Critical Discussion of Separate Legal Personality and Limited Liability Vis-À-Vis Corporate Groups

Example Company Law Essay

Question

'The doctrine of separate corporate personality and the privilege of limited liability should not have been extended to corporate groups. Furthermore, the problem of corporate groups is compounded by the lack of diversity in the board of directors.'

How far is one or both of these statements true?

Introduction

Separate Legal Personality (SLP) forms the foundation of company law. Determining the manner how a company exists and functions, SLP is perceived as one of the most profound and consistent principle of corporate jurisprudence. Ironically, this rule in reality has been subject to much negotiations, and is one of the most disputed aspects across the globe.1 While the legal fiction of SLP and limited liability have been acknowledged unanimously by national corporate legal systems as the "bedrock"2 feature,3 exceptions, i.e., when the corporate veil may be pierced,4 have been carved out by courts followed by statutes in enforcing these general rules. While the scope of such exceptions in general are yet not settled, significant conflict is evident more specifically in the context of group enterprises, i.e., in the conglomerate of parent and subsidiary companies.

Is the protection of "SLP and limited liability" relevant and justified for group companies?

SLP and Piercing of Corporate Veil

The rules of SLP and limited liability emerged with the increased complexity of the commercial world so as to attain diversification, liquidity, market competitiveness and efficiency, enhanced investments, and reduced risks and monitoring over corporate functions.5 This is corroborated by Pollock & Maitland - "every system of law that has attained a certain degree of maturity seems compelled by the ever-increasing complexity of human affairs to create persons who are not men . . . and to regulate their rights and duties".6 The above was further advocated in Rainham Chemical Works v Belvedere Fish Guano,7 and Re Baglan Hall Colliery Co.8 Hence, the need to limit the personal liability of business owners in the expanded gamut of commerce and newer business structures lead to the emergence of the rule of separate legal personality "SLP"- the core of corporate sustenance.

SLP provides a company with a legal identity separate and distinct from that of its owner/shareholders.9 Thus, any rights, obligations or liabilities of a company are independent from those of its shareholders, such that the responsibility of the latter are limited only to the extent of their capital contributions.10 This fiction enables a group of individuals to pursue an economic end as a single corpus, without being exposed to risks in one's personal capacity.11 As a corollary, a company, discrete of its members, can inter alia, own property, enter in to contracts, incur debt, expend funds, make investments,12 sue and be sued on its own name,13 and survive the death of its members.14

English law historically was ignorant of the principle of SLP and limited liability, as witnessed in the 1691 case of Dr. Salmon v Hamborough Company,15 where the Court ruled that a creditor could recover its dues from the members of a company if the latter was unable to repay its debt. The rule, however, came to be established in the celebrated case of Salomon v Salomon16, in which, Salomon as the majority shareholder was alleged to be personally liable for the company's debt at the time of liquidation. The liquidator, on behalf of the unsecured creditors, pleaded that the company was sham. While the Court of Appeal held the company to be a myth, the House of Lords ruled that, as the company was duly incorporated under the then Companies Act of 1862, it had a separate personality in the eyes of law with its rights and liabilities appropriate to itself, and that "the motives of those who took part in the promotion of the company are absolutely irrelevant in discussing what those rights and liabilities are".17

Thus, the fiction of law between the company and its owners/controllers18 - the "corporate veil" was created by the Salomon case, which later came to be adopted as the fundamental principle of corporate jurisprudence. Following the Salomon case, SLP and limited liability have been acknowledged as an uncompromising precedent19 in several subsequent cases like Macaura v Northern Assurance Co.20, Lee v Lee's Air Farming Limited,21 and the Farrar case.22

Having said that, this overarching rule is not devoid of exceptions. In other words, the courts may look through the veil to reach out to the insider members, known as "lifting or piercing of the corporate veil" in certain eventualities.23 As described by Sanborn J, "when the notion of the legal entity is used to defeat public convenience, justify wrong, protect fraud, or defend crime, the law should regard the corporation as an association of persons and pierce the corporate veil".24 Thus, "veil piercing"25 is an equitable remedy to the otherwise authoritative SLP and limited liability rule, so as to look beyond the incorporated form26 to track the owners or controllers who have defaulted in the legitimate corporate expectations..27

It is relevant here to refer to the case of Adams v Cape Industries,28 which examined the various grounds for veil piercing as evolved through case law,29 namely (a) agency;30 (b) fraud;31 (c) sham or façade;32 (d) group enterprises;33 and (e) unfairness or injustice.34

Group Enterprises

March of Law through Cases

This exception was devised by Lord Denning as the "single economic unit" theory, in the case of DHN Food Distributors v Tower Hamlets London Borough Council.35 The exception implies that a group of companies under common ownership and/or control would be considered as a single entity, notwithstanding their separate incorporated corpus.36 This explanation can be traced back to the 1969 decision of Littlewoods Mail Order Stores v Commissioners of Inland Revenue,37 where the Court refused to recognise the subsidiary as an independent entity.38

Although the later Albazero case39 continued its reliance on the SLP rule, the DHN Food Distributors case soon reversed the position, where the court stated that, as the subsidiaries were "bound hand and foot to the parent company and must do what the parent company says…this group is virtually the same as a partnership in which all three companies are partners", they should not be treated separately, rather "as one".40 This position was also reaffirmed in Re Polly Peck International.41

Also referred to as the "theory of enterprise entity",42 the exception of group enterprises considers the business enterprise as an entity.43 Accordingly, Phillip I. Blumberg advocates that limited liability does not apply to constituent members of affiliated corporations,44 a view similar to the 1981 draft ninth directive of the European Community, enunciating liability of the parent in respect of its controlled entities.45

Furthering this, courts have time and again declined the privilege of corporate veil to the controlling parent company in relation to any obligations or liabilities through its subsidiaries. For example, the Court, while deciding on grant of certain license in Merchandise Transport Ltd. v British Transport,46 reckoned the parent and its subsidiary as "one entity". Similarly, where a shareholder had formed a company to evade legal or contractual obligations, the Court pierced the corporate veil to reach out to the parent.47 Explaining further in Re A Company,48 where the shareholders had used the group structure to fraudulently dispose off assets, the Court pierced the veil between such affiliated companies, and ruled that the rule of SLP and limited liability may be forgone if it is necessary for justice.

This limitation to the SLP rule was soon challenged in Woolfson v Strathclyde Regional Council,49 which prescribed a two pointer test - (a) the extent of control, and (b) complete ownership, of the subsidiary, to determine if the group constituted a single enterprise.50 Likewise, Acatos & Hutcheson v Watson,51 reversed the emphasis back to the distinct legal identities of affiliated companies, except only where such affiliations were mere façade, sham or unlawful manipulations. This narrowing approach to the group enterprise exception was mirrored in Bank of Tokyo v Karoon,52 Stewarts Supermarkets v Secretary of State,53 and Reed v Nova Securities,54 to cite a few. Having said that, the exception is not yet redundant, as proved in more recent cases like Conway v Ratiu,55 and Beckett Investment Management Group v Hall.56

Statutory Exceptions

Having explored the judicial standpoint, it is worthwhile to assess the statutory position in this regard. The "group enterprises" exception is found in the Companies Act 2006 provisions57 concerning consolidated financial reporting of the group. Likewise, section 251 provides for "shadow director", i.e., a parent company may be considered to be a shadow director, if the subsidiary habitually accedes to the former's instructions. Also, the group theory is found in the employment law context, where pursuant to an intra-group transfer, an employee is considered to be on payroll without interruption or change.58 Similarly, tax provisions, such as transfer pricing norms59, and the recent Diverted Profits Tax60, permit veil piercing to check tax avoidance in related or affiliated party transactions. For instance, in Littlewoods,61 the Court pierced the veil between affiliated entities to deny tax deductions relating to the acquisition of certain property.

Board Diversity as a Precaution

It is thus clear from the above that the privilege of SLP and limited liability is much restricted in the context of group enterprises, more particularly, following the DHN Food Distributors case and the various statutory exceptions. Considering the complex matrix of ownership and control involved in such ambiguous group structures, such exception and limitation is desirable.

However, the recent trend of judiciary retracts back to the Salomon rule as demonstrated in Bank of Tokyo v Karoon,62 and VTB Capital Plc v Nutritek International Corporation63 where the court resorted to veil piercing as only a restricted equitable remedy. Likewise, in the most recent judgment of Prest v Petrodel64, the court narrowed down to only two situations, namely, (a) the "concealment principle", akin to the sham or façade exception; and (b) the "evasion principle", being the fraud exception, as valid grounds to invoke veil piercing.65 If this follows to be a precedent, the privilege of SLP and limited liability will be a strong shield in hands of group enterprises to avoid liabilities on account of affiliated companies, unless where there is a default falling within the purview of the above two grounds.

In the background of such shaky and uncertain judicial stand, practical measures like inculcating board diversity and independence may serve as alternate reliefs.66 This is because, diversity brings in the necessary levels of checks and balances, monitoring and supervision to prevent any corporate abuse. Difference of perspective, knowledge, experience and approaches can lead to better assessment of alternatives, and thus, result in better informed decisions.67 Moreover, board diversity brings in enhanced stakeholders' representation, thereby, balancing any friction of interests between creditors, minority groups, and the owners/controllers- conflicts normally warranting veil piercing.68 Without such diversity, the board tends to be driven by homogenous motives and dominant decisions, not subject to critical thinking.69 In other words, "group-think" as a consequence of absence of diversity results in biased decisions, often inflicted with errors, manipulations and unlawful disguises.70 A non-diverse board implies concentration of power and control in few hands with potential outfall of evasionary motives, abuse of corporate structures and impropriety.

Such diversity may take any form, whether demographic like age, race or gender, or functional like variances in perspectives, skills, competences and experiences.71 With countries like Norway, UK and India having promulgated laws in this regard, board diversity is undoubtedly a converging corporate governance subject in the contemporary times, which, inter alia, can help remedy the menace of abuse of SLP and limited liability in group structures.

Conclusion

Although the scope of veil piercing appears to have been limited more recently, the exceptions are far from being redundant in the UK, as it has been enforced by English courts in recent cases of Caterpillar Financial Services (UK) Limited v Saenz Corp Limited, Mr Karavias, Egerton Corp.72, Beckett Investment Management Group v Hall,73 Stone & Rolls v Moore Stephens,74 and Akzo Nobel v The Competition Commission.75 However, post Petrodel,76 the approach is more cautious and restricted.

More particularly for group enterprises, the specific exception carved out to this end explains the need to limit the privilege of SLP and limited liability in this context. However, such exception is not absolute, i.e., not every case of parent-subsidiary or affiliated enterprises is exposed to veil piercing and personal liabilities. Instead, pursuant to Woolfson77 and Acatos & Hutcheson,78 the privilege of SLP prevails as much to group enterprises only with limited exclusions. Nonetheless, the abuse of conglomerate structures for ulterior deceptive motives may well be prevented and curtailed by good governance practices such as stricter monitoring, increased accountability and independent supervision of a diverse board.

Footnotes

1 Max Radin, 'The Endless Problem of Corporate Personality' (1932) 32 Colum. L. Rev. 643.

2 Jonathan A. Marcanter, 'Because Judges Are Not Angels Either: Limiting Judicial Discretion by Introducing Objectivity into Piercing Doctrine' (2010-11) 59 U. Kan. L. Rev. 191, 193.

3 Rutherford B. Campbell, 'Limited Liability for Corporate Shareholders: Myth or Matter-of- Fact' (1975) 63 KY. L.J. 23.

4 Mark A. Olthoff, 'Beyond the Form-Should the Corporate Veil Be Pierced?' (1995) 64 UMKC L. Rev. 311.

5 Daniel Q. Posin, 'Turning Green: Louisiana's Piercing-the-Corporate-Veil Jurisprudence and Its Economic Effects' (2004) 79 Tul. L. Rev. 311.

6 F. Pollock & F. Maitland, The History of English Law (2d edn, Cambridge University Press 1968) 486.

7 1921 2 A.C. 465.

8 (1870) LR 5 Ch App 346.

9 Murray A. Pickering, 'The Company as a Separate Legal Entity' (1968) 31 Mod. L. Rev. 481.

10 P.W. Ireland, 'The Rise of the Limited Liability Company' (1984) 12 International Journal of the Sociology of Law 239.

11 Ayton Ltd. v Popely, 2005 EWHC 810 (Ch).

12 Farrar v Farrars Ltd., (1888) 40 ChD 395. See also, John Lowry & Arad Reisberg, Pettet's Company Law: Company Law and Corporate Finance (4th edn, Pearson 2012).

13 Metropolitan Saloon Omnibus Co. Ltd. v Hawkins, (1859) 4 Hurl & N 87.

14 Re Noel Tedman Holdings Pty Ltd., 1967 Qdr 561. See also, Mayson, French & Ryan, Company Law (29th edn, OUP 2012).

15 22 Eng. Rep. 763 (Ch. 1671).

16 1897 AC 22.

17 Ibid 30-31 (Lord Halsbury LC). See also, Gas Lighting Improvement Co. Ltd. v Commissioners of Inland Revenue, 1923 AC 723 (Lord Sumner).

18 Jennings v Crown Prosecution Service, 2008 UKHL 29.

19 Marc Moore, 'A Temple Built on Faulty Foundations: Piercing the Corporate Veil and the Legacy of Salomon v Salomon' (2006) JBL 180.

20 1925 AC 619.

21 1961 AC 12.

22 Farrar (n 12).

23 English courts have, however, differentiated between the terms 'lifting' and 'piercing', for instance, in Atlas Maritime Co SA v Avalon Maritime Ltd, 1991 4 All ER 769.

24 United States v Milwaukee Refrigerator Transit Co., (C.C.E.D. Wisc., 1905) 142 Fed. 247. See also, Carsten Alting, 'Piercing the Corporate Veil in American and German Law-Liability of Individuals and Entities: A Comparative View' (1994) 2 Tulsa J Comp & Int'l 187, 192.

25 Glenn D. West & Stacie L. Cargill, 'Corporations' (2009) 62 Smu. L. Rev. 1057.

26 Kenneth B. Watt, 'Piercing the Corporate Veil: A Need for Clarification of Oklahoma's Approach' (1993) 28 Tulsa L.J. 869.

27 Stephen M. Bainbridge, 'Abolishing LLC Veil Piercing' (2005) U. Ill. L. Rev. 77.

28 1990 Ch. 433.

29 Peter B.Oh, 'Veil-Piercing Unbound' (2013) 93 B.U. L. Rev. 89.

30 Smith Stone and Knight Ltd v Birmingham Corporation, 1939 4 A11 ER 116; Firestone Tyre & Rubber Co. Ltd. v Llewellin, 1957 1 All ER 561; Re F.G (Films) Limited, 1953 1 WLR 483; and Southern v Watson, 1940 3 A11 ER 439.

31 Gilford Motor Company Ltd v Horne, 1933 Ch 935; and Jones v Lipman, 1962 1 WLR 832.

32 Sharrment Pty Ltd v Official Trustee in Bankruptcy, (1988) 18 FCR 449; and Kensington International Limited v Republic of the Congo, 2005 EWHC 2684 Queen's Bench Division (Commercial Court).

33 DHN Food Distributors v Tower Hamlets London Borough Council, 1976 1 WLR 852.

34 Daimler Co. Ltd v Continental Tyre and Rubber Co. (Great Britain) Ltd., 1916 2 AC 307. See also, David H. Barber, 'Piercing the Corporate Veil' (1980-81) 17 Willamette L. Rev. 371.

35 DHN Food (n 33).

36 F. G. Rixon, 'Lifting the Veil between Holding and Subsidiary Companies' (1986) 102 LQR 415.

37 1969 1 WLR 1241.

38 R v MerBan Capital Corporation Ltd., 1985 1 CTC 1.

39 1977 AC 774.

40 DHN Food (n 33), 860.

41 1998 All ER (D) 194.

42 A.A. Berle, 'The Theory of Enterprise Entity' (1947) 47 Colum L. Rev. 343.

43 Manley Inc v Fallis, (1977) 38 CPR (2d) 74. See also, NC Sargent, 'Corporate Groups and the Corporate Veil in Canada' (1988) 17 Man LJ 155.

44 Phillip I. Blumberg, Law of Corporate Groups: Substantive Law (Little Brown & Co Law & Business 1987).

45 Sandra K. Miller, 'Piercing the Corporate Veil Among Affiliated Companies in the European Community and in the U.S.: A Comparative Analysis of U.S., German, and U.K. Veil- Piercing Approaches' (1998) 36 Am. Bus. L.J. 73- The draft was, however, criticised for ignoring limited liability and increasing administrative costs, and thus, was never formulated into a directive.

46 1962 2 Q.B. 173.

47 Jones (n 31). See also, Re H, (1996) 2 All ER 391.

48 (1985) 205 BCLC 333 (C.A.).

49 (1978) ALT 159.

50 Bernard Cataldo, 'Limited Liability With One Man Companies and Subsidiary Corporations' (1953) 18 Law & Contemporary Problems 475.

51 (1996) 1 BCLC 218.

52 1987 AC 45.

53 1982 NI 286.

54 1985 1 WLR 193.

55 2006 1 All ER 571.

56 2007 EWCA Civ 613.

57 Sections 399 and 409 of the Companies Act, 2006.

58 Section 218(6) of the Employment Rights Act, 1996.

59 Part 4- Taxation, International and Other Provisions Act, 2010.

60 Part 3- Finance Act, 2015. See also, HM Revenue and Customs, Diverted Profits Tax: Interim Guidance, 30 March 2015.

61 Littlewoods (n 37).

62 1987 A.C. 45, 64.

63 2013 UKSC 5.

64 2013 UKSC 34.

65 Restricting to these two situations was, however, not consented to by all the judges on bench. For instance, Mance J. stated -'It is .... often dangerous to seek to foreclose all possible future situations which may arise and I would not wish to do so'.

66 NF Sharpe, 'The Cosmetic Independence of Corporate Boards' (2010-11) 34 Seattle University Law Review 1435.

67 DP Forbes & FJ Milliken, 'Cognition and Corporate Governance: Understanding Boards of Directors as Strategic Decision-Making Groups' (1999) 24(3) Academy of Management Review 489.

68 SA Ramirez, 'A Flaw in the Sarbanes-Oxley Reform: Can Diversity in the Boardroom Quell Corporate Corruption?' (2003) 77 St. John's Law Review 837.

69 S Nielsen, 'Top Management Team Diversity: A Review of Theories and Methodologies' (2010) 12 International Journal of Management Reviews 301.

70 IL Janis, Victims of Groupthink: A psychological study of foreign-policy decisions and fiascos (Houghton Mifflin Company 1972).

71 Krawiec, Conley & Broome, 'Dangerous Categories: Narratives of Corporate Board Diversity' (2011) 89 North Carolina Law Review 759.

72 2007 I.C.R. 1539 (A.C.).

73 Beckett Investment Management Group (n 56).

74 2009 UKHL 39.

75 2013 CAT 13 (21 June 2013).

76 Petrodel (n 64).

77 DHN Food (n 33).

78 Acatos & Hutcheson (n 51).