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Lifting Corporate Veil Company Law 1

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Lifting Corporate Veil Company Law 1

Irwan John Imbayan

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Lifting The Corporate Veil

Lifting The Corporate Veil

By S. Chaitanya Shashank, Kaushalya T. Madhavan, KIIT School Of Law, KIIT University.

Editor’s Note:The principle of veil of incorporation is a legal conceptthat separates the personality of a corporationfrom the personalitiesof its shareholdersand protectsthem from being personally liablefor the company’s debtsand other obligations. While a company is a separate legal entity, the fact that itcan only act through human agents that compose it, cannot be neglected. Since an artificial person is not capable of doing anything illegal or fraudulent, the façade of corporate personality might have to be removed to identify the persons who are really guilty. This is known as lifting of the corporate veil.Besides the statutory provisions for lifting the corporate veil, courts also do lift the corporate veil to see the real state of affairs. However, even though the legislature and the courts have in many cases now allowed the corporate veil to be lifted, it should be noted that the principle ofveil of incorporationis still the rule and the instances of lifting or piercing the veil are the exceptions to this rule.

INTRODUCTION

Before dealing with the lifting of corporate veil it is pertinent to define what the meaning of a company is. Strictly, a company has no particular definition but section 3(1) (i) of the Companies Act attempts to provide the meaning of the word in context of the provisions and for the use of this act. It states: ‘a company means a company formed and registered under this Act or an existing company as defined in section 3 (1) (ii).’ The company must be registered under the Companies Act for it to become an incorporated association. If it is not registered it becomes an illegal association. This paper would deal with the lifting of corporate veil and its aspects with the judicial decisions. Let us first discuss the exact meaning of corporate veil and lifting of corporate veil with limited liability concept.

Corporate veil:

A legal concept that separates the personality of a corporation from the personalities of its shareholders, and protects them from being personally liable for the company’s debts and other obligations.

Lifting of Corporate veil:

At times it may happen that the corporate personality of the company is used to commit frauds and improper or illegal acts. Since an artificial person is not capable of doing anything illegal or fraudulent, the façade of corporate personality might have to be removed to identify the persons who are really guilty. This is known as ‘lifting of corporate veil’.

It refers to the situation where a shareholder is held liable for its corporation’s debts despite the rule of limited liability and/of separate personality. The veil doctrine is invoked when shareholders blur the distinction between the corporation and the shareholders. A company or corporation can only act through human agents that compose it. As a result, there are two main ways through which a company becomes liable in company or corporate law: firstly through direct liability (for direct infringement) and secondly through secondary liability (for acts of its human agents acting in the course of their employment).

There are two existing theories for the lifting of the corporate veil. The first is the “alter-ego” or other self theory, and the other is the “instrumentality” theory.

The alter-ego theory considers if there is in distinctive nature of the boundaries between the corporation and its shareholders.

The instrumentality theory on the other hand examines the use of a corporation by its owners in ways that benefit the owner rather than the corporation. It is up to the court to decide on which theory to apply or make a combination of the two doctrines.

Concept of limited liability:

One of the main motives for forming a corporation or company is the limited liability that it offers to its shareholders. By this doctrine, a shareholder can only lose what he or she has contributed as shares to the corporate entity and nothing more. This concept is in serious conflict with the doctrine of lifting the veil as both these do not co-exist which is discussed by us in the paper in detail.

DEVELOPMENT OF THE CONCEPT OF “LIFTING THE CORPORATE VEIL”

One of the main characteristic features of a company is that the company is a separate legal entity distinct from its members. The most illustrative case in this regard is the case decided by House of Lords- Salomon v. A Salomon & Co. Ltd [i]. In this case Mr. Solomon had business of shoe and boots manufacture. ‘A Salomon & Co. Ltd.’ was incorporated by Solomon with seven subscribers-Himself, his wife, a daughter and four sons. All shareholders held shares of UK pound 1 each. The company purchased business of Salomon for 39000 pounds, the purchase consideration was paid in terms of 10000 pounds debentures conferring charge on the company’s assets, 20000 pounds in fully paid 1 pound share each and the balance in cash. The company in less than one year ran into difficulties and liquidation proceedings commenced. The assets of the company were not even sufficient to discharge the debentures (held entirely by Salomon itself) and nothing was left to the insured creditors. The House of Lords unanimously held that the company had been validly constituted, since the Act only required seven members holding at least one share each and that Salomon is separate from Salomon & Co. Ltd. The entity of the corporation is entirely separate from that of its shareholders; it bears its own name and has a seal of its own; its assets are distinct and separate from those of its members; it can sue and be sued exclusively for its purpose; liability of the members are limited to the capital invested by them.[ii] Further in Lee v. Lee’s Air Farming Ltd .[iii]. it was held that there was a valid contract of service between Lee and the Company, and Lee was a therefore a worker within the meaning of the Act. It was a logical consequence of the decision in Salomon’s case that one person may function in the dual capacity both as director and employee of the same company.

In The King v Portus; ex parte Federated Clerks Union of Australia[iv] . where Latham CJ while deciding whether or not employees of a company owned by the Federal Government were not employed by the Federal Government ruled that the company is a distinct person from its shareholders. The shareholders are not liable to creditors for the debts of the company. The shareholders do not own the property of the company.

In course of time, the doctrine that a company has a separate and legal entity of its own has been subjected to certain exceptions by the application of the fiction that the veil of corporation can be lifted and its face examined in substance.

Thus when “Tata Company” or “German Company” or “Government Company” is referred to, we look behind the smoke-screen of the company and find the individual who can be identified with the company. This phenomenon which is applied by the courts and which is also provided now in many statutes is called “lifting of the corporate veil”. As a consequence of the lifting of the corporate veil, the company as a separate legal entity is disregarded and the people behind the act are identified irrespective of the personality of the company. So, this principle is also called “disregarding the corporate entity”.

LIFTING THE CORPORATE VEIL Meaning of the doctrine:

Lifting the corporate refers to the possibility of looking behind the company’s framework (or behind the company’s separate personality) to make the members liable, as an exception to the rule that they are normally shielded by the corporate shell (i.e. they are normally not liable to outsiders at all either as principles or as agents or in any other guise, and are already normally liable to pay the company what they agreed to pay by way of share purchase price or guarantee, nothing more).[v]

When the true legal position of a company and the circumstances under which its entity as a corporate body will be ignored and the corporate veil is lifted, the individual shareholder may be treated as liable for its acts.

The corporate veil may be lifted where the statute itself contemplates lifting the veil or fraud or improper conduct is intended to be prevented.

“It is neither necessary nor desirable to enumerate the classes of cases where lifting the veil is permissible, since that must necessarily depend on the relevant statutory or other provisions, the object sought to be achieved, the impugned conduct, the involvement of the element of public interest, the effect on parties who may be affected, etc.”. This was iterated by the Supreme Court in Life Insurance Corporation of India v. Escorts Ltd .[vi]

The circumstances under which corporate veil may be lifted can be categorized broadly into two following heads:

  1. Statutory Provisions
  2. Judicial interpretation
STATUTORY PROVISIONS

Section 5 of the Companies Act defines the individual person committing a wrong or an illegal act to be held liable in respect of offences as ‘officer who is in default’. This section gives a list of officers who shall be liable to punishment or penalty under the expression ‘officer who is in default’ which includes a managing director or a whole-time director.

Section 45 – Reduction of membership below statutory minimum: This section provides that if the members of a company is reduced below seven in the case of a public company and below two in the case of a private company (given in Section 12) and the company continues to carry on the business for more than six months, while the number is so reduced, every person who knows this fact and is a member of the company is severally liable for the debts of the company contracted during that time. In the case of Madan lal v. Himatlal & Co.[vii] the respondent filed suit against a private limited company and its directors for recovery of dues. The directors resisted the suit on the ground that at no point of time the company did carry on business with members below the legal minimum and therefore, the directors could not be made severally liable for the debt in question. It was held that it was for the respondent being dominus litus, to choose persons of his choice to be sued.

Section 147- Misdescription of name: Under sub-section (4) of this section, an officer of a company who signs any bill of exchange, hundi, promissory note, cheque wherein the name of the company is not mentioned is the prescribed manner, such officer can be held personally liable to the holder of the bill of exchange, hundi etc. unless it is duly paid by the company. Such instance was observed in the case of Hendon v. Adelman.[viii]

Section 239 – Power of inspector to investigate affairs of another company in same group or management: It provides that if it is necessary for the satisfactory completion of the task of an inspector appointed to investigate the affairs of the company for the alleged mismanagement, or oppressive policy towards its members, he may investigate into the affairs of another related company in the same management or group.

Section 275- Subject to the provisions of Section 278, this section provides that no person can be a director of more than 15 companies at a time. Section 279 provides for a punishment with fine which may extend to Rs. 50,000 in respect of each of those companies after the first twenty.

Section 299- This Section gives effect to the following recommendation of the Company Law Committee: “It is necessary to provide that the general notice which a director is entitled to give to the company of his interest in a particular company or firm under the proviso to sub-section (1) of section 91-A should be given at a meeting of the directors or take reasonable steps to secure that it is brought up and read at the next meeting of the Board after it is given.[ix] The section applies to all public as well as private companies. Failure to comply with requirements of this Section will cause vacation of the office of the Director and will also subject him to penalty under sub-section (4).

Sections 307 and 308- Section 307 applies to every director and every deemed director. Not only the name, description and amount of shareholding of each of the persons mentioned but also the nature and extent of interest or right in or over any shares or debentures of such person must be shown in the register of shareholders.

Section 314- The object of this section is to prohibit a director and anyone connected with him, holding any employment carrying remuneration of as such sum as prescribed or more under the company unless the company approves of it by a special resolution.

Section 542- Fraudulent conduct: If in the course of the winding up of the company, it appears that any business of the company has been carried on with intent to defraud the creditors of the company or any other person or for any fraudulent purpose, the persons who were knowingly parties to the carrying on of the business, in the manner aforesaid, shall be personally responsible, without any limitation of liability for all or any of the debts or other liabilities of the company, as the court may direct. In Popular Bank Ltd. In re [x] it was held that section 542 appears to make the directors liable in disregard of principles of limited liability. It leaves the Court with discretion to make a declaration of liability, in relation to ‘all or any of the debts or other liabilities of the company’. This [xi] section postulates a nexus between fraudulent reading or purpose and liability of persons concerned.

JUDICIAL INTERPRETATIONS

By contrast with the limited and careful statutory directions to ‘lift the veil’ judicial inroads into the principle of separate personality are more numerous. Besides statutory provisions for lifting the corporate veil, courts also do lift the corporate veil to see the real state of affairs. Some cases where the courts did lift the veil are as follows:

  1. United States v. Milwaukee Refrigerator Transit Company[xii] In this case the U.S. Supreme Court held that “where the notion of legal entity is used to defeat public convenience, justify wrong, protect fraud or defend crime, the law will disregard the corporate entity and treat it as an association of persons.”

Some of the earliest instances where the English and Indian Courts disregarded the principle established in Salomon’s case are:

  1. Daimler Co. Ltd. v. Continental Tyre and Rubber Co. (Great Britain) Ltd[xiii] – This is an instance of determination of enemy character of a company. In this case, there was a German company. It set up a subsidiary company in Britain and entered into a contract with Continental Tyre and Rubber Co. (Great Britain) Ltd. for supply of tyres. During the time of war the British company refused to pay as trading with an alien company is prohibited during that time. To find out whether the company was a German or a British company, the Court lifted the veil and found out that since the decision making bodies, the board of directors and the general body of share holders were controlled by Germans, the company was a German company and not a British company and hence it was an enemy company.
  1. Gilford Motor Co. v. Horne[xiv] This is an instance for prevention of façade or sham. In this case an employee entered into an agreement that after his employment is terminated he shall not enter into a competing business or he should not solicit their customers by setting up his own business. After the defendant’s service was terminated, he set up a company of the same business. His wife and another employee were the main share holders and the directors of the company. Although it was in their name, he was the main controller of the business and the business solicited customers of the previous company. The Court held that the formation of the new company was a mere cloak or sham to enable him to enable him to breach the agreement with the plaintiff.
  1. Re, FG (Films) Ltd[xv] In this case the court refused to compel the board of film censors to register a film as an English film, which was in fact produced by a powerful American film company in the name of a company registered in England in order to avoid certain technical difficulties. The English company was created with a nominal capital of 100 pounds only, consisting of 100 shares of which 90 were held by the American president of the company. The Court held that the real producer was the American company and that it would be a sham to hold that the American company and American president were merely agents of the English company for producing the film.
  1. Jones v. Lipman[xvi] In this case, seller of a piece of land sought to evade specific performance of a contract for the sale of the land by conveying the land to a company which he formed for the purpose and thus he attempted to avoid completing the sale of his house to the plaintiff. Russel J. describing the company as a “devise and a sham, a mask which he holds before his face and attempt to avoid recognition by the eye of equity” and ordered both the defendant and his company specifically to perform the contract with the plaintiff.
  1. Tata Engineering and Locomotive Co.Ltd. State of Bihar[xvii] – In this case it was stated that a company is also not allowed to lay claim on fundamental rights on the basis of its being an aggregation of citizens. Once a company is formed, its business is the business of an incorporated body thus formed and not of the citizens and the rights of such body must be judged on that footing and cannot be judged on the assumption that they are the rights attributable to the business of the individual citizens.
  1. N.B. Finance Ltd. v. Shital Prasad Jain[xviii] In this case the Delhi High Court granted to the plaintiff company an order of interim injunction restraining defendant companies from alienating the properties of their ownership on the ground that the defendant companies were merely nominees of the defendant who had fraudulently used the money borrowed from the plaintiff company and bought properties in the name of defendant companies. The court did not in this case grant protection under the doctrine of corporate veil.
  1. Shri Ambica Mills Ltd. v. State of Gujarat[xix] It was held that the petitioners were as good as parties to the proceedings, though their names were not expressly mentioned as persons filing the petitions on behalf of the company. The managing directors in their individual capacities may not be parties to such proceedings but in the official capacity as managing directors and as officers of the company, they could certainly be said to represent the company in such proceedings. Also as they were required to so act as seen from the various provisions of the Act and the Rules they could not be said to be total strangers to the company petition.
COMPANIES BILL 2011

India being one of the top three emerging economies, has been longing for strong and cogent corporate laws that will enable the country’s international trade to conduct its affairs on a par with the western industrialized nations. The proposals in the Bill are expected to act as a catalyst to fostering growth of the economy. One of the main highlights of this Bill is that it proposes a mechanism for vigilance that will reward whistle blowers. This measure will allow companies to follow transparency at every move they initiate. The authors have mentioned a few provisions which bring in responsibilities and liabilities upon a director.

Section 127- A director of a company is punishable with imprisonment or fine if a dividend which is declared has not been paid or a warrant which in respect thereof has not been posted within 30 days of the date of declaration.

Section 159 r/w 156- It is the duty of every existing director to intimate his Director Identification Number to the company or all companies wherein he is a director within one month of the receipt of the same from the Central Government. If any director of a company contravenes, such director shall be punishable with imprisonment or with fine under Section 159.

Section 166- Under this section various duties of a director are enumerated such as the duty of good faith, of due and reasonable care, to act in accordance with the articles of association etc. Any director in violation of these duties will be punishable with a fine of not less that Rs 1 lakh and not more than Rs 5 lakhs.

Section 184- This section imposes a duty upon a director of a company to disclose his concern or interest, including shareholding, in any company or companies, or bodies corporate, companies, firms, or other associations of individuals or if he is a party to any contract or agreement with a body corporate in which such director holds more than 2% shareholding or otherwise as mentioned or any firm in which such director is a partner or owner etc. Sub-section (4) is the penalty clause.

Section 194- This section puts a prohibition in forward dealings of securities of the company, its subsidiaries or in its holding or associate company by a director of such company. In any contravention to this effect, the director will be punishable with imprisonment or/and fine as prescribed.

APPROACH OF THE INDIAN COURTS IN THE 21ST CENTURY
  1. Subhra Mukherjee v. Bharat Coking Coal Ltd.[xx] Sham or façade- In this case a private coal company sold its immovable property to the wives of directors prior to nationalization of the company. In fact, documents were ante-dated to show the transaction was prior to nationalization of the company). Where such transaction is alleged to be sham and collusive, the Court was justified in piercing the veil of incorporation to ascertain the true nature of the transaction as to know who were the real parties to the sale and whether it was genuine and bona fide or whether it was between the husbands and wives behind the façade of the separate entity of the company.
  1. Bajrang Prasad Jalan v. Mahabir Prasad Jalan[xxi] Subsidiary-holding company- The court, for the purpose of considering a complaint of oppression held that the corporate veil can be lifted in the cases of not merely of a holding company, but also its subsidiary when both are family companies.
  1. Singer India v. Chander Mohan Chadha[xxii] The concept of corporate entity was evolved to encourage and promote trade and commerce but not to commit illegalities or to defraud the people. Where therefore the corporate charter is employed for the purpose of committing illegality or for defrauding others, the court would ignore the corporate character and will look at the reality behind the corporate veil so as to enable it to pass appropriate orders to do justice between the parties concerned.
  1. Saurabh Exports v. Blaze Finance & Credits (P.) Ltd. [xxiii] Defendant no. 1 was a private limited company. Defendant no. 2 and 3 were the directors of that company. Defendant no. 4 was the husband of D-3 and the brother of D-2. Allegedly on representation of D-4 that D-1 company was inviting short term deposits at good interest rates, plaintiff made a deposit of Rs. 15 lakhs in the company for a period of 6 months. When the company failed to pay the amount, the plaintiff sued it for the said amount along with interest. D-2 and 3 denied their liability in the ground that there was no personal liability of the directors as the deposit was received in the name of the company. D-4 denied the liability on the ground that it had nothing to do with the transaction in question as he was neither a director nor a shareholder of the company so it was held that he had no locus in the company and hence not liable. It was held that D-3 being a house wife had little role to play and therefore could not be made liable. The plaintiff was sought to be defrauded under the cloak of a corporate entity of D-1 and, therefore, corporate veil was lifted taking into consideration that D-1 was only a family arrangement of the remaining defendants. D-2 was running the business in the name of the company. So D-1 and D-2 were both personally liable.
  1. Universal Pollution Control India (P.) Ltd. v. Regional Provident Fund Commissioner[xxiv] This is a case of ‘default in payment of employee’s provident fund’- Certain amount was due and payable to provident fund office by the sister concern of the petitioner-company, a demand was raised on the petitioner company only on the ground that two directors of these two companies were common. It was held that the contention raised by the respondent that the Court should lift the corporate veil and fasten the liability on the petitioner was without any merits and was baseless. Both the companies were separate legal entities under the provisions of the Companies Act and there was no provision under the Provident Fund Act that a liability of one company can be fastened on the other company even by lifting the corporate veil.
  1. The Decision of Karnataka High Court. Decided On 24.03.2011 –Richter Holding Ltd. v. The Assistant Director of Income Tax[xxv] Richter Holdings Ltd. a Cypriot company and West Globe Limited, a Mauritian company purchased all shares of Finsider International Co. Ltd. (FICL), a U.K. company from Early Guard Ltd. another U.K. company. FICL held 51% shares of Sesa Goa Ltd. (SGL), an Indian company. The Tax department issued a show cause notice to Petitioner alleging that the Petitioner had indirectly acquired 51% in Sesa Goa Ltd and was therefore, liable to deduct tax at source before making payment to Early Guard Limited. The Income Tax Department contended that as per section 195 of the Act, the Petitioner is liable to deduct tax at source in respect of payment made for purchase of capital asset. The High Court of Karnataka held that the Petitioner should reply to show-cause notice issued by the Tax department and urge all their contentions before it. The High Court also emphasized that the fact finding authority (Tax Department) may lift the corporate veil to look into the real nature of the transaction to ascertain the vital facts.

The aspect that deserves greater attention is that the Karnataka High Court demonstrates a keen interest in lifting the corporate veil. This has a number of implications. First, the Richter Holding Case extends even further the scope of the principles laid down in the Vodafone Case. For example, in Vodafone the Bombay High Court did not consider lifting the corporate veil to impose taxation in case of indirect transfers. Second, it is not clear from the judgment itself whether the tax authorities advanced the argument regarding lifting the corporate veil. Third, the Karnataka High Court appears to have readily permitted lifting the corporate veil without at all alluding to the jurisprudence on the subject-matter. Generally, courts defer to the sanctity of the corporate form as a separate legal personality and are slow to lift the corporate veil, as evidenced by Adams v. Cape Industries[xxvi] . unless one of the established grounds exist.[xxvii]

CONCLUSION

It should be noted that the principle of Salomon v. A. Salomon & Co. Ltd.[xxviii] is still the rule and the instances of piercing the veil are the exceptions to this rule. The legislature and the courts have in many cases now allowed the corporate veil to be lifted. The principle that a company has its own separate legal personality of its own finds an important place in the Constitution of India as well. Article 21 of the Constitution of India, says that: No person shall be deprived of his life and personal liberty except according to procedure established by law. Under Article a company also has the right to life and personal liberty as a person. This was laid down in the case of Chiranjitlal Chaudhary v. Union of India[xxix] where the Supreme Court held that 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 right compels the inference that they are applicable only to natural persons.

So, a corporation can own and sell properties, sue or be sued, or commit a criminal offence because a corporation is made up of and run by people, acting as agents of the company. It is under the ‘seal of the company’ that the members or shareholders commit fraud or such acts and therefore the company should also be liable as it also a person which is accorded fundamental rights under Article 21 of the Constitution of India.

The other side of this coin can be that, as the company is privileged to have its own right to life and personal liberty, how can its fundamental right be taken away by disregarding its corporate entity for the wrongs committed by its members and not the company itself.

As a result of incorporation, an incorporated company wears a ‘corporate veil’ and thus acquires the ‘corporate personality’, behind which there are shareholders who have formed the company. Although in law the company has an independent personality, it is an artificial person and hence, behind the corporate curtain, there are natural persons, i.e. shareholders who have associated themselves into a company. So if this corporate personality is uncovered or unveiled, the shareholders or the directors mostly are found to be behind the veil.

[i] [1897] AC 22 (House of Lords)

[ii] Guide to Companies Act, 17 th edn 2010, part 1, A. Ramaiya, Pg 582

[v] See Sealy’s Cases and Materials in Company Law,9 th edn. Len Sealy, Sarah Worthington;Oxford,Pg 53

[vi] [1986] 59 Comp.Cas. 548

[vii] [2009] 99 Comp. Cas. 266 (M.P)