Veil Of Incorporation - Law 200 Assignment 4a2f

LAW 200 (SECTION 6)

Veil of Incorporation Final Assignment Prepared for Barrister Saheen Ahmed Faculty Member North South University

Prepared by M Abu Saleh Chowdhury ID # 072 407 030

Date of Submission: December 8, 2010

Table of Contents INTRODUCTION .......................................................................................................................... 1 WHAT IS “VEIL OF INCORPORATION”? ................................................................................. 4 ANALYSIS OF THE LEADING CASES ...................................................................................... 5 Salomon v Salomon & Co Ltd (1897) ........................................................................................ 5 Lee v Lee‟s Air Farming Ltd (1961) ........................................................................................... 7 Battle v Irish Art Promotion Centre Ltd (1968) .......................................................................... 7 State Trading Corporation of India Ltd. AIR (1963) SC 1811 ................................................... 8 In C.I.T. v. Meenakshi Mills Ltd. (AIR 1967 SC 819) ............................................................... 8 PIERCING THE CORPORATE VEIL .......................................................................................... 9 Factors for courts to consider ...................................................................................................... 9 CONCLUSION ............................................................................................................................. 10 BIBLIOGRAPHY ......................................................................................................................... 11 WEB REFERENCES.................................................................................................................... 11

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INTRODUCTION "The company is at law a different person altogether from the subscribers to the Memorandum, and though it may be that after incorporation of the business is precisely the same as it was before and the same persons and managers, and the same hands receive the profits, the company is not in law the agent of the subscribers or trustees for them. Nor are the subscribers or liable in any shape or form except to the extent and in the manner provided by the act." This notation was made by the House of Lords in 1897, which has later emerged as one of the most debated and talked about doctrines in the history of company law. This eventually had given birth to the term “Veil of Incorporation” and afterwards helped solve many disputed cases and also managed to carry negative remarks as well. Against the backdrop of the possibility of that limited liability (which protects investors, shareholders) can be a vehicle for facilitating fraud, parliament via statutory legislations and judiciary via decided cases have sometimes intervened to mitigate the harsher effect of corporate personality and limited liability but this does not mean that the two doctrines are no respected or recognized by the courts as holding sway as rigid construct of English company law. However it is in dealing with companies operating as group structures and their subsidiaries that we have witness intensive statutory and judicial intervention/watchdog in the core area of company law. As corporate affairs became more complex and group structures emerge, the Companies Act began to recognize that treating each company in a group as separate was misleading. Overtime a number of provisions were introduced to recognize this fact. For instance, the English Companies Act 1985, section 227 provides that parent companies have a duty to produce a group s and section 231 also requires that parent companies to provide details of the names of subsidiaries country of activity/operation and the shares it holds in the subsidiary.

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WHAT IS “VEIL OF INCORPORATION”? One of the purposes of incorporating is to separate an individual from legal liability of a company. The veil of incorporation ensures that a company is a separate legal entity from its directors and shareholders, thus protecting the personal assets of owners and investors from lawsuits. Once a company incorporates, it becomes its own legal person, thus a legal entity, separate and distinct from the people who formed, own or invest in it. It then retains its own rights and responsibilities such as owning property or entering into contracts, and it can sue or be sued only in its own name. This principle behind the veil of incorporation is known as limited liability. The concept of limited liability protects a company's while furthering the company's commercial endeavors. The significance of the veil of incorporation is that a shareholder or owner incurs no debt that the business acquires. Furthermore if a company is sued and a judgment is granted against said company, the shareholders only stand to lose the amount that they each invested. There are situations when the veil of incorporation can be pierced or lifted, thus is not a legal ground for defense. When a company carries on trading with less than 2 , or when fraudulent or wrongful trading is found to have occurred, action can be taken against individuals of the corporation. Courts have also ignored the veil of incorporation in cases in which companies have been established or used for fraudulent purposes. These types of companies are often referred to as an alter ego, a sham or cloak corporation, and in these cases ability belongs to the person responsible for the illegal action.

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ANALYSIS OF THE LEADING CASES Salomon v Salomon & Co Ltd (1897) The Salomon principle has stood the test of time because it has meant that corporations do have practical utility. As a separate legal entity subject to limited liability and defined by share transferability, perpetual existence, flexible financing methods, specialized management, majority rule and the other attributes or consequences of incorporation, the corporation has many economically and socially beneficial functions. Primarily, a corporation enables the investing public to share in the profits of an enterprise without being involved in management. It also enables a single trader or a small partnership to carry on a business. Similarly, a corporation provides a structure for t venture; holding family assets; continuing trusteeship; fund management; corporatized government enterprise; and, the co-enjoyment of property. Marshalling participants in large commercial enterprises and acting as a nominee to hold the legal title to assets are two other important functions. Corporate personality is essentially a metaphorical use of language clothing the formal group with a single legal identity by analogy with a natural person... [But] As Cardozo J said in the American case of Berkey v Third Avenue Rly [(1926) 244 NY 84 at 94-5]: "metaphors in law are to be narrowly watched, for starting as devices to liberate thought, they often end by enslaving it." In stressing the independent nature of corporate personality, the House of Lords legitimized the usage of the corporate form by individual traders and small partnerships: private enterprises which do not seek to raise capital from the public but are anxious to interpose an entity between themselves and their creditors. The Law Lords concluded that once ed in a manner required by the Act, a company forms a new legal entity separate from the shareholders, even where there is only a bare compliance with the provisions of the Act and where all, or nearly all, of the company's issued shares are held by one person. Furthermore, the Court held that it was possible for traders not merely to limit their liability to the capital which they invested in the enterprise but even to elude any serious risk to the major part of that by subscribing for debentures rather than shares.

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As noted in The Law Quarterly Review, Salomon's case was not about "a dry point of construction". The House of Lords had sanctioned a change in ideas about what the company was and about the uses to which it could be put. It gave priority to the separate identity of the legal form and essentially ignored the economic reality of a one-person company. Basically, Goulding explains, the reason for criticism of Salomon's case is two-fold. First, the decision gives even apparently honest incorporators the benefit of limited liability in circumstances in which it is not necessary in order to encourage them to initiate or carry on their trade or business. Second, the opportunities that the decision affords to unscrupulous promoters of private companies to abuse the advantages that the Corporations Act gives them by achieving a "waferthin" incorporation of an undercapitalized company. First, limited liability attracts small traders to the corporate form not because it represents an effective device with which to raise capital, but because it gives them access to an avenue via which to escape the "tyranny of unlimited liability". Criticisms of limited liability are addressed at its impact on creditors and on society at large. The principle is that a limited company's creditors must look at the capital, the limited fund, and that only. Limited liability discourages shareholders from monitoring and controlling their company's commercial ventures. The company's creditors bear the burden of the risks inherent in dealing with limited liability companies. At issue is whether it is right that limited liability should operate to restrict the size of the company's capital. Different types of creditors have different capacities to protect themselves against these risks. While banks and similar financial creditors easily overcome such risks, the same cannot be said of trade creditors, employees and tort creditors. Because trade creditors rarely insist on security before they supply goods on credit, they bear a considerable part of the risk of corporate insolvency. Employees are in an even more precarious position. In stark contrast to finance and trade creditors, employees have no opportunity to obtain security or diversify the risk of their corporate employer's insolvency. Moreover, the majority of employees has minimal information about their employer's financial standing (but see the Corporations Act). While contract creditors bear a degree of risk when they deal with a limited liability company, they at least enter into the contract by their own will. This is not so for a company's tort creditors. Victims of torts committed by a company bear an uncompensated risk in case of the company's insolvency. 6|Page

From a more technical perspective, the economic benefits brought about by limited liability are absent with respect to closely held or private companies. The reduction in monitoring costs, for example, is irrelevant because owners and managers are one and the same. Moreover, the benefit of fostering an efficient market for shares through limited liability does not apply as there is no market for the shares of closely held companies. Furthermore, limited liability encourages such companies to take excessive risks because the directors of closely held companies have more to gain personally by shifting the risk of commercial collapse to corporate creditors than is the case with public companies' directors. Second, ever since the House of Lords handed down its decision in Salomon's case, legal doctrine regards each corporation as a separate legal entity. When coupled with the consequent attribute of limited liability, the Salomon principle provides an ideal vehicle for fraud. Because of its malleability and facility for protecting directors and against the claims of creditors, the corporate form has been responsible for the development of many different forms of fraudulent or anti-social activity. Lee v Lee’s Air Farming Ltd (1961) In this case, Mr. Lee formed his crop spraying business into a limited company in which he was director, shareholder and employee. When he was killed in a flying accident, his widow sought social welfare compensation from the State, arguing that Mr. Lee was a „worker‟ under the law. The State argued that Mr. Lee was self-employed and thus not covered by the legislation. The court held that Mr. Lee and the company he had formed were separate entities, and it was possible for Mr. Lee to be employed by Lee‟s Air Farming. The following case is similar to Salomon and Lee, but the principle of separate personality worked to the disadvantage of the plaintiff. Battle v Irish Art Promotion Centre Ltd (1968) The defendant company was involved in legal proceedings but did not have enough money for legal representation. The plaintiff, who was the major shareholder and managing director of the company, sought to conduct the company‟s defence. The court held that while a human person

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can represent him or herself in court, a legal person such as a company can only be represented by a solicitor or barrister. The principle in Salomon‟s Case that a company is a legally different person from those who control it represents the current law in Ireland. For example, if I form a company called „Murphy & Co Ltd‟ in which I own one hundred per cent of the shares and am a director and employee, legally speaking the company and myself are two distinct people. The „corporate veil‟ surrounds the company of Murphy & Co Ltd and prevents outsiders challenging the operation of the company. However, although the principle of separation is central to company law, there are a number of situations when the company and its can be identified together and treated as the same. These are the exceptions to the rule in Salomon‟s Case, when the corporate veil is lifted and the reality of the situation is examined. State Trading Corporation of India Ltd. AIR (1963) SC 1811 It was held that As soon as citizens form a company, the rights guaranteed to them by article 19(1)c has been exercised and no restraint has been placed on the right and no infringement of that right is made. Once a company or corporation is formed, the business which is carried on by the such company or corporation is the business of that company or corporation and is not the business of the citizens who get the company or corporation incorporated and the rights of the incorporated body must be judges on that footing and cannot be judged on the assumption that they are the rights attributed to the business of individual citizens. In C.I.T. v. Meenakshi Mills Ltd. (AIR 1967 SC 819) The court held that the income-tax authorities were entitled to pierce the veil of corporate entity and to look at the reality of the transaction to examine whether the corporate entity was being used for tax evasion. In this case, a separate corporate entity was brought into existence outside the taxable territory with the ulterior motive of evading the tax obligation by the assessee mills. The Supreme Court observed: "It is true that from the juristic point of view, the company is a legal personality entirely distinct from its and the company is capable of enjoying rights and being subjected to duties which are not the same as those enjoyed or borne by its . 8|Page

But in certain exceptional cases the Court is entitled to lift the veil of corporate entity and to pay regard to the economic realities behind the legal facade. For example, the Court has power to disregard the corporate entity if it is used for tax evasion or to circumvent tax obligation.

PIERCING THE CORPORATE VEIL Piercing the veil of incorporation is one of the most litigated topics in business law. It is also one of the most controversial. Courts have yet to provide a comprehensive definition of the corporate being and specific circumstances in which the veil can be lifted. To fully protect themselves, shareholders should stay abreast of the financial condition of the corporation as well as be able to maintain that the company has a legal objective. Factors for courts to consider 

Absence or inaccuracy of corporate records;

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Concealment or misrepresentation of ;

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Failure to maintain arm's length relationships with related entities;

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Failure to observe corporate formalities in of behavior and documentation;

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Failure to pay dividends;

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Intermingling of assets of the corporation and of the shareholder;

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Manipulation of assets or liabilities to concentrate the assets or liabilities;

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Non-functioning corporate officers and/or directors;

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Other factors the court finds relevant;

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Significant undercapitalization of the business entity (capitalization requirements vary based on industry, location, and specific company circumstances);

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Siphoning of corporate funds by the dominant shareholder(s);

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Treatment by an individual of the assets of corporation as his/her own;

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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.

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CONCLUSION Despite numerous sophisticated attempts in recent years at providing theories which explain company law, it is noteworthy that we have not yet fully understood the essence of the corporate being. It will, suffice to say, that if three persons incorporate a company, the company will become a fourth person separate and different from these three persons individually or collectively. However, when the company or corporate form is a sham or a mere façade concealing the true facts, the veil of corporate personality can be torn aside. The question of whether the negative aspects of the decision in Salomon's case outweigh the good ones is best left unanswered for it is far too broad. One is inclined towards the view that the principle of separate legal entity established in Salomon's case has been instrumental in the development of modern capitalism and the immense social and economic wealth which it has generated. The House of Lords extended the principle so far as to cover small private enterprises. This move has had several negative consequences over time. However, it is also true that these have been largely neutralized by t legislative and judicial action. Indeed, "the legislature can forge a sledgehammer capable of cracking open the corporate shell." And, even without statutory assistance, the courts have often been ready to draw aside the veil and impose legal liability on and directors where to apply the Salomon principle strictly would lead to injustice, inconvenience or damage to government finances.

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BIBLIOGRAPHY 1. Sen, A. K. (2008). Commercial Law Including Company Law And Industrial Law (26th Ed.). Kolkata: The World Press Private Ltd. 2. Zahir, M. Company Law.

WEB REFERENCES 1. http://www.lexvidhi.com/article-details/case-study-on-separate-legal-entity-of-a-company-129.html 2. http://www.murdoch.edu.au/elaw/issues/v7n3/puig73a_text.html 3. http://en.wikipedia.org/wiki/Piercing_the_corporate_veil 4. http://en.wikipedia.org/wiki/United_Kingdom_company_law 5. http://en.wikipedia.org/wiki/Salomon_v_A_Salomon_%26_Co_Ltd 6. http://www.jonesbahamas.com/?c=135&a=11675 7. http://www.law-essays-uk.com/resources/sample-essays/company/corporate-veil-extract.php 8. http://www.ehow.com/about_4727895_what-veil-incorporation.html

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