Piercing_the_corporate_veil

Piercing the corporate veil

The corporate law concept of piercing (lifting) the corporate veil describes a legal decision where a shareholder or director of a corporation is held liable for the debts or liabilities of the corporation despite the general principle that shareholders are immune from suits in contract or tort that otherwise would hold only the corporation liable. This doctrine is also known as "disregarding the corporate entity". The phrase relies on a metaphor of a "veil" that represents the veneer of formalities and dignities that protect a corporation, which can be disregarded at will when the situation warrants looking beyond the "legal fiction" of a corporate person to the reality of other persons or entities who would otherwise be protected by the corporate fiction.

Piercing the corporate veil is not the only means by which a director or officer of a corporation can be held liable for the actions of the corporation. Liability can be established through conventional theories of contract, agency, or tort law. For example, in situations where a director or officer acting on behalf of a corporation personally commits a tort, he and the corporation are jointly liable and it is unnecessary to discuss the issue of piercing the corporate veil.

The doctrine is often used in cases where liability is found, but the corporation is insolvent.

Basis for limited liability

Corporations exist in part to shield the personal assets of both shareholders and directors 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 directors. The limits of this protection have narrowed in recent years. Directors are increasingly personally liable.

Piercing the corporate veil typically is most effective with smaller privately held business entities in which the corporation has no assets, and a plaintiff seeks to hold liable a related person with more assets.

It is rarely to the plaintiff's advantage to pierce the corporate veil with a large publicly traded corporation as the assets available by suing the corporation are usually much larger than those that might be recovered by suing the individual shareholders, and because large corporations have legal staffs to avoid the technical issues which may cause the corporate veil to be pierced.

Basis for piercing the veil

In the United States, corporate veil piercing is the most litigated issue in corporate law . 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;
  • Other factors the court finds relevant;
  • 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.

Use by the United States 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.

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 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"; 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 [1976], but this has largely been repudiated. In Woolfson v Strathclyde BC [1976], 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 [1987] (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 [1990], 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 [1992] 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 [1998], and these doubts were shared by Moritt V-C in Trustor v. Smallbone (No. 2) [2001]: the corporate veil cannot be lifted merely because justice requires it.

The "Fraud" Exception (English Law)

The cases of Jones v. Lipman [1962], 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 [1933], 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 [2000], 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.

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. The often cited case Macaura v Northern Assurance Co Ltd [1925] 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.

Graham, Stanford A. and Jensen, Rees U. "The Myth of Corporate Veil Protection: Are Your Assets At Risk?" Ed. Rees Jensen. 2005. Compliance Management & Insight, Inc. 23 April 2007.

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