- INTRODUCTION
The general rule about companies is that as the liability of a company’s members is limited by shares or by guarantee, then the company’s creditors cannot seek satisfaction from the members, even if the company has insufficient funds to pay its own liabilities in full.
However, are there some exceptions to the general rule? Are there are times where the company’s members can be called upon, by outsiders, to meet the company’s unpaid liabilities?
It is not difficult to imagine situations where outsiders might wish to do this. For example, if a profitable holding company has an under-funded subsidiary that cannot meet tort liabilities to hundreds of victims of the subsidiary’s negligence, then the victims may want payment from the parent company that is the subsidiary’s shareholder. The answer is no.
Another example is, If a one man company for example, is completely under resourced and unable to meet its trading debts, but it’s one man owner is personally wealthy, can the company’s creditors claim against the owner shareholder? The answer is also no as was seen is Salamon vs Salamon.
The ruling from the Salomon case lies at the heart of corporate personality and is in principal, the difference between companies and partnerships. There are some situations where the courts look beyond the personality to members or directions of companies, by doing this the courts are said to lift or pierce the corporate veil.
Salomon v. Salomon and Co. Ltd. (1897)
Mr. Salomon was in control of his on business which manufactured boots. His children wanted to become a part of the business as owners, so Mr. Salomon sold his business to the new company which he had planned to form for 40000 pounds. He was selling his business as he knew that the company is separate legal entity. Mr. Salomon needed 7 shareholders to form the new company, Mr. Salomon’s family all became members, his wife and 5 children to make 7 shareholders. He then gave himself 20000 shares, 1 share to each child and 1 share to his wife. Two children were elected to become directors of the company, with this, Mr. Salomon become a shareholder. The company still owes Mr. Salomon 20000 pounds so the company gave him debentures of 10000 pounds, the rest of the amount was paid in cash. After the first year the company went into liquidation as the liabilities were more than the assets by a certain amount, this meant the creditors needed to pay. The liquidator asked Mr. Salomon to pay the creditors since he was the owner of the company, Salomon didn’t agree with this, but trial judge Vaughan Williams agreed with the liquidator, he then asked Salomon to pay on behalf of the company. Salomon appealed to the court of appeal as he didn’t want to have to pay the debts owed to creditors by the company. The court of appeal ruled that Salomon just found 6 people to form the company, the 6 are merely nominees. The court of appeal also asked Mr. Salomon to pay. Mr. Salomon then appealed to the high court, the House of Lords, who rejected all the judgments made by Judge Vaughan Williams in the court of appeals; they said that there was no fraud in the manner in which Mr. Salomon formed the company. So Mr.. Salomon didn’t have to pay to the company’s creditors since Mr. Salomon and the company ware deemed as two separate entities. In this case it was established that, actions made by the company are that of the company and not of the shareholders themselves.
This principle may be referred to as the ‘Veil of incorporation’. The courts in general consider themselves bound by this principle. The effect of this Principle is that there is a fictional veil between the company and its members. But, in a number of circumstances, the Court will pierce the corporate veil or will ignore the corporate veil to reach the person behind the veil or to reveal the true form and character of the concerned company. The rationale behind this is probably that the law will not allow the corporate form to be misused or abused. In those circumstances in which the Court feels that the corporate form is being misused it will rip through the corporate veil and expose its true character and nature disregarding the Salomon principal as laid down by the House of Lords.
In this article; i am going to look at the exceptions to the general rule i.e what we are calling; lifting the corporate veil.
Lifting the corporate veil refers to the possibility of looking behind the company framework (or behind the company’s separate personality) to make the member liable, as an exception to the rule that they are normally shielded by the corporate shell; that is they are not liable to outsiders at all, and are only normally liable to pay the company what they agreed to pay by way of share purchase price or guarantee.[1]
THE PROCESS OF LIFTING THE CORPORATE VEIL.
In as much as the principle of separate corporate personality is unshakable, exceptionally in some instances the law is prepared to disregard or look behind the corporate personality and have regard to the realities of the situation.
In Dumbly and Sons Limited vs National Union of Journalists (1984) 1 wlr 427 at 435 , HL, Lord Diplock , whilst not wholly excluding the possibility that a contrary construction maybe sometimes be justified said;
“ the corporate veil in the case of companies incorporated under the company’s act is drawn by statute and it can be pierced by some other statute if such other statute provides ; but in view of its raison d’tre and its constant recognition by the courts since salmon vs salmon and co.ltd , one would expect that any parliamentary intention to pierce the corporate veil would be expressed in clear and unequivocal language.
In Conway vs Ratiu (2006) 1 all er 571, Allud LJ speaks of the readiness of courts, regardless of the precise issue involved, to draw back the corporate veil to do justice when common sense and reality demand it. His lordship went on; “there is a powerful argument of principle for lifting the corporate veil where the facts require it.”
On the other hand, in matters of property and contract, the courts should surely be most hesitant to lift the veil in response to superficial considerations of common sense or reality or fairness. Those who adopt the corporate form should surely be expected to take the rough with the smooth.[2]
- STATUTURY LIFTING OF THE CORPORATE VEIL.
The Companys Act Kenya 2015 seems to ignore the possibility of lifting the corporate veil to make members of a company liable for the company’s wrongs. Instead, attention is given to making directors and other officers liable for corporate wrongs in specified circumstances.
However, Article 1002 provides that each person who knowingly participates in carrying on business in fraudulent manner commits an offence. this could, in some circumstances, make shareholder liable if it is established that they had an intention to defraud creditors as will be seen later in this article.
The Insolvency Act Kenya 2015 contains a number of sections providing for directors ( and others) to be held personally liable for the debts of a limited company , or to make a contribution to its assets in a liquidation; eg where there has been fraudulent or wrongful trading or the improper re-use of an insolvent company’s name.
- CIRCUMSTANCES UNDER WHICH THE CORPORATE VEIL MAY BE LIFTED.
(i) IN ORDER TO DETERMINE WHETHER A COMPANY IS TO BE CHARACTERISED AS AN “ENEMY” IN TIMES OF WAR. (PUBLIC INTEREST/POLICY)
Companies do not have a nationality. But the people responsible for the workings of the company have a nationality. During times of war, transactions among multi-national companies are suspended in order to ascertain whether the persons behind the veil are a friend or an enemy.
Daimler Co. Ltd vs. Continental Tyre and rubber Co.(Great Britain) Ltd.
In this case, a company was incorporated in England for the purpose of selling their tyres manufactured in Germany by a Germany company. Its majority shareholders and all the directors were Germans. On declaration of war between England and Germany in 1914, the persons in control of its affairs became alien enemies and accordingly the company was declared to be an enemy company. During the war period the company filed a suit to recover a trade debt, which was dismissed by the court and observed that such payment would be a trading with an enemy company and to allow alien enemies to trade under the corporate facade will be against public policy.
(ii) WHERE AN AGENCY OR TRUST RELATIONSHIP BETWEEN A COMPANY AND ITS SHAREHOLDERS OR CONTROLLERS IS FOUND TO EXIST.
In Re: FG (films) Ltd ; an American company provided all the funds for producing a film, which it sought to register as British film because the film had been produced by arrangement with a British company in which the American company owned 90 of the 100 pound capital.
Held; the British company was no more than an agent of the American company which was the true maker of the film.
The other argument which found support in lower courts in Salamons case, based on trust rather that an agency, will similarly fall to the ground unless a trust can be affirmatively proved. The evidence of such a trust in the case next cited was , to say the least , tenuous; but the court was plainly moved to find that it existed by the close analogy with an unincorporated members club.
In Trebaniog Working Mens Club and Institrute Ltd Vs Macdonald (1940) I kb (kings bench divisional court), where the club was incorporated under the industrial and provident societies act (1893-1913) and bought liquor in its own name, paid for it by a cheque drawn on its own bank account, and served it to members in exchange for a money payment, the society was charged with selling liquor by retail without a license, and was convicted. It appealed successfully to the divisional court. The court stated that ; “what is essential is that the holding of the property by the agent or trustee must be a holding for and on behalf of, and not a holding antagonistic to, the members of the club. “
(iii) THE CORPORATE VEIL MAY BE DISREGARDED IF THE COMPANY IS USED AS A MEANS GO PERPETRATE A FRAUD.
The previous Companies Act provided that if in the course of the winding up of the company it appears that any business has been carried on with the intent to defraud the creditors, or for any fraudulent purpose, the courts on the application of the official receiver, the liquidator or member may declare that any persons who are knowingly parties to the fraud shall be personally responsible without any limitation on liability for all or any of the debts or other liabilities of the company to the extent that the court might direct the liability. The Companies Act Kenya 2015 provides at section 1002 that if a business of a company is carried on with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose, each person who knowingly participates in carrying on the business in that manner commits an offence.
This Section does not define the term fraud nor have the courts defined it. However, in Re William C. Leitch Ltd, the company was incorporated to acquire William’s business as a furniture manufacturer. The directors of the company were William and his wife and they appointed William as the Managing Director at a Salary of £1000 per annum. Within the period of one month, the company was debited with an amount which was £500 more than what was actually due to William. By that time the company had made a loss of £2500. Within 2 years of formation, and while the company was still in financial problems, the directors paid to themselves the dividends of £250. By the end of the 3rd year since incorporation the company was in such serious difficulties such that it could not pay debts as they fell due. In spite of this William ordered goods worth £6000 which became subject to a charge contained in a debenture held by them. At the same time he continued to repay himself a loan of £600 (six hundred pounds) which he had lent to the company at the beginning of the 4th year the company with the knowledge of William owed £6500 for goods supplied. In the winding up of the company the official receiver applied for a declaration that in no circumstances William had carried on the company’s business with intent to defraud and therefore should be held responsible for the repayment of the company’s debts. It was held that since that company continued to carry on business at a time when William knew that the company could not comfortably pay its debts, then this was fraudulent trading within the meaning of Section 323 and William should be responsible for repaying the debts- Justice Maugham J.
In the Case of Re Patrick Lyon Ltd (1933) which had similar facts to the Williams case, the same Judge Maugham J. said as follows: “the words fraud and fraudulent purpose where they appear in the Section in question are words which connote actual dishonesty involving according to the current notions of fair trading among commercial men real moral blame. No judge has ever been willing to define fraud and I am attempting no definition.”
(iv) THE VEIL OF INCORPORATION MAY BE LIFTED TO PREVENT THE DELIBERATE EVASION OF A CONTRACTUAL OBLIGATION.
A company will not hide under the corporate shield where it wants to deliberately evade a contractual obligation.
In Gilford Motor Company Ltd v. Horne, Mr. Horne was an ex-employee of The Gilford motor company and his employment contract provided that he could not solicit the customers of the company. In order to defeat this, he incorporated a limited company in his wife’s name and solicited the customers of the company. The company brought an action against him. The Court of appeal was of the view that “the company was formed as a device, a stratagem, in order to mask the effective carrying on of business of Mr. Horne” in this case it was clear that the main purpose of incorporating the new company was to perpetrate fraud. Thus the Court of appeal regarded it as a mere sham to cloak his wrongdoings.
In Jones v. Lipman, a man contracted to sell his land and thereafter changed his mind in order to avoid an order of specific performance he transferred his property to a company. Russel judge specifically referred to the judgments in Gilford v. Horne and held that the company here was “a mask which (Mr. Lipman) holds before his face in an attempt to avoid recognition by the eye of equity” .Therefore he awarded specific performance both against Mr.Lipman and the company.
(v) THE VEIL OF INCORPORATION MAY SOMETIMES BE LIFTED TO ALLOW A GROUP OF ASSOCIATED COMPANIES TO BE TREATED AS ONE.
Sometimes in the case of group of enterprises the Salomon principal may not be adhered to and the Court may lift the veil in order to look at the economic realities of the group itself.
In the eyes of law, the holding company and its subsidiaries are separate legal entities. A holding company under section3 (1) of the Company’s Act 2015 is defined (of another company) means a company of which the other company is a subsidiary company of the company;
But in the following two cases the subsidiary may lose its separate entity-
Where at the end of its financial year, the company has subsidiaries, it must lay before its members in general meeting not only its own accounts, but also attach therewith annual accounts of each of its subsidiaries along with copy of the board’s and auditor’s report and a statement of the holding company’s interest in the subsidiary.
The Court may, on the facts of a case, treat a subsidiary as merely a branch or department of one large undertaking owned by the holding company
In the case of D.H.N.food products Ltd. V. Tower Hamlets, it has been said that the Courts may disregard Salomon’s case whenever it is just and equitable to do so. In the above-mentioned case the Court of appeal thought that the present case was one which was suitable for lifting the corporate veil. Here the three subsidiary companies were treated as a part of the same economic entity or group and were entitled to compensation.
Lord Denning has remarked that ‘we know that in many respects a group of companies are treated together for the purpose of accounts, balance sheet, and profit and loss accounts. Gower too in his book says, “There is evidence of a general tendency to ignore the separate legal group”. However, whether the Court will pierce the corporate veil depends on the facts of the case. The nature of shareholding and control would be indicators whether the Court would pierce the corporate veil. The Indian Courts have held that a ‘single economic unit’ argument could work in certain circumstances. These circumstances would depend on the factual control exercised. This view is strengthened by the Supreme Court decision (cited in Novartis v. Adarsh Pharma) In New Horizons v. Union of India.
In Renusagar case, the Court proceeded, on the basis of prior English law which had accepted the ‘single economic unit’ argument. Thus, Renusagar case seems to support the conclusion that a ‘single economic entity’ argument would succeed in India for lifting the corporate veil.
Holsworth & Co. v. Caddies [1955] ,The Defendant Company had employed Mr. Caddies as their Managing Director for 5 years. At the time of that contract the company had two subsidiaries and Caddies was appointed Managing Director of one of those subsidiaries. He fell out of favour with the other Directors consequent upon which the board of directors stated that Caddies should confine his attention to the affairs of the subsidiary company only. He treated this as a breach of contract and sued the company for damages. It was held that since all the companies form but one group, there was no breach of contract in directing Caddies to confine his attention to the activities of the subsidiary company.
(vi) IN DETERMINING RESIDENCE OF A COMPANY FOR TAX PURPOSES
The test is normally the place of its central management of control usually the place where the board of directors operate. But it can also be the place of business of the Managing Director where he holds a controlling interest.
In Unit Construction Co. Ltd v Bullock – 3 wholly owned subsidiaries of a company in U.K were registered in Kenya. The board of the 3 subsidiaries was distinct from the board of the parent company. In addition, under the Articles, Directors’ meetings could not be held in the U.K. the management of the subsidiaries was in fact in the hands of the parent company in England.
Held; for taxation purposes, the issue was not where the companies’ central management and control ought to have been, but where in fact they were.
(vii) WHERE THERE IS REDUCTION OF NUMBER OF MEMBERS
As provided under the Companies Act Kenya (2015), If at any time the number of members of a company is reduced below two in case of private company or below seven in case of public company and it carries on business for more than six months while the number is so reduced, every member who knows of this fact will become liable to unlimited extent for the payment of the whole debts of the company contracted during that time. It should be noted that the section limits the members liability to debts contracted after six months. It does not make the member liable for any debts incurred during the six months which follow the reduction in membership.
(viii) MISDESCRIPTION OF THE COMPANY
Section 67 of the Companies Act, 2015, a company is mandated to disclose its name, it requires that a company’s name should appear whenever it does business on its Seal and on all business documents, if an officer of a company or any person who on its behalf signs or authorizes to be signed on behalf of the company any Bill of Exchange, Promissory Note, Cheque or Order for Goods wherein the Company’s name is not mentioned as required by the Section, such officer shall be liable to a fine and shall also be personally made liable to the holder of a Bill of Exchange Promissory Notes, Cheque or order for the goods for the amount thereof unless it is paid by the company. The effect of this section is that it makes a company’s officer incur personal liability even though they might be contracting as the company’s agents. Liability under this Section normally arises in connection with cheques and company officers have been held liable where for instance the word limited has been omitted or where the company has been described by a wrong name
(ix) CONCLUSION
The doctrine of piercing the corporate veil is not subject to any specific guidelines. Courts have struggled for years to develop and refine their analysis of this doctrine and each new action brings a different set of facts and circumstances into the equation and a separate determination has to be made as to whether the plaintiff has provided sufficient evidence of dominion or control, improper purpose or use and the ensuing damage. At such times, the opinion of qualified experts are adhered to. Particularly, expert testimony is helpful to the judge in determining whether the corporation has been adequately capitalized for its intended purpose.
Eventually, however, the judgment whether to disregard the corporate entity will be based upon a balance of numerous factors all or some of which are necessary but may not be sufficient to lift the veil. The bottom line being the court will lift the veil only when facing grave violation of the corporate form and not otherwise. Also the connection between the judicial pronouncements of two separate cases regarding lifting of veil of a corporate entity cannot be ascertained as every court’s view on lifting of corporate veil depends on the facts of each case.
REFERENCES
Books
Len Sealy and Sarah Worthington Cases and Materials in company law 8th Edition
TL Hazen and JW Markham,Corporations and Other Business Enterprises (2003) ISBN 0-314-26476-0 124-144.
Articles
AW Machen, ‘Corporate Personality’ (1910) 24Harvard Law Review 253
J Dewey, ‘The Historic Background of Corporate Legal Personality’ (1926) 35Yale 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
