Veil Piercing in Corporate Governance, Dissertation

Abstract

The dissertation’s inquest was born out of an appreciation of the concern expressed by a plethora of related contemporary literature that, the veil protecting directors and shareholders of corporations may sometimes act as an injustice to creditors. The paper’s mandate then became to review and objectively critique the place of accountability and disclosure in contemporary corporate governance as regards the interests of creditors and shareholders, and further, to establish whether the existing veil of corporate finance laws enacted to validate corporations and their operations ought to be pierced in certain instances.

The dissertation appreciates the fact that contemporary corporations are in themselves a genius through which mega business entities with varied interests are given a personality, an individualism that is recognized by law, an ability to be taxed, to conduct contractual business, to be an entity in legal proceedings, to acquire and trade in capital and assets, and most importantly to be independent from the individuals who run, trade with or own them. This legal veil, as the paper finds, is an important feature of corporations and must be protected at all times if progress is going to be made in advancing corporate business. According to the study, many of the modern mega-corporations owe their success to the protective veil around corporations as granted by contemporary corporate law.

However, the paper emphatically concludes that whenever a corporation becomes a sham, whenever they engage in fraudulent and even wrongful acts, such as when the corporations are used solely for personal benefit of the officers, directors and shareholders, the court of law within the jurisdiction should disregard (pierce) the veil and protect the involuntary creditors, creditors during insolvency and minority shareholders.

The paper assumes a global perspective, and concentrates on global corporate governance and its link to veil piercing debate as can be gleaned from exemplification drawn from the UK and the US jurisdictions. The Document analysis method of data collection, analysis and presentation has been employed to combine two research methodologies into one, namely exploratory research and explanatory/critical research.

It is the conclusive argument of the paper and to that extent a recommendation, that the veil protecting corporation’s directors and shareholders only be pierced if these members did not practice the legal responsibility assigned them of maintaining auditory accountability and disclosure of their statements of accounts. It is recommended that if the level of accountability and disclosure attained is deemed sufficient, it should be used to determine the extent that creditors and minority shareholders are themselves liable for taking the risk of investing or lending to that corporation, before the veil is pierced for their claims.

CHAPTER 1

1.0 Introduction

1.1 Background Information

As shall be discussed later in the dissertation, corporations are among the single greatest instruments of corporate governance in large business establishments that man has ever conceived (Griffin, 2004; Davies, 2003). Corporations are in themselves a genius through which mega business entities with varied interests are given a personality, an individualism that is recognized by law (Easterbrook & Fischel, 1985; Barnet& Muller, 1974). This allows the businesses and their varied investment interests to be taxed as a singular entity, to conduct contractual business, to be a legal entity in legal proceedings, to acquire and trade in capital and assets, and most importantly to protect the individuals running such corporations from a mountain or financial and legal risks (Davies, 2003).

Corporations are simply artificial establishments (better thought of as instruments of modern corporate governance) created as per the provisions of state statutes, treated like individuals in business under the ordinances of law (Griffin, 2004; Davies, 2003), having a legally enforceable set of rights, carrying the ability to legally acquire debts from creditors and also pay out their profits to shareholders, having an ability to acquire, hold and even transfer capital (property), having a status to enter into legally enforced contracts, able to meet the requirement of paying taxes and perhaps more importantly having an ability to be sued and to sue (Easterbrook & Fischel, 1985).

This more or less makes corporations individuals in the eyes of corporate law across the globe, giving the corporations an ability to carry the burden that would otherwise be placed on its owners, such as of liability to debt (Easterbrook & Fischel, 1985). Corporate law in America and in the UK especially, have been veiled behind a network of laws that protect shareholders and directors from legal liability of the actions of that business entity, the liability that is usually placed on owners of unincorporated partnerships and sole entrepreneurships, and in so doing placing lenders to the business in great risks (Easterbrook & Fischel, 1985). Here is an entity legally allowed to incur debts and yet operated under the will, whims and personal interests of directors and shareholders, at the expense of the creditors (Grossman, 1995; Easterbrook & Fischel, 1985).

The risk placed among lenders to corporations, whom for the purposes of this dissertation shall be referred to hence in the more appropriate term creditors, is that they can be tricked to lend their capital to businesses at a certain estimated risk level (which determines the interests they charge on the loans), only for the directors and shareholders to mismanage and acquire the same capital with self interest (Griffin, 2004), yet when the corporation is sued, the shareholders and directors are shielded against liability by the ‘veil’ of corporate laws (Easterbrook & Fischel, 1985).

The term veil in this sense will refer to the curtain of legal protection accorded to the persons in corporation governance against any liability of the corporations operations and engagements. After all, the corporation is recognized by law to enter into contracts and if they default on such contractual terms, it is the corporation to be held liable and not the personalities in its governance (Davies, 2003). Some interesting questions arise from this scenario. What happens if the directors and shareholders of the corporation, wilfully and maliciously govern the corporation in a way that benefits their worth and defrauds the creditors? What if the directors and shareholders exploit the opportunity of their protective veil to serve their own interests with disregard to what their actions portend for the creditors? While corporations are conceived as individuals before corporate law (Davies, 2003), where does the shareholders liability (the accountability of their governance of that corporation), lie?

This dissertation was born out of the concern and appreciation of the concern of others as expressed by a plethora of related contemporary literature that the veil protecting shareholders of corporations may be an injustice to creditors (Easterbrook & Fischel, 1985). The paper’s mandate is to review this scenario and present an objective criticism about the place of accountability and disclosure in corporate governance as regards the interests of creditors and shareholders, further, whether the existing veil of corporate finance laws enacted to validate corporations and their operations ought to be pierced /removed.

The concerns here is that the veil as defined above only provides for the responsibilities and rights of corporations as independent and even distinct entities from the very people who govern, own and invest in them (Griffin, 2004), thus making corporations mere avenues for people to run businesses and share the profits made in such business exploits, with minimal accountability and risk for their investment in case of losses and insolvency (Davies, 2003).

It is important to note that this concern is not newly raised or just realized. Even before corporations were largely accepted by laws in various jurisdictions across the world, they were criticized for this same weakness and vulnerability to abuse. The debate has been ongoing (Easterbrook & Fischel, 1985). Whenever corporation become shams, whenever they engage in fraudulent and even wrongful acts, such as when the corporations are used solely for personal benefit of the officers, directors and shareholders, the court of laws within the jurisdiction are sometimes mandated to disregard the veil (protection granted the shareholders and directors from the liability of the corporation) that legally separates the corporate existence of a business entity from its governors, owners and investors (Griffin, 2004), and in so doing, impose a liability on the persons of officers, directors and shareholders running and owning the corporation (Davies, 2003).

In this conception, the courts may thus pierce the veil by trampling the very law that separates corporation as entities in terms of liabilities and assets, distinctly from those people who are behind such a corporation (Easterbrook & Fischel, 1985). This veil as described above is the legal platform justifying the creation of a separate, individualized, legally recognized corporate establishment that shields shareholders and directors from any personal liability in the operations and outcomes of the corporation’ (Easterbrook & Fischel, 1985). Interestingly therefore, the dissertation seeks to analyze the circumstances, logic and validity of the instances that courts of law can invalidate the protective veil of corporations in modern business setups.

An example of the instances in which courts of law may look beyond the veil is when the substance of a corporation’s actions is indicative of misuse of that corporate privilege fraudulently, mischievously and maliciously, such as in increasing the risk faced by creditors (Easterbrook & Fischel, 1985). According to Easterbrook & Fischel (1985), if the directors and shareholders act in such a way that is fraudulent, misrepresentation of the corporations business partners, illegally or without fairness or equity in the distribution of the corporation’s assets and capital, then courts gain the right to pierce the veil, limit the corporate privileges and even transfer the corporate liability to the persons governing the corporation.

1.2 Statement of the Problem

This dissertation was born out of the concern and appreciation of the concern of others as expressed by a plethora of related contemporary literature that the veil protecting shareholders of corporations may be an injustice to creditors (Griffin, 2004). The paper’s mandate is to review this scenario and present an objective criticism about the place of accountability and disclosure in corporate governance as regards the interests of creditors and shareholders, further, whether the existing veil of corporate finance laws enacted to validate corporations and their operations ought to be pierced/removed (Easterbrook & Fischel, 1985).

The concerns here is that the veil as defined above only provides for the responsibilities and rights of corporations as independent and even distinct entities from the very people who govern, own and invest in them (Griffin, 2004), thus making corporations mere avenues for people to run businesses and share the profits made in such business exploits, with minimal accountability and risk for their investment in case of losses and insolvency (Easterbrook & Fischel, 1985; Davies, 2003). This phenomenon has an assortment of variant factors and has as many variant practical repercussions in many jurisdictions of the world (Griffin, 2004). The dissertation is interested in the role that the need for accountability and discloser to both shareholders and creditors plays, in corporate governance in regards to piercing of the veil (Easterbrook & Fischel, 1985).

An example that properly fits the concerns of this dissertation is a car licensing model in which the car is recognized by law as a separate entity, liable for its acts and omissions. In such a scenario, the car would need a separate licence from that of its driver. Similarly, in the occasion of an accident, the car will be liable for a legal suit for having wrecked the damage consequent to that accident. This however may give a freeway to careless and irresponsible drivers such that they drive even when heavily intoxicated. For as long as the drivers are protected by law from the liability of the accidents in which the car is involved, they will have a form of a legal veil. The chaos that would result from such a scheme are gigantic even to imagine. Victims of road accidents would have to paid damages equivalent to the value of the car, which may sometimes be a marginal value.

As a deterrent towards such negligent driving however, the courts of law within the jurisdiction may have the right to overlook the legal identity of the car and its liability to punish the negligent drivers for the faults they cause their cars to commit. In so doing, the courts will have pierced the protective veil that accord privileges to drivers behind the wheels of a car (Easterbrook & Fischel, 1985). The drivers driving under the influence for instance may in such cases be forced to compensate the accident victims.

This is the exemplification of modern corporate law as it relates to governance and ownership, where the car is the corporation and the driver, the accident victims a corporation’s lenders and the corporate governors and shareholders. While corporations have a separate legal identity, the shareholders and directors can and should, in certain circumstances such as of illegality, fraud, negligence and self interest, be held liable for the corporation’s liability to creditors (Easterbrook & Fischel, 1985; Davies, 2003).

This phenomenon has an assortment of variant factors and has as many variant practical repercussions in many jurisdictions of the world. The dissertation is interested in the role that the need for accountability and discloser to both shareholders and creditors plays, in corporate governance in regards to piercing of the veil (Easterbrook & Fischel, 1985). What this paper seeks to substantiate is concept of corporations, their features, their governance and their legal privileges in contrast to how accountability and disclosure to shareholders and creditors sometimes call for the protective legal veil granted to corporations to be pierced. This paper is an informative exploration into corporate governance and the concerns of accountability and disclosure to shareholders and creditors, especially in how this relationship is laid out in instances of veil piercing.

1.2 Objectives of the Study

This dissertation has a very global outlook and does not look into any jurisdictional practices of corporate governance or corporate finance law. The core interest of the essay lies in the conventional understanding of corporations as legal and commercial entities, specifically how accountability and disclosure to shareholders and creditors play out in the governance of such companies. The law of corporations in many nations of the world grants corporations many rights and recognitions, which if taken without checks and balances, could wreck the corporate finance world (Easterbrook & Fischel, 1985). One such check and balance is the requirement to uphold accountability and disclosure to shareholders and creditors in their operations and how the failure to meet this requirement may call for the statutes that protect and provide for their establishment, to be overlooked (Easterbrook & Fischel, 1985).

In this understanding, it is the broad objective of this dissertation to establish how the legal requirement to uphold accountability and disclosure to shareholders and creditors may trigger veil piercing in contemporary corporate governance. This is a far too broad mandate for a singular study, especially one of this magnitude. To overcome the possible limitations that taking on this broad objective may bring, the dissertation divides up the broad objective into seven narrow objectives that can be pursued more comprehensively to ultimately tally as the attainment of the broad objective. The seven narrow objectives thus include:

Exploring the contemporary process of forming a corporation and the logic behind corporate formation

Discussing the legal principles and or tenets governing the operations of a corporation or the legal logic providing for the existence of modern corporations

Identification of the different forms of a corporation in existence today

Identification of the roles played by shareholders and creditors in modern corporations

An elaboration of corporate law in terms of a veil

Discussing and contextualizing the legal foundation, application and validity of corporate veil piercing incidences

Discussing the appropriateness and or lack thereof, of veil piercing in modern corporate governance

1.3 Scope of the Study

As stated in the foregoing section, this dissertation has a very global outlook and does not look into any jurisdictional practices of corporate governance or corporate finance law. This means that the essay seeks to review corporate governance with a global outlook and how the dynamics of veil piercing in regards to accountability and disclosure demands, can be conceived without approaching the issue from a regional perspective, such as that of the Oriental nations, UK, USA etc. Nonetheless, as shall emerge in later discussions, the USA and UK have had the largest share of contribution to the conception, implementation and legal constitution of the modern corporation and have assumedly, the best literature documenting the phenomena under study (Barnet & Muller, 1974).

As such, while assuming a global perspective, this study concentrates on the corporate governance and its link to veil piercing debate as can be gleaned from the UK and the US. These two regions shall in most part, provide the largest share of the information analysed herein, ranging from statutes, court cases etc. Rather than be a comparative and or contrastive study on corporate governance in these two regions, the study chooses the accumulative the body of knowledge gleaned in the regions discussed to synthesize and sum up the available knowledge on the issue of interest.

The scope of the study lies within a very focused area of study. The study explores contemporary corporate governance. Within corporate governance, the paper focuses on the interesting subject of accountability and disclosure to shareholders and creditors, ignoring many other facets of corporate governance such as employees, structural establishment, corporate theory and other such areas. Further, within this area of accountability and disclosure to shareholders and creditors, the paper’s interest is constrained on how this requirement relates to the dynamics of veil piercing and ignores other areas such as risk management, capital and profit distribution, insurance etc. The focus of the paper as discussed above can be represented as follows:

Figure 1

A Diagrammatic Representation of the Scope/Focus of the Dissertation’s Topic

Accountability & Disclosure

to Shareholders & Creditors

Issues in Corporate Governance

Corporate Governance

Issues in Accountability & Disclosure

Dynamics of Veil Piercing in Corporations & Corporate Law

Taxation

Theory

Employees

Insurance

Risk Management

1.4 Research Questions

Given that the area under study is very wide, there was the risk of covering far too many issues that could be comprehensively discussed by the dissertation. This spelt out the need to constrain the core interests of the study to those issues that could sufficiently be deliberated on.

Consequently, seven research questions were created based on the seven narrow objectives of the study to act as the guide posts for the exploration of this study and to consolidate the conclusive findings or convictions of the discussion. Answering these seven research questions sufficiently would in this regard be termed as a conclusive coverage of the paper’s mandate. The seven research questions thus formulated were:

What is the contemporary process of forming a corporation and further what constitutes the logic behind formation of corporations?

What are the legal principles and or tenets that govern the operations of a corporation or the legal logic providing for the existence of modern corporations in USA and UK today?

How many different forms of a corporation are in existence today and how do they differ from each other?

Which roles do shareholders and creditors play in modern corporations?

In what ways can contemporary corporate laws in the USA and UK be conceived as a veil?

What is the legal foundation, application and validity of corporate veil piercing incidences?

In which ways can veil piercing in modern corporate governance be deemed as appropriate and or inappropriate?

1.5 Definition of Terms

The following is a list of technical terms central to this paper’s discussion and which will be encountered severally in the course of the paper just as in numerous related literature. Here, they are defined and associated with the meanings implied within the context they occur, at the very least for the purposes of this paper, and in the general understanding of the literature. They have been arranged alphabetically and not in order of importance.

Term

Contextual Meaning

Common Seal

A common seal can be described as the unique official seal/stamp of an incorporated business that helps to distinguish it from other businesses and which makes all of its appearances such as in documentation, give such transactions the formal and legal authority or indeed approval as being authentic representation of the corporation (Griffin, 2004).

Corporation

The artificial business entities created under the state statutes, and which in their conception, are treated like individuals in the eyes of the law, to the extent that they have legally enforceable set of rights, an ability to pay out profits, acquire debts, hold or transfer property, enter into contracts, pay taxes, and sue or be sued (Davies, 2003).

Corporate Governance

The structure and practice of administrating/managing a corporation as a player in financial markets and with the intent of making such corporations compliant to corporate law and successful in the realization of the business objectives that led to their formation (Grossman, 1995).

It can be understood as the leadership and administration of a corporate entity, which seeks to realize management accountability, market integrity, business results etc, by appropriately distributing the rights, the profits, the resources and the responsibilities legally granted such organisations to its members (directors, managers, shareholders, creditors etc) during its dealings (Grossman, 1995).

The governance provides the structure under which the corporation acquires a management arm, set objectives, performance criterion, a business culture, an assignment of responsibilities, control of resources, accountability for the stewardship of resources and decision making protocols (Grossman, 1995).

Corporate Law

Corporate/corporation law is the single most dominant statute provision for incorporated business enterprises of the modern world, with a special interest for the large business setups. In this understanding, corporate law provides the legal responsibilities, rights and definition of the interactions and partnerships holding among directors, shareholders, creditors, employees, consumers, community, environment and other publics (stakeholders) within a single firm (Easterbrook & Fischel, 1985).

Corporate laws are a component part of the broader company law also called law of business association applicable to even other business association types such as partnerships, trusts, limited companies by guarantee etc (Easterbrook & Fischel, 1985; Davies, 2003).

Creditors

Creditors are the legal entity or party (individual, company, organization, company, or government) who acquire a claim to the resources, capital and profits of another party such as a business entity by virtue of being owed by that second party, part of the resources that funds its existence and operations (Griffin, 2004).

A creditor provides property, service or capital to a business entity under the terms of an enforceable contract with the intent of having that which is lent, being refunded in equivalence, with interests or with proportional shares of the profits or income earned by the business entity or person (Easterbrook & Fischel, 1985). In this regard, the business entity or individual receiving the loan becomes the borrower or debtor (Easterbrook & Fischel, 1985).

Disclosure

A disclosure refers to the act and attainment of such act, of giving out particular information to interested parties, which can be either voluntarily or in compliance to statutory requirements and institutional regulations, so that the interested parties can act in accordance and with due knowledge provided by the information given (Easterbrook & Fischel, 1985).

In corporate governance, disclosure mainly accrues in the relationship of directors of a corporate entity providing crucial financial information to shareholders and creditors so that the two parties can make informed decisions based on the information thus revealed (Grossman, 1995).

Involuntary Creditors

In corporate law, there are creditors who lend to a business entity to gain an interest for the risk they take that such loans shall be refunded (Grossman, 1995), and who are not party to the distribution and disclosure regulations of such business entities (Griffin, 2004). In insolvency, corporate law conceives such creditors as deserving of full payment of their claims without subjecting them to additional risks for which their lending terms were not made contingent (Griffin, 2004).

Liability

In corporate law, a liability the legal status/hindrance/requirement that puts individuals or companies at a legal disadvantage in a claim, in so doing placing such an individual or company as the one to be held responsible for an error, omission or act, for having caused it, triggered its occurrence or failed in executing a mandatory responsibility (Griffin, 2004; Easterbrook & Fischel, 1985).

Liability can either be legal or public, and in most times define the responsibilities of an act, omission or error for which one should be held as solely or jointly responsible for (Easterbrook & Fischel, 1985).

Limited Liability

In corporate finance, limited liability as a concept refers to the legal understanding that a company or individual has financial liability up to a limited amount (a predefined sum) (Griffin, 2004). In common practice, limited liability accrues in determining the shareholders level of liability in a company’s debts, where such shareholders are deemed as only liable to the debts to the extent of their personal investment in such companies/partnership/corporations with the limited liability (Griffin, 2004).

As such, whenever a company sued in a court of law has limited liability, the plaintiffs (most frequently creditors) can only sue the company itself as a legal entity and not the owners, directors or investors of such a company (Griffin, 2004; Davies, 2003). This provision of corporate law ensures that shareholders of a limited company are not to be held personally liable to and for any debts acquired by the company, beyond the market value of their investment to the company (Griffin, 2004).

In liquidation therefore with intent to pay off debtors, the shareholder’s divided are deemed zero (having been held liable to the debts), but is as far as the liability goes and can not extend to the resources owned personally by such shareholders (Easterbrook & Fischel, 1985). This is a provision normally spared for corporations, limited liability partnerships, limited partners in a limited partnership, as opposed to the spread of liability from accompany thorough to the owners of a sole proprietorship or general partnerships (said to have an unlimited liability) (Grossman, 1995).

Perpetual Succession

A tenet of corporate law, the concept of perpetual succession refers to the continued existence of a corporation, or the continuation of an organization’s existence, beyond and after the bankruptcy, death, insanity, exit, membership change or stock transfer of any of the owners and or members of that corporation/organisation (Easterbrook & Fischel, 1985).

To understand this concept, one must visualize of the legal entity of corporations as separate form their owners and directors, and as thus with a separate life of their own (Easterbrook & Fischel, 1985). The corporation will therefore continue to exist irrespective of whether a particular owner is in existence or not. Just like the common seal, perpetual succession is a feature of corporation’s legal existence, holding it as separate to and from that of its directors or owners (Easterbrook & Fischel, 1985).

Shareholders

In corporate law, mutual shareholders or stockholders of a corporation or company are entities (individuals, organisations or companies) who legally own a valued share of the stocks (value of resources) of a joint stock business entity. The shareholders therefore collectively own a particular company or corporation and are thus deemed as members of that company in their rights to sign the company/corporation’s memorandum of association (Davies, 2003).

Corporations primary role is to make profits and in so doing enhance the shareholders value (the value of each share part of the company’s net worth). Owning shares comes with it several special privileges and rights, depending on stock classification (Griffin, 2004), such as the right to vote in decision-making matters like elections of directors, where each share is representative of a single vote, the right to articulate shareholders resolutions, the right to share in the distribution of the income made by the company (dividends), the right to buy more shares whenever that company reissues, and the right to assets owned by that company in the event of a liquidation (Griffin, 2004).

Notably, shareholders’ rights deemed subordinate to creditors’ rights in liquidation (Griffin, 2004).

Solvent/Insolvency

In regards to corporate law, being solvent refers to the capability to meet the financial obligations that a business entity has acquired during its operations such as paying off its creditors from the resources and profits that such a business entity already owns. On the other hand, being insolvent an adjective describes the inability to meet the financial obligations, in this case an inability pay off the debts acquired over time as their due date arrives (Griffin, 2004). Insolvency here refers to the inability of a comp