Personal Liability on Sham Companies

Abstract

The stakeholder interests are better represented in the presence of insolvency, company and employment law. The board of governance consist on executive and non-executive director. Non executive directors play a role of supervision on management directors. United Kingdom’s system of corporate governance places the interests of shareholders above those of other corporate stakeholders, such as employees and creditors.

Introduction

Company is considered as a legal person [1]. Investors establish companies to keep their businesses separate and personal life separately [2]. Directors are not personally liable for company’s business, debts or losses. Therefore, directors feel security and protection in business by establishing a company. However, court may disregard the separate corporate existence and impose personal liability on directors when a corporate is a sham, engages in fraud or other wrongful acts or it is used only for the personal benefits of its directors [3]. In other words, courts may remove the veil that law uses to divide the corporation and its liabilities from the people behind the corporation [4]. Corporate veil is used to create a separate, legal entity and shields the people behind the corporation from personal liability [5].

Before exploring the veil of incorporation [6] in a company, we need to understand about incorporation of a company [7]. The incorporation of a company creates two legal effects. It creates a person [8] which is different from private person and it survives until company is liquidated by court order.

In simple words, private businessman as a person will be responsible for all his private business. In case of liquidity, he may loose everything he owns in either business capacity or in private capacity. However, in case of company liquidity, private belongings of partners or directors remained save.

Different political and economical systems are present in the world. The economical and political thinking is different in various regions and cultures. The relax economical systems means less accountability of company directors. In other words it is a concept of less restricts control over director activities. Business in the form of private, public and limited companies started from ancient and got popularity in the time of western bloom [9].

A strict approach is required to control corruption and discrepancies in companies through effective and strict law [10]. On the other hand, a soft approach should be adopted to provide incentives to companies to get more investment and flourish their business [11] . How much security should be given to creditors is another debate in company law of various countries (Baird et al 2002).

The term veil of incorporation is wide enough in its actual meanings [12] . Veil of incorporation in general meaning is used to mention violation of corporation boundary where directors have taken undue advantage of their rights [13] . Therefore court can look at environment of company and if thinks that directors should be framed for company loss as a fraud rather than to liquidate only company assets. A company is a legal entity and therefore reserve various legal rights. A company may dissolve to end its existence [14] .

Either it is in individual directors or a group of directors, if ever it is proved that they have taken some benefit to harm the company, and then their right to benefit company incorporation is suspended. For example, in the legal case Salomon V Salomon [15] Co Ltd 1987. When speaking fraudulent context, it describes an activity where director’s intention was to take personal benefit on the expense of company welfare. For example, director can sell shares to someone by getting some bribe or commission. Normally, company directors have no limitation or restrictions on their powers. What are the monitoring and inventory control systems adopted by most of companies in the world to control their director’s power so that they cannot abuse their unlimited powers? The answer is rarely found in any uniform form. But it is always present in company’s own policies to address the matter [16]. The proportion of incorporate cases in most of the world is in high number where court has taken decision against directors.

Background

The companies of various types are widely dispersed in each country’s economy [17]. Most of major companies are quoted an on stock market [18]. If companies are public limited, then voting control is not concentrated in the hands of families, banks and other firms. However, the proportion of private, public and public limited companies vary in different countries. For example, in UK, three out of ten public companies have a major shareholder which owns more than one fifth of the shares.

The companies in UK and USA have well controlled protection to share holders. In other European countries and in market oriented economies, monitoring system defending share holder’s rights are different [19]. Company law in UK was pioneer in protection of company structure as USA has adopted the veil of incorporation from English company law. In UK, principles governing veil of incorporation were first time explained as a result of a famous case known as Salomon V Salomon in 1897. It was decided in the case that subsidiaries within conglomerate were to be decided on separate entities of the actual parent company. Before the decision of this case people were scared to invest in companies due to personal risk involved to their investment. There are several cases when the veil of incorporation can be lifted on fraudulent or wrongful trading by directors. In these cases Courts have rejected directors right if their actions have proved wrongful or with wrongful intentions.

Literature Review

The veil of incorporation can be lifted under various circumstances [20] . Under section 67(3), the veil of incorporation can be lifted if a company breaches the probation against providing financial assistance for the purpose of its shares, then its officers will be defaulted not the company. According to sections 303 and 304, an officer who intentionally make contract of debt knowing the company’s financial position will be liable to pay the debt himself. Under section 169, the directors of a holding company are required to prepare consulate accounts consolidating the financial position of the holding company and its subsidiaries. In fact, act doesn’t treat each company in a group as a separate legal entity but recognises the reality that a group of related companies act as a single entity. Under section 36, if the numbers of members of a company is reduced below two and it carries on business for more than six months while the number is so reduced, then the member of the company will be personally liable for all of the debts of the company incurred after the period of six months. Similarly if a person intentionally trade fraudulently on behave of company will be personally responsible. In section 21, an officer will be personally liable if he signs any bill of exchange, cheque or promissionary note where the company’s name is not properly or legally written and therefore the company refuse to pay. The veil of incorporate can be lifted under common law [21] . The intention of a person is much concerned and if a director tries to get personal benefit on behalf of company, then he is liable himself [22] . In other words, directors cannot use incorporate shield for their personal use [23] . Directors cannot use their position to escape from liability [24]

There are two well demarcated post war era in the history of UK corporate governance [25] . One is between 1950s 1nd 1960s. It was management control era in which family owners maintain control over large firms. The later era starts in 1980s when financial institutions started taking ownership. It is an era when indirect ownership control has become stronger. In this era dominant shareholders were institutional. The later era represented the UK’s present outsider dominated system. As a history, the institutions have not been much interested in the corporate governance of their investee companies. However, institutions participate in the performance of companies by buying and selling shares depending upon their personal judgment either company working is profitable or not. The institutions are not restricted to use their votes. In addition institutions can directly intervene in emergency or crises times. UK corporate governance is arms length or outsider-dominated system of corporate governance. The system tends to inhibit the share holders’ direct involvement in management. Instead, the firms are involved as financial instructions. In this system, the firms are constantly exposed to takeover and the takeover mechanism makes it difficult to develop a co-operative relationship with stakeholders. On the other hand, firms participation in share business and stock market activities [26] . It creates a caring relationship between shareholders and financial institutions. The participating financial institutions include investment banks, stockbrokers, insurance companies, mutual funds and other investment firms.

Discussion

Statement 1 Discussion

“The veil of incorporation serves to encourage rather than restrict director innovation in managing a company”.

In UK, the company board [27] has responsibility to ensure that the company is properly managed and shareholder’s rights are protected. The board of directors consist on various no of directors depending upon the size of a company. The board of directors has long term strategic, business, financial, control, management and monitoring objectives [28] . The board of directors also manage the company’s internal affairs. For example, management of finances, resources, policy and procedures etc. Directors function to enable the company to meet its objectives.

In UK, company’s structure presents the idea of two types of directors. One type is executive and other type is non-executive director. The non-executive directors play a role of supervision on executive directors (UK Listing Authority, 2002) [29] . The non-executive directors are usually one third of the board members. They use their experience, consultancy, supervision, expertise and independence for their views to carry significant weight in the board’s decisions.

Now , we need to look at directors duties in UK company structure to evaluate the discussion that veil of incorporate encourage directors to involve into company management or not. Various factors including Director’s powers and duties, the structure of board, range of companies by size and structure, company’s right to contract and control will be considered before answering the said question.

Financial institutions are responsible for the protection of shareholders in UK. Shareholders in minority are also well protected in UK company law [30] . Let’s see how directors influence a company due to their powers. Directors have power by virtue of their duties. Directors have various duties in a company.

Their duties in relation to the company members, employees and creditors are very responsible. Directors have responsibility for strategic planning, management, safe guarding the interests of a range of stakeholders and functioning in fair way to save company reputation.

A Combined Code formulated in 1998, consists on code of best practice and principles of corporate governance in UK. It allows companies to formulate their own governance practices, procedures, processes and principles. As directors have powerful responsibly, they are also responsible and accountable for their actions. A general trend of self regulation instead of judicial intervention is promoted in UK company law. Private actions like claims to protect personal rights are still available to members and a director cannot escape court sanction on corruption.

In UK, companies have internal regulatory system adopted to resolve conflicts instead of approaching minority members to the courts. It is in best interest of the minority members but also for company as time and money is saved by resolving matters outside the courts. However, minority members are not left only on company procedures but there is still option.

The personal rights of minority members are dually protected through the courts. Companies develop internal regulatory system to decrease the risk of claims against individual directors. The developing concept of better corporate governance in UK has decreased the effect of judicial intervention in company affairs. Minority shareholders have various remedies available for protection of their rights by common law and under statute [31]. As Directors look after the company affairs, they have opportunity to abuse their position. They can earn illegal profit at the expense of company and at the expense of shareholders of the company. Resultantly, law imposes duties, burdens and responsibilities upon directors to prevent any chances of abuse. Company laws create a balance to allow directors to manage the company and as well preventing them to earn profit by abusing their freedom. Directors are responsible to ensure correct accounts of the company. Directors may be liable to pay company debts even considered as a separate person [32] . For example, a company director who tries to trade out of difficulty and fail may be considered guilty of wrongful trading. In this case they may be liable to pay debts. Directors are more vulnerable if they take personal benefits. The directors therefore have many responsibilities. Directors must use their power for the purpose; the creditors have given him/her. Director must exercise in the best interest of company and shareholders. Especially, when there is conflict of interest for his personal interest and company interest, a director must consider the company interest. Directors and even shadow directors are required to consider the interests of employees of the company [33] . However, professional advisers giving advice in their professional capacity are specifically excluded from the definition of the shadow director. Again directors are responsible for company’s negligence and fraud. The directors are liable for negligence or breach of trust where shareholders rights are affected or the company suffer financial loss [34] . Limited liability of company may protect directors but not for their intentional negligence or wrongful act [35] . The directors may be held personally liable if they know the company’s financial troubles but carries on trading to the detriment of its creditors. The director may be cleared from responsibility if court finds that when director released that the company was not able to recover, he took responsible steps to minimise potential losses to creditors [36] . The court takes very careful consideration of factors to put liability on director [37] . The court look at factors like; was board constituted properly, did board meetings took pace with detailed agendas, Were board meetings properly minute, was proper management information provided and record kept. A director may be cleared from claim partially if he proves that anyone else was also responsible for negligence. The directors cannot escape form their responsibility under the separate person umbrella of a company [38] .

Statement 2 Discussion

‘The power of majority shareholders and rights of minority shareholders has little or no effect in removing or restricting director activity’

The member’s power in company management has decreased recently in UK companies [39] . In UK corporate governance, it is common practice to delegate management powers to boards of directors. The members had little powers to interfere management activities. The UK company structure has passed through a series of evolution .The power was shifted from members to management in 1930’s. In the Modern company structure of UK, the stakeholder is given vital importance. There was change in power distribution and control of company activities in last few decades. The change in power direction is obvious towards control rather than management. Management and control has been classified in two separated tasks particularly in the large public company. The majority of members and directors are different parties. A well structured monitoring system is present in UK to protect minority members. However the member’s right to participate in day to day management activities is reduced due to 2006 act. The decrease in the rights of minority shareholders to use the courts due to the Companies Act 2006 has been balanced by an increase in supervisory control within the company. Directors generally act on the behalf of members. Directors have duties in relation to the company members, employees and creditors [40] . Directors have responsibility for strategic planning and looking after the interests of a range of stakeholders. The right of the minority members to pursue claims for breach of duty is limited. The fair rules of UK corporate governance have encouraged the self-regulation of director’s duty in addition to the Companies Act 2006, statutory and common law. A Combined Code was produced in 1998. It consists on code of best practice and principles of corporate governance in UK. It allows companies to formulate their own governance practices, procedures, processes and principles. A general trend of self regulation instead of judicial intervention is promoted in UK corporate governance. Private actions like claims to protect personal rights are still available to members and a director cannot escape court sanction on corruption. An internal regulatory system has been adopted to resolve conflicts instead of approaching minority members to the courts. It is not only beneficial for the minority members but also for company as time and money are saved by resolving matters outside the courts. However, there is still option and the personal rights of minority members are dually protected through the courts. By development of internal regulatory system, the risk of claims against individual directors is reduced resulting in less pressure on board. The developing concept of better corporate governance in UK has decreased the effect of judicial intervention in company affairs. The basic principle of UK Combined Code is known as a ‘Comply or Explain’. In other words, companies have choice to comply or not with specific provisions. But, in that case, company will have to provide a proper public explanation of their decision. Minority shareholders have the right to claims at common law and under statute, seeking relief on behalf of the company ( see the Foss v Harbottle 1843) [41] .

Individual claims related to personal rights e.g. breach of contract claims are well respected and solved at company or court level (See Pender v Lushington 1877) [42] . UK corporate governance practice is heavily weighted towards shareholder interests. In case of international trade mutual treaties are also respected [43] .However, the larger companies are not much engaged in the interplay of ownership and control by a consideration of the rules governing shareholder rights and board structure. Recently, restructuring of UK corporate governance has involved insolvency law, employment law, and the functional role of employment and creditor’s representation in company. UK institutions pose their governance activity in shareholders interest at firm level by three main ways (Stapledon, 1996; Davies, 2000; Crespi-Cladera and Renneboog, 2000; Pye, 2001). These include the exercise of voting rights at general meetings, ongoing dialogue, meetings, information transfer and informal discussion with managers and the attachment of conditions to further injections of funds [44] .

Interpretation of statements

Veil lifting decision is sometimes a difficult choice for Judiciary. A care decision is taken to look where the loss should lie. In the beginning Judiciary has applied Saloman principle to declare corporate as a separate legal entity but later on more interventionist approach was taken to achieve justice in a peculiar situation. For example an injunction was issued against Mr Holme in a case Gilford Motor Company LTd v Horne [1993]. In another example, Mr Lipman tried to excape his sale transaction by forming a company and presenting excuse that he has transferred land to the company. The court did not accept his excuse that he did not want to complete contract as he did not own the land. After 1960, group structure of companies was beginning to cause courts some difficulties with strict application of the Saloman principle. Let us examine one case example. For example, where ZLtd owns three subsidiaries known as A Ltd, B Ltd and C Ltd. As Z Ltd controls all three subsidiaries, the strict application of Solamon principle means that if things go wrong then assets of Z Ltd as a shareholder of A Ltd company in theory cannot be touched. The situation was tried to explain in various court cases. For example , Lord Denning argued in DHN Ltd V Tower Hamlets[1976] that group of company should be treated as one entity. However, two years later, Denning’s views were disapproaved in a case Woolfson v Strathclyde[1978]. Later on the case Adams v cape industries plc[1990] represented a significant explanation by senior judiciary towards application of Salmon principal.

When a director carry out torturious activity, the liability against director is possibly negated by the Solman principle. Every day, courts are dealing cases with Solman principle. A leading case known as Williams v Natural Life Health Foods Ltd[1998]2AllER577 emphasised on the Solaman principle in the context of a negligent misstatement claim. The managing director of the company was major shareholder of accompany. The Natural Life Health Foods (NLHF) was selling franchise to run retail business. One franchise was sold to the claimant on the basis of a broucher which included the detailed financial projection. The managing director had provided much information in browser. However the claimant had not dealt with the managing director but with ban employee. The claimant lost business as financial difficulties and filed a suit against company that he suffered only due to negligent information contained in the broucher. The Natural Life Health Foods (NLHF) ceased business and was dissolved. As the company was dissolved, the claimant brought a claim of personal responsibility against the managing director. It was case where effect of claim was a try to nullify the protection offered by limited liability. However , in judgment, the house of Lords said that a director of a company can be only personally liable for negligent misstatement if there was reasonable proof by the claimant on the assumption of personal responsibility on director as it has been presentation that a special relationship between them had been created by misstatement. The director of NLHF was not found guilty as there was no evidence in the case that there had been any personal dealings which could have conveyed to the claimant. The same type of conclusion has been found in case law Noel v Poland[2002] Lyold’s Rep.IR 30.

Other cases; Daido Asia Japan Co Ltd v Rothen[2002] BCC589 and Standard Chartered Bank v Pakistan Shipping Corp Co Ltd(No 2)[2003]1AC959 suggest that if the tort is deceit rather than negligence the court will more readily allow personal liability to flow to director or employee. But directors liability in tort has proved less than settled. The courts look at director’s intention even their action is within the company control to find out liability bar . For example court took very relaxed approach to consider liability on a director authorizing infringement of law; See Charly Records Ltd(no 5)[2003]1BCLC93. The court said that a director should be liable with the company as a joint tortfeaser if he is not exercising control according to company articles and law. For example see Koninkliije Philips Electronics NV v Princo Digital Disc GmbH[2004]2BCLC50 where director was held responsible.

Conclusion

The primary players in a company are shareholders, directors and officers. Shareholders are investors and owners of the company. Shareholders elect or remove the directors by voting method. Shareholders also vote on specific corporation transaction or operation. On the other hand board of directors is the top governing body. Directors establish corporate policy and employ officers. The directors may delegate their powers to officers to carry out administration ,management and daily jobs. Shareholders are investors in company, therefore they receive some rights to protect their investment. The investment share of shareholders may be different. Shareholders have power to vote . Shareholders use vote elect or remove directors.Their vote is also used t change or add bylaws, to ratify director’s action where the bylaws require shareholder’s approval. Shareholders also have power to vote on accepting or rejection of any changes that are not of the regular course of business e.g merges or dissolution. The shareholders power to vote provide a sense of strength in corporate business even it is limited.

Shareholders use their votes at annual or special meetings. An advance notice is provided to shareholders for an annual or special meeting. Shareholder can get et court notice for annual meeting if it has not held for within a specified period of time. Annual meetings primary objective is to elect directors but it can discuss any issue brought under consideration. Shareholders elect directors with majority of vote. Same number of vote required to elect a directors are required to remove a director. Shareholders don’t need any solid reason, proof or cause to remove a director. A special meeting is different than an annual meeting. Only issues which were mentioned in advanced notice can be discussed in meetings. The bylaws of a company decide the person who can call meeting. It may be director, an officer or a shareholder with specific percentage.

The voting system is complicated. The shareholders having his vote in company records can vote. Corporation issue share certificates in the name of person who become owner in records.The record owner is treated as sole owner of the shares. The record of company with entry of these transactions is called stockbooks or share registers. A shareholder who does not receive a share certificate is called as the beneficial owner and cannot vote.The beneficial owner is a real owner and can force the record owner on his behalf.