Liability of Parent Company for actions of Subsidiary

The basic feature of corporate personality is that the corporation is a legal entity distinct from its members. The main advantage that it has is that it is capable of having rights and of being subject to duties which are not identical as those enjoyed or borne by its members. It has legal personality and is over and over again described as an artificial person distinguishing with a human being a natural person.

It is very difficult to think of a world without corporations which are not related to another in one way or other at the present day. So in the present world where economy is the most important thing it is inherent that there arises problems with regard to concept of limited liability of parent company towards subsidiary company.

Lord Macnaghten has stated that

“the company is at law a different person altogether from the subscribers….; and, though it may be that after incorporation the business is precisely the same as it was before, and the same personas are managers, and the same hands receive the profits, the company is not in law the agent of the subscribers or trustee for them. Nor are the subscribers, as members, liable in any shape or form, except to the extent and in the manner provided by the Act.” [1]

This decision revealed that it was possible for a trader not merely to limit his liability to money which he put into the enterprise but even to avoid any risk to the major part of that by subscribing for debentures rather than shares.

The corporation is a separate person and the members are not as such liable for its debts [2] . If there is no express provision regarding the liability of the members, they will be free from any personal liability. But with regard to a company incorporated under the Companies Act an absolute absence of any kind of liability is not allowed.

Section 1159 of the Companies Act 2006 says

“A company is a “subsidiary” of another company, its “holding company”, if that other company—

(a) holds a majority of the voting rights in it, or

(b) is a member of it and has the right to appoint or remove a majority of its board of directors, or

(c) is a member of it and controls alone, pursuant to an agreement with other members, a majority of the voting rights in it,

or if it is a subsidiary of a company that is itself a subsidiary of that other company.”

Section 1162(2) [3] says that

“An undertaking is a parent undertaking in relation to another undertaking, a subsidiary undertaking, if—

(a) it holds a majority of the voting rights in the undertaking, or

(b) it is a member of the undertaking and has the right to appoint or remove a majority of its board of directors, or

(c) it has the right to exercise a dominant influence over the undertaking—

(i) by virtue of provisions contained in the undertaking’s articles, or

(ii) by virtue of a control contract, or

(d) it is a member of the undertaking and controls alone, pursuant to an agreement with other shareholders or members, a majority of the voting rights in the undertaking.”

Liability with Regard to Parent Corporation

The liability of a corporation which is a parent one towards the acts of a subsidiary of the parent is regulated in accordance with the basic concepts of limited liability and separate entity in company law. The result of such a process and the justification given by courts for such an effect has drawn to such a reality that it overrides a registered company’s autonomous legal personality. From the period of 1944 itself companies were regarded as autonomous legal personality. They were entitled to get this status once they have made a legal incorporation and independent existence with proper administration. The result of such a process is that it will lead to a situation where the company will be considered as a separate legal entity and it will not be in the hands of the persons who incorporated it but with the persons who are the Board of Directors of the company.

We all know that there are certain liabilities for the shareholders towards the company. The liability of the shareholder towards the debts of the company was analysed by the House of Lords in the case of Salomon v. Salomon which gives further support to the English Company Law as it stands. One of the fundamental principles of company law is that a company is a separate legal entity distinct from the shareholders of the company. The rule with regard to it was laid down in Salomon v. Salomon & Co. by the House of Lords in which it was held that “even if one individual held almost all the shares and debentures in a company, and if the remaining shares were held on trust for him, the company is not to be regarded as a mere shadow of that individual”.

The English courts followed the judgment of Salomon’s case in the subsequent cases. In Adams v Cape Industries Plc [4] , it was held that ;

“the court is not free to disregard the principle of Salomon v Salomon & Co Ltd merely because it considers that justice so requires. Our law, for better or worse, recognises the creation of subsidiary companies, which though in one sense the creatures of their parent companies, will nevertheless under the general law fall to be treated as separate legal entities with all the rights an liabilities which would normally attach to separate legal entities …”

The Court of Appeal faced an issue with regard to the enforceability of a foreign judgment in England in Adams v. Cape Industries Plc. [5] In this case the subsidiary company in South Africa employed the claimants. The complaint was relating to health hazards caused to the employees by asbestos. The complaint was filed against the Parent Company for personal injury. The court discussed the issue of corporate personality in this case along with the issue of lifting or piercing the corporate veil. In this case the court held that primary judgment obtained against the subsidiary company and in default of parent company’s appearance cannot be enforceable in England. The reasoning given by the court in the present case was that the parent company is having a separate legal existence entirely different from the subsidiary company and consequently it cannot be held liable as there is no presence of the parent company in the foreign country were the case came up and was adjudged. In the case of claims of personal injury against the parent company this judgment was making serious implications with regard to enforcement. This was mainly because the parent company can always decide not to take part in the suit proceedings and avoid litigation on the basis of separate legal existence of a corporate entity.

The dilemma based on this issue forced the courts to give greater thrust to exceptions laid down in the Salomon’s case with regard to the liability of parent company like that of Sham constructions and Agency relationship. This paced way to the beginning of creation of the concept of group liability. Several terms are used to denote the relationship between a subsidiary company and parent company. The words like holding companies or subsidiaries, dominant influence and participating interest etc are some of the commonly used terms in English company law. Lifting of corporate veil is the most commonly used concept in cases relating to group liability and is applied on a case to case basis. Thus it may be right to say that though English law has dealt with the concept of group liability it is not specified in any law.

From an analysis of the above cases it can be concluded that the English courts have always been reluctant to adhere to the principle of attaching liability on the parent company for the acts of its subsidiary and for the purpose of this they have always taken refuge on the doctrine of corporate veil. For the purpose of this the courts have gone to the extent of creating various exceptions to the ratio laid in the Salomon case so that the same can be exploited by the parent companies to their advantage. Of these exceptions the major is the sham exception whereby the legal personality of a corporate entity will be looked into by the court if it can be proved that such entity had nothing to do with the act from which the liability arose other than a facade or sham created to distinguish as legal inoculants.

The approach of the English court to find ways and means to apply the exceptions to the principle evolved in the Salomon case can be clearly seem from the decision of the Court of Appeal in Adams v Cape Industries Plc. [6] Here the court refused to apply the doctrine of lifting of the corporate veil so as to impose liability on the actual minds that control the activities of the subsidiary company. It was a case where the parent company used low capital subsidiary company through a multifaceted transnational contract for the purpose of marketing harmful asbestos products. Permitting the utilization of such transnational agreement for the purpose of building strong corporate structures on behalf of the Court Slade L. J., held that

“as to ensure that the legal liability (if any) in respect of particular future activities of the group … will fall on another member of the group rather than the defendant company”.

This decision shows that the attitude of judiciary has not changed much since the Salomon decision for the reason that the decision follows the same line. In both these cases the court permitted the corporate entities to take the maximum advantage of their name and goodwill and at the same time structure the matters in such a manner that they are absorbed of the liability to their creditors. The present case has further tapered the applicability of the doctrine of corporate veil fundamentally to three situations which are:-

“where the court is interpreting a statute or document.

where the company is a mere façade

where the subsidiary is an agent of the company” [7] .

Exceptions to the general rule were a need in the 20th century. There were several attempts made to develop exceptions. The general rule was that the company will be considered as a separate legal entity. In the case of Smith, Stone & Knight v. Birmingham Corp. [8] an exception with regard to agency relationship was developed by Atkinson J. The exception of single unit was developed in DHN Food Distributors v. Tower Hamlets LBC. [9] In the case of Creasey v. Breachwood Motor [10] Richard Southwell’s interest of justice was developed. The grounds put forward by the court in Adams v. Cape Industries Plc for disregarding the so called separate entity by piercing the corporate veil. The most important exceptions developed by the court in this case were the façade or sham exception and the agency exception.

Exceptions

There are certain exceptions developed by the courts in order compete with the general rule of separate legal entity of a company. Even though the courts were reluctant to develop some exceptions for the general rule, by the pass of time the need for developing exception reached a situation where in the companies especially the parent companies were not able to work. For that some exceptions were developed of which the ones related to limited liability of parent companies are the Sham or Fraud Exception and the Agency.

Exception of Sham or Fraud

Subsidiary company is a company that is publicly-traded but will be having stocks more than half owned by another company, known as the parent company. When the parent company is having stocks more than half the control the company will be maintained by the parent company. Some subsidiary company may be based on the industry of the parent company itself, but it may trade on some other industry also if the parent company has decides to go for some other industry.

A parent company will have subsidiary companies for so many reasons. Some subsidiary companies will be maintained to conceal the true facts or to shield the works of the parent company. One of the main purposes of the sham or fraud exceptions for the court is to examine whether the corporate structure of subsidiary companies is used to conceal the true facts or to perpetuate fraud or for any manipulative circumstances. In circumstances where the court comes across with such a situation , the usual phenomenon is to lift the corporate veil to the decide on the liability.

The exception of sham or fraud was developed by the courts by way of two cases. Those cases are Gilford Motor Co v. Horne [11] and Jones v. Lipman [12] . In the case of Gilford Motor Co v. Horne the defendant started a new company and incorporated it inorder to get the customers from his previous employer keeping it in direct competition with the former employer’s company. The Court of Appeal lifted the corporate veil to provide the former employer an injunction which will be effective against the company as well as the defendant as his company was merely created to sham to breach the restrictive covenant against the defendant.

In the case of Jones v. Lipman [13] the defendant entered into contract to sell land with the plaintiff and later changed the mind to sell the property. In order to evade from specific performance of the contract the defendant created a company and transferred the property to it. Russell J. refused to recognise the separate corporate entity of the company under the circumstances of the case to make the defendant as well as the company liable for the specific performance of the contract.

Agency relationship

The other main exception to the Salomon principle identified by Slade L.J. is based on the decision in the case of Smith, Stone & Knight Ltd v Birmingham Corp. [14] , in which the parent company’s business was carried on by the subsidiary. In this situations the business relationships together whether the controlling persons will be treated as the head and brain of the venture by bringing the concept of effective and constant control of the business.

Instead of concluding that a case by case approach should be followed the court held that for identifying the agency relationship more than mere control over the company and its shares is essential. Thus the court to hold in Adams v Cape Industries that even though the group can be treated as single economic unit, to bring liability the subsidiary should be identified as utterly and totally under the control of its parent company. It can thus be summarised that the Salomon principle implies that the single economic unit will be treated as a single legal entity when there is no artificial separation into different legal entities.

The cases were the plaintiffs was allowed to lift the corporate veil is very limited. As held by Slade L.J. in Adams’ case the mere fact that the parent company is controlling the business of the group is not sufficient to provide an agency relationship. For instance, in the case of Smith, Stone & Knight Ltd v Birmingham Corp., the parent company purchased an unincorporated business and after registration made it a subsidiary to do business lie an internal department of the parent company. The parent company had complete access to the books and accounts of the subsidiary and it provided parent company’s premises for subsidiary’s operation without any consideration. The only factor which identified the subsidiary is its separate name as it does not have any employees of its own. The Court of Appeal allowed the contention of the parent company that the subsidiary was carrying on the parent company’s business and allowed to claim compensation by the parent company for the compulsory acquisition of the premises of the subsidiary company. This case have difference from the other cases since the beneficiary in this case is the parent company in contrast with other cases were the main grounds will be the liability of the parent company over the actions of eth subsidiary.

Case Laws

The limitation of the agency exception to pierce the corporate veil has led to a whole body of cases in which the sham or façade exception was used to provide liability to the parent corporation. In this aspect Slade L.J. insistence of ‘sham’ exception as the general ground for lifting the corporate veil gets much importance. The decision in Adams attains significance in the context that it allowed the continuance of corporate entity’s separate integrity and autonomy while at the same time provided space for courts in future to prevent the abuse of corporate structure by parent companies. The decision in Adams case does not reflect the real jurisprudence the English court have developed for finding the doctrinal basis of the test for piercing the corporate veil which finds its basis on the two doctrines of head and brains rule and the cloak or sham rule. The developments of this rule and its ramifications can be examined by analysing the following cases:

Gilford Motor Co v Horne

This case came before the House of Lords and it involved the setting up of a company with the objective to evade the effect of a restrictive covenant. An injunction was allowed against the defendant and the company by piercing the corporate veil without any reference to the case of Salomon v. Salomon. The court only given secondary importance to the corporate veil as it was mainly concerned with the interpretation of the restrictive covenant that prevented the soliciting of former employer’s customers. On appeal Lord Hanworth observed the company as “a mere channel used by the defendant Horne for the purpose of enabling him, for his own benefit, to obtain the advantage of the customers of the plaintiff company”.

In this aspect it will be worth to discuss the role played by a Smith v. Hancock, a non company law case which formed the basis of the decision in Gilford. It involved whether a new grocery business having defacto similarity with Hancock’s earlier business can be established or not. But later in Salomon’s case the court failed to provide liability to the trader due to the absence of express legislative provisions.

Woolfson v Strathclyde Regional Council [15]

In this case the Court justified piercing the corporate veil to give effect the realities of the business situation. Even though there is no issue in the case that the company is fraudulent or sham, Lord Keith expressly stated that “any departure from a strict observation of the principles laid down in Salomon has been made to deal with special circumstances when a limited company might well be a façade concealing the true facts”. The court disregarded the approach laid down in DHN Ltd. v Tower Hamlets by Lord Denning that to treat a group of companies as single economic entity making it a single entity before law.

The approach of the court for piercing the corporate veil based on the “realities of the situation” and “interests of justice” where later disregarded by the court in Adams v. Cape and Ord v. Belhaven Pubs. In the case of Ord [16] , Belhaven Pubs was a subsidiary company of the parent company Ascot Holdings. In case against the Belhaven Pubs the plaintiffs were not able to recover their claims due to insufficient assets. The shortfall in the company was caused due to the restructuring of the company by the parent company in response to a recession in the market. The Court of Appeal refused to lift the corporate veil and upheld the separate identity of the subsidiary from the parent company. It was stated by Hobhouse L.J. that the restructuring was done in conformity with the liberties given by the Companies Act 1985.

In the aspect of this case the decision in Creasey v Breachwood Motors [17] , attains significance. In this case Mr Creasey obtained an award of damages for the unlawful dismissal of him from his job in Welwyn Motors. The two traders of eth Welwyn Motors transferred the asset of the company to another company Breachwood Motors controlled by them so that the award cannot be enforced. Mr. Creasey approached the court for an order to obtain the damages from Breachwood another company of the group which was allowed by Mr Richard Southwell Q.C. by lifting the corporate veil. This case was disregarded in Ord, on the ground that “only where a company is recognised as a fraud or sham can its autonomous legal existence within a group be disregarded”. Without distinguishing the case from Ord the proposition laid down in Breachwood was struck down as a valid authority.

DHN Ltd. v. Tower Hamlets

In the case of DHN Food Distributors Ltd v. London Borough of Tower Hamlets [18] , Lord Denning put forward the need to treat a group of companies as one since in reality it works like a single economic entity. This decision can be treated as a continuation to the approach taken by lord Denning in Littlewoods Mail Order Stores Ltd v. McGregor [19] which highlighted the need for giving careful consideration of the Salomon doctrine in applying to groups of companies. The DHN case involved the compulsory acquisition of one company’s premises in a group owned entity the court examined the concept of “single economic unit” to recognised the group as a single entity.

San Paulo (Brazilian) Railway Co v Carte

The San Paulo case involved a single English domiciled company’s attempt to refute liability to pay income tax arising from its foreign operations. In contrast to the other two cases the court was not called to pierce the corporate veil a sit involved a single company. The court held that the intra-corporate activities in several jurisdictions will be treated as part of one business enterprise for taxation purposes.

Apthorpe v Peter Schoenhofen Brewing Co

In this case an English brewing company tries to evade the Law of the American State of Illinois which prohibited foreign companies to hold property in the state. The English company purchased all the shares except three shares of an existing American brewing company and it also entered into an agreement with the members of the acquired company who held the remaining three shares to obtain full rights of control over the business of the subsidiary company. There was provision in that agreement that the day to day business will be managed by the members of the acquired company in Illinois.

The issue of the case was that whether the English company was “carrying on” a business in United States of America for fixing the liability to pay income tax. As per law then prevailed an English company should pay income tax in Britain for the income generated from overseas operations. Lord Justice Smith the contention of the company that the principle in Salomon v, Salomon to be followed to give separate entity to eth two companies so that the income tax cannot be charged. Smith L.J used “the heads and brains” of the business operation in the American which is the management in England to fix liability for income tax.

St Louis Breweries v Apthorpe

In this case similar to the Schoenhofen, the English court pierced the corporate veil as the company was used by the English parent company as a sham. In this case an Anglo-American parent- subsidiary company attempted to evade a prohibition in the American state of Missouri related to income tax liability. The English court to fix income tax liability used a similar reasoning as developed in the case of Schoenhofen to refuse the argument that eth American company is conducting business completely different from its English parent company. It was held by Wills J. that to determine the boundaries of the company’s identity, “one ought to look at the substance, and not merely at matters of machinery and form”. This gives importance to the approach taken in the earlier case of Schoenhofen for taking a fact based and open ended approach by taking into consideration the actual operations of the company.

Gramophone and Typewriter v Stanley

This case concerned the liability of an English company to pay income tax after obtaining controlling stake in a German company. As the English company later obtained full ownership of the company the HM Inland Revenue argued that the fully owned German subsidiary is eth business of the English parent company and so that it can be taxed for the additional profit through subsidiary’s operation. This view was rejected by the Court of Appeal unanimously to hold that;

“the German company was not at first, and there is no evidence that it has ever become, a sham company or a mere cloak for the English company”.

Lord Buckley differentiated the facts of the case from the earlier cases like Schoenhofen on the basis that the English company enjoyed ownership only as shareholders and with the German company carrying the business activities. While in Schoenhofen the English parent company was carrying out the business of the American subsidiary.

Daimler Co v Continental Tyre and Rubber Co.

In Daimler Co. case the Court examined the importance of Salomon principle in contrast to the earlier cases. The company was registered in England and all but one of the directors of the company was German. During the wartime in 1915 question arised whether it should be considered as an enemy for assessing the validity of the transactions it entered with other English countries. Even though the House of Lords recognised the company as an enemy company the importance lies in the recognition of the Salomon case.

The House of Lords clearly stated that the English company in question was not a sham or mask or to conceal the identity of persons, the fact that the company genuinely trading between England and Germany Lord Reading held that consideration of justice should take precedence over matters of legal form.

Tunstall v Steigmann

Turnstall v. Steigmann concerned the dispute over the interpretation of Landlord and Tenant Act 1954, s.30(1)(g). in this case the landlord gave notice to acquire possession of the property from the tenant for extending the business. Later landlord decided to incorporate the business which caused the tenant to claim that it was the new company which has to provide the notice. It was argued that since the company was a separate legal entity it cannot be treated that the landlord is continuing the business. Lord Justice Ormerod rejected tenants argument identified the need for asking whether

“there [is] anything to merit a departure from the main principle of Salomon v Salomon & Co Ltd … that a company and the individual or individuals forming a company were separate legal entities, however complete the control might be by one or more of those individuals over the company…that any departure from the Salomon principle has been made to deal with special circumstances when a limited company might well be a façade concealing the true facts”.

The court also referred the decision in Gramaphone & Typewriter case in support of the decision and it represents an attempt to use the “sham” exception for piercing the corporate identity in the light of the decision in Salomon’s case.

Pioneer Concrete Services v.Yelnah Pty Ltd

In the New South Wales case of Pioneer Concrete Services v. Yelnah Pty Ltd [20] Young J considered the authorities and held that the veil should only be lifted where there was in law or in fact a partnership between the companies, or where there was a sham or façade.

Littlewoods Mail Order Stores Ltd v. McGregor

In Littlewoods Mail Order Stores Ltd v. McGregor29 Lord Denning warned that the Salomon doctrine had to be carefully watched, and said that Parliament had shown the way as regards the scrutiny of groups of companies, and that the courts should follow suit.

Conclusion

The net effect of the decisions in San Paulo, Schoenhofen, St Louis and Gramophone and Typewriter, and the reasoning deployed by the English courts therein, was that sham became a recognised exception to the general principle of corporate autonomy as laid down in Salomon. This was so despite the fact that in none of these four cases did the courts pay any more than a dismissive reference to the Salomon judgment, undoubtedly ignoring the effect that this decision might have on their ability to disregard the legal boundary between independently registered companies with the ease and for the reasons that they did. Consequently, the doctrine that later became known by the courts as the “sham” exception to the principle in Salomon had, within just over a decade of the decision in Salomon, taken on its own autonomous trajectory of development, existing independently of and without either reference to or respect for the significance of the Salomon judgment itself.

In this aspect the need to develop the concept of enterprise liability gets much importance. Rather than debating the concept of the role of piercing the corporate veil, the use of enterprise liability will help to bring liability to the parent corporation for subsidiary’s action. The present approach has provided wide discretion to the courts to decide the liability of the parent company.