The Corporate Veil in the UK and US - Coursework Example

?The Corporate Veil in the UK and US Introduction Since the birth of the corporate veil, there has been a great deal of debate surrounding attempts to define the courts approach to the lifting of the veil. This paper will examine the birth of the corporate veil and analyse how the courts have made exceptions so that the veil may be lifted in the UK and the US. The corporate veil will be looked at in relation to the attempt to heighten levels of corporate governance, especially in terms of shareholder rights and directors. How do the different approaches of the US and the UK to the corporate structure affect the veil? Which is the most desirable and why? It will be argued that the separation of ownership and management under the UK system is not suitable, and this causes problems when bodies try to monitor corporate governance. This separation has caused shareholders to have their rights decreased, and the lack of a universal definition of what corporate governance needs is also a problem in properly enforcing it. The Birth of the Corporate Veil The case of Salomon v Salmon & Co Ltd1 was a major step forward for company law because it had the effect that “the company is ex hypothesi a distinct legal person” from its members,2 and “the company is at law a different person altogether from the subscribers to the memorandum…nor are the members as subscribers liable…except to the extent and in the manner provided by the Act”.3 The decision of the House of Lords in Salomon brought a big amount of new and good consequences, and the boundaries and reach of the Companies Act 1862 was defined properly for the first time in company law. More importantly, the House of Lords made clear the principle that the company is to be viewed as a separate unit (or body) from those who are a member to it, and this made the company take its own personality. This personality allowed the company as a separate body to sue and be sued,4 to enter into its own contracts under the company name,5 to make its own profits and losses,6 and to own its own property. Also, the decision of the House of Lord in Salomon caused the creation of limited liability which was given to shareholders of the company, protecting their shares and liability to the value of their shares. Salomon quotes have been repeated many times over history, and it is described by Lord Templeman as an “unyielding rock”,7 especially after its being codified in the Companies Act 2006 in section 16(2). But how does the corporate veil affect corporate governance? What are the consequences of the veil, especially when it is lifted? Have directors been able to use the veil to commit fraudulent activities, or have shareholders’ rights been made stronger? It is important to first examine the concept of corporate governance, in particular in relation to directors and shareholder’s rights. Shareholder Rights and Directors in Corporate Governance Shareholders are defined as the investors in the company; they are often described to have considerable amounts of power to elect and even remove directors from the board, although it will be shown below that this is not actually the case anymore because their rights have been greatly reduced. On the other hand, the directors are the upper most governing body of the company, although they are restricted in many ways by way of their directors’ duties to act in the best interests of the company and to promote the business as a whole. Directors create and put into action the company’s policies and manage the actions and interactions of the company. Shareholders also possess some non-financial rights, especially in relation to the protection of their invested shares. Shareholders, as well as vote to appoint and remove directors, can also have an effect on the laws of the company, and change directors’ acts so they act according to the company laws, or articles of association. This does not mean that shareholders have a lot of power over the company generally, but their ability to vote does give them some importance and power over how the company is run. Perhaps the ability of the shareholders to vote directors out of the company is the most effective way of ensuring that directors act in the interests of the company as a whole, as well as the shareholders. The power of shareholders as well as duties of directors to act in a fiduciary way all exist to restrict the directors’ actions to those that are good for the company rather than just for the directors themselves. A director, if he is found to violate any of his duties, will be found personally liable for the losses caused to the company. This is not so simple, however, because if it is held that the director acted in good faith, he may be indemnified so long as he thought he was acting in the best interests of the company. The structures of the company in the US and UK are slightly different.8 The recent Enron and Worldcom scandals in the US have increased the topic of corporate governance and tried to find its lacking elements which made such scandals possible. Corporate governance in the UK was brought into the spotlight by the Cadbury Report in the early nineties,9 which had a voluntary quality to it and was not as demanding as the US approach to corporate governance. The UK and indeed Europe has now adopted the more rigorous approach of the US to corporate governance which has compulsory measures with punitive repercussions for failure to implement corporate governance policies. This now means that fraudulent directors in the UK can face criminal charges as defined in the Combined Code.10 In relation to the aim of maximising shareholder value, both the US and the UK adopt such a model of corporate governance, though it is argued that despite their similar approach, “there are striking differences in the financing strategies of UK and US” systems.11 In the UK, the Code of Conduct has been recently changed to limit large penalties to only “exceptional cases, such as fraud”.12 The non-executive director in the UK now has a bigger role, which was a response to previous problems caused by a single managing director dominating the company which “reflected more widespread defects in the corporate governance systems of large British companies”.13 Such dominance has been made less possible by the restructuring of the board. It is clear that the main problem focused on by corporate governance principles is the prevention of minorities in a company, especially minority shareholders.14 The failure of a company to protect the minority shareholders is thus seen as failure to adhere to even basic corporate governance rules. It is noted that while many countries understand the need to increase corporate governance standards, how they propose to do this is done in different ways. While some states focus on reforming the board, others focus on the importance to uphold shareholders’ rights.15 In the UK it seems that the strong self-regulatory system will be used, which trusts directors with universal powers,16 restricted to their duties and obligations in sections of the Companies Act 2006, especially section 172. The UK has managed to balance the “importance of ensuring that firms are managed efficiently” with the aspects of shareholder ownership.17 The Consequences of the Corporate Veil and When it will be Lifted in the US In the US, the courts have taken an approach to lifting the veil that needs some form of fraudulent or illegal behaviour.18 Although this is generally done when directors act in such a way, the courts have also lifted the veil when it seems that majority shareholders have abused the corporate veil, or where the corporate veil has been used to avoid formalities, or has become bankrupt or avoids taxation charges. The courts take two main approaches, though it is difficult to separate them in practice. When the members of the company have such a big amount of power over the finances and functions of the company that the company has little separation of existence, the courts will lift the veil in most cases. This level of control with fraudulent or illegal activity which causes harm to others increases the likelihood that the veil will be lifted. In the second approach, the courts will lift the veil when shareholders ignore the separate personality of the company and use it as a tool to do their own business transactions, resulting in fraudulent behaviour to continue if the courts do not lift the veil.19 The courts will also look at undercapitalization which is found when the assets of the company are really small when compared to the business characteristics and the risks connected to dealing with it. Such undercapitalization allows the company to abuse the degree of limited liability its members are given without losing the profits achieved by the company. In such situations the company is called a sham, and the courts will decide whether the shareholders or another person must suffer the loss caused.20 The US courts will also lift the veil when it is seen that the company did not follow Statute requirements. This is often done when the majority shareholders are found to use the company as a sham or alter ego.21 This is also the case when the funds of the company are combined with the funds of the majority shareholders, causing a lack of separation between corporate property and personal property.22 When a subsidiary company has been set up in order to conduct fraudulent allocations of losses and profits to favour the parent at the loss of the subsidiary, the courts will also lift the veil, as well as when a group of companies have been set up yet are seen to be conducted under an enterprise.23 The approach to the corporate veil in the US is based on its attempt to heighten corporate governance levels and prevent fraud on the part of both the directors and the majority shareholder. The Consequences of the Corporate Veil and When it will be Lifted in the UK In the UK the approach of the courts is not entirely different. The courts have been criticised for not adopting any specific approaches to the lifting of the corporate veil, though it is again suggested that they attempt to avoid fraudulent behaviour. The courts have kept the power to lift the veil and ignore Salomon, though it is generally unwilling to lift the veil in all cases, whereas the courts in the US seem more willing to lift the corporate veil.24 They take two different approaches to exceptions to Salomon; the broad and the narrow approach. The narrow approach is found in the Companies Act 2006 and says that the rights, property, liabilities and obligations of the company belong only to the company itself and not its members. The wide approach says that the members of the company are not allowed to be given the legal obligations and liabilities of the company because they are separate from it.25 The courts use statute and common law decisions in order to decide whether the veil should be lifted or not. Common law principles and statute provisions are used to treat “the rights or liabilities or activities of a company as the rights or liabilities or activities of its shareholders”.26 This means that the corporate veil is ignored, when the interests of good corporate governance seem to not be followed or respected. The statutory tools for lifting the corporate veil are criticised as being uncertain, and the courts use them in an unpredictable way,27 though it is said that the courts favour the importance of the corporate veil and do not lift it willingly: they are often reluctant to.28 Lord Diplock has said that the statutory tool for lifting the veil is limited so that “any Parliamentary intention to pierce the corporate veil would be expressed in clear and unequivocal language”, though the absence of the clear language does allow the courts to use a “purposive construction’ of Parliament’s intention”.29 The case of Tunstall v Steigmann has said that the construction of the statute must be more than presumed because it is not allowed to be implied on little evidence.30 The UK courts lift the veil under statute when issue of taxation occur, especially in group companies. Some say that this is not lifting the veil; it is alternatively piercing the veil slightly to give extra obligations to subsidiaries. Of course, fraud is a big example of the courts’ lifting the veil, as it is in the US. The Insolvency Act 1986 makes the directors or shareholders personally liable if they seem to have formed the company to hide fraudulent activities under section 213. The statute also allows the veil to be lifted if directors act incorrectly (section 212), and if they did not wind up the company when it had little chance of surviving (section 214).31 The sections are broad, but the courts are careful to lift the veil under their authority and mainly use them to prevent the members’ abuse of the veil, which compromises corporate governance principles. The courts in the case of Merchandise Transport v British Transport Commission (No.1) decided to lift the corporate veil when it found that the members had created a subsidiary company to escape the need to fulfil legal formalities so that they could get a licence which would favour them. This is the equivalent of the US company sham approach, which is term a facade in the UK. The courts have lifted the veil when they found that the company was created to avoid an employment contract also.32 It was held by Richard Southwell QC that the veil could be lifted because the directors of the company had ignored the separate personalities of more than one companies when moving assets between them. The courts however generally say that a reorganisation of a group of companies is not exactly illegal as long as it is in good faith.33 The courts do try to avoid companies being used to avoid legal requirements, as well as statutory provisions, as it is also done in the US. The courts require that some form of fraudulent behaviour or dishonesty is evident before they will lift the veil and remove separate legal personality; more than unconscionable conduct is needed. Russell J said that the company must be “a device and a sham, a mask which he...[the member]...holds before his face in an attempt to avoid recognition by the eye of equity.”34 The courts also see group structured companies suspiciously, especially if they are being used as a way to avoid taxes and regulations, obligations and liabilities. The parent company creates subsidiaries which are completely owned by it, yet with limited liability so that if the subsidiary gets into financial problems, the parent company is protected.35 There is disagreement with the courts as to whether groups of companies are single units,36 though the general approach is that each company in a group is “a separate legal entity possessed of separate legal rights and liabilities so that the rights of one company in a group cannot be exercised by another company in that group”.37 The veil is only lifted if the group of companies seems to be a blatant facade,38 although it will be lifted also in the interests of justice and good corporate governance.39 The approach of the courts is narrow here, and limited to special circumstances in which it is extremely necessary to enforce principles of corporate governance and prevent fraud conducted under facade companies. The veil is lifted to make the principal company liable for the actions of its agent.40 Again, the courts are not willing to lift the veil in a agency situation, it must be an express agency and the courts take a case by case approach to the facts of each situation.41 Corporate Governance and the Corporate Veil Corporate Governance principles have a big effect on the aspect of the corporate veil. The company structure which separates the power contained by directors in their managing roles and the ownership in the hands of the shareholders has caused problems as to how the corporate veil can affect corporate governance. How can directors be made properly accountable to the shareholders, and does this improve corporate governance? Davies terms this as “the quest for stockholder democracy”,42 and says the apparent simple solution of improving levels of democracy and increasing accountability in the corporate structure is difficult to apply in reality. It is suggested that increased participation of shareholders is difficult and maybe not even desirable because it makes decision making more difficult to achieve. It is said that the corporate governance principles in the US are more a result of “path-dependent history than the ‘natural’ result of an inevitable evolution toward greater efficiency”.43 Yet it has been said that the UK system of separate ownership prevents corporate governance from being monitored properly.44 Such critics say that a more central application of corporate governance is needed, so that it can be more objective and can be implemented more quickly.45 Shareholders are also not willing in many cases to start litigation when fraud or abuse has happened, because of the costs of litigation that directors often have little trouble of paying but which shareholders may have problems financing in the UK. In the US, litigation has happened more often, which allows corporate governance to be applied more effectively, and makes directors more aware of the consequences of not implementing corporate governance requirements. The UK approach seems to have used the corporate veil to reduce their willingness to implement corporate governance in the UK, when they actually need to increase their participation in the monitoring of corporate governance. The Cadbury Committee had suggested a more updated approach to issues or corporate governance, which suggested that non-executive persons in the company should have larger importance and more roles in the functioning of the company, especially as representing the shareholders.46 It is suggested that the fast increase in globalisation and competition will cause the UK to develop its system to be like that of the US,47 and move the importance of promoting non-shareholder interests to promoting shareholder interests when they conflict with directors powers.48 It is clear that the separation of ownership and management causes problems for making directors answerable to shareholders. Also, the practices of piercing or lifting the veil are not found in any specific set of rules or principles, making it difficult to understand when the veil will be lifted and how corporate governance can be properly monitored.49 If the company is given separate liabilities from its members, how are members placed in terms of ensuring that corporate governance is monitored and enforced? At what point is the line drawn, considering that the actions and transactions of the company are dependent on its members essentially? The cases of lifting the corporate veil do not show any principled approach of the courts, more in the UK than in the US. It is thus difficult to predict when the courts will lift the veil, although it has been said that fraud is an important aspect for lifting the veil.50 In the UK, the courts have lifted the veil in some situations, yet not lifted the veil in similar situations; this is confusing and difficult to conceive of in terms of achieving high levels of corporate governance.51 It is clear that the main basis of company law is that the company is owned by its shareholders, and the actions of company law have tried to overcome problems caused by the separation of the company and its members, yet the ownership of the company by its members.52 It is evident that the influence of shareholders has been very much weakened over time; they do not have actual property rights in the company’s assets, they have little or no direct participation in the day to day running of the company in terms of its management. It is as a result difficult to understand what rights shareholders have or should have any more. If this is difficult to state, then it is even more difficult for corporate governance to uphold or protect in reality.53 Additionally, the biggest problem posed by corporate governance is that “there is still not a standard or universally accepted definition and so it lacks an officially endorsed assessment standard”.54 Even though it cannot be universally defined, it has not lost importance, however.55 The Green Paper of the European Commission has said that “corporate governance should take account of the interests if other stakeholders” as well as the shareholders of the company, which should not have their rights lowered by the recommendation.56 Corporate governance has been mainly aimed at financial companies or bodies, but their governance is difficult to approach in a simple way, and corporate governance has had problems in regulating specific conflicts of interest between shareholders and directors.57 This requires that corporate governance principles be adapted to specific sectors of business because it can not be applied the same to all sectors, as they are governed differently and have different types of relationships between shareholders and directors. It is said that the corporate personality does not and can not hide all aspects of a companies’ business, and this has been shown above by the US and the UK courts’ use of lifting the corporate veil in certain situations.58 There is a need to separate ownership from management, it is suggested, due to and depending on the specialist nature of the company:59 the actual separation of management and ownership can be said to reduce risks by way of limited liability enjoyed by shareholders. The importance of shareholders’ rights has been kept central despite the separation under the corporate veil; the fact that the company must be conducted in order to benefit the shareholders is an important aspect and aim of corporate governance.60 It is said that “the law respects the right of shareholders to determine the objectives of their association...and that by virtue of their capital contributions they should be regarded as the owners of the company”.61 It is important that shareholder rights are not entrenched too much, because this could allow them to use the corporate veil to prevent “outsider monitoring”.62 It is however argued that the difference in corporate personality structures in different countries cannot be used as an argument to suggest that there is not a single application and development of corporate governance systems. Instead, it can be said that every corporate structure or system contains fiduciary duties of directors which are aimed at limiting them to act in the best interests of the company. This underlying principle which can be found in almost every corporate structure around the world leads to a suitable application of different corporate governance systems depending on the nature of the duties and the importance of shareholder rights in each country.63 References Publications Abugu, JEO, ‘A Comparative Analysis of the Extent of Judicial Discretion in Minority Protection Litigation: The United Kingdom and United States’ [2007] CCLR 181. Bainbridge, SM, 2000, ‘Abolishing Veil Piercing’, UCLASL. Accessed:24/11/2011. http://papers.ssrn.com/paper.taf?abstract_id=236967 Blumberg, PI, The Multinational Challenge to Corporation Law - The Search for a New Corporate Personality (Oxford University Press, New York 1993). 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