Piercing the corporate veil

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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. 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 sets 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 confers entity status on partnerships, but also provides that partners are individually liable for all partnership obligations. Therefore, this shareholder limited liability emanates mainly from statute.[2]

Basis for limited liability[edit]

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 company, 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[edit]

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, shareholders 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 the corporation may claim compensation, even in an insolvency proceeding.

United Kingdom[edit]

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. According to a 1990 case at the Court of Appeal, 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".

The issue is discussed at length in a 2013 UK Supreme Court case, Prest v Petrodel Resources Ltd.[6]

Tort victims and employees[edit]

Tort victims and employees, who did not contract with a company or have very unequal bargaining power, have been held to be exempted from the rules of limited liability in Chandler v Cape plc. In this case, the claimant was an employee of Cape plc's wholly owned subsidiary, which had gone insolvent. He successfully brought a claim in tort against Cape plc for causing him an asbestos disease, asbestosis. Arden LJ in the Court of Appeal held that if the parent had interfered in the operations of the subsidiary in any way, such as over trading issues, then it would be attached with responsibility for health and safety issues.[7] Arden LJ emphasised that piercing the corporate veil was not necessary. There would be direct liability in tort for the parent company if it had interfered in the subsidiary's affairs. The High Court before it had held that liability would exist if the parent exercised control, all applying ordinary principles of tort law about liability of a third party for the actions of a tortfeasor. The restrictions on lifting the veil, found in contractual cases made no difference.

"Single economic unit" theory[edit]

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".[8] The rule also applies in Scotland.[9]

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.[10] However this has largely been repudiated and has been treated with caution in subsequent judgments.

In Woolfson v Strathclyde BC,[10] 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,[11] 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,[12] 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[13] 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,[14] and these doubts were shared by Moritt V-C in Trustor v Smallbone (No 2):[15] 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.[16]

Existing obligation[edit]

The cases of Jones v Lipman,[17] 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,[18] 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,[19] 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[edit]

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.[20] The often cited case Macaura v Northern Assurance Co Ltd[21] 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[edit]

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 can, depending upon the particular facts of the case as found by the court, be regarded as having been 'obtained' by an individual (who is usually, but not always, a director of the company). In consequence those monies may become an element in the individual's 'benefit' obtained from criminal conduct (and hence subject to confiscation from him).[22] 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[23] 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[edit]

In the United States, corporate veil piercing is the most litigated issue in corporate law.[24] Although courts are reluctant to hold an 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 United States, 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".[25]

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[edit]

  • 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.

Undercapitalization[edit]

  • 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[edit]

In recent years, the Internal Revenue Service (IRS) 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 U.S. 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 U.S. 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[edit]

Notes[edit]

  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. ^ e.g. Gilford Motor Ltd v Horne and Jones v Lipman
  4. ^ e.g. Daimler v Continental Tyre and Re FG Films Ltd
  5. ^ e.g. Lubbe v Cape Plc
  6. ^ MacLeod, Ceit-Anna (January 2014). "Case Commentary: Prest v Petrodel". Scottish Parliamentary Review (Edinburgh: Blacket Avenue Press) I (2). 
  7. ^ See further, E McGaughey, 'Donoghue v Salomon in the High Court' (2011) 4 Journal of Personal Injury Law 249, on SSRN
  8. ^ see The Coral Rose (No 1) [1991], per Staughton LJ.
  9. ^ MacLeod, Ceit-Anna (January 2014). "Case Commentary: Prest v Petrodel". Scottish Parliamentary Review (Edinburgh: Blacket Avenue Press) I (2). 
  10. ^ a b [1976]
  11. ^ [1987] (PC)
  12. ^ [1990]
  13. ^ [1992]
  14. ^ [1998]
  15. ^ [2001]
  16. ^ Capuano, Angelo (2009), "The Realist's Guide to Piercing the Corporate Veil", Australian Journal of Corporate Law 23 (1): 56–94 
  17. ^ [1962]
  18. ^ [1933]
  19. ^ [2000]
  20. ^ Lindgren, Kevin E.; R. B. Vermeesch (1995), Business Law of Australia, Butterworths, ISBN 0-409-30675-4 
  21. ^ [1925] AC 619
  22. ^ David Winch, "Confiscation: lifting the veil of incorporation" (2013)
  23. ^ [2009] EWCA Crim 1303
  24. ^ Thompson, Robert B. (1991), "Piercing the Corporate Veil: An Empirical Study", Cornell Law Review 76: 1036–1074 
  25. ^ Trucounsel.com Elements of Alter Ego

References[edit]

Books
  • TL Hazen and JW Markham, Corporations and Other Business Enterprises (2003) ISBN 0-314-26476-0 pg. 124-144.
Articles
  • AW Machen, 'Corporate Personality' (1910) 24 Harvard Law Review 253
  • J Dewey, 'The Historic Background of Corporate Legal Personality' (1926) 35 Yale Law Journal 655
  • C Alting, 'Piercing the corporate veil in German and American law - Liability of individuals and entities: a comparative view' (1994–1995) 2 Tulsa Journal Comparative & International Law 187
  • AA Berle, 'The Theory of Enterprise Entity' (1947) 47(3) Columbia Law Review 343
  • EJ Cohn and C Simitis, Lifting the Veil' in the Company Laws of the European Continent' (1963) 12(1) 'The International and Comparative Law Quarterly 189
  • H Hansmann, R Kraakman and R Squire, 'Law and the Rise of the Firm' (2006) 119 Harvard Law Review 1333
  • H Hansmann and R Kraakman, 'Toward unlimited shareholder liability for corporate torts' (1991) 100(7) Yale Law Journal 1879