Piercing the corporate veil

The corporate law concept piercing (lifting) the corporate veil describes a legal decision where a shareholder of a corporation is held personally liable for the debts of the corporation despite the general principle that those persons are immune from suits in contract or tort that otherwise would only hold the corporation liable. This doctrine is also known as "disregarding the corporate entity".

Basis for limited liability

Corporations exist in part to shield their shareholders from personal liability for the debts of a corporation. Prior to the invention of the limited liability corporation in the 17th century, any partner in a general partnership could be held responsible for all the debts of the corporation. As the capital needed to finance the largest projects grew, and along with it the necessity of raising money, investors were reluctant to invest because of the risk involved in essentially guaranteeing the entire debt of the business entity.

In modern times, the only large business entity that can result in personal liability for huge sums of money is acting as a "name" for a large insurance underwriting concern, such as Lloyds of London. If, for example, any shareholder of General Motors were responsible for the entire amount of its losses, it is unlikely that any person would invest in the shares of the company (though this is far from clear in the case where responsibility for losses would be spread among thousands or millions of investors). As such, shareholder liability serves a useful purpose in allowing huge sums of capital to be raised with less risk to the individual investors.

Similarly, officers and directors of corporations, like other employees, are generally not held liable for the losses of the corporation. In a similar manner, people would be less willing to serve as an officer or director if they were liable for the entire amount of the corporation's losses (though not necessarily for a fractional amount).

However, for corporations with only one shareholder, officer and director (often the same person), courts of law have found that individuals could escape liability for their own misconduct by holding assets in the name of the corporation. Unlike a large corporation where no individual shareholder could possibly obtain management authority over the corporation, closely held corporations are potentially expressions of the will of a few shareholders. Historically, corporations with 10 or more shareholders are not likely to be affected by piercing.

Basis for piercing the veil

Although courts will generally not hold a shareholder liable for actions that are legally the responsibility of the corporation, even if the corporation has a single shareholder, it will often do so if holding only the corporation liable would be singularly unfair to the plaintiff and the shareholder's actions were clearly designed to attempt to pass personal liability off to the corporation. Generally, courts are reluctant to rebut the presumption of limited liability and pierce the veil. In most jurisdictions, no bright line rule exists and the ruling is rather based on case-by-case decisions. 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".

Generally, the plaintiff has to prove that the corporation was set up to perpetrate a fraud, or at least show that the incorporation was merely a formality and that the corporation never held proper shareholder meetings to distribute profits as dividends. 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 Court to Consider

So grossly undercapitalized that fraud is likely
Failure to observe corporate formalities
Intermingling of assets of the corporation and of the shareholder
Treatment by an individual of the assets of corporation as his/her own
Failure to pay dividends
Siphoning of corporate funds by the dominant shareholder(s)
Non-functioning corporate officers and/or directors
Concealment or misrepresentation of members
Absence of corporate records
Was the corporation being used as a "façade" for dominant shareholder(s) personal dealings
Failure to maintain arm's length relationships with related entities
Manipulation of assets or liabilities to concentrate the assets or liabilities
Other factors the court finds relevant

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.

The demise of the "single economic unit" theory (English law)

It is an axiomatic principle of English company law that a company is an entity separate and distinct from its members, who are only liable to the extent that they have contributed to the company's capital: Salomon v Salomon 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"; see The Coral Rose (No 1.) [1991, per Staughton LJ.

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 adumbrated the theory of the "single economic unit" theory in DHN Food Distributors v Tower Hamlets but this has largely been repudiated. In Woolfson v Strathclyde BC ^* (PC), Lord Goff, who had agreed with Lord Denning 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 where Slade LJ held that cases where the rule in Salomon had been circumvented were merely instances where. The view expressed at first instance by HHJ Southwell QC in Creasey v. Breachwood Ord v Bellhaven ^*," target="_blank" >and these doubts were shared by Moritt V-C in Trustor v. Smallbone (No. 3) [2001: the corporate veil cannot be lifted merely because justice requires it.

The "Fraud" Exception (English Law)

The cases of Jones v. Lipman where a company was used as a "façade" (per Russell J.) to defraud the creditors of the defendant and Gifford v. Horne Gencor v. Dalby [2000" target="_blank" >^*, 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 extra-judicially, 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.

Disadvantages of not piercing

It is occasionally a disadvantage to company owners when the courts will not lift the veil.Business Law of Australia, eighth edition, 1995, ISBN 0-409-30675-4 The often cited case Macaura v Northern Assurance Co Ltd ^* AC 619 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.

References

Thomas Lee Hazen and Jerry W. Markham, Corporations and Other Business Enterprises (2003) ISBN 0-314-26476-0 pg. 124-144.

Business organizations | Corporations law