Lifting the Coporate Veil

LIFTING THE CORPORATE VEIL (i) Introduction (ii) Principles of Corporate Personality (iii)Statutory Exceptions (iv)Common Law and the Mere Facade Test (v) Agency and Groups (vi)Conclusions INTRODUCTION 1. When a creditor discovers that a debtor company is insolvent, the creditor will frequently want to recover the debt from a shareholder, director or associate of the insolvent company. There exist various statutory and common law mechanisms by which the corporate veil can be lifted and liability imposed on individuals or other companies.This lecture sets outs and discusses those mechanisms in the light of recent authorities and of the Companies Act 2006. PRINCIPLES OF CORPORATE PERSONALITY 2. One of the fundamental principles of company law is that a company has personality that is distinct from that of its shareholders. This rule was laid down by the House of Lords in Salomon v. Salomon & Co1, in which it was held that even if one individual held almost all the shares and debentures in a company, and if the remaining shares were held on trust for him, the company is not to be regarded as a mere shadow of that individual.Lord MacNaughten stated2: â€Å"The company is at law a different person altogether from the subscribers to the Memorandum and, although it may be that after incorporation the business is precisely the same as it was before, and the same persons are managers, and the 1 [1897] A. C. 22 2 Ibid, at p. 51 2 same hands receive the profits, the company is not in law the agent of the subscribers or the trustee for them. Nor are subscribers as members liable, in any shape or form, except to the extent and in the manner provided by theAct3. † The rule in Salomon lies at the heart of corporate personality, and is the principal difference between companies and partnerships. However, there are situations in which the courts look beyond that personality to the members or directors of the company: in doing so they are said to lift or pierce the corpor ate veil. There is no single basis on which the veil may be lifted, rather the cases fall into several loose categories, which are examined below. STATUTORY EXCEPTIONS 3.There are certain statutory exceptions to the rule in Salomon which involve a director being made liable for debts of the company because of breach of the companies or insolvency legislation. Eg: (a) Failure to obtain a trading certificate 4. Where a public company fails to obtain a trading certificate in addition to its certificate of incorporation before trading, the directors will be liable to the other parties in any transactions entered into by the company to indemnify them against any loss or damage suffered as a result of the company’s failure to comply with its obligations.This provision Companies Act 1985, s. 117(8) has been retained in the 2006 Act. See CA2006 s767(3). (b) Failure to use Company’s name 5. Section 349(4) of the CA 1985 provided that if an officer of a company or a person actin g on its behalf signs a bill of exchange, cheque or similar instrument on behalf of the company, in which the company’s name is not mentioned4, that person will be personally liable to the holder of the instrument in question for the amount of it (unless it is duly 3 i. e. Companies Act 1862 4 Thus contravening s. 349 (1)(c) of CA 1985 3 aid by the company). However, although CA2006 s. 84 imposes criminal penalties for failure to use the company name on relevant documents, there is currently no equivalent provision in the 2006 Act imposing such a personal liability. (c) Disqualified Directors 6. Under s. 15 of the Company Directors Disqualification Act 1986, if a person who has been disqualified from being a director of, or involved in the management of a company acts in contravention of his disqualification he will be liable for all those debts of the company which were incurred when he was so acting.The same applies to a person who knowingly acts on the instructions of a di squalified person or an undischarged bankrupt. (d) Just and Equitable Winding Up 7. Under s. 122(1)(g) of the Insolvency Act 1986 a petition may be presented to wind up a company on the grounds that it would be just and equitable to do so. This may involve lifting the veil of incorporation, for example to examine the basis on which the company was formed5. (e) Fraudulent Trading 8.Section 213 of the Insolvency Act 1986 deals with fraudulent trading. Under that section, if it appears to the court that â€Å"any business of the company has been carried on with intent to defraud creditors of the company or of any other person, or for any fraudulent purpose†, it may order that â€Å"any persons who were knowingly parties to the carrying on of the business in the manner above-mentioned are to be liable to make contributions (if any) to the company’s assets as the court thinks proper†. (f) Wrongful Trading 9.Section 214 of the Insolvency Act 1986 concerns wrongful tra ding, and enables the court to make a declaration, when a company has become gone into insolvent liquidation, that a former director is liable to make a contribution to the company’s assets. Such a declaration can be made where the director in question knew or ought to have concluded, 5 E. g. Ebrahimi v. Westbourne Galleries [1973] AC 360. 4 at some point before the commencement of the company’s liquidation, that there was no reasonable prospect that the company would avoid going into insolvent litigation. By s. 214(7), the provisions of s. 214 also apply to hadow directors. (g) Phoenix Companies 10. The Insolvency Act 1986 also allows the court to lift the corporate veil in cases of socalled â€Å"Phoenix Companies†, in which a new company is created with the same or a similar name to an insolvent company. S. 216 of the Act makes it an offence for anyone who was a director of the insolvent company during the 12 months before liquidation to be associated with a company with the same name as the insolvent company or a name so similar as to suggest an association6. S. 217 provides that where a person is involved in the management of a company in contravention of s. 16, or where he acts, or is willing to act, on instructions given by a person whom he knows to be in contravention of that section, he is himself jointly and severally liable with the company for all the relevant debts of that company. (h) Unfair Prejudice 11. The Courts’ powers under s. 459 of the 1985 Act (the provisions of which are duplicated in s. 994 of the 2006 Act) apply where â€Å"the company’s affairs are being or have been conducted in a manner which is unfairly prejudicial to the interests of its members generally or of some part of its members (including at least himself). The general proposition that the conduct of a parent company in control of a subsidiary can be relevant where a s. 459 petition is presented by shareholders of a subsidiary is unsurp rising7. It has also been held by the Court of Appeal8 that directors’ unfairly prejudicial conduct of a subsidiary may be actionable by shareholders of the parent under s. 459 if the parent and subsidiary have directors in common. (i) Third Party Costs Orders 6 Unless that person is given leave by the court so to act: s. 216 (3) 7 see Nicholas v Soundcraft [1993] BCLC 360 Citybranch Ltd v Rackind [2004] EWCA Civ 815 5 12. The court has jurisdiction to make a costs order against a party to the proceedings in favour of a non-party (including the directors or shareholders of a litigant company) by virtue of s. 51 Supreme Court Act 1981 and CPR 48. 2. This has recently been applied by the Court of Appeal in the case of Alan Phillips Associates Ltd v Terence Edward Dowling9. A contract was accepted by a company on headed paper almost identical to that of a business run by Mr Phillips prior to incorporation.Mr Phillips wrongly issued proceedings in his own name and the company was then substituted as Claimant. The company’s claim was dismissed and a third party costs order was made against Mr Phillips. 13. More typical circumstances for a third party costs order arose in Goodwood Recoveries Ltd v Breen10 which held that where a non-party director could be described as the â€Å"real party† seeking his own benefit and controlling and/or funding the litigation, then even where he had acted in good faith or without any impropriety justice might demand that he be liable in costs. 4. Similarly in CIBC Mellon Trust Co v Stolzenberg11 when the court held that there was no reason in principle why, if a shareholder (not being a director or other person duly authorised, appointed and legally obliged to act in the best interests of the company) funded, controlled and directed litigation by the company in order to promote or protect his own financial interest, the court should not make a costs order against him. COMMON LAW AND THE MERE FACADE TEST Engine o f Fraud 15.It has long been established that the Courts will not allow the Salomon principle to be used as an engine of fraud, or to avoid pre existing legal obligations. Probably the bestknown example of this rule is Gilford Motor Company Ltd v. Horne12, in which the Defendant had been managing director of a the Claimant company, and had entered into a 9 [2007] EWCA Civ 64 10 [2005] EWCA Civ 414 11 [2005] EWCA Civ 628 12 [1933] Ch. 935 6 covenant not to solicit customers from his employers when he ceased to be employed by them.On leaving the company’s employment, Horne formed a company to carry on a competing business, the shares in which were held by his wife and a friend, and he thereby solicited the Claimant’s customers. The Court of Appeal held that this company was a mere facade or sham to cloak his breach, and granted an injunction to enforce the covenant against both Horne and the company. 16. Similarly, in Jones v. Lipman13 the Defendant had entered into a con tract to sell property, but then sought to avoid the sale by transferring the property to a company which he controlled.Russell J held that specific performance could be ordered against the company, which he described as â€Å"the creature of the First Defendant, a device and a sham, a mask which he holds before his face in an attempt to avoid recognition by the eye of equity†14. 17. A recent example of the application of the principle is Kensington International Ltd v Congo15. The Claimant had obtained various judgments against the Republic of Congo which it sought to enforce by way of third party debt order against money payable to a company called â€Å"Sphynx† who had sold a cargo of oil.Sphynx had bought the oil from Africa Oil. Africa Oil had bought the oil from the Congolese state owned oil company (â€Å"SNPC†). Sphynx and Africa Oil were both controlled by the president and director general of SNPC. The court held that the various transactions and compa ny structures were a sham or facade and had no legal substance, and were set up with a view to defeating existing claims of creditors against the Congo. SNPC and Sphynx were simply part of the Congolese state and had no existence separate from the state.It was not necessary for there to be a divestment of assets at an undervalue to justify the court piercing the corporate veil in relation to the particular transactions. 13 [1962] 1 WLR 832 14 ibid, p. 836 15 [2005] EWHC 2684 (Comm) 7 18. It should be noted that the mere fact that there is fraudulent activity does not necessarily justify the piercing of the corporate veil. In Dadourian Group v Simms16 individuals who had fraudulently misrepresented that one of them was a mere intermediary when in fact he was a co-owner and ontroller of a contracting company was liable for deceit but the veil was not lifted so the individuals were not found liable for the company’s breach of contract to buy equipment. In this case there was no conspiracy to injure the Claimant and there had been a genuine intention that the company would buy the equipment. The now defunct â€Å"Interests of Justice Test† 19. In Creasey v. Breachwood Motors Ltd17 the facts were slightly different from those of Gilford v. Horne and Jones v. Lipman.Creasey had been the manager of a garage owned by Breachwood Welwyn Ltd (â€Å"Welwyn†), but was dismissed from his post and intended to sue for wrongful dismissal. In anticipation of his claim, and wanting to avoid having to pay him damages, the proprietors of Welwyn formed another company, named Breachwood Motors Ltd (â€Å"Motors†), and transferred the entire business of the old company to it. Creasey obtained judgment in default against Welwyn, which was then struck off of the register of companies. Creasey obtained an order substituting Motors as defendants, against which Motors appealed. Richard Southwell Q.C. , sitting as a judge of the Queen’s Bench Division, he ld that Motors could be substituted as defendants, and that the veil could be lifted because Welwyn’s assets had been deliberately transferred to Motors in full knowledge of Creasey’s claim18. Richard Southwell Q. C. specifically decided that it was right to allow the veil to be lifted as regards Motors, rather than force Creasey to apply to have Welwyn restored to the register and apply for an order that its assets be restored to it under s. 423 of the Insolvency Act 1986 (an alternative which the judge described as a â€Å"procedural minefield†). 0. In Ord & Anor v. Belhaven Pubs Ltd19 the Court of Appeal has however decided that the decision in Creasey was wrong. In Ord the defendant company had made various 16 [2006] EWHC 2973 (Ch) 17 [1992] BCC 638 18 Ibid, p. 648 B 19 [1998] BCC 607 8 misrepresentations to the claimant. By the time these came to light, the company had all but ceased trading, and had negligible assets. The claimant sought to substitute the defendant company’s holding company, and the judge at first instance followed Creasey and allowed the substitution.The Court of Appeal decided that this was incorrect, as the original company had not been a mere facade for the holding company, nor vice versa. Unlike the new company in Creasey, neither company had not been created as a sham to avoid some liability, there had been no element of asset stripping and so the veil should not be lifted. Hobhouse LJ, giving the judgment of the court, stated: â€Å"There may have been elements in that case [i. e. Creasey] of asset stripping. I do not so read the report of [Richard Southwell QC’s] judgment†¦ But it seems to me to be inescapable that the case in Creasey v.Breachwood as it appears to the court cannot be sustained. It represents a wrong adoption of the principle of piercing the corporate veil and an issue of the power granted by the rules to substitute one party for the other following death or succession. The refore in my judgment the case of Creasey v. Breachwood should no longer be treated as authoritative. †20 The Current State of the Law 21. The courts are now increasingly reluctant to lift the veil in the absence of a sham. In particular, it is clear that the veil will not be lifted simply because it would be in the interests of justice.In Adams v. Cape Industries plc21 the Court of Appeal was unequivocal on this point. Slade LJ said22: â€Å"Save in cases which turn on the wording of particular statutes or contracts, the court is not free to disregard the principle of Salomon v. Salomon & Co Ltd [1897] AC 22 merely because it considers that justice so requires. Our law, for better or worse, recognises the creation of subsidiary companies, which though in one sense the creatures of their parent companies, will nevertheless under the 20 Ibid, p. 616 B 1 [1990] Ch 433 9 general law fall to be treated as separate entities with all the rights and liabilities which would normally attach to separate legal entities. † 22. That the courts are now less willing to lift the corporate veil than was once the case is also indicated by the judgment of the House of Lords in Williams v. Natural Life Health Foods Ltd23. The defendant company was effectively run by one man, a Mr Mistlin, and had given negligent advice to the claimant regarding the profitability of a franchise.On the company being wound up the claimant joined Mr Mistlin as a defendant on the basis that he had assumed personal responsibility. The House of Lords unanimously rejected the Court of Appeal’s finding that Mr Mistlin had assumed responsibility to the Claimant, holding that in order for a director to be personally liable for negligent advice given by the company, it had to be shown both that the director had assumed personal responsibility for that advice and that the claimant had reasonably relied on that assumption of responsibility.As there had been no personal dealings between Mr M istlin and the claimant, these tests were not met, and the corporate veil should remain intact24. 23. A court will also be justified in disregarding a company’s personality so as to prevent the corporate form being used as a medium through which to lawfully carry out an activity which would otherwise be a wrongdoing. In Trustor AB v.Smallbone25 the defendant Smallbone had effected the payment of considerable sums of money from Trustor AB, a company of which he was managing director, to a company called Introcom, which he controlled. Sir Andrew Morritt V-C found that Introcom was simply a vehicle for receiving the money, and that the payments were made in breach of Smallbone’s duty to Trustor. Summary judgment was ordered against Smallbone and Introcom. 24. What then is the law following the decisions in Ord and Williams?Neither case, of course, involved findings that the relevant company had been a facade. Ord should not be 22 Ibid p. 536. 23 [1998] 2 All ER 577 24 The Court of Appeal has held that the principles identified by the House of Lords in Williams are equally applicable to torts other than negligence, although this decision has been criticised: see Standard Chartered Bank v. Pakistan National Shipping Corp. (No 2) [2000] 1 Lloyd’s Rep 218 25 [2001] 1 WLR 1177 10 thought to prevent the veil being lifted in cases where there is a sham or facade.Subsequent authorities, as well as the House of Lords decisions prior to Ord26, show that the law is still that the courts will be willing to lift the veil in cases where there is a sham and that principle is still at the heart of the test to be applied. AGENCY AND GROUPS 25. Although Salomon made it clear that a company is not automatically the agent of its shareholders, in exceptional cases such a relationship can exist, and it will be a question of fact whether there is a relationship of agency in any particular case, so that it is appropriate to pierce the veil.Questions of agency most o ften arise in the context of associated or group companies, and so the two areas are here considered together. Statute 26. Companies Act 1985 ss. 227-231 (and CA 2006 s. 399 et seq) provide that groups of companies must prepare group accounts, which must comprise consolidated balance sheets and profit and loss accounts for the parent company and its subsidiary undertakings.The aim of the accounts is to give a true and fair picture of the state of the undertakings included in the consolidation as a whole, which are treated for the purposes of the accounts as an economic unit. The process naturally requires that the corporate veil be lifted in order to identify which companies form the group. The courts are also sometimes willing to treat a group of companies as a unit for other purposes, and have tended to justify the decision to pierce the veil by analogy with the legislation, or by finding that one group company was the agent of another.Case Law 27. The development of the courtsâ⠂¬â„¢ attitude to agency in a company context has tended not to produce clear rules, perhaps until recently, and so the historical case law is summarised below. The principles leading to a finding of agency were considered by Atkinson J in 26 E. g. Woolfson v. Strathclyde Regional Council [1978] SLT 159, in which Lord Keith of Kinkel stated that it was appropriate to lift the veil â€Å"only where the special circumstances exist indicating that [the company] is a mere facade concealing the true facts†. 1 Smith, Stone & Knight Ltd v. Birmingham Corporation27, in the context of whether a subsidiary company was the agent of its holding company. That was a case where agency was established and the veil lifted – the parent company had full and exclusive access to the subsidiary’s books, the subsidiary had no employees other than a manager, it occupied the parent’s premises for no consideration and the only evidence of its purportedly independent existence was its name on the stationery.Atkinson J said that the question of whether a company was carrying on its own business or its parent’s was a question of fact, and identified six questions which he considered determinative: (i) Were the profits of the subsidiary those of the parent company? (ii) Were the persons conducting the business of the subsidiary appointed by the parent company? (iii) Was the parent company the â€Å"head and brains† of the venture? (iv) Did the parent company govern the venture? v) Were the profits made by the subsidiary company made by the skill and direction of the parent company? (vi) Was the parent company in effective and constant control of the subsidiary? These questions, while still relevant, can no longer be viewed as a complete statement of the law. As will be discussed below, the trend of the authorities has been away from findings of agency unless particular circumstances dictate that such a finding should be made. 28. It is relevant to consider the purpose for which the relevant company structure was created. In Re F. G. Films) Ltd28 an American holding company set up a British subsidiary to produce a film, in order that it might be classified as a British film. The Board of Trade refused to register it as such, and the matter came to court. It was held that the British company’s participation in the making of the film was so small as to be practically negligible, and that it had been brought into existence for the sole purpose of being put forward as having made the film, and for thus enabling it to qualify as a British film, and that therefore there was a relationship of agency. 2 29. In Littlewoods Mail Order Stores Ltd v. McGregor29 Lord Denning warned that the Salomon doctrine had to be carefully watched, and said that Parliament had shown the way as regards the scrutiny of groups of companies, and that the courts should follow suit. 30. An influential case in this area was DHN Food Distributors Ltd v. Tower Hamlets London Borough Council30, which concerned compulsory purchase: one company in the group owned the freehold of premises, from which another group company traded and which it occupied as bare licensee.The Court of Appeal stressed the significance of the existence of a â€Å"single economic unit† and recognised the group as a single entity, allowing it to recover compensation, but the exact reasons behind the decision are unclear, as the members of the court were each apparently influenced by different factors. Lord Denning MR noted that the subsidiaries were wholly owned, Shaw LJ pointed out that the companies had common directors, shareholdings and interests, and Goff LJ referred to ownership and the fact that the companies had no business operations outside the group.Goff LJ also stated that not all groups would be treated in this way, and there have been cases since DHN Food Distributors in which wholly owned subsidiaries have not been identified as a unit wit h their holding companies31. 31. To further confuse the position, DHN Food Distributors was not followed by the House of Lords in the Scottish appeal of Woolfson v. Strathclyde Regional Council32, and also runs counter to many decisions of courts in Australia and New Zealand. In Industrial Equity Ltd v.Blackburn33 the High Court of Australia said that the group accounts legislation did not operate to deny the separate legal personality of the company. In Re Securitibank Ltd (No. 2)34 the New Zealand Court of Appeal considered the decision in Littlewoods Mail Order Stores and thought that the approach in that case was the wrong way around– the court considered that the Salomon principal should be the starting point 13 for any examination of a group of companies, and any departure from it should be considered carefully.In the New South Wales case of Pioneer Concrete Services v. Yelnah Pty Ltd35 Young J considered the authorities and held that the veil should only be lifted wher e there was in law or in fact a partnership between the companies, or where there was a sham or facade36. 32. The English position was again considered by the Court of Appeal in Adams v. Cape Industries plc37, in which the Claimants with default judgments obtained in Texas against a company sought to enforce those judgments against an its ultimate holding company in the United Kingdom.The Court of Appeal held that although a parent company exercised supervision and control over its subsidiary in a foreign country, the parent company was not present in that country, and did not submit to that jurisdiction, by a subsidiary which did business in its own right. In the passage quoted above, Slade LJ stated that the Salomon principle will not be disregarded simply because justice so requires, and that subsidiary companies should be considered as individuals unless special circumstances dictated otherwise.Members of a corporate group were perfectly entitled to use the corporate structure e ven if the consequence was that only lowly capitalised subsidiaries were exposed to potentially harmful asbestos claims. 33. It is suggested, therefore, that the present position is that the courts are likely to be unwilling to lift the veil as against groups of companies in the absence of some agreement of agency, and that Littlewoods Mail Order Stores and DHN Food Distributors cannot any longer be considered authoritative. CONCLUSIONS â€Å"Genuine Ultimate Purpose†- An alternative test? 4. Some shams or facades may be obvious, but many others will not. The courts are reluctant to provide precise guidelines so as to define what constitutes a sham preferring the flexibility of a case by case approach. Useful tests to be employed when trying to identify a sham are: * Are the relevant entities in common ownership? * Are the relevant entities in common control? * Was the company structure was put in place before or after a particular liability (or serious risk) arose, and if th e latter then to what extent was he liability or risk a motivating factor for those who set up the structure? * Was the company structure put in place in an attempt to allow an activity which would be unlawful if carried out personally? 35. It has been suggested by some commentators38 that a â€Å"genuine ultimate purpose† test should replace the traditional established sham or facade test. However, this novel approach may throw up as many problems as the traditional test.Further, it seems to strike at the heart of the concept of the limited liability company since a primary (and often sole) purpose of incorporation is to reduce personal exposure to trade creditors, a motive that has been held to be acceptable since the concept of the limited company first became part of the legislative framework. Parliament, when passing the Companies Act 2006, had ample opportunity to conduct a wholesale revision of this principle but deliberately left the topic well alone. There currently appears to be little judicial enthusiasm for such revision either. DOV OHRENSTEIN RADCLIFFE CHAMBERS LINCOLN’S INN