Lifting the Corporate Veil: Limited Liability of the Company Decision-Makers Undermined? Analysis of English,U.S., German, Czech and Polish Approach
Written by: Anna Farat & Denis Michoň
More than 100 years ago the UK’s House of Lords in the famous Salomon case1 established a maxim that a company is a separate legal entity distinct from its members. Thereby, it determined the direction of modern company law and the nature of private limited companies. Similar doctrines are incorporated in the statutory provisions of Continental countries. A separate legal personality and limited liability has aimed to induce investment, encourage trade and to be an incentive for entrepreneurs to start up new business even if it might involve commercial risk.
This article will fi rstly explain what is understood by the terms corporate veil and lift ing or piercing the corporate veil.2 Secondly, it will discuss several U.K. cases that are dealing with this issue. It will analyse how the doctrine of lift ing the corporate veil has developed over time. Thirdly, it will compare this doctrine with the approach accepted in the USA and under German law. Fourthly, it will discuss the Czech and Polish view. Then, it will deal with some economic implications of lift ing the corporate veil. Finally, it shall try to answer the question whether the doctrine of piercing the corporate veil undermines the principle of limited liability.
2. What is the Problem with the Corporate Veil?
2.1 Legal Aspects
Since a company is treated as a separate legal entity, the metaphor of “corporate veil” separating the members of the company from the corporate body has arisen. Although the principle of Salomon in the U.K. has never been doubted, under certain circumstances the courts may be poised to disregard this principle and “lift the corporate veil.”3 Nevertheless, the cases in which the courts have allowed the veil to be lift ed and disregard the separate entity principle are diffi cult to predict and no clear set of principles has emerged yet.4
From the creditors’ point of view, the consequence of the limited liability principle is that creditors’ claims are restricted to the company’s assets and cannot be asserted against the shareholders’ assets. On the other hand, shareholders benefi t from the limited liability principle because (i) once the business is successful, it is them who gain the profi t, and (ii) in the event that the company is wound up their liability would be limited only to the value of their unpaid shares or their guarantee;5 i.e. the satisfaction of unsecured creditors’ claims is endangered without shareholders being responsible.
2.2 Economic Justification
Every transaction involves costs. In the ideal state they are kept at the lowest possible level. Th eir externalisation takes place when The question is who should reimburse the costs (debts) incurred by the company.6 To achieve a maximum economic efficiency the costs should be borne by “the cheapest risk avoider”, i.e. the person who can most easily and cheaply prevent costs from occurring. In consequence, it should be optimal if costs are incurred by shareholders, i.e. the persons with the strongest voice in the company, rather than creditors who have little no infl uence over the investment costs of the company. However, the principle of limited liability causes externalisation of the costs incurred by the company, i.e. the person who generated the costs is not obliged to pay for them.7 Should the debts (costs) of the limited liability company exceed its assets, these costs will ultimately be borne by those creditors whose claims could not have been satisifed from the assets of the company at the moment of its dissolution. Th is transfer is justifi ed by the fact that under certain circumstances companies must disclose to the public the details of their fi nancial situation and the creditors check the latest in which fi nancial conditions the company is before concluding any contracts with it.
3. Lifting the Corporate Veil at Common Law
3.1 Adams vs Cape Industries plc8
In the landmark English Court of Appeal case Adams v Cape Industries plc the case law on Salomon was subject to a complete review. This case involved liability within a group of companies. The claimant, Adams, sought to ignore the separate legal personality of a parent (Cape) and its subsidiary company and to hold the parent liable for the obligations of the subsidiary. The court had to determine whether the defendant, a producer of asbestos, had presence in the United States and, thus, whether the Texan judgement could be enforced against them. It was held that “the court is not free to disregard the principles of Salomon v A. Salomon & Co Ltd merely because the justice so requires.”9 This decision is crucial to the understanding of lift ing the corporate veil because the Court of
Appeal went through three possible justifi cations for piercing the veil: (i) “single economic unit”, (ii) agency, and (iii) “façade.”
3.2 The Agency Exception
Agency is an apparently accepted exception to the separate entity principle and is sometimes viewed as the most common one.10 It was already decided in Salomon that if a company acts as an agent for another party the corporate veil can be lifted. However, the courts seem to be unwilling to determine that a principal/agent relationship exists, or imply it, especially when concerning an individual controlling shareholder. Yet, the courts are less reluctant to imply that a principal/agent relationship exists when the alleged agency is between a holding company and its subsidiary, probably because in these circumstances the management of the holding company may have a better opportunity to take advantage of the limited liability principle. Sometimes it is argued, however, that the concept of the agency is not a real exception to the separate entity principle.11 The parent company is bound by the acts of its agent automatically as long as those acts are within the scope of the agent’s authority. Under such circumstances the agency might be implied.
In Adams v Cape the Court of Appeal held that the veil of incorporation could in essence be pierced when there was an express agency agreement, for example, between the parent and the subsidiary company. In the absence of such an agreement, no agency relationship can be presumed. According to the facts of the case, the U.S. company rendered certain services to Cape Industries plc and even acted as its agent in relation to some specifi c transactions, but this was not suffi cient to constitute a general agency agreement. Consequently, though there is no presumption of an agency it can be implied, i.e. agency is not automatic but also not precluded.
The English Court of Appeal in Ebb Vale Urban District Council v South Wales Traffic Area Licensing Authority12 considered the relationship between the parent and 100 per cent owned subsidiary company. It was stated that under “the ordinary rules of law a parent company and subsidiary company, even a hundred per cent subsidiary company, are distinct legal entities, and in the absence of a contract of agency between the two companies one cannot be said to be the agent of the other.” According to Cohen LJ this was clearly established by Salomon v Salomon and Co Ltd.
To conclude, under Adams v Cape International Ltd there is a requirement that an express agency agreement between the parties needs to exist. In the absence of the express agreement the concept of agency will be very diffi cult to establish.13 Consequently, a creditor of an undercapitalised subsidiary is in a better position if he proves that an express agency agreement exists because the implied agency might not be possible to be proved. If the creditor is unable to prove the existence of an agency agreement he needs to support his claim with reference to another exception to the separate legal entity principle.
3.3 The Concept of the Single Economic Unit
In Adams v Cape it was argued that for a group of companies the essential principle is that each company within a group is a separate legal entity. However, in certain circumstances, the court can ignore this principle and treat several companies as a single one.14 In Adams v Cape the court held that a group of companies may be treated as a single unit only where specifi c statutes15 or contractual provisions allow to do so. Otherwise the Salomon rule should apply.
In another English case DHN Food Distributors Ltd v Tower Hamlets London Borough Council16 the Court of Appeal, or more precisely Lord Denning MR, always keen on lift ing the corporate veil, treated a group of companies as a single economic entity and enabled compensation for compulsory purchase of land to be paid.
From this decision it had been said that there is “but a short step” to “the proposition that the courts may disregard Salomon’s principle whenever it is just and equitable to do so.”17 Such situations are nowadays considered as exceptional18 and the verdict in the DHN case has been subject to doubt several times since, e.g. in Woolfson v Strathclyde Regional Council19 and Industrial Equity Limited and Others v Tower Hamlets.20 In Woolfson the House of Lords not only distinguished the earlier decision of the Court of Appeal in DHN but also doubted whether the Court of Appeal “properly applied the principle that it is appropriate to pierce the corporate veil only where special circumstances exist indicating … a mere façade concealing true facts.”21
3.4 Façade or Sham
In Adams v Cape Industries the court accepted the existence of one well-recognised situation where the corporate veil could be pierced – a situation where the corporate structure is a “mere façade concealing the true facts.”22 It was even held that one of the Cape companies could have been considered as falling into this category. According to Bowmer, “the admission that separate legal personality could be ignored and the veil pierced on the grounds that the group structure was a ‘façade’ is far more interesting. Perhaps unfortunately, leave to appeal to the House of Lords was rejected by both the Court of Appeal and the House of Lords.”23
In the abovementioned House of Lords case Woolfson the concept of façade was discussed. However, Lord Keith did not explain the meaning of this term. Whatever the precise meaning of this term for the courts applying24is, the House of Lords made it clear that the Salomon principle cannot be disregarded whenever justice or equity requires so.25
Re Southard & Co Ltd26 concerned granting a winding-up order. The Templeman LJ’s analysis of the views of the creditor, though, is worth noticing. According to him in the situation of a subsidiary company that turns out to be the “runt of the litter” (undercapitalised) and becomes insolvent, the parent and/or other subsidiary companies may prosper without any liability for the debts of the insolvent company. Therefore, it is comprehensible that the unsecured creditors wish to examine the fi nances of the company and its relationship to the other members of the group to assure that any assets have leaked away.27
In another important case of Ord v Belhaven Pubs Ltd 28 the Court of Appeal held that holding company as a shareholder enjoy limited liability and it is not liable for the debts of the companies whose shares it owns, i.e. subsidiary companies.
It can be concluded that the issue of piercing a corporate veil in the U.K. is quite disputable. The way it is viewed by courts and commentators varies over time. The optimistic predictions are followed by the pessimistic ones. Recently, however, some commentators are quite positive with the development of this phenomenon. Sometimes there have been merely attempts to pierce to corporate veil29 but also in a number of recent cases the courts have declared to pierce the corporate veil.30
3.5 Current Position of English Courts
With respect to the U.K. it is important to mention that the creditors are, inter alia, protected by numerous statutory provisions concerning the lift ing the corporate veil.31 Th e Parliament is always authorised to enact exceptions to the Salomon principle and has done so several times. The courts, therefore, have to accept that even though the principle of separate legal entity may cause injustice, unless the Parliament in its Act provides so, the court should not interfere.32 A crucial exception enacted by the Parliament in the U.K. is Section 213 of the 1986 Insolvency Act. Accordingly, the creditors are protected where the business of the company has been carried out to defraud them, and the courts on a winding-up are entitled to look behind the corporate veil in such a case.
To summarise English common law exceptions to the Salomon principle according to Hicks, it is fair to say that the courts probably will not lift the corporate veil in order to impose liability on a shareholder for the company’s debts. He also states that “in rare instances the courts will look to the substance rather than the form to deny benefi ts of corporate status which they think should not be enjoyed.”33 He goes on contemplating that it is diffi cult to predict when the courts will do so, however, the judges’ subjective perception of fairness or policy might be a useful guide.
It has also been presented that the notion that “the judges are increasingly prepared to disregard the autonomous personality of companies to facilitate the legitimate interests and expectations of those who come in contact with them, is clearly ‘ overstatement’ of the position.”34
3.6 U.S. Approach to the Doctrine of Piercing the Corporate Veil: Differences35
The doctrine of lift ing the corporate veil (in the USA mostly under the name of “piercing the corporate veil” or “disregard of legal entity”) has its true origins in the American law 36 and – in contrast to Europe – it is considered there to be a normal part of the legal system. Whereas European judges, not excluding the English ones, rather carefully reach a conclusion to dislodge the separate legal entity of the company, their American colleagues hand down rulings in favour of creditors, apparently without much doubt. If one realizes that apart from Texas37 there are no statutory examples of restrictions regarding the institution of piercing the corporate veil, it remains apparent what a great deal of responsibility they shoulder.
The maxim that a company is a separate legal entity distinct from its members was established in the USA even earlier than in the UK in the case of Bank of Augusta v. Earle (1839).38 Attempts to disregard
the separate entity preserve a close link to equity. This may be the reason for which in the United States the piercing of the corporate veil has been equated to a lightning: “it’s rare, severe and unprincipled.”39 One can say that every factual state develops its own set of elements that should be taken into account. Traditional tests aim to prevent fraud and achieve equity.40
For the reason of clarity some authors have tried to provide a viable alternative to the rather changeable combination of facts and proposed using the term “the totality of circumstances rule”41. Notwithstanding how practical it seems in the debates, it remains still a blanket term and is just a better name of saying that the doctrine of piercing the veil is based on diff erent elements adjudicated ad casu. In fact, much is dependent on the judge and what she considers an equitable result. Consequently, the outcomes of similar cases may diverge.
The U.S. courts lift the company’s immunity in a variety of situations.42 The piercing concept does not come from the laws of the states or federal government but it is a judicial creation which varies from state to state. The scope of abuses relating to groups of companies is the most popular reason for which the courts disregard the separate entity principle. If a controlled company is organized as a mere tool in the hands of a parent enterprise and the separateness of the two corporations has ceased (instrumentality rule 43), one can assume that holding only the subsidiary corporation liable for any damages resulting from fraud or dishonesty of the parent company would result in injustice. Similar conclusion can be drawn under the alter ego doctrine which is also demonstrated by showing a blending of identities between two corporations and thus, in practice, it is difficult to distinguish them.
4. Corporate Veil in Continental law.
4.1. The German Approach: the Qualified Natural Holding
German law is a model example of how the doctrine of piercing the corporate veil (in German: Durchgriff ) could be truly instilled in a Continental law system without causing any fragrant breach in its statute-based structure. In fact, German courts departed from accepted legal patterns without having a good statutory or even academic basis for doing so.44 It was only later that the German courts tried come up with an acceptable theoretical justifi cation.
Not every undue infl uence can cause the separate legal entity of a controlled company to be disregarded. The piercing of corporate veil was allowed only in the event of a qualifi ed natural holding (in German: qualifi ziert faktischer Konzern). Under the concept of the qualifi ed natural holding an abusing practice can give a reason for dislodging the corporate veil when a controlling company limited by shares allocates its economic activity to many dependent limited liability companies and runs them as a sole shareholder in a way that jeopardizes the fi nancial situation of these companies.45 This is especially dangerous for the creditors of these dependent companies. Th e courts and the scholars are unanimous in their opinion that piercing the corporate veil is desirable in such a situation; however, in order to impose liability certain requirements need to be satisfied among others existence of a factual, contract-like steering. 46
4.2 Lifting the Corporate Veil in the Czech Republic?
The Czech limited liability companies guarantee their liabilities by their assets.47 The members of the private limited company are jointly and severally liable for the company obligations merely up to the unpaid portion of their investment contribution to the company as registered in the Commercial Registry.48 Th e members are not only liable for their unpaid investment contributions, but they are also jointly liable for the total sum of all unpaid contributions; a creditor of the company can, therefore, seek the due payment from any member of the company no matter whether the particular member has paid up his contribution or not. Once all of the investment contributions have been paid up, and information thereof is registered in the Commercial Registry, the members of the private limited company are not liable for the debts of the company.
Even though the members are not liable for company’s debts,under Czech law there are provisions that have particular application to groups of corporate entities which seek to make a controlling company of a group subject to certain obligations and liabilities vis-à-vis a controlled company. Th is issue is primarily covered in Section 66 and 66a of the Czech Commercial Code. Under these sections persons infl uencing the performance of the company in any material way (so-called shadow directors) shall be liable to the same extent as if they were members of its bodies. Furthermore, Section 66a requires disclosure of related party transactions, i.e.agreements and contracts between controlling and controlled persons.
Even though the limited liability principle in private limited company is widely accepted, there is a possibility that the courts could look behind the corporate veil and held the directors or other statutory bodies of the company liable for the debts of company without relevant statutory authorisation. For this purpose, the courts could apply the provisions of Czech Civil Code49 regulating the liability for damage. Section 415 of the Civil Code impose an obligation on every person to act in a way that does not cause damage to property and Section 420 creates a consequential liability for a a breach of any legal duty. Undoubtedly, the diminution of funds of a creditor whose loan to the controlled company has become unrecoverable due to the insolvency of such a company caused by the controlling person could be considered a damage to property. The legal duty breached would consist in the violation of Section 66a (8) of the Czech Commercial Code. The additional requirements for establishing a liability of the controlling company, i.e. the causality and culpability, would depend on the facts of the case.
4.3 Lifting the Corporate Veil in Poland?
Polish lawmakers have been so far very much devoted to the traditional demarcation of the liability border between the company and its members. For this reason lift ing the corporate veil has not been established in the Polish legal system as such. Consequently, no court would dare to rely on this doctrine without an explicit statutory norm; this, however, makes the legal system open to abuse.50
Company directors are those who are in charge of the management of the company. Hence, it is considered just to hold them jointly and severally liable for any obligations of the company, provided that enforcement against the company proves to be ineff ective.51 Th e only situation when a company member who is not a company director would be held liable is in the case when she overstated the value of inkind contribution52 or received payment in violation of law or articles of association.53 She would then be jointly and severally liable with other company directors but only towards the company; their liability towards directors is, thus, merely indirect.
The doctrine of piercing the corporate veil has its historical origins in equity law and is a creation of judge-made law systems. Equitable judicial approach to limited liability manifests itself in treating it not as an indefeasible right but rather as a privilege a company is accorded which might be withdrawn in case of alleged abuse. According to Griffi n54 lift ing the corporate veil is not a sword but a shield. Th efore, the separate legal entity principle cannot be considered a value per se. Nowadays diff erent forms of piercing the corporate veil exist also in a few Continental law systems (e.g. Germany); this proves an existence of a need both for a workable and pragmatic solution to the problem of formal separation of legal entities as well as for the introduction of the discretion demanding institution of lifting the corporate veil into statute-based legal systems. where reliance on equity as such is not admissible.
Anna Farat is a student of Adam Mickiewicz’s University, Poznań, Poland and former student of Universität Bayreuth, Germany.
Denis Michoň is a student of the Charles University Law School, Prague, and a former student of the Cardiff University Law School.