commit fraud or wrong, to perpetrate the violation of a statutory or other positive legal duty, or dishonest and unjust act in contravention of plaintiff’s legal right.” Thus, this second inquiry focuses on the relationship between the plaintiff and the corporation. It is an explicit recognition that some improper conduct must have occurred beyond establishing that the corporation was controlled and dominated.

3.      Resulting damage or harm: In this test the plaintiff must show that the defendant’s control, exerted in a fraudulent, illegal or otherwise unfair manner toward it, caused the harm suffered. In other words, the plaintiff must prove that, unless the corporate veil is pierced, it will have been treated unjustly by the defendant’s exercise of control and improper use of the corporate form and, thereby, suffer damages.

Therefore, the most important thing for the courts to remember while lifting the corporate veil is to exercise care to balance the competing goals of incorporation and protecting creditors.

 STATUTORY PROVISION IN INDIA SUPPORTING LIFTING OF CORPORATE VEIL

The Companies Act provides for circumstances when corporate veil will be lifted and the individual members/directors will be made liable for certain transactions. The statutory provisions are as follows:

1. Reduction of membership below statutory minimum (Section 45 of the Act): This section provides that if the number of member of a company is reduced below 7 in the case of public company or below 2 in the case of private company and the company continues to carry on the business for more than 6 months, while the number is so reduced, every person who knows this fact and is a member of the company is severally liable for the debts of the company contracted during that time.

2. Improper use of name (Section 147of the Act): Under sub-section (4) of this section, an officer of a company who signs any bill of exchange, hundi, promissory note, cheque wherein the name of the company is not mentioned in the prescribed manner, such officer can be held personally liable to the holder of the bill of exchange, hundi etc. unless it is duly paid by the company.

3. Liability for fraudulent conduct of business (Section 542 of the Act): If in the course of the winding up of a company, it appears that any business of the company has been carried on with intent to defraud the creditors of the company or any other person or for any fraudulent purpose, the persons who were knowingly parties to the carrying on of the business, in the manner aforesaid, shall be personally responsible, without any limitation of liability for all or any of the debts or other liabilities of the company, as the court may direct.

CONCLUSION

The doctrine of piercing the corporate veil is not subject to any bright line tests. Courts have struggled for years to develop and refine their analysis of these claims. However, each new action brings a different set of facts and circumstances into the equation and a separate determination must be made as to whether the plaintiff has adduced sufficient evidence of control and domination, improper purpose, or use and resulting damage. The decision whether to pierce the corporate veil may be assisted, at least in part, upon the opinion of qualified experts. In particular, expert testimony would be helpful to the trier of fact in determining whether the corporation has been adequately capitalized for its intended purpose. Ultimately, however, the judgment whether to disregard the corporate entity will be based upon a balancing of various factors all or some of which are necessary but may not be sufficient to pierce the veil. The Judgment of the Court Of Appeal in the Adams case can be said to be the current law, which is nothing more than a reiteration of the law laid down by the House of Lords in Solomon’s case. The bottom line being only the court will lift the veil in the face of grave abuse of the corporate form and not otherwise. Also the trend regarding the increase or decrease in the judicial pronouncement regarding lifting of veil of a corporate entity cannot be ascertained as each the courts view on lifting of corporate veil depends on the facts of each case.