Reducing the Scope of Limited Liability and Corporate Flexibility - Essay Example

Corporate Group Structure Introduction: In recent years, with the emergence of technology, the global economy has been increasingly characterized by multinational corporations that function across the world with the help of subsidiary organizations. These organizations are provided with high levels of autonomy and flexibility in order that they can adapt themselves best to the local conditions and business practices of a particular geographical region. But there have also been a spate of corporate scandals such as Enron, Maxwell Insurance and others, which have shown how subsidiary organizations are sometimes used as a means to escape liability for the financial consequences of risky decisions. They have functioned as entities where parent companies are able to deflect their risks and liabilities. The existence of the limited liability principle further serves as a means whereby such parent companies may be able to legally escape the consequences of their risk taking and where there is additional scope provided for financial manipulation of accounts. The doctrine of limited liability allows a parent company's responsibility to be limited to its own liabilities and thereby increases the scope for risk taking and profit enhancing behavior, which are generally beneficial for the economy. In the wake of the corporate scandals, reforms have been introduced in most countries, with increased focus on corporate governance and accountability. There have also been further proposals to introduce a more comprehensive regime dealing with corporate liability, wherein parent corporations would also be held responsible for tortuous claims arising out of the actions of their subsidiaries. But such reforms have been opposed on the grounds that they would limit corporate flexibility and function as a deterrent to economic growth because they would hinder risk taking behavior. The analysis below examines the pros and cons of reducing the scope of limited liability and corporate flexibility. Limited Liability: The limited liability basis of Company law arises out of the decision in the case of Salomon v Salomon and Co1. The case of Solomon v Salomon & Co Ltd2 established the corporation as a distinct legal entity in common law, with an existence and personality separate from the people that comprise it. In this case, the Court held that a corporation has a separate and distinct legal personality apart from its owners and/or shareholders. Irrespective of the extent to which a shareholder has an interest in the Company, even if such an individual is the director in complete control of the Company's affairs, the acts and liabilities of the Company are held to be separate and not his/her acts or liabilities. The corporate body as an entity is impersonal and individuals may function in different capacities within an organization3, with their financial activities being shielded from the public eye, by virtue of the corporate veil. The corporation as a legal entity propagates itself and individuals associated with it are able to be exempted from liability for the debts of the Company. The limited liability aspect has been deemed beneficial for the improved efficiency of the securities markets.4 . Limited liability has been deemed to promote "innovation, investment and risk taking by the corporation."5 Limited liability is deemed to have a positive effect in terms of providing incentives for investment, diversification of portfolios and for the efficient operation of security markets. Corporate structure and limited liability: The significance of the Salomon case is that it established (a) a corporation as a separate legal entity and (b) the principle that the debts of a corporation are not the debts of its members, officers or directors. This decision establishing the independent legal personality of the corporation in relation to a single company that was rendered in the Salomon v Salomon6 case was extended to groups of companies by the decision rendered in the case of Adams v Cape Industries Plc7. Extension of this principle recognizes that a corporate group structure comprising several companies can be treated as a single unit8. The issue raised in the Adams v Cape Industries case was the question of corporate structure involving the transference of legal liability from one member of the corporate group to another. The Court of Appeal held in this instance that it was not entitled to lift the corporate veil against a defendant company that protected it from legal liability, merely because its corporate structure was such that legal liability for certain future activities of the Company would fall on a subsidiary rather than the parent corporation. The Court did not deem it fit to lift the corporate veil, merely on the basis that the parent company and its subsidiary companies were a single economic entity. In the case of U.S. v Kayser Roth Corp9 the Court stated that the parent company's status as a shareholder would not of itself, be adequate grounds to hold it responsible for a subsidiary's liabilities, unless the parent company also exercised a pervasive level of control over the subsidiary. The limited liability function set out in the case of Salomon sets out a basic corollary that when the corporate structure is such that apparent company is functioning through subsidiaries, then it may not be responsible for the subsidiary's liabilities. The risks that are posed by corporate group structure are that parent companies can be held liable for the debts of the subsidiary as well as its tortuous liabilities, hence the limited liability function allows some degree of protection to parent companies so that they are not held responsible for the activities and debts of a subsidiary that is functioning independently without much input from the parent concern. Hoffstetter offers the view that the limited liability of subsidiary corporations represents an efficient solution to the problem of internalizing political risks.10 He argues that it is best that such risks are borne by the political community at large, because it is in the bets position to ensure that such risks do not materialize in the future. U.K. tax authorities may impose liability on a parent company on the basis that it is carrying on its business in the U.K. through a subsidiary. Other instances where the corporate structure may not hold good and liability may be established on the parent company, apart from trying to evade tax are (a) when the corporate structure is being used for purposes of fraud (b) as a mere facade to conceal facts or escape a legal obligation or (c) where there has been dishonesty or abuse of the corporate form. In the case of Truster AB v Smallbone and Others11 an attempt was made to convince the Court that the range of circumstances that warranted the piercing of the corporate veil should be broadened. But the Court held that only if one of the basic principles set out above was applicable, the corporate veil could be pierced, not otherwise. Hoffstetter proposes three exceptions to limited liability with respect to corporate structure, which justify the piercing of the corporate veil: (a) when a parent abused a subsidiary (b) when the parent diluted or washed out the subsidiary's assets through its level of interference and (c) when a parental concerns causes direct and separable harm to the subsidiary's creditors.12 This has also been the basis on which the application of limited liability to corporate groups may be generally challenged. The corporate veil is generally preserved in order to ensure that the profit making incentive and productivity of organizations that choose to adopt a group corporate structure. But a parent concern of a corporation also has the facility of passing on its legal and financial liabilities to intermediaries, such as its subsidiary companies. Through the use of such subsidiary companies, a parent company can often escape a legal, contractual relationship with a customer, as the relatively independent subsidiary assumes the responsibility for a product within a particular area13 and unless there is clear written consent given by the corporation with extent of responsibilities and authority clearly spelt out, the parent corporation may escape liability for a subsidiary's actions.14 In such instances, limited liability functions as a means for a parent concern to abuse the corporate structure for its own benefit. It may also be noted that while limited liability has been promoted and encouraged in order to increase the incentive for investment, this fact is applicable in the context of individual shareholders who may also be investors. There may be very different circumstances involved when a shareholder is not an individual investor but the parent company of a wholly owned subsidiary. Hardie points out that limited liability exists to protect the shareholders who are unable to personally monitor and control the type and amount of risk arising out of loss of their assets.15 But a parent-subsidiary relationship generally involves only one corporate corporate investor who also functions in a managerial role and is therefore fully aware of the risks involved. While risk taking behavior would generally be avoided by a corporation or engaged in only to the extent that might safely result in profits, limited liability encourages corporate entities to take higher levels of risks, because the liability can be passed on to16 the subsidiaries. Hardie also contends that the arguments in favor of limited liability because it encourages wide distribution of shares and portfolio diversification, do not apply in the case of a parent corporation because it is essentially the sole shareholder in the subsidiary, while investors have the opportunity for diversification at the holding company level itself. He has also pointed out while the original purpose of limited liability was to provide an incentive for some risk taking behavior that is economically desirable, when applied to groups of companies, the reality is that it becomes a method of shifting risk and also shifting the responsibility for the losses arising out of that risk. The imposition of an integrated regime on companies: There have been calls for imposition of a more integrated regime on companies in order to address the scope existing within the limited liability doctrine for corporate entities within a group structure to shift risk to others in the group. But such an imposition would also lessen or remove the flexibility that currently exists and strike at the limited liability doctrine that is currently the underlying basis of corporate law. To support the argument that corporate flexibility should not be tampered with, it has been contended that there is no evidence of the abuse of corporate status by parent companies. But as detailed further below, this position may not necessarily be borne out in corporate history. There have been many instance of parent companies abusing the doctrine of limited liability in different ways, in shifting risk on to subsidiary companies. During the Enron scandal which erupted in 2000, Enron officials were discovered to have bribed tax officials and paid no taxes at all between the years 1996 and 1999, despite being the seventh largest corporate entity in the United States.(BBC Report, 2003). Deceptive financial reporting was one of the means used, whereby Enron reported profits from subsidiaries for years into the future; profits that had not yet been received. The practice is to "include capital profits from the sale of properties or shares'.as operating profits" although these had not actually been realized and were subject to speculation; booking "unrealized capital gains as operating profit" despite the fact that some of these so called profits were generated in transactions with business associates or within the same firm17. In such cases, there may also be secret arrangements in place whereby the so called "buyer" in the transaction can later transfer the assets back to the seller, just after the period when the balance sheet has to be generated. If liability is to be imputed upon a parent concern that seeks to abuse the corporate group structure for illegal purposes or for unethical financial gains, then this may justify a piercing of the corporate veil. If a court is to hold that an agency/principal relationship exists between a subsidiary/parent company must be one of the parent exerting "effectual and constant control" of the subsidiary18. Merely exercising control over the capital of the subsidiary is not enough, the parent needs to control the day to day functional activities of the subsidiary. This was also the finding of the Court in the case of Stocznia Gdanska SA v Latvian Shipping Co and Others.19 In this case, a parent company had agreed to provide funding for a subsidiary to enter into shipbuilding contracts. Accordingly the subsidiary entered into a contract with a shipyard, but the parent company did not provide the necessary funding. The shipyard filed for a breach of contract against the parent company on the grounds that it has directly instructed its subsidiary not to go through with the completion of the contract and had thus induced a breach of contract. The parent company argued that holding it accountable for inducement of the subsidiary merely because it controlled the subsidiary would amount to a violation of the legal protection offered by limited liability as set out in the Salomon case. The Court in this case, agreed and upheld the corporate veil because it held that a request was made by the parent company, which was considered by the subsidiary Company that made its own decision. Ignoring this aspect and holding the parent company liable would have meant ignoring the principles underlying separate incorporation of the subsidiary. The precedent in the above case, upholding the corporate veil, shows that the corporate veil is generally not pierced, largely due to the perceived advantages that are seen to arise out of the practice. Corporate structure that includes subsidiaries is viewed as a positive development because within a global context, it enables self supporting management by introducing wage and employment practices that are specific to a particular area, region or industry and thereby improving productivity. In a study of corporate structure in Japan's publicly listed companies, Komoto found that increasing the number of subsidiaries proved to be beneficial in enhancing the productivity of the organization and corporate performance.20 In the wake of the Information Revolution where there has been an increasing use of technology and the globalization of markets, a centrally controlled, hierarchical system may be unable to withstand the turbulence and change in the global arena.21 The ideal corporate working structure is therefore to create small, independent subsidiaries that are free to manage their own affairs while remaining integrated into the parent corporation. For example, Johnson and Johnson has organized itself into 166 separate companies, each of which fiercely retains its own autonomy. In the case of MCI, the earlier hierarchical corporate stricture has been revised to provide more autonomy to managers.22 By designing organizations that operate as markets rather than as hierarchies, productivity and profitability has soared. The CEO is viewed as the profit center in these organizations, wherein revenue is derived from assets are invested in business units. It may be noted that such decentralization is occurring in almost all major organizations. For instance, Sony Corporation, as of March 2002 had 1068 subsidiaries.23 But with corporate social responsibility increasingly being demanded of organizations in the wake of corporate scandals such as Enron, there may be less scope for parent companies to abuse their corporate status. Moreover, when organizations are designed such that the CEO is the profit center in the organization, an additional corollary is the increased autonomy that is provided to subsidiaries and other regional control centres. When parent companies are increasingly organizing themselves to provide optimum levels of autonomy and flexibility to the subsidiary organizations, there is merit in the argument that they are not abusing their corporate status by using the limited liability doctrine because they do not exercise similar levels of control that they were doing in earlier years before the onset of the global economy. When there is increased autonomy for subsidiaries, the corresponding levels of parental abuse would also be diminished. Amaeshi et al point out that multinational corporations are often challenged by the global outreach of their supply chains, especially because there may be irresponsibility exercised alone these chains at various levels24. Bring forced to assume corporate responsibility for the actions of all its suppliers places a great burden on a corporation, yet with the increased focus on corporate social responsibility, this is almost an inevitable outcome. In view of this, Ameshi et al have challenged the assumption which is often taken for granted, that firms should be ethically responsible for the practices of their suppliers25. These authors conclude that excluding instances where corporate control exists, the use of power is a critical factor in allocation of ethical responsibility. Since many organizations are implementing steps to ensure corporate social responsibility, this suggests that organizations in general are not abusing their new decentralized corporate group structures. Within a global environment, such a decentralized corporate structure that allows for the existence of subsidiaries has become almost mandatory. The United Kingdom views each entity within the corporate structure as an individual organization and does not advocate a piercing of the corporate veil except in exceptional circumstances that involve intentional actions.26 The U.K. adopts the entity liability approach wherein the parent company is only held liable for its own individual actions. The question of reducing limited liability for corporate groups in order to prevent abuse was the subject of a proposal that was circulated for formulation into a European Directive, which included rules on reporting by third parties on the exact corporate structure of companies. This was targeted at reducing the misuse of directorships and setting up of fake organizations solely for the purposes of deflecting profits27. But this proposal was never implemented, because it was unable to elicit widespread agreement on the undermining of limited liability that was proposed. The Law Reform Commission of Australia also undertook a detailed study of the principle of limited liability, especially in terms of reforms restricting it in tort and personal injury actions against a company that is a part of the corporate group. But the Law Commission did not recommend the reforms and contended that lifting the corporate veil would be inappropriate in the circumstances.28 The objections that were offered against the reforms proposed to limited liability was that it would discourage investment and increase litigation arising out of claims made against corporate entities. Yet another ground that was cited was that such reforms would place Australia out of step with other countries and make it less competitive in the global market. It was also argued that introducing a more comprehensive regime to crack down on possible misuse of limited liability would weaken the central economic foundation of all the other group companies. All of these objections reflected the underlying premise that introducing a more comprehensive corporate regime by restricting the application of limited liability would in effect produce a detrimental effect on the economy. This is the basis of the arguments against any reforms to corporate law, because with the interlinking of the economies of the world, restricting limited liability could function as a significant deterrent to economic growth and expansion. If parent companies are made responsible for the activities of their subsidiaries and made to bear responsibility and accountability for them, it could function as a major disincentive to higher levels of investment and risk taking that is so vital for the healthy and rapid growth in an economy. The prospect of introduction of subsidiary obligations would for instance, be especially troubling for those corporations which have domestic or foreign subsidiaries, especially because it gives rise to complication litigation that may also involve conflict of laws issues as well as issues of jurisdiction and forum non conviens. Parent companies in large organizations are already being subjected to pressures to be socially and environmentally responsible. But including personal tort and injury for example, as areas where the limited liability principle may be restricted, would be detrimental to the economy because parent companies are already burdened enough as it is and corporate misuse of the principle is not so widespread as to merit comprehensive reforms. On all of the grounds above, it would therefore appear that there is merit in the argument that a tougher and more comprehensive regime would take away the flexibility that corporations now have to organize themselves in the best possible way in order to survive in a competitive environment. Level of control as a factor in establishing liability: The lack of enthusiasm for corporate reform and lifting of the corporate veil does not however mean that is it not being used when needed. For example, in 1990, a computerized survey found that 1600 cases had raised the issue of piercing the corporate veil29. The corporate veil is not inviolable, in certain circumstances when corporate structure is used as a cover for fraud, tax evasion or other illegal activities, it may be pierced. In the United States for example, piercing of the corporate veil requires that the parent company should have controlled the subsidiary for illegitimate purposes, or that the manner of control which was exercised over the subsidiary was illegitimate30. The extent of control exerted by a parent company on its subsidiary is measured using factors such as stock ownership, directorships - for example assessing the level to which they may be interlocking, inadequate capitalization of the subsidiary or its total financial dependence on the parent company, shared ownership of assets between the parent and subsidiary or the failure to observe formal legal requirements.31 The existence of the above elements can indicate that the subsidiary is not truly independent, because it is largely controlled by the parent company, hence liability will have to be imputed on the parent company. For instance, in the case of Lowendahl v Baltimore & ORR, the degree of control that would be required to male limited liability provisions inapplicable was stated as follows: "Control, not merely majority or complete stock control, but complete domination, not only of finances but of policy and business practices in respect to the transactions attacked so that the corporate entity had at the time no separate mind, will or existence of its own."32 The extent of control was the basis on which responsibility was imputed on the parent company for environmental damage in the State of Idaho v Bunker Hill.33The Court found that the operations of the parent and subsidiary company were so closely entwined and that the parent controlled the management and operations of the subsidiary to such a considerable extent that to all intent and purposes, it was effectively controlling the activities of the subsidiary and as a result could also be held liable for environmental damages caused by the subsidiary. . In the case of Briggs v James Hardie and Co Ltd34 the Court held that the corporate veil could be pierced in those instances where a victim of a negligent act has no choice as to the corporation that will do him harm. Similarly, in the case of Autokran,35 the Court held that where a parent concern was extensively and permanently involved in the management of a subsidiary which subsequently went bankrupt, the degree of control it had exercised rendered it liable. As a result, the parent concern in this case was held responsible for the debts of the subsidiary and was directly liable to the subsidiary's creditors. There was however a qualification to this proviso of control provided by the German Federal court in its decision in the case of Tiefbau.36 In this case, the Court held that a parent concern could provide a valid defense which could uphold the corporate veil, if it was able to show that the subsidiary's "losses were caused by circumstances outside the parent's managerial control."37 On the basis of the above, it would this appear that there may be instances when restricting limited liability may be desirable and even necessary to prevent financial fraud and manipulation. This doctrine provides parent companies of corporations with the opportunity to deflect their potential losses from risk taking behavior onto their subsidiaries, so that they are able to escape liability for them. Although legal reforms have been introduced after corporate scandals like Enron, such as the Sarbanes Oxley Act in the United States, these may not be comprehensive enough to tackle the issues of corporate fraud arising out of the limited liability doctrine and flexibility provided to corporations. One very important aspect that must also be considered is that unless parent organizations are deterred from engaging in risk taking behavior that results in losses being pushed on to subsidiaries, the net result will be that the shareholders will suffer38. For example, in the Enron case, it was the shareholders and employees that found their savings and investments wiped out in a flash. This will only provide a cumulative effect wherein shareholders will become hesitant to invest in companies because of the fear that they may sustain huge losses through an inadequate level of corporate control at the legal level. Such a reduction in shareholder activity would also have a detrimental effect on the economy. Conclusion: On the basis of the above, it may thus be noted that corporate group structure may be beneficial for corporations because it enables a parent concern to shift responsibilities to subsidiaries that are able to function better in a particular geographical environment. Allowing corporate flexibility and limited liability allows a corporation to organize itself in the best manner possible within a global economy, to ensure maximum productivity and strong economic performance. Limited liability also provides corporations with the incentive to engage in risk taking behavior that enhances productivity. Moreover, in the aftermath of corporate scandals such as Enron, corporate reform has already been introduced through legislation, which already demands higher levels of corporate accountability and governance in corporations. Hence, the introduction of a comprehensive regime that proposes to further limit corporate flexibility is likely to seriously inhibit risk taking behavior in corporations and thus produce a concomitant depression in economic growth. It could also increase litigation levels and thereby increase costs to corporations, making them less productive. The counter arguments that may be offered in support of introduction of comprehensive reforms is that unless the scope for financial fraud is minimized and victims of tort and injuries are allowed to pursue action against corporations, there is likely to be a reduction in shareholder confidence. The victims of corporate fraud and financial manipulation are generally the investors and stock holders as well as employees of the corporations who are also often its shareholders. The increased incidence of financial scandals functions as a deterrent to shareholder activity. In the long run, decreased action and willingness by investors to risk their funds would also prove to be detrimental to the economy. As a result, a balance needs to be achieved between retaining corporate flexibility and risk taking incentives, while also ensuring that instances of fraud are minimized. Since most countries have already introduced significant corporate governance legislation, this may have already addressed the issue of fraud to some degree. Measures are also available through common law to address specific instances of tortuous action or personal injuries, hence it does not appear that any further measures are necessary, including the introduction of an integrated regime. Bibliography Amaeshi, Kenneth M, Onyeka, Osuji K and Nnodim, Paul, 2008. "Corporate Social responsibility in supply chains of global brands: A boundaryless responsibility' Clarifications, Exceptions and Implications", Journal of Business Ethics, 81:223-24 Blumberg, Philip, 1987. "The law of corporate groups, substantive law", Little, Brown and Co, at 185ff Griffiths, Ian, 1992. "Creative Accounting: How to make your profits what you want them to be." London: Routledge Hardie, James. "No soul to be damned and no body to be kicked", Sydney Law Review, http://www.austlii.edu.au/au/journals/SydLRev/2005/15.html; Hofstetter, Karl, 1990a. "Multinational enterprise Parent liability: Efficient legal regimes in a world market environment", North Carolina Journal of International law and Commercial Regulation, 299 Hofstetter, 1990b. "Parent Responsibility for subsidiary corporations: Evaluating European Trends", International and Comparative Law Quarterly, 576 Komoto, Keisha, 2003. "An empirical analysis of the effect of corporate group structure on profitability", NLU Research, 08.07.2003. Let's turn organizations into markets!" The Futurist, 28(3): 8-15 Miller, Sandra K, 1998. "Piercing the corporate veil among affiliated companies in the European Community and in the U.S.: A comparative analysis of I.S., German and U.K. veil piercing approaches", American Business Law Journal, 36(1): 73-77 Ramsay IM and Noakes DB, 2001. "Piercing the corporate veil in Australia",19 Company and Securities law Journal 250, Watson, S, 2002. "Who hides behind the corporate veil' Finding a way out of "the legal quagmire" 20 Company and Law Securities Journal 198 Cases cited: Adams v Cape Industries plc (1990) Ch 433 Alliance Acceptance Company Ltd v Oakley (1987) 48 SASR 337 Autokran , 95 BGHZ 330 (1985) Briggs v James Hardie and Co Ltd (1989) 16 New South Wales Law Review 549 Hamilton v Whitehead (1988) 14 ACLR 493 International Harvestor Co v Carrigans (1958) 100 CLR 644 Lowendahl v. Baltimore & ORR, 247 AD 144, 157, 287 NYS 62 at 76 (1936) Metal Manufacturers Ltd v Lewis (1988) 13 ACLR 357 Salomon v Salomon and Company (1897) AC 22 Smith Stone and Knight v Birmingham Corporation (1994) 4 All ER 116 Stocznia Gdanska SA v Latvian Shipping Co and Others (1998) 1 WLR 574 State of Idaho v Bunker Hill, 635 F Supp 665 Tiefbau , 107 BGHZ 7 (1989) Truster AB v Smallbone and Others (2001) 1 All ER 908 U.S. v Kayser Roth Corp, 724 F Supp 15 (DRI 1989) Read More