Piercing the corporate veil


Piercing the corporate veil

Piercing the corporate veil or lifting the corporate veil is a legal decision to treat the rights or duties of a corporation as the rights or liabilities of its shareholders or directors. Usually a corporation is treated as a separate legal person, which is solely responsible for the debts it incurs and the sole beneficiary of the credit it is owed. Common law countries usually uphold this principle of separate personhood, but in exceptional situations may "pierce" or "lift" the corporate veil.

A simple example would be where a businessman has left his job as a director and has signed a contract to not compete with the company he has just left for a period of time. If he set up a company which competed with his former company, technically it would be the company and not the person competing. But it is likely a court would say that the new company was just a "sham", a "fraud" or some other phrase,[1] and would still allow the old company to sue the man for breach of contract. A court would look beyond the legal fiction to the reality of the situation.

Despite the terminology used which makes it appear as though a shareholder's limited liability emanates from the view that a corporation is a separate legal entity, the reality is that the entity status of corporations has almost nothing to do with shareholder limited liability.[2] For example, English law conferred entity status on corporations long before shareholders were afforded limited liability. Similarly, the Revised Uniform Partnership Act (RUPA) confers entity status on partnerships, but also provides that partners are individually liable for all partnership obligations. Thus, this shareholder limited liability emanates mainly from statute.[2]

Contents

Basis for limited liability

Corporations exist in part to shield the personal assets of shareholders from personal liability for the debts or actions of a corporation. Unlike a general partnership or sole proprietorship in which the owner could be held responsible for all the debts of the corporation, a corporation traditionally limited the personal liability of the shareholders. The limits of this protection have narrowed in recent years. Shareholders are increasingly personally liable.

Piercing the corporate veil typically is most effective with smaller privately held business entities (close corporations) in which the corporation has a small number of shareholders, limited assets, and recognition of separateness of the corporation from its shareholders would promote fraud or an inequitable result.

There is no record of a successful piercing of the corporate veil for a publicly traded corporation because of the large number of shareholders and the extensive mandatory filings entailed in qualifying for listing on an exchange.

Germany

German corporate law developed a number of theories in the early 1920s for lifting the corporate veil on the basis of "domination" by a parent company over a subsidiary. Today, shareholder can be held liable in the case of an interference destroying the corporation. The corporation is entitled to a minimum of equitable funds. If these are taken away by the shareholder to corporation may claim compensation, even in an insolvency proceeding.

United Kingdom

The corporate veil in UK company law is pierced very rarely. After a series of attempts by the Court of Appeal during the late 1960s and early 1970s to establish a theory of economic reality, and a doctrine of control for lifting the veil, the House of Lords reasserted an orthodox approach. On a strict reading of the most prominent recent case, Adams v Cape Industries plc, the only true "veil piercing" may take place when a company is set up for fraudulent purposes, or where it is established to avoid an existing obligation.[3] The veil is also often ignored in the process of interpreting a statute,[4] and as a matter of tort law it is open as a matter of authority that a direct duty of care may be owed by the managers of a parent company to accident victims of a subsidiary.[5] There are also significant statements still among the judiciary in support of a broader veil lifting approach in the interests of "justice".

"Single economic unit" theory

It is an axiomatic principle of English company law that a company is an entity separate and distinct from its members, who are liable only to the extent that they have contributed to the company's capital: Salomon v Salomon [1897]. The effect of this rule is that the individual subsidiaries within a conglomerate will be treated as separate entities and the parent cannot be made liable for the subsidiaries debts on insolvency. Furthermore, it can create subsidiaries with inadequate capitalisation and secure loans to the subsidiaries with fixed charges over their assets, despite the fact that this is "not necessarily the most honest way of trading".[6]

Although the secondary literature refers to different means of "lifting" or "piercing" the veil (see Ottolenghi (1959)), judicial dicta supporting the view that the rule in Salomon is subject to exceptions are thin on the ground. Lord Denning MR outlined the theory of the "single economic unit" - wherein the court examined the overall business operation as an economic unit, rather than strict legal form - in DHN Food Distributors v Tower Hamlets.[7] However this has largely been repudiated and has been treated with caution in subsequent judgments.

In Woolfson v Strathclyde BC,[7] the House of Lords held that it was a decision to be confined to its facts (the question in DHN had been whether the subsidiary of the plaintiff, the former owning the premises on which the parent carried out its business, could receive compensation for loss of business under a compulsory purchase order notwithstanding that under the rule in Salomon, it was the parent and not the subsidiary that had lost the business). Likewise, in Bank of Tokyo v Karoon,[8] Lord Goff, who had concurred in the result in DHN, held that the legal conception of the corporate structure was entirely distinct from the economic realities.

The "single economic unit" theory was likewise rejected by the CA in Adams v Cape Industries,[9] where Slade LJ held that cases where the rule in Salomon had been circumvented were merely instances where they didn't know what to do. The view expressed at first instance by HHJ Southwell QC in Creasey v Breachwood[10] that English law "definitely" recognised the principle that the corporate veil could be lifted was described as a heresy by Hobhouse LJ in Ord v Bellhaven,[11] and these doubts were shared by Moritt V-C in Trustor v Smallbone (No 2)[12]: the corporate veil cannot be lifted merely because justice requires it. Despite the rejection of the "justice of the case" test, it is observed from judicial reasoning in veil piercing cases that the courts employ "equitable discretion" guided by general principles such as male fides to test whether the corporate structure has been used as a mere device.[13]

Existing obligation

The cases of Jones v Lipman,[14] where a company was used as a "façade" (per Russell J.) to defraud the creditors of the defendant and Gilford Motor Co Ltd v Horne,[15] where an injunction was granted against a trader setting up a business which was merely as a vehicle allowing him to circumvent a covenant in restraint of trade are often said to create a "fraud" exception to the separate corporate personality. Similarly, in Gencor v Dalby,[16] the tentative suggestion was made that the corporate veil was being lifted where the company was the "alter ego" of the defendant. In truth, as Lord Cooke (1997) has noted extrajudicially, it is because of the separate identity of the company concerned and not despite it that equity intervened in all of these cases. They are not instances of the corporate veil being pierced but instead involve the application of other rules of law.

Reverse piercing

There have been cases in which it is to the advantage of the shareholder to have the corporate structure ignored. Courts have been reluctant to agree to this.[17] The often cited case Macaura v Northern Assurance Co Ltd[18] is an example of that. Mr Macaura was the sole owner of a company he had set up to grow timber. The trees were destroyed by fire but the insurer refused to pay since the policy was with Macaura (not the company) and he was not the owner of the trees. The House of Lords upheld that refusal based on the separate legal personality of the company.

Criminal law

In English criminal law there have been cases in which the courts have been prepared to pierce the veil of incorporation. For example in confiscation proceedings under the Proceeds of Crime Act 2002 monies received by a company have been regarded as having been 'obtained' by an individual (who is usually, but not always, a director of the company). In consequence those monies become an element in the individual's 'benefit' obtained from criminal conduct (and hence subject to confiscation from him).[19] A useful brief summary of the position regarding 'piercing the veil' in English criminal law was given in the Court of Appeal judgment in the case of R v Seager [2009] EWCA Crim 1303 in which the court said (at para 76):

"There was no major disagreement between counsel on the legal principles by reference to which a court is entitled to "pierce" or "rend" or "remove" the "corporate veil". It is "hornbook" law that a duly formed and registered company is a separate legal entity from those who are its shareholders and it has rights and liabilities that are separate from its shareholders. A court can "pierce" the carapace of the corporate entity and look at what lies behind it only in certain circumstances. It cannot do so simply because it considers it might be just to do so. Each of these circumstances involves impropriety and dishonesty. The court will then be entitled to look for the legal substance, not the just the form. In the context of criminal cases the courts have identified at least three situations when the corporate veil can be pierced. First if an offender attempts to shelter behind a corporate façade, or veil to hide his crime and his benefits from it. Secondly, where an offender does acts in the name of a company which (with the necessary mens rea) constitute a criminal offence which leads to the offender's conviction, then "the veil of incorporation is not so much pierced as rudely torn away": per Lord Bingham in Jennings v CPS, paragraph 16. Thirdly, where the transaction or business structures constitute a "device", "cloak" or "sham", i.e. an attempt to disguise the true nature of the transaction or structure so as to deceive third parties or the courts."

United States

In the United States, corporate veil piercing is the most litigated issue in corporate law.[20] Although courts are reluctant to hold a director or active shareholder liable for actions that are legally the responsibility of the corporation, even if the corporation has a single shareholder, they will often do so if the corporation was markedly noncompliant, or if holding only the corporation liable would be singularly unfair to the plaintiff. In most jurisdictions, no bright-line rule exists and the ruling is based on common law precedents. In the US, different theories, most important "alter ego" or "instrumentality rule", attempted to create a piercing standard. Mostly, they rest upon three basic prongs - namely "unity of interest and ownership", "wrongful conduct" and "proximate cause". However, the theories failed to articulate a real-world approach which courts could directly apply to their cases. Thus, courts struggle with the proof of each prong and rather analyze all given factors. This is known as "totality of circumstances".

There is also the matter of what jurisdiction the corporation is incorporated in if the corporation is authorized to do business in more than one state. All corporations have one specific state (their "home" state) to which they are incorporated as a "domestic" corporation, and if they operate in other states, they would apply for authority to do business in those other states as a "foreign" corporation. In determining whether or not the corporate veil may be pierced, the courts are required to use the laws of the corporation's home state. This issue can be significant, for example, the rules for allowing a corporate veil to be pierced are much more liberal in California than they are in Nevada, thus, the owner(s) of a corporation operating in California would be subject to different potential for the corporation's veil to be pierced if the corporation was to be sued, depending on whether the corporation was a California domestic corporation or was a Nevada foreign corporation operating in California.

Generally, the plaintiff has to prove that the incorporation was merely a formality and that the corporation neglected corporate formalities and protocols, such as voting to approve major corporate actions in the context of a duly authorized corporate meeting. This is quite often the case when a corporation facing legal liability transfers its assets and business to another corporation with the same management and shareholders. It also happens with single person corporations that are managed in a haphazard manner. As such, the veil can be pierced in both civil cases and where regulatory proceedings are taken against a shell corporation.

Factors for courts to consider

  • Absence or inaccuracy of corporate records;
  • Concealment or misrepresentation of members;
  • Failure to maintain arm's length relationships with related entities;
  • Failure to observe corporate formalities in terms of behavior and documentation;
  • Failure to pay dividends;
  • Intermingling of assets of the corporation and of the shareholder;
  • Manipulation of assets or liabilities to concentrate the assets or liabilities;
  • Non-functioning corporate officers and/or directors;
  • Significant undercapitalization of the business entity (capitalization requirements vary based on industry, location, and specific company circumstances);
  • Siphoning of corporate funds by the dominant shareholder(s);
  • Treatment by an individual of the assets of corporation as his/her own;
  • Was the corporation being used as a "façade" for dominant shareholder(s) personal dealings; alter ego theory;

It is important to note that not all of these factors need to be met in order for the court to pierce the corporate veil. Further, some courts might find that one factor is so compelling in a particular case that it will find the shareholders personally liable.

  • Berkey v. Third Avenue Railway, 244 N.Y. 602, 155 N.E. 914 (1927). Benjamin Cardozo decided there was no right to pierce the veil for a personal injury victim.
  • Perpetual Real Estate Services, Inc. v. Michaelson Properties, Inc. 974 F.2d 545 (4th Cir. 1992). The Fourth Circuit held that no piercing could take place merely to prevent "unfairness" or "injustice", where a corporation in a real estate building partnership could not pay its share of a lawsuit bill
  • Fletcher v. Atex, Inc., 68 F.3d 1451 (2d Cir. 1995) (http://scholar.google.com/scholar_case?case=16439332799546168049&hl=en&as_sdt=2002].

Undercapitalization

  • Minton v. Cavaney, 56 Cal. 2d 576 (1961). Mr. Minton's daughter drowned in the public swimming pool owned by Mr. Cavaney. Then-Associate Justice Roger J. Traynor (later Chief Justice) of the Supreme Court of California held: "The equitable owners of a corporation, for example, are personally liable . . . when they provide inadequate capitalization and actively participate in the conduct of corporate affairs."
  • Kinney Shoe Corp. v. Polan, 939 F.2d 209 (4th Cir. 1991). The veil was pierced where its enforcement would not have matched the purpose of limited liability. Here a corporation was undercapitalized and was only used to shield a shareholder's other company from debts.

Internal Revenue Service

In recent years, the Internal Revenue Service in the United States has made use of corporate veil piercing arguments and logic as a means of recapturing income, estate, or gift tax revenue, particularly from business entities created primarily for estate planning purposes. A number of US Tax Court cases involving family limited partnerships (FLPs), such as Strangi, Hackl, Shepherd, and Bongard, show the IRS's use of veil piercing arguments. Since owners of US business entities created for asset protection and estate purposes often fail to maintain proper corporate compliance, the IRS has achieved multiple high-profile court victories.

See also

  • US corporate law
  • UK company law

Notes

  1. ^ see HG Henn and JR Alexander, Corporations (3rd edn, Hornbooks 1983) ch 7, 344, n 2 for a list of terms the court uses. They are, mere adjunct, agent, alias, alter ego, alter idem, arm, blind, branch, buffer, cloak, coat, corporate double, cover, creature, curious reminiscence, delusion, department, dry shell, dummy, fiction, form, formality, fraud on the law, instrumentality, mouthpiece, name, nominal identity, phrase, puppet, screen, sham, simulacrum, snare, stooge, subterfuge, tool.
  2. ^ a b Melvin Aron Eisenberg, "Cases and Materials on Corporations & Other Business Organizations (concise 9th Edition) ch 4, 171
  3. ^ eg Gilford Motor Ltd v Horne and Jones v Lipman
  4. ^ eg Daimler v Continental Tyre and Re FG Films Ltd
  5. ^ eg Lubbe v Cape Plc
  6. ^ see The Coral Rose (No 1) [1991], per Staughton LJ.
  7. ^ a b [1976]
  8. ^ [1987] (PC)
  9. ^ [1990]
  10. ^ [1992]
  11. ^ [1998]
  12. ^ [2001]
  13. ^ Capuano, Angelo (2009), "The Realist's Guide to Piercing the Corporate Veil", Australian Journal of Corporate Law 23 (1): 56–94, http://ssrn.com/abstract=1369110 
  14. ^ [1962]
  15. ^ [1933]
  16. ^ [2000]
  17. ^ Lindgren, Kevin E.; R. B. Vermeesch (1995), Business Law of Australia, Butterworths, ISBN 0-409-30675-4 
  18. ^ [1925] AC 619
  19. ^ David Winch, "Confiscation and piercing the veil of incorporation" (2011)
  20. ^ Thompson, Robert B. (1991), "Piercing the Corporate Veil: An Empirical Study", Cornell Law Review 76: 1036–1074 

References

Books
  • TL Hazen and JW Markham, Corporations and Other Business Enterprises (2003) ISBN 0-314-26476-0 pg. 124-144.
Articles

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