Abuse of Separate Entity - Essay Example

Abuse of Separate Entity: Lifting of Corporate Veil 0 Introduction; A company incorporated under the Companies Act has invariably been regarded asa separate entity as distinct from its shareholder. Though several legal pronouncements had reiterated this point, the decision in the case of Salomon V Salomon & Co [1897] AC 22 had been a landmark decision to stress this point. This is the sort of a protection for the available to the shareholders to escape from the liabilities committed by them with third parties on behalf of the company. Hence sometimes the courts would decide to pierce through the veil and fix up the liability on the shareholders or any other person who is responsible for any wrong committed with respect to the position of the company. 2.0 Necessity to Consider Disregarding the Corporate Personality: One of the biggest advantages for incorporating a business as a corporate entity is to enjoy the broad protection available under the law from being personally held liable for the liabilities contracted on behalf of the company. Under normal circumstances the creditors of the company can have recourse for their dues against the assets of the company and they cannot attach the liability to the personal assets of the shareholders. Under certain circumstances it may become necessary for the company to fix up the responsibility on individuals in respect of some liabilities contracted by them on behalf of the company. The exact circumstances under which the courts will 'pierce the corporate veil' as it is technically known, depends on the state laws. However in general under the following circumstances the courts will look beyond the corporate veil phenomenon and provide a remedy to the creditors. Where the companies are standing in relationship to each other as holding and subsidiary companies Where the circumstances are such that the shareholder has lost the privilege of limited liability and has become liable personally to the creditors. This situation may arise when the company continued to carry on the business for a period of six months after the number of its members was reduced below the minimum as prescribed by law with the knowledge of the shareholder Where there are issues concerning taxes, death duty or stamp duty Where the controlling interest is in question in that the affairs of the company are being conducted with an absolute control over all the financial and other issues by the shareholders In the law relating to exchange controls, and in the law relating to trading with the enemy where the test of control is adopted (Palmer's Company Law; page 215, 24th Edn., 1987) Fraud: "A court may also pierce the corporate veil to prevent a fraud, where the corporation is found to be a "sham" meant to facilitate fraud against third parties." (Aaron Larson 2004) 3.0 Circumstances under Which Common Law Courts would lift the Corporate Veil: Under the common law courts would allow the lifting of the corporate veil only in cases where the company is a 'mere facade concealing the true facts', or, in the parlance of earlier cases, a mere 'sham', Gower,LCB (1992) However the circumstances under which the courts will find such a 'faade' or 'sham' are considered to be very rare. In the case of Woolfson v StratchclydeRegional Council, 1978 SLT 159 at 161:the House of Lords observed that the corporate veil can be pierced only where special circumstances exist to indicate that the company is a mere faade concealing true facts. "The recent decision of the Court of Appeal in China Ocean Shipping Co v Mitrans Shipping Co Ltd, (1995) 3 HKC 123appears to have narrowed the already limited circumstances in which a court will lift the corporate veil." Following the ruling of this case if a person uses the corporate veil to protect him from legal obligation prior to the arising of the legal obligation then the corporate veil will not be pierced. On the contrary if the person uses the corporate veil to protect him after the legal obligation is established then the corporate veil can be pierced. 4.0 Legal Concepts that can be used to lift the Corporate Veil: Historically the courts have been reluctant in piercing the corporate veil and it is correct for them to do so, since without the protection under the limited liability scope, the entire basis on which the company form of organization exists. However under the following circumstances, the courts find the legality in looking beyond the corporate veil and fix the liability on the individuals. Gross Undercapitalisation: One of the legal concepts under which the courts would take the step of lifting the veil is when there exists a financial insufficiency on the part of the company that renders the assets of the company insufficient to pay off the creditors. It is important such financial insufficiency existed at the time when the debt was incurred and not when the creditors began action to collect the debts. Organisational Formalities: In a situation when the company has failed to comply with the formal requirements like appointment of directors or other important formalities required, then the court may take the legality behind this action for piercing the corporate veil. Where the dominant shareholder of a company failed to attend the annual meetings or election and appointment of directors and thereby eliminated or rendered those positions ineffective, then courts may intervene to rule for the piercing of the corporate veil. Intermingling of Assets: Any substantial intermingling of personal assets and the company assets may result in the shareholders being subjected to personal liability beyond the corporate veil protection. "It is important to understand that the overriding principle of piercing the corporate veil is that equity requires the court to disregard a shareholder's traditional insulation from personal liability if the corporate form is used as a sham or facade for the pleasure of a dominant shareholder" (Wolf, Baldwin Associates) Perpetration of Fraud: Among the purposes for which the courts may allow the creditors to have their liabilities settled by the shareholders personally, the important one is when the unscrupulous shareholders use the corporate veil to perpetrate fraud on creditors. However there is only limited guidance on what action will constitute fraud that will lead to piercing the corporate veil. 5.0 Sources of Common Law Courts' Power to Pierce the Corporate Veil: In the United States the state law determines the circumstances under which the court can order the piercing of the corporate veil. All along there had been confusing circumstances surrounding the usage of the principle of piercing the corporate veil. However the changes in the statutory laws in general made changes in the approach of the courts o use this doctrine frequently. The courts in the United States where the doctrine has been well recognized depend primarily on the provisions of statutory law which give them the power to invoke the doctrine to render justice in appropriate cases. In the case of developing countries like China where the statutory laws are still needed refining, the courts draw their power from the established judgments defined by the common law provision. This leaves the courts to limit their usage of the doctrine based on the common law principles of intention to defraud the creditors or infringement of the company's assets for private use etc. 6.0 Sources of Chinese Courts to Pierce the Corporate: Prior to the year 1994, in China there was no national uniform legal framework that provided a clear and established understanding of the rights and responsibilities of the shareholders and also a clear and concise system of managing the corporate entities was not evolved, In contrast to the situation in United States and other Western countries where the powers to manage the company is vested in the Board of Directors, in China the absolute power of managing the affairs of the company is vested with the 'shareholders' meetings that have the authority to run the company. Enormous powers have been vested with the shareholders for running the company and this is in view of the fact that the Chinese government was a major shareholder in most of the companies. The Company law originally formed did not recognize the doctrine of piercing the corporate veil nor any of the subsequent amendments except the latest one made in the year 2006. Hence the powers of the Chinese courts to pierce the corporate veil were drawn from the Chinese civil law system which had severe restrictions on the power of the judiciary. This led to the situation that only statutory recognition of the doctrine could lend the powers to the courts to apply the doctrine and this has more than restricted the occasions on which the doctrine was employed in the Chinese company legislation history. 7.0 Piercing of Corporate Veil and Chinese Courts: Piercing the corporate veil is an important doctrine in the company legislations, as it decreases the incentives on the part of the companies to stretch themselves to do activities that are in excess of its capabilities. As far as China is concerned the country has taken few necessary steps in improving the corporate legislation. The various doctrines of the company law has been codified which leads to a meaningful understanding of the law relating to the functioning of the companies. However the country has not far enough in establishing the standards that can be used by the courts in determining when to use the power of piercing the corporate veil. Basically the company law has not differentiated the situations where the doctrine of piercing the goodwill would attract another company or would impose the liability on the individuals. The law must also provide the guidelines for the courts that can be followed in each situation for using the weapon of piercing the corporate veil. Virtually there is no way that torts and contract creditors can be distinguished under the company law. This is an area where sufficient improvements can be brought about by suitably amending the relevant provisions. As compared to the legal system prevailing in the United Stated, the legal system prevalent in China presents unique problems in the common law systems, in that Chinese law only allows the court to interpret the various circumstances through legislative mandates. The courts cannot use the changes in common laws to exercise their powers to use the doctrine of the piercing of the corporate veil. Hence it is important the Company Law provisions of China are amended to give wider powers and scope for the courts especially in the matter of using their discretion in piercing the corporate veil. 8.0 Common Law Approaches of Chinese Courts: Under the common law the legal position is taken by the courts after the facts are determined whereas in the case of statutory law the lines are drawn by the courts before the incidence of the events. Under common law it is possible to maintain the appropriate equilibrium between the law and the social norms in which the common law is embedded. It is possible under common law to have the changes on an incremental basis which allows the changes to take place without straining the legitimacy of the rule of law. However in the circumstances prevailing in China there is quite some ambiguity in exercising the doctrine of piercing the corporate veil through common law approaches. The ambiguity centers around: The courts often justify their decision to lift the corporate veil by saying that the company was a 'sham' or the 'defendants' alter ego'. However still these words are not precise enough to explain the reasons to arrive at the decision to pierce the veil, though they describe the result of the action. Moreover these terms imply the in genuine intention of the creator of the entity which is highly subjective. Secondly the multi -factor approach being used by the courts under common law makes the whole doctrine devoid of effectiveness and make it indeterminate. Relying on a multitude of factors only create a confusing situation and lead to incomprehensible decisions taken by the judges of the common law courts. According to Reed Bradely (2006) the disadvantages of allowing the doctrine of piercing the corporate veil under common laws overweigh the advantages resulting from them. In the Chinese context the veil piercing provision in the company law is short of providing the courts with precise directions on the use of the doctrine so that it would be possible for the judges to apply the doctrine effectively and uniformly to prevent the entrepreneurs finding ways to circumvent the rule. Since there is limited ability of the Chinese courts to interpret the statutory law and also they are handicapped in developing common law to suit the needs it is important that company law should be made in an explicit way as to give specific directions and circumstances under which the corporate veil can be pierced. 9.0 Conclusion: In spite of several hindrances in the form of the local communist party branches slowing the proceedings, the difficulties in collection of evidences, the lack of knowledge of the inexperience judges and the genera tendency to protect the local companies, the courts in China tried to adopt the doctrine of piercing the corporate veil in different cases in a limited way. However with the latest amendments to the company law and the changed outlook of the government towards the development of the economy, this doctrine is gaining momentum. References: Aaron Larson 2004 Piercing the Corporate Veil Law Offices of Aaron Larson http://www.expertlaw.com/library/business/corporate_veil.html Gower,LCB (1992) Principles of Modern Company Law (1992) pp 130. Reed Bradely (2006) Clearing away the mist: suggestions for developing a principled veil piercing doctrine in China Vaderbilt Journal of Transnational Law http://www.accessmylibrary.com/coms2/summary_0286-29776331_ITM Timothy Loh Revisitng the Corporate Veil Commercial Lawyer http://sunzi1.lib.hku.hk/hkjo/view/15/1500675.pdf Wolf, Baldwin Associates Piercing the Corporate Veil - Breakdowns in Limited Liability Protection in PA http://www.wolfbaldwin.com/lawyers_attorneys/Articles.aspArticleID=19&Page=pierce_corporate_veil_limited_liability_LLC_PA_Pennsylvania.asp Read More