Lifting The Veil Company Law Essay Competitions

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):

  1. 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;
  2. 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;
  3. 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.

Conclusion

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.

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I obtained a 2.1 LLB degree and an LLM with distinction from a UK University. I had worked at two leading law firms before joining the legal team of an international bank and I intend training to qualify as a lawyer. My research interests include international law, international politics, human rights, public law, competition law, commercial law and social theory.

Explain and discuss the importance of the House of Lords’ judgment in Salomon v. Salomon & co. [1897] in developing the principle of separate corporate personality and the exceptions to that principle in UK Company Law.

The landmark case of Salomon v A. Salomon and Company [1897] A.C. 22 saw the House of Lords firmly uphold the principle of separate corporate personality which has been the starting point for any discussion on the topic ever since.

Mr Salomon controlled a boot-making business as a sole trader. He incorporated a company called A Salomon and Co Ltd to which he sold his business. Complying with The Companies Act of 1862 which specified that there be a minimum of seven members for a company to be properly formed, Mr Salomon held the majority of the shares while six members of Mr Salomon’s family held one share each. Mr Salomon continued to exercise dominant control over the company as he had done while he was a sole trader. Unfortunately, the company went in to liquidation and Mr Salomon was the only secured creditor. The company’s liquidator fought on behalf of the other creditors to impose personal liability on Mr Salomon for the company’s debts.

In both the High Court, where Vaughan Williams J found that the company was a mere alias or agent of Mr Salomon, and the Court of Appeal, where it was found that the company was Mr Salomon’s trustee, Mr Salomon was held liable to indemnify the company against the creditors’ claims. However, when the case came to the House of Lords, the views of the lower courts were rejected and it was held that Mr Salomon was not personally liable. In giving judgment, Lord Halsbury stated that once a company had been legally incorporated, it must be ‘treated like any other person with its rights and liabilities appropriate to itself’, and further, that Mr Salomon’s motives for forming the company were ‘for the purposes of establishing those rights and liabilities’.[1] Indeed, as Lord Herschell stated: ‘The Company is ex hypothesi a distinct legal persona’.[2]

The significance of the principle of separate corporate personality is that the company, as a separate legal entity, can be in a legal relationship. Accordingly, a company can own property, enter into contracts and be a party to legal proceedings. As persons separate from the company, the members do not own the company’s property, do not carry on its business and do not owe its debts. The advantages of incorporating a company are numerous with perhaps the most important of these being limited liability which allows companies to raise vast amounts of capital. This is seen as promoting entrepreneurship. In addition, a company can issue transferable shares and securities and is able to create a floating charge over the company’s assets. Companies also gain perpetual succession once incorporated.

The principle has subsequently been upheld in many different contexts. In Macaura v Northern Assurance [1925] A.C. 619, Mr Macaura was the sole owner and controller of a company, but insured the company’s timber in his own name. After a fire, Northern Assurance refused to pay out to Mr Macaura, as he did not own the timber. In the House of Lords, it was found that Mr Macaura had no legal or equitable interest in the property owned by the company, as it was a distinct legal entity, despite suffering economically by its destruction. In Lee v Lee’s Air Farming [1961] A.C. 12, it was found that the wife of a deceased owner of a company was entitled to compensation under the Workers’ Compensation Act 1922 as her husband was an employee of that company. Lord Morris found that: ‘a man acting in one capacity can make a contract with himself in another capacity. The company and the deceased were separate legal entities.[3]

However, there are instances where the separate corporate personality of a company will be ignored. This is often referred to in metaphorical terms as ‘lifting the veil’ or ‘piercing the veil’ of incorporation. This term can be used in a broad sense to refer to a divergence from the general principle of separate legal personality but, as Lord Sumption noted in Prest v Petrodel Resources Ltd [2013] UKSC 34, it should most accurately be used in the narrow sense of disregarding the corporate veil and the separate corporate personality of a company.

A court may attribute certain characteristics or knowledge to a company in order to make companies subject to laws that are only applicable to persons who have knowledge or intention. This may be referred to as lifting the veil of incorporation in its broadest sense. In fact, such imputation of knowledge or intention takes into account the artificial nature of the company without disregarding its separate existence as a legal person. As such, it can be viewed as an affirmation of the separate legal personality of a company.

In the case of statutory provisions, the principle of separate corporate personality may be diverged from. For example, Section 213 of the Insolvency Act 1986 provides for the offence of ‘fraudulent trading’.[4] Under this provision, directors and others may be held liable for the company’s debts if its business has been carried on with the intent to defraud creditors. The principle of fraudulent trading is complemented by Section 214 of the Insolvency Act 1986, which provides for the concept of ‘wrongful trading’, a liability which applies to a director or shadow director if they knew or ought to have concluded that there was no reasonable prospect that the company would avoid going in to liquidationat some time before it did.[5] In addition, Section 216 of the Insolvency Act 1986 restricts the use by a director of a company known by a prohibited name.

Besides statutory provisions, there is one instance where the limited liability the members gain from incorporation may be nullified. This is when the parties contract around such arrangements. It is common that members of an owner-managed company make contracts agreeing to guarantee its obligations. Indeed, this is often insisted upon by major creditors or suppliers. However, it is vital that the member or director of the company accepts an express legal obligation to be liable on this basis as by not formalising such arrangements, the consequences for the other party can be severe.[6]

Furthermore, there is nothing in company law to prevent a person from agreeing to a company being their agent. This makes that person liable for what that company does within the agency. As was established in Salomon, the fact that a person is a member of the company does not make the company that person’s agent in the absence of a specific intention to create an agency relationship. In Smith, Stone & Knight Ltd v Birmingham Corporation [1939] 4 All ER 116, it was found that a parent company which incorporated a wholly owned subsidiary company nominally operating a waste-paper business was entitled to compensation on the compulsory purchase of the land on which the business was conducted. This was because the parent company had never formally transferred ownership of the waste-paper business to that subsidiary and retained ownership of the land on which the business was operated. This case differs crucially from Salomon in that Mr Salomon formally transferred the business to A Salomon and Co Ltd. By contrast, the business operated by the subsidiary company in the instant case was never transferred to it and remained the property of its principal member. Since an agency relationship demands two legally recognisable parties, rather than being an example of disregarding the separate corporate personality of a company, treating a company as an agent of its controllers is in fact a complete affirmation of the principle.

Another exception to the principle of separate corporate personality may be found in trusteeship and liability in equity.  In Petrodel, Mr Prest was found to have procured the transfer of various residential properties to companies which he owned and controlled and in so doing, had received no consideration from the companies. Based on the evidence available, the Supreme Court held that the companies must be presumed to hold the properties on resulting trust for Mr Prest. Therefore, the properties could be treated as the personal assets of Mr Prest for the purposes of matrimonial proceedings. Lord Sumption found that this did not involve piercing the corporate veil, but was an example of the ‘concealment principle’. Rather than piercing the veil, the court was simply looking behind it to discover the true facts.

In Petrodel, the Supreme Court recognised a limited power to pierce the corporate veil and to disregard the separate personality of a company in carefully defined circumstances. In giving leading judgment, Lord Sumption articulated the principle as a very narrow one. Indeed, he found that ‘most cases in which the corporate veil was pierced could have been decided on other grounds’.[7] Lord Sumption drew a distinction between the concealment principle and the evasion principle. For his lordship, the first was ‘legally banal and did not involve piercing the veil, as the courts in these cases were not disregarding the façadebut were looking behind it to discover the true facts. However, the second principle was different. It existed so that a court could disregard the corporate veil where there was a legal right against the person in control of it which existed independently of the company’s involvement and where this legal right was defeated or frustrated by the interposition of a company and its separate corporate personality.

In his extensive judgment, Lord Sumption examined two cases most often associated with piercing the corporate veil in the narrow sense, where the evasion principle was engaged. In the first, Gilford v Horne [1933] CH 935, the defendant attempted to evade a covenant not to compete with the claimant by arranging for his wife to form a company for the purpose. As Lord Hanworth MR stated in the case, the company was a ‘device, a stratagemutilised to mask the effective carrying on of the business by Mr Horne. The company was restrained in order to deprive Mr Horne of the benefit he would have derived from the company’s separate legal personality. However, Lord Sumption went on to speculate that even this case might have been decided on different grounds. This would not have involved piercing the corporate veil, such as the imputation of knowledge to the company so as to make their conduct unconscionable or tortious.[8] In Jones v Lipman [1962] 1 WLR 832, the defendant entered into a contract to sell his house. He sought to escape his obligation by conveying the property to a company in which he and a nominee of his controlled all the shares and were the directors. Russell J found that the company was a mask which [Mr Lipman] holds before his face in an attempt to avoid recognition by the eye of equityand that the company had the same obligation to convey the property to the plaintiff as Mr Lipman, despite not being a party to the contract of sale.

Lord Sumption concluded that there was a limited principle which applied when a person was under or subject to an existing legal obligation, liability or restriction which that person deliberately evaded by interposing a company under their control. In these circumstances, the court may pierce the corporate veil for the express purpose of depriving the controller or the company of the advantage which they would otherwise have obtained by the company’s separate legal personality.[9]

Although Lady Hale and Lord Mance were less willing than Lord Sumption to draw sharp distinctions between cases of concealment or evasion or to foreclose all possible future situations, the Petrodel judgment brings much needed limitations and clarity to the doctrine of piercing the corporate veil.[10] Indeed, Lord Walker stated that it was not a doctrine at all, but merely a label that has been used to describe the disparate occasions where the court disregards or makes an exception to the principle of separate corporate personality. Petrodel may signal a more conservative use of the term by the courts in future.

Finally, a possible exception to the principle of separate corporate personality has been considered in the context of groups of companies. In DHN Foods v Tower Hamlets [1976] 1 WLR 852, the Court of Appeal, led by Lord Denning, treated a group of companies as a single entity to justify an entitlement to full compensation for the compulsory purchase of land, which one company owned and on which another company carried on a business. Unlike Smith, Stone and Knight, where an agency relationship was established, this case was decided on the basis of ‘enterprise theory’. Lord Denning felt that on the facts, the three companies involved should be treated as one. DHN Foods was not enthusiastically received, and in Adams v Cape Industries [1990] CH 433 (CA), the case was confined to being a decision on the relevant statutory provisions of compensation. The Court of Appeal stated that a court was not free to disregard the Salomon principle because it considered that justice so required.[11] Furthermore, it was held that structuring a group of companies in such a way so as to shield the group’s assets from future potential liabilities and ensuring these liabilities would be incurred by one company was a legitimate use of the corporate veil. In Bank of Tokyo v Karoon [1987] AC 45, Lord Goff summed up the approach of UK law to groups of companies, stating that the court was interested not with economics, but with law; in law the distinction between parent and subsidiary is fundamental. In Petrodel, Lord Sumption went further, adding that the distinction was also economically fundamental, since limited companies have been the principal unit of commercial life for more than a century.[12]

The Salomon principle has survived for over 100 years and has shaped UK Company Law. Following the judgment in Petrodel, it is clear that this principle will only be ignored or disregarded by a court in carefully defined circumstances. In most cases where the corporate structure is utilised to conceal the reality, the court will merely establish the true facts of the case in order to reach a decision. This decision may be reached on the basis of established legal principles such as agency or trusteeship. However, this should not be mistaken for the court piercing the veil or ignoring the fundamental principle. Rather, these cases involve the affirmation of the doctrine of separate corporate personality since the application of such principles requires two or more distinct legal persons.

[1] Salomon v A. Salomon and Company [1897] A.C. 22, dicta of Lord Halsbury.

[2] Ibid, dicta of Lord Herschell.

[3] Lee v Lee’s Air Farming [1961] AC 12, dicta of Lord Morris.

[4] Section 213, Insolvency Act 1986; http://www.legislation.gov.uk/ukpga/1986/45/section/213

[5] Section 214 (2) (b); http://www.legislation.gov.uk/ukpga/1986/45/section/214

[6] Carlton Communications and Grenada Media v The Football League [2002] EWHC 1650.

[7] Prest v Petrodel Resources Ltd [2013] UKSC 34, Lord Sumption at [27].

[8] Ibid at [29].

[9] Ibid at [35].

[10] Ibid at [92] and at [100].

[11] Adams v Cape Industries [1990] CH 433 (CA),

[12] Prest v Petrodel [2013] UKSC 34 at [8].

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