LLM International Corporate Law

“Critically Assess The Claim That The Principles Of Separate Corporate Personality And Limited Liability Are So Fundamental To Company Law That The Courts Should Not Haphazardly Lift The Veil To Make The Holding Companies Liable For The Debts Of Their Subsidiaries.”

Introduction

The internationalisation of business is deviously changing the legal scenery. With globalization we have witnessed a growing flow of goods, services and finances across the globe. The international arena is no longer the sphere of large public companies. Privately-held as well as publicly-held corporations via branches, foreign subsidiaries and joint ventures are seizing business opportunities. However, under this entire web of high stake and complex acquisitions and mergers the basic principle on incorporation remains the same, i.e. “separate legal personality” and “limited liability” of a company. In reality all companies are managed by individuals like in “Gallaghar v. Germania Brewing Company”, it was held that a corporation is a distinct entity yet in reality, it is an association of persons who are in fact beneficiaries of the corporate property. Therefore there is always a possibility of fraud and malpractices based on these concepts and it is then the courts pierce the corporate veil for justice.

The twin concepts that I have just mentioned above are the major pillars of modern company law and the courts have tried hard to retain them which is evident in number of cases. Before making an attempt to justify that “separate corporate existence” and “limited liability” are fundamental to a company, it is necessary first to explain both the terms individually. The primary purpose of this essay is to critically analyse the well founded concepts on which company law is based on and to eventually draw a conclusion as to whether it is right for the courts to lift the veil holding the parent companies liable for the debts of their subsidiaries with the help of case laws. As a first step the concepts will be discussed and subsequently shall focus on the criticisms that they have invited and an attempt will be made to examine the extent to which the veil can be lifted and to reach a relevant conclusion with regard to the sustainability of piercing for the governance of the system.

Separate Corporate Personality

Incorporation by registration was first made possible by the Joint Stock Companies Act, 1844 but at that time the concept of limited liability was not known. Thereafter company law was a major consolidating legislation and the consequence of incorporation is that the incorporated ‘thing’ (company) becomes a distinct legal entity, it is a ‘legal person’, capable of holding legal rights and obligations which exists separately from its members. It is often described as an artificial person but its implications were not fully realized until the end of 19th century in a leading case “Salomon v Salomon & Co. [1897] AC 22” where Lord Macnaghten states, “ The Company is at law a different person altogether from the subscribers…; and though it may be that after incorporation the business is precisely the same as before and the same persons are managers, and the same hands receive profits, the Company is not in law the agent of the subscribers or trustee for them. Nor are the subscribers as members liable in any shape or form, except to the extent and in the manner provided by the Act.” Hence the House of Lords affirmed that the company is not per se the agent of its shareholders even if it is controlled by them.

The invention of the company as separate is vital as it means that it is free to develop as an instrument of business shaped by people running it. The famous research of Berle and Means showed that ownership and control of company were in different hands, where the company is a creature of its own rights. However the Marxists criticized it that it leads to depersonalization of relationship between labour and capital and technically this concept can be disadvantageous for shareholders at times especially if they claim for reflective loss. There are numerous cases where this rule has been upheld, for e.g.: “Lee v lee’s Air Farming (1961)” where it was held that the company and Mr. Lee were distinct legal entities and could act in dual capacities .It was also asserted in cases in which the principle wasn’t in favour of the person creating the company, as in “Macaura v Northern Assurance (1925)” . This evinces the accuracy of Gooley’s observation that the separate legal entity doctrine is a “two-edged sword”. At a general level, it was a good decision whereby a company was made a powerhouse for capitalism but again this led to a lot of fraudulent activities. Therefore we see that ever since Solomon’s decision the rule of a company being a separate entity has been firmly embedded in the English System.

Limited Liability

Another important principle to common law is the rule of limited liability. This goes hand in hand with separate corporate personality. The essence lies with the fact is that the members of the company are liable only up to the nominal value of their shares and anything beyond that cannot be recovered. However the principle applies only so long as we concentrate on the position of members, and as long as the company is a going concern. Members who involve themselves in the management will not get any protection and to what extent can they be held liable depends on the doctrine of agency. But now we are more concerned about those who usually get the protection from personal liability. We all know that a company can be limited or unlimited, so when a company is limited by shares, each member is liable to contribute the full value of shares unless it is paid wholly. Therefore when a company incurs obligations, it is the company and not the member’s who is liable. The concept is just opposite of an unincorporated association. In English law the real bite of limited liability shows itself in a legal relationship between the company and its members if the company becomes insolvent. In liquidation, a question arises whether the liquidator can claim contributions from its members. One cannot find the answer with regard to limited liability in such situations and on referring Insolvency Act, 1986, members are made liable but fortunately in case of a company which has issued shares no further contributions are required, thereby effectively granting limited liability to its members.

Undoubtedly the grant of limited liability helped to make possible the growth of the large modern companies which are dominating the economy. Earlier this privilege was given to enterprises which raised large share and loan capital, but now it has been conferred to entrepreneurs and investors leading to a booming market. The main importance of the limited liability concept is that it protects the company and its members, as well as to facilitate commercial ventures in which the company may be interested. The principle further encourages corporate investment, much needed in any society to speed up development. Even then it can be argued here that the principles may have been effective to a certain extent but it has opened a window for the shareholders to escape liabilities leading to rampant malpractices and it cannot be said that the claims of the creditors are wholly being satisfied. In company law there has been two major attempts to curb situations wherein the rule has been abused. They are fraudulent and wrongful trading. The former was introduced to penalise those who defraud creditors and the latter was conceived as an attempt to discourage and penalise abuses which stemmed from negligent rather than fraudulent conduct. Here in this connection it is worthwhile to discuss about the alternatives to limited liability which is proportionate liability meaning when the company has insufficient assets to satisfy the creditor’s claim, the creditor is entitled to recover the amounts owed to him from each member equal to an amount proportionate to that member’s equity interest in the company but however it is always not possible to bring about the intended result with such alternatives.

Exceptions To The Principles:

There are two exceptions to the fundamental principles of company law discussed earlier, namely, where on the facts an agency relationship exists between a company and its shareholders. We know that as per Salomon’s case a company is not per se the agent of the shareholders but on certain facts it may exist like in “Smith, Stone and Knight Ltd. v. Birmingham Corporation”, where the parent company agreed that the subsidiary carried on the business as an agent of the former. Atkinson J. identified certain factors to determine the relation of agency for instance, who carried on the business, who received profits, who was the head etc. This case confirms that it is possible to have agency relation but it must do so from circumstances other than mere control of shares. The other exception is where the corporation structure is a mere facade concealing the true facts and the courts have played an active role in declaring that some companies are nothing more than a name for e.g. in “Gencor ACP ltd. V Dalby”, it was held that the company had no stuffs and existed to receive profits. Therefore the whole concept of limited liability may be easy to employ but it encourages shareholders to start gambling with the money which may lead to huge losses for the creditors and some may not be able to deal with it.

Piercing The Corporate Veil To Hold Subsidiaries Liable: A Critical Analysis

With the enlargement of business it is not possible for a company to control the entire business and in order to effectively discharge its duties it distributes its business amongst various companies which itself enjoy a corporate personality. All the companies subsequently formed are interrelated where each of the company is a separate legal person and its shareholders have limited liability. Now question arises as to whether a holding company can be held liable to pay the debts of the subsidiary company. The law on this point is not clear as there is no precise legislative provision in company law or at common law but however there are case laws holding and relieving the parent company whichever deems fit.

Companies which hold shares in other companies also enjoy limited liability. In Re Polly Peck plc [1996] 2 All ER 433, a subsidiary company incorporated in the Cayman Islands, made a public issue of debt securities and lent the proceeds to its parent company. The parent company guaranteed the issue. It was held that that as a guarantor, the parent company was a contingent creditor of its subsidiary and was entitled to lodge a proof in its liquidation on that basis. The court refused to lift the veil and also rejected the argument that the subsidiary company was acting as an agent of the parent company in issuing its debt securities. The principles laid down in Salomon’s case have been considered the cornerstone of company law but however that did not impede the courts from lifting the veil to prevent miscarriage of justice. Piercing the corporate veil means disregarding the structure and looking beyond the company to hold a person liable for malpractices. But English courts resorting to such symbolic terms as “mere fraud,” “sham,” “dummy,” “alter ego” in their judgments indicates their difficulties. Nonetheless this did not stop the courts from lifting the veil as noted by 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.” Thus, the court maintains a watchful eye on any misuse of the corporate form. Even in the case of “Jones v Lipman”, it was held that the company is a facade. On careful analysis of these cases, it will clearly reveal the reasons for lifting the veil i.e. when the motive of the holding company in forming a subsidiary company is to perpetrate a fraud, the corporate veil will be lifted and the motive is to be inferred from the circumstances and evidence of the case.

The problem with English courts, for group of companies with regard to piercing is to render shareholders liable for the company’s debts and majority of decisions concerning group law orbit around the Salomon principle, thus underlining the separate legal identity of each group member. The way courts do this is quite often described as robust strictly upholding the Salomon principle. This issue also came up in another landmark case which brought about changes in the concept of separate entity, i.e. “Adams v Cape Industries Plc.”which modified the attitude of the courts on the question of lifting the veil to establish a controlling interest and that is, if the holding company exerted a substantial degree of control over the affairs of the subsidiary company, to the extent that the holding company controlled the corporate policy of its subsidiary, then it would be held liable for the debts of the subsidiaries. Since then the courts have strengthened the principles and stated the reasons for piercing which are, firstly when the court is construing a statute, contract or other document which requires the veil to be lifted; secondly when the court is satisfied that the company is a ‘mere facade’ and thirdly when it can be established that the company is an authorised agent of its members. In “Allen v Amalgamated Construction Co Ltd” the European Court of Justice showed itself willing to have a poke around in the internal workings of a company to the extent that it was acceptable. In “Pirelli Cable Holding NV v IRC” the court lifted the veil to examine the workings of parent and subsidiary companies. It seems that the courts will go to great lengths to avoid penetration of the corporate veil, while still making inquiries that would be satisfied. Taking note of the present situation it is very difficult to conclude that the Courts should haphazardly lift the veil, to tab the functioning of a subsidiary. My personal opinion is that the Courts should take note of the circumstances prevailing therein. Taking another view it can also be argued that when the courts are considering holding the parent company liable, it should keep the distinctness of the subsidiary and not merge to make things easier, as we cannot overlook the separate entity rule of company law, for there are evidences of treating group of companies as one unit and that cannot operate to deny the separate legal personality of each company in a group. Moreover the decision given in “D.H.N. Food Distributors Ltd. v. Tower Hamlets London Borough Council” where the companies were treated as one while lifting the veil has always been ridiculed and open to criticisms. In contrast it has also been argued that a parent should not always be relieved of the disadvantageous consequences and whenever just, the veil should be lifted.

EU courts apply the “economic unit theory,” to define the corporate entity and considers a number of separate corporations a single entity if they are controlled by the same members imputing the rights and obligations of one corporation to another which permits lifting the corporate veil of a parent corporation to meet the obligations of the subsidiary when they are subject to the same control. Therefore if the subsidiaries lack autonomy the courts do not apply this rule to look beyond the veil. Hence when members of an enterprise are subjected to the same control, the fact that they have separate corporate personalities is meaningless. Accordingly, anti-competitive actions of any member of the enterprise may be imputed to the parent corporation which is the real force behind the prohibited conduct.

These rules play a dominant role in the company law, not only in UK but have considerable importance even in other countries. If we draw a comparative study we will see that in UK, certain factors are being considered before lifting the veil for instance fraud or sham as discussed above, or what kind of control the parent has on the subsidiaries etc. In the US too the rule of separate entity is recognized and till 1980 the veil was lifted on the principle of equity but later the courts decided that mere control cannot be a reason to look beyond the veil, there must be dominant control of the subsidiaries by the parent company and looked into improper conduct. Both the UK and the US courts discovered various factors to satisfy the unity of interest and ownership and dominant control between the parent and subsidiary companies. With time, UK courts found that in the interest of justice, corporate veil can be pierced. Similarly US courts mostly based their decisions depending on the case. Therefore we see that there is an unpredictable gap between the two judicial systems which eventually creates a threat for the corporate world. The right view would be if the Legislature would frame and enact laws on this issue and clearly elucidate the factors that are to be considered by the courts would make it easier to deliver justice and not haphazardly lift the veil holding the parent company liable for the acts of the subsidiary. In Canada the leading case concerning piercing the corporate veil on the basis of an agency was the Supreme Court’s decisions in “Toronto (City) v Famous Players Canadian Corp.” [1936] S.C.R. 141 where Rand J. stated that the corporate veil may be pierced where “it can be said that the [subsidiary] company is in fact the puppet of the [parent]; when the directing mind and will of the [parent] reaches into and through the corporate façade of the [subsidiary] and becomes, itself, the manifesting agency”.

Nonetheless, despite all reasons the sacredness of Salomon’s decision is still upheld which was again seen in “Ord v Belhaven Pubs Ltd [1998] BCC 607, CA” and this clearly portrays that the conservatism of the courts is set to continue. Another scholar in “Overcoming Corporate Law: Instrumentalism, Pragmatism and the Separate Legal Entity Concept’, argued that the main problem with the Salomon case is the failure by the English House of Lords to give any indication of what the courts should consider in applying the separate legal entity concept and the circumstances in which one should refuse to enforce contracts associated with the corporate structure”.

The Adams decision is clearly advantageous to companies seeking to avoid liabilities in certain situations and it is submitted that Denning’s approach and attitude to Salomon at least brought with it the universal applicability, certain degree of predictability to adhere to a principle and on this ground it is argued that Adams decision is far from an answer for business, there is a darker, rigid face to the decision that will deny many companies rights. No doubt till date the verdict is considered to be more practical but the question is if it is considered universal then why are the courts so reluctant to consider the factors and moreover at times the veil is lifted unsystematically in the name of justice. It is time the judiciary realize that if the veil is so lifted then the whole concept of a registered corporation having separate entity is put to stake.

More and more companies as subsidiaries are coming up owned by the parents company and groups are managed as single unit with no respect to the separate entity rule. Where the subsidiary becomes insolvent the creditors try to recover their losses from the parent company but the question is to what extent is the parent liable for the acts of the subsidiaries? The corporate form is posing new difficulties especially for the creditors. At times when a group is failing the parent usually is tempted by the doctrine of limited liability, thereby letting the subsidiary fail. This way the creditors of the subsidiary face the brunt of loss. Even then we should bear in mind that the Parent company will be vicariously liable for the acts of the subsidiaries officers when they are acting within the scope of their employment but it must be considered whether such liability impinges upon the fundamental tenets of company law i.e. separate entity and limited liability. The difficulty of this approach, however, is that once one looks at the commercial realities the tension between the principles of vicarious liability and those of company law become more distinct and imposing such liabilities diminishes the subsidiary’s separate existence.

In order to tab the extent of essentiality of separate corporate personality and limited liability one must first assess the degree of their title applicability. In the words of the Court of Appeal in Adams v Cape Industries plc [1991] 1 All ER 929, 1019: “Our law, for better or worse, recognises the creature of subsidiary companies, which though in one sense the creatures of their parent companies, will nevertheless under the general law fall to be treated as separate legal entities with all the rights and liabilities which would normally attach to separate legal entities.” Hence if an unsecured creditor lacks the bargaining power then the only hope for such an unsecured creditor against the parent company would be to pursue the parent by a liquidator of the subsidiary company under the ‘wrongful trading’ provision which would be successful only if, the parent company had been acting as a ‘shadow director. However, it may be that in many instances the listed parent company would not be a ‘shadow director’ of some subsidiaries. It may, therefore, be of benefit to describe briefly a set of provisions introduced in 1993 into the Australian Corporations Law which serve to lift the corporate veil to a greater extent than Insolvency law where a liquidator of a ‘subsidiary’ company is empowered to bring proceedings for compensation against the ‘holding company and any compensation recovered is treated as a debt due to the subsidiary and is not available to pay a secured debt of the subsidiary unless the unsecured debts have been paid in full, thereby giving priority to the unsecured creditors. But however even such provisions can be tactfully defended which can absolve the parent company from the debts incurred by the subsidiaries.

Conclusion

The act of piercing the corporate veil until now remains one of the most controversial subjects in corporate law. By and large, as discussed in the essay, the doctrine of piercing the corporate veil remains only an exceptional act of the courts who are prepared to respect the rule of corporate personality. Generally, one will not be able to “pierce the corporate veil”, although it is often the ardent wish and belief of litigants that one should be able to do so. See, for example, “Ord and another v Belhaven Pubs Limited (1998) BCC 607” where claimants said that the companies in the group had acted as a single entity in transferring assets, and that the court would therefore be justified in lifting the corporate veil but the court dismissed the claim, stating that all the inter-group transactions were overt and were conducted as per the liberties conferred upon corporate entities by the Companies Act. There are number of cases where it was argued that the court should recognise that separate legal personality should not be allowed to act as a vehicle for fraud but the courts have not been all that helpful. Here lies the paradox of the corporate veil. The company is an individual and has contractual obligations. Within the veil there are individual persons who manage the company having contractual obligations, which must not be confused with those of the company. This apparently straightforward principle, has, however, sometimes been ignored, mainly in situations where there has been a possibility of fraud. However, the principle has generally survived because it is simple and therefore allows consistent judgments.

There are a number of traditional corporate law doctrines which are applied in the EU to deal with situations wherein the facade of ‘corporation’ is used to commit fraud. In India as well Supreme Court and the High Courts have used the concept of “lifting of corporate veil” in order to mete out justice to all parties and stakeholders concerned. Once the veil is lifted by the Indian Courts the liability of the management and shareholders is unlimited, they have to make good all the losses or else suffer from penal consequences. However, the EU, on the other hand, requires a demonstration of fault before the parent becomes liable. The potential for liability is smaller in the EU, hence the aggrieved party may be at an economic disadvantage and it allows corporations to hide behind the corporate shield while committing wrongs. Hence European Community should immediately issue the Directive on fundamental rules regarding the recognition of the corporate entity and must see to it that is effectively enforced and uniformly implemented and must lay down the circumstances under which the corporate veil will be pierced. It has been suggested by some commentators that a “genuine ultimate purpose” test should replace the traditional established sham test as it has been criticized as uncertain. Parliament, when passing the Companies Act 2006, had ample opportunity to conduct an extensive revision of this principle but deliberately left the topic. There currently appears to be little judicial enthusiasm for such revision.

The doctrine of piercing the corporate veil is apparently in an evanescent state in many common law jurisdictions and what the Common law courts typically consider is injustice. Where this is the case, the only motive of the courts in lifting the veil is for the restoration of equity. But other courts such as in the United States have adopted a more liberal approach to veil piercing such as for instance the shareholders’ improper conduct in controlling the corporation and the causal link between improper conduct and the plaintiff’s injury. In my view, it is appropriate to lift the veil only when there are strong grounds supporting the same which will help restore the tenets of company law but at the same time deliver justice as one cannot deny the importance of limited liability and separate entity and so it is best left alone for the base of company law cannot be uprooted.

Other commentators argue that the decision to pierce the corporate veil is not based on a single factor, but that various elements are required to be considered. According to L Gallagher and P Ziegler, the discrepancy between the various cases is not problematic, but rather indicates that the courts want to make decisions based on evidence of an injustice. It might be, for this very reason, that there has been a reluctance to create a rigid category of circumstances as to when the veil will and will not be pierced. Consequently all that is required is a clear framework of law that would help fight the controversies brought every time due to different decisions which is hampering the reputation of the judiciary as a whole. There is a need to formulate a sound fundamental basis without which no statute or case law can subsist. The initiation of this process will ignite to productive dialogue which in the long run will help improve company law.

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