COMMERCIAL LAW: Lifting the Veil of Incorporation essay
Limited Liability Company is undoubtedly one of the most outstanding inventions of mankind. Along with technological advances, it provided an opportunity for rapid economic development of our civilization over the past century and a half. Such a company, first, is a subject to law separate from its members, and, second, the parties are not liable for its obligations. The latter makes it possible to attract funds of investors into various businesses, including high-risk ones, which creates favorable conditions for the realization of all kinds of innovative projects.
Unfortunately, limited liability companies are often used in bad faith, in particular, as a tool to defraud creditors. This raises the question whether it is necessary to always adamantly follow the principle of limited liability, or sometimes this principle can be omitted placing the responsibility to the creditors on the participants of the company or other responsible persons. It is obvious that such exceptions are sometimes quite feasible and can be realized in the frameworks of piercing the veil of incorporation doctrine. At the same time, these conditions must be sufficiently restrictive so as not to discredit the very concept of limited liability. Further in this paper, we will explain the concept of lifting corporate veil by using real life examples and show the imperativeness of its importance.
Lifting the veil: law practice
Perhaps for the first time the issue of lifting the corporate veil was discussed at a high judicial level in a classic case of Salomon v A. Salomon & Co Ltd of 1897. The majority shareholder owned 20001 shares of the company, while his wife and children owned six more (under the law of time the company should have had at least seven shareholders). Despite the fact that the majority shareholder completely controlled the shoe factory, which eventually went bankrupt, the House of Lords, acting as a court of highest resort, denied liquidator to entrust the shareholder liable for the debts of the company. The court in this case took quite a formalistic position, stating that all the requirements of the law regarding the establishment of a limited liability company had been met, and the court had no right to add any additional requirements to them (Presser, 2012, p.24). However, development of corporate forms in global business environment led the jurisprudence to the fact that in some cases the courts recognized the need to retreat from the principle of limited liability of shareholders (participants) of the company and the company’s management bodies, as well as the liability of parent companies for the actions of their subsidiaries.
The essence of the doctrine of lifting the corporate veil is in assigning responsibility of an independent legal entity to third parties. In practice, this term is used in three cases (Presser, 2012; Franklin, 2013):
- When the court in dealing the issue of liability of the legal entity departs from the principle of the limited liability of the founders (participants) and places the responsibility on them;
- When the court ignores the separateness of legal entities belonging to a holding or a group of legal entities, and, based on the principle of “single economic unit”, imposes liability of an independent legal entity on separate legal entities comprising the holding or group;
- When the court imposes liability on the bodies of the legal entity.
However, the most difficult issue in such cases is to determine the criteria by which the company will be subject to lifting the veil. In general, basing on Presser (2012), Franklin (2013), and Nyombi (2014), in the context of civil proceedings the courts have identified at least three situations where it is appropriate to lift the corporate veil. First, if the offender is trying to hide behind the corporate facade or veil to hide one’s crime and benefits from it. Second, if the offender commits an act on behalf of the company, which (with the mandatory presence of guilt) constitutes a criminal offense leading to one’s conviction; in this case the corporate veil is not even lifted but rather offhandedly torn off. Third, if the transaction or commercial structures are “device”, “cloak” or “sham”, that is, an attempt to disguise the true nature of the transaction or structure to defraud third parties or courts. Thus, we can conclude that the corporate veil lifting in civil disputes is based on the criteria of “ownership and control’ and “bad faith” subject to mandatory proof.
The first element is denoted by the term “dominance” and the idea is that the controlling person has the ability to fully define actions of the controlled entity. To establish the fact of control, a number of factors can be used that considered together may indicate the presence of total control feature (situation where the company is the alter ego or instrumentality of its owner), as researched by Nyombi (2014), Franklin (2013) and OECD (2001):
- Insufficient independence, i.e. providing a minimum ownership capital insufficient for conducting activities;
- Milking the company – use of company’s funds for personal needs of the owner (direct payment of personal telephone calls, personal vehicles, personal purchases, expenses of relatives, etc. from the corporate accounts);
- Misrepresentation – distortion of facts regarding business activities, information about location, company’s assets, managerial staff, providing false addresses, nominees as the administrative body of the company;
- Commingling and holding out – the use of joint accounts, facilities, transport and other property;
- Non-compliance with corporate procedures/formalities: the absence or irregular conduct of meetings of participants, absence or merely a nominal presence of directors and other employees, inobservance of recordkeeping requirements, lack of bank account or conducting corporate transactions from the owner’s account, conducting business on behalf of the company and not on behalf of the owner, submitting no reports or irregular reporting documentation to the public and other authorities;
- Non-payment of dividends, non-distribution of profits;
- Using the company to pay the debts of other companies or those of the owner.
The main criteria for the recognition of a company as the shareholder’s agent were established in 1939 in the case of Smith, Stone & Knight Ltd v Birmingham Corporation (BC wanted to compulsorily acquire the land owned by SSK’s subsidiary Birmingham Waste Co Ltd, and parties disputed the compensation directly to Smith, Stone & Knight Ltd, cited in Presser (2012, p.65), which included the following noticeable ones (Presser, 2012, p.69):
- Profit of the company is considered as the profit of the shareholder;
- Shareholder appoints the persons carrying out activities on behalf of the company;
- Shareholder is the brain center of the company;
- Shareholder has permanent control over the company’s business;
Turning to more modern precedents, we should remember the case of DHN Food Distributors v Tower Hamlets London Borough Council of 1976, though it was not quite usual in the sense that the very controlling entity of the company demanded to lift the corporate veil (Presser, 2012, p. 93). Thus, the parent company wanted to take the place of the subsidiary it controlled. In this case, a plot of land in London formally owned by the company belonging to DHN-holding group that owned a grocery store was subject to the mandatory buyout for public use. DHN store warehouse was located on the buy-out land, and by the agreement with the affiliate DHN enjoyed the right perpetual lease of land. Its withdrawal led to the cessation of DHN business, and it could claim for damages if it owned the plot. DHN applied to the court for the corporate veil lifting, referring to the fact that it completely controlled its subsidiary. Namely, (1) it participated in the affiliate’s capital by 100%, (2) directors were the same people, and (3) the affiliate was used by the holding exceptionally to own the land and did not conduct any independent activity. The Court agreed with the arguments of the plaintiff and lifted the corporate veil, allowing DHN receive compensation for withdrawal of the land instead of the subsidiary.
In all cases of principal-agent relationship between the company and its shareholder, the company actually lost its independence, which gave courts the grounds for departing from the principle of Solomon. At the same time, ownership and control are not sufficient criteria to lift the corporate veil. The court cannot lift the veil only because, in its opinion, it meets the interests of justice, but the corporate veil should be lifted if the case also involves impropriety, abuse of rights, deception or offense (Anderson, 2012, p. 133). As explained by OECD Taxation (2001, p.39), the essence of this criterion is that the controlled entity is used by the controlling person to the detriment of a third party and at the same time as the tool to escape from responsibility of the controlling person itself. In this situation, the case goes about using the corporate structure of the company as a facade to conceal the facts.
For example, in Jones v Lipman (1962) (cited in Franklin, 2013, p.10), the defendant made a commitment by the contract to sell the land to the plaintiff, after which the one decided not to carry out the sale, set up a company being its shareholder and director, passed the land to its possession and refused to execute the contract with the plaintiff. Respondent filed suit for specific performance. The court obliged the director of the established company, and the company itself which was the creation of the controlling director, tool and veil, the mask which he held in front of his face to become invisible to the law of justice. Furthermore, in Adams v CapeIndustries (1990), it was found that there is no general principle according to which a group of companies should be regarded as one person (Anderson, 2012, p. 134). Thus, in Polly Peck International Plc (1996) it was found that a subsidiary being a financial mechanism created with the sole purpose of obtaining a loan should not have been considered part of the holding company (respectively, holding’s responsibility was not attached), even despite the fact that lenders issuing the loan, obviously, gave the money based on the trust to the latter (Presser, 2012, p.111). The precedent for further monitoring of offshore companies and for the recovery of lost revenue due to the activities of their owners was also created y the case of Antonio Gramsci v Stepanovs (2011) (Anderson, 2012, p. 135).
Thus, in case of the presence of dominant control and impropriety related to the use of corporate structure to avoid or conceal liability, corporate veil should be lifted in order to prevent corporate fraudulent activities and avoidance of executing contractual or other legal obligations. At the same time, shareholders may be accepted as personally liable if their illegal purposes or deliberate concealment of the true state of affairs is proved.
Under current law, a legal entity is separate, individual and independent from its founders, having the ability to own property, to enter into commitments, and sue and be sued. An immanent feature of the legal entity’s independent nature is the limited liability of its founders: they are not liable for the obligations of the legal entity, that is, they are behind its veil. Development and complication of civil turnover led to the need to develop a list of exceptions to this principle, mainly to counteract the abuse of this right. “Lifting the veil” doctrine is included today in the corporate law of many countries aimed at providing diligent and proper exercise of civil rights and civic duties.
Piercing the corporate veil is an instrument for balancing the interests of the companies’ members (shareholders) and the interests of creditors, and is valid to uncover the ultimate beneficiary and fulfill the rights of creditors, if the entity is created only for the use of participants’ limited liability in terms of debts, which is particularly evident in activities of “one person” companies. In our opinion, despite the existing differences in interpretation, the institution should be used not to destruct the limited liability, but to prevent the unlimited one. In particular, it makes sense to consider the doctrine of lifting the corporate veil in the overall context of the fight against abuse of corporate relations, as well as a kind of addition to the norms of the written law, stipulating that under certain circumstances company participants can be deprived of their privilege of limited liability.