Lifting The Corporate Veil

LIFTING OR PIERCING THE CORPORATE VEIL

ACKNOWLEDGEMENT The project on “LIFTING OR PIERCING THE CORPORATE VEIL” would not have seen light of the day without the following people and their priceless support and co-operation. Hence we extend our heartfelt gratitude to all of them. First and foremost, we would show appreciation to Prof. GRACIAS who set the ball rolling for our project. We are grateful to him for guiding us throughout the project. Without his invaluable help we wouldn’t have being able to do real justice to the project. On the same lines, we would like to thank our college librarian for being very obliging and patient to our needs. Last, but definitely not the least, we would like to thank our principal Prof. Phadnis for providing all the encouragement &

LIFTING OR PIERCING THE CORPORATE VEIL •

From the juristic point of view, a company is a legal person distinct from its members [Salomon v. Salomon & co. ltd., (1897) A.C. 22]. This principle may be referred to as “the veil of incorporation”. The courts in general consider themselves bound by this principle. The effect of this principle is that there is a fictional veil (and not a wall) between the company and its members. That is, the company has a corporate personality which is distinct from its members.

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The human ingenuity, however, started using this veil of corporate personality blatantly as a cloak for fraud or improper conduct. Thus it became necessary for the courts to break through or lift the corporate veil or crack the shell of corporate personality and look at the persons behind the company who are the real beneficiaries of the corporate fiction.

And while by fiction of law a corporation is a distinct entity, yet in reality it is an association of persons who are in fact the beneficial owners of all the corporate properly. •

“The doctrine laid down in Salomon v. Salomon & co. ltd. Has to be watched very carefully. It has often been supposed to cast a veil over the personality of a limited company through which the courts cannot see. But that is not true. The courts can and often do draw aside the veil. They an, and often do, pull off the mask. They look to see what really lies behind.”

JUDICIAL EXCEPTIONS. The various cases in which corporate veil have been lifted are as follows:

1. PROTECTION OF REVENUE. The courts may ignore the corporate entity of a company where it is used for tax evasion. Tax planning may be legitimate provided it is within the framework of law. The following cases illustrate the point: Sir Dinshaw Maneckjee Petit, Re, A.I.R. (1927) Bom. 371. D, an assessee, who was receiving huge dividend and interest income, transferred his investments to 4 private companies formed for the purpose of reducing his tax liability. These companies transferred the income to D as a pretended loan. Held, the companies were formed by D purely and simply as a means of avoiding tax

They did no business but were created simply as legal entities to ostensibly receive the dividends and interest and to hand them over to D as pretended loans. Where it is desired to determine for tax purpose the residence of a company, the court will lift the veil and find out where it central management is, and that place will determine the residence of the company. Note the following case: •

Apthorpe v. peter schoenhofen brewing Co. Ltd., (1899) 4T.C. 41. an English company bought the assets and business of an American company only as a matter of convenience. The American company was managed by directors appointed by the English company. Held, the American company was the agent of the English company and the whole or its profits

2. PREVENTION OF FRAUD OR IMPROPER CONDUCT:The legal personality of a company may also be disregarded in the interest of justice where the machinery of incorporation has been used to some fraudulent purpose like defrauding creditors or defeating or circumventing law. Prof. Grower observes in this regard that the veil of a corporate body will be lifted where the “corporate personality is being blatantly used as a cloak for fraud or improper conduct.” Thus in the following case where a company was incorporated as a device to conceal the identity of the perpetrator of the fraud, the court disregarded the corporate personality. •

Jones v. Lipman. (1962) all E.R. 442. L. Agreed to sell a certain land to J. He subsequently changed his mind and to avoid the specific performance against L and the company. The court looked to the reality of the situation. ignored the transfer, and ordered that the company should convey the land to J

3. DETERMINATION OF CHARACTER OF A COMPANY WHETHERN IT IS ENEMY. A company may assume character when persons in de facto control of its affairs are residents in an enemy country. In such a case, the court may examine the character of persons in real control of the company, and declare the company to be a enemy company. •

Daimler Co. Ltd. V. continental tyre & rubber co. ltd., (1916) 2 A.C 307. A company was incorporated in England for the purpose of selling in England tyres made in Germany Company which held the bulk of shares in the English company. The holders of the remaining shares, except one, and all the directors were Germans, resident in Germany. During the First World War, the English company commenced an action for recovery of a trade dept. held, the company was an alien company and the payment of dept to it would amount to trading with the enemy, and therefore the company was not allowed to proceed with the action

4. WHERE THE COMPANY IS A SHAM. The courts also lift the veil where a company is a mere cloak or sham (hoak). The following case illustrates the point: •

Gilford Motor Co. Ltd. V. Home, (1933) Ch. 935 C.A. Horne, a former employee of a company, was subject to a covenant not to solicit its customers. He formed a company to carry on a business which, if he had done so personally, would have been a breach of the covenant. An injunction was granted both against him and the company to restrain them from carrying on the business. The company was described in this judgement as “a device, a stratagem”, and as “a mere cloak or sham for the purpose of enabling the defendant to commit a breach of his covenant against solicitation.

5. COMPANY AVOIDING LEGAL OBLIGATIONS. Where the use of an incorporated company is being made to avoid legal obligations, the court may disregard the legal personality of the company and proceed on the assumption as if no company existed. •

Example. A and B, partners in a film, sell their business to C and undertake not to start a similar business and not to compete with C for a certain number of years. After some time they form a private limited company, become the principal shareholders and directors and start a similar business. The court may restrain the company from carrying on the business competing with C.

6. COMPANY ACTING AS AGENT OR TRUSTEE OF THE SHAREHOLDERS. Where a company is acting as a agent for its shareholders, the shareholders will be liable for the acts of the company. It is a question of fact in each case whether the company is acting as agent for its shareholders. There may be an express agreement to this effect or an agreement may be implied from the circumstances of each particular case. Note the following case: •

F.G.Film Ltd. In re (1953) 1 All E.R. 615. An American company financed the production of a film in India in the name of a British company. The president of the American company held 90 per cent of the capital of the British company. The board of trade of Great Britain refused to register the film as a British company acted merely as the nominee of the American

7. AVOIDANCE OF WELFARE LEGISLATION. Avoidance of welfare legislation is as common as avoidance of taxation and approach of the courts in considering problems arising out of such avoidance is generally the same as avoidance of taxation. It is the duty of the courts in every case where ingenuity is expended to avoid welfare legislation to get behind the smoke screen and discover the true state of affair (workmen of association rubber industry ltd. V. associated rubber industry ltd., (1986) 59 comp. CAS. 134 (S.C.))

8. PROTECTING PUBLIC POLICY. The courts invariable lift the corporate veil to protect the public policy and prevent transaction contrary to public policy. Thus where there is a conflict with public policy, the courts ignore the form and take into account the substance [Connors v. conners Ltd., (1940) 4 All

STATUTORY EXCEPTIONS. •

NUMBER OF MEMBERS BELOW STATUTORY MINIMUM (SEC 45):- If a company carries on business for more than 6 months after the number of its members has been reduced below 7 in case of a public company or 2 in case of a private company, every person who knows this fact and is a member during the time that the company so carries on business after the 6 months, is severally liable for the whole of the debts of the company contracted during that time, i.e. after 6months. It may be noted that in such a case the continuing members (i.e., those who continue to be members after 6months)-

(b) Can be sued and not those who have withdrawn from the membership;

2. FAILURE TO REFUND APPLICATION MONEY (SEC. 69(5)):- The director of a company are jointly and severally liable to repay the application money with interest if the company fails to refund the application money of those applicants who have not been allocated shares, within 130days of the date of issue of the prospectus.

3. MISDESCRIPTION OF COMPANY’S NAME (SEC 147(4)):- Where an officer or agent of a company does any act or enters into a contract without fully or properly mentioning the company’s name and the address of its registered office, he shall be personally liable. Thus where a bill of exchange, hundi or promissory note is signed by an officer of a company or any other person on its behalf, without mentioning this fact that he is signing on behalf of the company, he is personally liable to the holder of the instrument unless the company has already paid the amount. Hendon v. Alderman, (1973), 117 S.J. 631. The

4. FRAUDULENT TRADING (SEC. 542):- Sometimes in the course of the winding up of a company it may appear that some business of the company, or any other person or for any fraudulent purpose. In such a case, the court may declare that any persons who were knowingly parties to the carrying on of the business in this debts or other liabilities of the company as the court may direct. The court may do so on the application of the official liquidator, or the liquidator or any creditor or contributory of the company.

5.HOLDING AND SUBSIDIARY COMPANIES. In the eyes of the law, the holding company and its subsidiaries are separate legal entities. Even a 100 per cent subsidiary is a separate legal entity and its creator and controller (i.e., the holding company) is not liable for its breaches of contracts and torts. Nor can the

Free Wheel (India) Ltd. V. Ved Mitra, A.I.R. (1969) Delhi 258. A holding company requested the court for restraining its subsidiary from issuing further capital as it would depreciate the value of its shares. The injunction prayed for was refused on the ground that the subsidiary company had not lost its identity as a separate legal entity. But in the following two cases, a subsidiary company may lose its separate identity to certain extent:3. Where at the end of its financial year, a company has subsidiaries, it must lay before its members in general meeting not only its own accounts, but also a set of group accounts showing the profit or loss earned or suffered by the holding company and its subsidiaries collectively, and their collective state of affairs at the end of the year.

SALOMON VS. SALOMON CO. LTD (1897) Mr. Salomon had his own business of boot manufacturing, etc. Since his children wanted to be a part of the business as owners, Mr. Salomon sold his business to the New Company (the company, he was planning to form) for a certain amount of money (40000 pounds). He was selling his business to the new company as he knew that the COMPANY IS SEPARATE LEGAL ENTITY. He needed 7 members (shareholders) to form that company. Fortunately or unfortunately, he had 5 children. 7 members were found: 5 children, 1 wife, and Mr. Salomon himself. So, he gave himself 20000 shares (1 pound each), 1 share to each child (total 5 shares for 5 children) and 1 share to his wife. He elected his two children together with him to be the Directors of the company. Therefore Mr. Salomon became a SHAREHOLDER.

But since the company still owes Mr. Salomon 20000 pounds, the company gives him debentures of 10000 pounds and rest 10000 pounds were paid in cash, etc. Therefore he is a SHAREHOLDER in the company, and now, a DEBENTURE HOLDER too. But he was a DIRECTOR also. So, He was SHAREHOLDER, DIRECTOR & DEBENTURE HOLDER. He was an ORDINARY SHAREHOLDER who would be paid after all the creditors are paid IF THERE IS LIQUIDATION OF THE COMPANY. After 1 year, the company went into Liquidation (because the liabilities were more than assets by certain amount) and the creditors needed to pay. The LIQUIDATOR asked Mr. Salomon to pay all the creditors since Mr. Salomon was the OWNER of the company. Salomon did not agree with that. Because He

TRIAL JUDGE VAUGHAN WILLIAMS agreed with Liquidator and asked SALOMON to pay on behalf of the company since Salomon was the owner, but Salomon didn't agree. He appealed to COURT OF APPEAL so that he (Salomon) didn't have to pay the debts owed to creditors by the company. COURT OF APPEAL said that Salomon just found 6 people (his 5 children & wife) to form the company. Those 6 people are mere nominees of Mr. Salomon. COURT OF APPEAL also asked Mr. Salomon to pay. This time Salomon appealed to the highest court "HOUSE OF LORDS". HOUSE OF LORDS rejected all the judgments made by TRIAL JUDGE VAUGHAN WILLIAMS, COURT OF APPEAL.HOUSE OF LORDS said that there is neither fraud in the manner which Mr. Salomon formed the company, nor did Mr. Salomon form the

So, Mr. Salomon did not have to pay to the COMPANY'S Creditors since Mr. Salomon and The Company are two Separate (Legal) Entities. The company is separate from its members.... In this case it was established that the actions of a company, are that of the company and not of the shareholders themselves. This is written into the Companies Act 1993 which states that “a company is a legal entity in its own right separate from its shareholders” (Legislative Extracts, School of Accountancy, 2001). This law separates the company as another individual person/entity which will be held responsible for the fortunes of the company and separates all blame from the directors/shareholders of the company except under situations where the veil is lifted. This will however lead to situations where justice can not be carried out as people will commit

IS COMPANY A CITIZEN Although a company is regarded as a legal person(though artificial),it is not a citizen either under the Constitution of India or the Citizenship Act,1955-Heavy Engineering Mazdoor Union v.State of Bihar[1969]39 Comp. CAS. 905(SC).The Supreme Court of India in State Trading Corporation of India Ltd. V. CTO[1963]33 Comp. CAS. 1057 held that a Corporation (including a company) cannot have the status of a citizen under the Constitution of India. Thus, under the Constitution; a company has no fundamental rights which are expressly available to citizens only. It can, however, claim the protection of those fundamental rights which are available to all persons, whether citizens or not, for example, the right to own property.

In Narasaraopeta Electric Corp.. Ltd. V. State of Madras [1951]21 Comp.Cas.297 (Mad), the High Court observed that a company incorporated under the Indian Companies Act does not satisfy the requirements of the definition of ‘citizen’ in Article 5 of the Constitution and therefore is not a citizen. Similar view was upheld by the Supreme Court in the case of State Trading Corporation of India Ltd. V. CTO[1963]33 Comp.Cas.1057(SC).The Supreme Court, in this case observed that the rights of citizenship and the rights flowing from the nationality or domicile of a Corporation are not coterminus.It would thus appear that the makers of the Constitution had altogether left out the consideration of juristic persons when they enacted PartII of the constitution relating to citizens and made a clear distinction between ‘persons’ and ‘citizens’ in

PartIII,which proclaims fundamental rights was very accurately drafted, delimiting those rights like freedom of speech and expression, the right to assemble peacefully, the right to practice a profession, etc, as belonging to citizens only and those more general rights like the right to equality before the law, as belonging to all persons. Corporation may have nationally in accordance with the country of their incorporation; but that does not necessarily confer citizenship on them. There is also no doubt that Part II of the Constitution when dealing with citizenship refers to natural persons only. This is further made absolutely clear by the Citizenship Act which confines citizenship to natural persons only.

A company is also not allowed to lay claim to fundamental rights on the basis of its being an aggregation of citizens. Once a company or a corporation is formed, the business of the company or corporation is not the business of the citizens but that of the company or corporation formed as an incorporated body, and the rights of the incorporated body must be judged on that footing and cannot be judged on the assumption that they are the rights attributable to the business of individual citizens-Telco Ltd. v. State of Bihar [1964]34 Comp. CAS. 458(SC). It should, however, be noted that certain fundamental rights enshrined in the Constitution are for protection of any person, for e.g., right to equality, etc (Article 40) are available to a company.

In Chiranjilal Chaudhari v. Union of India [1951] 21 Comp. CAS. 33(SC),the Supreme Court held that the fundamental rights guaranteed by the Constitution are available not merely to individual citizens but to corporate bodies as well except where the language of the provision or the nature of the right compels the interference that they are applicable only to natural persons. Similarly in Bennet Coleman Comp. v. Union of India[1972] S.C.C. 788,806, the Supreme Court extended the rule by stating “it is now clear that the fundamental rights of shareholders as citizens are not lost when they associate to form the company. When their fundamental rights as shareholders are impaired by State action, their rights as shareholders are protected the reason is that the shareholders’ rights are equally and necessarily affected if the rights of the company are affected.