Exceptions to Principle of Separate Legal Entity

It is said that the principle of separate legal entity “forms the foundation of modern company law. Any exceptions to this principle must therefore be seen as challenges to those foundations.” [1] Thompson in Piercing the Corporate Veil: An Empirical Study states: [2]

“As a general principle, corporations are recognized as legal entities separate from their ………. liability of the entity and not of the shareholders, directors, or officers who own and/or act for the entity.”

Therefore the way in which the law challenges the doctrine of separate legal entity is through a process called lifting the corporate veil. [3] It is the purpose of this essay to demonstrate the instances in which the courts have been prepared to pierce the corporate veil, together with examples of when the courts have been reluctant to do so.

Part 2 Section 15 of the Companies Act 1993 [4] codifies that a company is a legal entity in its own right. However it was the landmark UK case of Salomon v Salomon & Co. Ltd [5] in 1897 which first tackled the issue of separate legal entity in the court, as well as the rules and principles of separate legal entity and ultimately decided that the legal metaphor of corporate veil was to be accepted at law. [6] Sixty years later in the case of Lee v Lees Air Farming Ltd [7] that New Zealand accepted and followed the judgement of Salomon. Lee outlined that a shareholder, director and employee could be the same one person but still hold a separate legal entity for each entity in law. Following paragraphs will demonstrate through the means of case law when the courts have been prepared to pierce the corporate veil, as well as examples of when the courts have been reluctant to do so. The rule as to if a court will pierce the corporate veil is relatively general, and it is held that the corporate veil should be lifted in circumstances where the persons controlling a company have acted fraudulently, where the company is regarded as a “sham”, and where a company is used to avoid an existing legal duty. [8] There is another cause in which the court will consider the legal personality and lift the corporate veil not afore mentioned and that is in times of national emergency as seen in the case of Daimler.

In Daimler Co Ltd v Continental Tyre & Rubber [9] the company Continental Tyre & Rubber was incorporated in England however all the shareholders and directors except one were German Nationals. In 1914 there was an outbreak of war between the two nations. Continental Tyre & Rubber sued Daimler Co Ltd for an unpaid debt. The argument of Daimler Co Ltd was that Continental Tyre & Rubber was an alien enemy and that it was illegal to trade with an enemy, and further wanted to avoid funds going towards the Germans war effort. The court had to consider whether they would lift the corporate veil and inquire as to the nationality of the shareholders and consider the ownership of the company. It was held by the court as a matter of national emergency that the corporate veil could be lifted, and was. Daimler Co Ltd did not have to pay Continental Tyre & Rubber the dept due.

The case of Macaura v Northern Assurance Co Ltd [10] M owned real estate on which stood timber. M sold the real estate as well as the timber to a company M formed and received as consideration every one of the wholly paid shares. The company carried the business of felling and milling timber. A fire destroyed all timber which had been felled. Macaura had earlier insured the timber against loss of by fire in his own name. He had not transferred the insurance policy to the company. The question of law was whether M had an insurable interest in the timber, further did M have an equitable or legal interest in timber thereby allowing M an insurable interest. It was held by the House of Lords that shareholders have no legal or equitable interest in their company’s property. Furthermore the insurers did not have to pay out as M and the company where two separate legal entities and the insurance policy was not held in the correct legal name as M did not personally own the timber, M did hold the requisite insurable interest.

In the case of Gilford Motor Co Ltd v Horne [11] the court found that the veil of incorporation may be lifted in instances were there is evidence of fraud. The brief facts of this case are that Gilford employed Horne as a managing director for a six year term. Horne’s employment contract contained a restraint of trade clause where he agreed if he terminated his employment he would not solicit customers away from Gilford. Horne did leave Gilford and set up a rival business in which enticed customers away from Gilford. Gilford sued Horne to enforce the restraint of trade clause, however Horne argued on the grounds of separate legal entity that it was the company that enticed the customers away not Horne personally. The Court of Appeal allowed the enforcement of the clause in contract against the company. They did this because Horne had used the company as a “mere cloak or sham” [12] , the court lifted the corporate veil and allowed liability to be imposed on the reasons of fraud, Horne used a separate legal personality to carry out an action that was personally prohibited for him to do.

As the case of Gilford [13] has demonstrated the court will disregard corporate personality if it is used as a sham or façade to avoid personal contractual obligations, however this fraud must be clear. Paterson J did pierce the corporate veil in this final demonstration on when the courts will lift the veil. In Official Assignee v 15 Insoll Avenue Limited [14] Paterson J held that it was appropriate to pierce the corporate veil because of special circumstances indicating that it was a façade concealing the true facts. As well as the company formed had not been genuinely and honestly used. He measured he was able to put the company structure to one side on the basis, that the company was a façade and a sham, and that the corporate veil could be lifted.

The following cases demonstrate when a court will not put the company structure aside and pierce the corporate veil. In Savill v Chase Holdings (Wellington) Ltd [15] the court was asked to lift the veil and treat three companies as one. [16] The Savills requested that the veil be lifted so the actions of one company could be connected to the other subsidiary companies. The Court of Appeal said no, that the veil would not be lifted unless it was so: [17]

“unsatisfactory as to warrant some departure from the normal rule. In a contractual context when it is sought to lift the corporate veil against a situations …………where there is some element of fraud or sharp practice in that party’s conduct or where it would otherwise be unconscionable if strict adherence to the principle of separate corporate entity were maintained.”

This was further demonstrated in the 1996 case of Chen v Butterfield [18] in this case a company was formed for the sole purpose of acting as lessee to avoid personal liability. Chen argued that this was a mere sham and façade, Chen needed to prove to the court that it was appropriate to lift the corporate veil. Chen did not succeed it was stated by Tipping J that there was not concealment of true facts further it was said the “façade” approach was not adequate. Tipping J followed and applied the judgment of Re Securitibank [19] in which was made by Richmond P: [20]

In essence the corporate veil should be lifted only if in the particular context and circumstances its presence would create a substantial injustice which the Court simply cannot countenance. They are firmly and deeply engrained in our commercial life. If they are genuinely and honestly used they should not be set aside.

This case clearly demonstrates the statement corporate obligations remain the liability of the entity, further it enforces the idea that that if a company is bona fide the corporate veil will not be lifted. To create a personal liability it requires further evidence outside the “façade” argument.

As the afore mentioned cases suggest doctrine of separate legal entity and the corporate veil are distinctly intertwined, and corporations are given legal personality which means limited liability companies are treated as artificial entities. Thus gives the company’s shareholders protection from personal judicial action. There has been on occasion a situation when legal entities are not recognised as separate from their shareholders. When this is the case it is court who decides if the Veil of Incorporation will be lifted. The lifting of the veil is an exception to the legal principle of separate legal entity and as established through the demonstrated cases it is used sparingly.