Lifting the Corporate Veil

A corporation is an artificial legal person that exists independently of its individuals members (Pheng, 2004, p. 344). As such, the company’s assets, debts and obligations are not the assets, debts and obligations of its shareholders, directors and employees. Similarly, in group enterprise, the parent (holding) and its susidiary company are two separate legal entities which have distinct, independent legal rights and liabilities of the others.

Effects of incorporating a company pursuant to section 16(5) of the Company Act 1965 and the certificate of incorporation issued by the Registrar such as a corporate body, power of performing all functions of an incorporated company, capability of suing and being sued, perpeptual succession, limited liability of its members, ability to acquire,hold and dispose property, are all depended on the corporate’s separate personality.

This principle was first established by the English House of Lords in Salomon v. Salomon & Co. Ltd. [1] and well accepted as part of Malaysian company law. The brief facts are as follow: Aron Salomon had for some year been a prosperous leather merchant and wholesale boot manufacturer running the business as a sole trader. He then decided to transfer the business into a limited liability company. The subcribers of the memorandum include Salomon, his wife and five of his children. Besides, he also received for his business debentures and continued to carry on the business as before. A year after, the company went bankrupt and was put into liquidation. There was just enough assets to pay off the debenture holders including Salomon himself. The unsecured creditors claimed that the company was “mere nominee and agent of Salomon”. Salomon should be ordered to pay compensation for the company against its debts other than Salomon himself. The Lord Macnagthen held that “though it may be that afer incorporation the business is precisely the same as it was before, and the same persons are managers, and the same hands receive the profits, the comany is not in law the agent of the subcribers or trustee for them” [2] (Chan & Koh, 2006, p.92-93; Pheng, 2004, p.345-348). Therefore, even though a person held almost all shares and debetures, and controlled the compay’s oporations, one was entitled to be deal with the company as a separate legal existence from oneself. As such, one is treated as other secured creditors who have priority over unsecured creditors in the event of the company being insolvent (Ohrenstein, 2010).

Hence, a company is a artificial legal person distinct from its individual members. Corporation or subsidiaries, not its directors or individual members or the parent corporation, is liable for its own contract made, torts commited or debts inccurred (Shub, 2006). This principle is regarded as the veil of the corporation.

Benefits of corporate veil.

A primary advantage of the corporate form of organization is to achieve the doctrine of limited liability, which serves as the “corporate veil” to its members, due to separate legal entity characteristic of a corporation. The corporate veil shields the members from personal liability for corporate debts, taxes and obligations. In the event of the company is wound up, shareholders’ losses are limited to their contributions to the company’s capital in the form of decreased value of the shares and any loans made to the company (Shub, 2006). In othe word, owing to corporate veil, shareholders can asume less personal risk of financial ruin if the company flounders and falters. None of individual members are personally liable for actions taken on the behalf of the corporation, and parent corporate are not liable for actions of its subsidiaries (Howell, 2007). By constrast, the sole proprietor or the partnership owner, which is regarded as one and the same legal entity with one’s business in the eye of law, is subject to personal risk and unlimited legal responsibility (Liability Protection). Therefore, many sole proprietorship or partnership owners decide to convert the business into a company.

The benefit of limited liability which is also known as a corporate veil has become highly significant in today’s litigious society. Without such limited liability, a corporation can not raise large amounts of capital by investors and get enhanced capacity for borrowing to secure financing in order to obtain more efficient operation.

Section 2: Lifting the Corporate Veil

2.1. Concept.

Lifting the corporate veil is a method applied of courts to look beyond, and disregard the independent corporate legal personality, holding liability on owners, managers and staff for the obligations of the corporation or on Parent Corporation for the obligations of a subsidiary (Howell, 2007; Ohrenstein, 2010).

2.2. Rationales for lifting the corporate veil.

Although the principle that a company is an independent legal personality separate from its individual members can derive benefits [3] , is still open to abuse, and used as a means to circumvent the law. The corporate form can produce exceptionally inequitable or unjust results in certain circumstances. Hence, in the quest of finding fair solutions to such problems, several exceptions to this principle have evolved under the legal concept of “piercing the corporate veil” (Chan & Koh, 2006, p.98; Pheng, 2004, p.349; Romelio Hernández).

2.3. When to lift the corporate veil

It has been suggested that the doctrine of piercing the corporate veil, which is a exception to the principle of limited liability, may be invoked in a wide range of situations, may be not just depended on a single factors, and determined on a case by case basis. However, there are three substantive bases in general that plaintiffs may show in any given case to penetrate corporate veil of a corporation, access its shareholders’ assets as well as impose liability upon shareholders, officers or the corporation for the corporation’s obligations and tortious acts. First, the corporation does not exist separately from its shareholders or its parent corporations. D.H.N. Food Distributors Ltd. v Tower Hamlets London Borough Council [4] where a parent company DHN owns all the shares of the subsidiaries and completely controlled and directed them, the court held that the parent corporation and its subsidiaries should be treated as one (Chan & Koh, 2006, p.116) addresses this basis. Second, the corporation is run and controlled as a mere sham or alter ego of a controlling shareholder or another corporation for illegal or criminal purpose. A Malaysian case illustrating this point is Tan Lai v Mohamed Bin Mahmud [5] where a company was incorporated with 25 percent of the shares owned by A and B, and the remainder owned by C, in order to work sawmill licence of A and B which was nontransferable and technically should not have been worked by the company. Since the company was virtually wholly owned by C and completely managed by him, A and B were not entitled to have operated within the terms of the licence, and the transfer of the licence to the company was illegal (Collier, 1998). Third, the misconduct caused the plaintiff’s asserted injury. (Mccloskey, 2008; Sweeney, 2009)

Section 3: Law Applied in Corporate Veil Lifting Circumstances

3.1. Statutory exceptions.

There are certain statutory exceptions to the rule in Salomon which involve piercing the corporate fiction and treating individual members, directors of the corporation or two corporations in a group as a single legal entity. Several main exceptions include:

Failure to use the company name.

Section 121(2) (c) of the Company Act 1965 provided that if an officer of a company or a person signs or issues on its behalf certain documents like a bill of exchange, promissory note, cheque etc in which the company’s name is not stated properly, that person will be personally liable to the holder of the instrument or order for the amount of it unless it is duly paid by the company. (Pheng, 2004, p. 350; Ohrenstein, 2010, p.3)

Wrongful trading.

Under Section 303 (3) and 304(2) of the Company Act 1965, the court can make a declaration that when a company has become gone into insolvent, the director who knew or should have known there is no reasonable or probable expectations of the debts being paid but still continues to contract debts, will be guilty of wrongful trading and liable to personally pay the debts to creditors in the event of the company’s liquidation. (Chan & Koh, 2006, p.101; Ohrenstein, 2010, p.3-4)

In Re William C. Leitch Brs.Ltd. (No.1) [6] the company went bankrupt but its directors continue to carry on its business and buy more goods on credit. Maugham J. held one of the directors personally liable for the price of those goods. (Pheng, 2004, p. 350)

Fraudulent trading.

Section 304(1) of the Company Act 1965 concerns fraudulent trading. Under that section, if it appears to the court that the company is carried for any fraudulent purposes, the court may hold any person who were knowingly parties to the fraud personally responsible for all or any of the debts or other liabilities of the company as the court thinks proper. (Chan & Koh, 2006, p.102; Ohrenstein, 2010, p.3)

H Rosen Engineering BV v. Siow Yoon Keong [7] is a case where K.L Rekraj J.C. declared the Defendant “intent to defraud” and “fraudulent purpose”.

Payment of dividends out of capital.

Section 365(2) (b) of the Company Act 1965 allows the court to lift the corporate veil in cases of dividends are paid even though there are no available profits out of which to pay them, then directors who declared the dividend will be liable to pay the debts that the company is unable to pay the creditors when due, to the extent by which the dividend exceed the available profits. (Chan & Koh, 2006, p.102-103)

3.2. Common law.

a) Illegality or criminal purpose (Chan & Koh, 2006, p.114; Collier, 1998,p.54-55)

The two Malaysian cases illustrate this point: Tiu Shi Kian v Red Rose Restaurant Sdn Bhd [8] ; Lim Kar Bee v Duofortis Properties (M) Sdn Bhd [9]

Tiu Shi Kian v Red Rose Restaurant Sdn Bhd

Fact: The plaintiffs operated a nightclub and restaurant in in Hotel Shangrila. The defendants were the owners of Red Rose Restaurant and also controllers of Hotel Berjaya Sdn Bhd, which owned the Hotel Shangrila. The parties made an agreement that plaintiffs were continued to use the premises, however three days later the plaintiffs were locked out of the premises. The plaintiffs acquire an interim injunction restraining the defendants from further action which relied on their agreement; however the defendants still locked the plaintiff out of the premises. It was disputed that the company locked up the restaurant is Hotel Berjaya, not Red Rose.

Holding: The learned judge determined that the two entities function as one single entity.

Reasoning: the structure of the two companies which provided an evidence of breaching the separate corporate existence principle; so the court notwithstanded the technical separateness of the companies and assigned responsibility upon The Hotel Shangrila for the Red Rose Restaurant’s acts.

Lim Kar Bee v Duofortis Properties (M) Sdn Bhd

Fact: Lim Kar Bee was a wealthy landowner who incorporated a company, Duofortis to buy the relevant land so as to avoid payment of estate duty in respect of the land in the event of his death. The consideration for which was basically shares in the company. The directors and shareholders of the company were the wife and children of Lim Kar Bee. When Duofortis required putting in force the contract for the purchase of the land against Lim Kar Bee, Lim Kar Bee claimed, inter alia, that the consideration for the transfer was illegal.

Holding: the court lifted the corporate veil of Duofortis in order to recognise that the controllers of the company were the wife and children of Lim Kar Bee who would otherwise have to pay estate duty on the land in the event of his death, and held that the agreement for the sale and purchase of the land and related documentation were unenforceable.

Reasoning: Lim Kar Bee intended to form the company to escape the wife and children from payment of estate duty in the event his death. Therefore, Lim Kar Bee abused the corporate privilege for illegal purpose. As a result, the court lifted the corporate veil of companies with a view to do justice particularly when an element of fraud was involved.

b) Agency (Pheng, 2004, p.354-355; Collier, 1998, p.56)

Hotel Jaya Puri Sdn Bhd V National Union Bar & Restaurant Workers [10]

Facts: Jaya Puri Chinese Garden Restaurant Sdn Bhd was closed down and workers were cut down. This company was wholly owned subsidiary of Hotel Jaya Puri Bhd whose premises the restaurant was located. The Union claimed that the actual employer was the hotel and the hotel was still in business. Therefore the workers had been fired rather than retrenched on the closure of a business.

Holding: in reality, the companies shared the same functions in an integral whole, officers and have unity management. Hence, in fact the workers were employees of the hotel. As such, the restaurant and the Hotel should be treated as one single entity.

c) Fraud or improper purpose (Pheng, 2004, p.358-359; Collier, 1998, p.60)

This issue is addressed by Aspatra Sdn Bhd &21 Ors v. Bank Bumiputra Malaysia Bhd & Anor [11] .

Fact: The defendants sued against Lorrain Esme Osman, who was at all times a director of the first defendant and chairman of the second defendant, for the secret profits made by Lorrain without their knowledge and approval, arising from transactions. The defendants also applied for a Mareva injunction to prevent Lorrain from removing his assets out of jurisdiction and for an order of find out value, nature of all his assets. The trial judge Zakaria J had granted the Mareva injunction against Lorrain in the light that the assets of Aspatra Sdn Bhd were the assets of Lorrain. The defendants appealed to the Supreme Court.

Holding: The Supreme Court of Malaysia stated that the sole purpose of disregard the corporate veil is to decide whether the assets of the appellant companies could be held or deemed to be the assets of Lorrain. The Court held that the trial judge had been correct to lift the corporate veil between the companies and Lorrain.

Reasoning: the fact that Lorrain had hidden funds fraudulently attained in corporate entities was enough to pierce the corporate veil. In addition, the almost complete control he kept over the companies in question provided further evidence that he was mere instrumentality of Aspatra and Bank Bumiputra, Lorrain and the two companies concerned are a single entity. Thus, the assets of the appellant companies are also Lorrain’s assets.

Section 4: Conclusion

The general principle in term of the status of corporate entities is that a corporation is an independent person separate from their individual members or another corporation. Hence, shareholders, officers, director, or parent corporation will not be liable for debts, nor any of the corporate acts or obligations of its corporation or subsidiary corporation even if they are consider illegal. It can be supposed that one of the biggest advantages to incorporating a business is that shareholders of the corporation can enjoy broad protection from personal exposure to trade creditors. However, in certain situations this corporate privilege is used as a device to exploit loopholes in the law for insulate oneself from liability for one’s own misdeeds or to hide the true state of affairs from the court. Therefore, accordingly where justice demands, the court will pierce the veil, go after individual corporate officials, holding them liable for the misconduct under the coporate name (Mccloskey, 2008). Similarly, when the corporate veil is disregarded, a group of companies may be treated as a single corporate entity, although the general rule is that each company within a group is distinct entity from its subsidiaries. The court’s decision on whether pierce the corporate veil is not rest on a single factor, and there are diversified circumstances relating to disregard corporate veil. It is recognized that there is no warranty that the courts will excise the power to pierce the corporate veil in every related case. Hence, it is suggested to take the facts of each case on ‘its merits’. (Collier, 1998,p.61)