Introduction
Reverse lifting of corporate veils is a relatively new concept in company law and is slowly becoming the chosen method of dealing with the personal liabilities of shareholders who have committed fraud. But I will be arguing in my paper that the doctrine is far from capable of dealing with cases of fraud of shareholders who use companies as alter egos. I will argue that the very criterion for invoking reverse lifting is flawed and that the doctrine is inherently problematic as it runs contrary to the protections offered by limited liability. The doctrine also does not protect the interests of those who are directly affected by the lifting of the veil but are not directly involved in the fraud. I will also be presenting an alternative model which better protects the rights of all the innocent parties involved. But first let us understand some key concepts.
Separate Legal Entity and Lifting the veil
A company becomes a separate legal entity upon registration. This is a well settled principle in company law. As per S9 of the Company Act, 2013 upon incorporation a company becomes a body corporate capable of partaking in all the activities that a legal person can like entering contracts etc. First propounded in the Salomon case, the doctrine of separate legal entity states that the company and its members are separate from each other and cannot be held accountable for the activities of the other. This is done to protect the company and its members. So, if one of the shareholders of a company has taken a loan from someone and has defaulted on the payment, the creditors cannot sue the company. The actions of the individual cannot be traced back to the company in any way. This is true in most cases. But in some cases, as an exception, the distinction between the company and the shareholder can be blurred.
The term corporate veil is derived directly from the doctrine of separate legal entity. There is supposed to be a metaphorical “veil” separating the actions of the company from the actions of the individual which cannot be lifted when the company or the individual is involved in legal proceedings. This is the general principle. But under exceptional circumstances, this so-called veil can be lifted and the company or the individual can be asked to pay for the actions of the other. This means that the individual can be found guilty of company’s failure to pay a loan back and the same individual can be asked to pay compensation to the creditors of the company. This is called lifting the veil.
The traditional method of lifting the veil is called forward lifting of the veil wherein the shareholder is found to be liable for the actions carried in the name of the corporation. This happens in circumstances where foul play can be detected on the part of the shareholder, and they are suspected of having carried out illicit activities in the name of the company. In reverse lifting of the corporate veil, conversely, the corporation is found guilty of the actions of the shareholder. This occurs in situations where the corporation has been set up by the shareholder as a shell company or a company that exists only to serve the interest of the controlling shareholder. In these cases, they are made liable by holding the company liable. So, creditors can claim compensation from the shareholder by holding the company responsible.
Criterion for Reverse Lifting
Alter Ego Test
Alter Ego or domination is where most of the shares of a company are owned by one shareholder or a holding company. So, the company effectively becomes a puppet to the wishes and profits of the holding company or the shareholder themselves. But the mere fact of complete domination is not considered to be problematic. What is considered wrong, and illegal is the unethical practices followed by the company. There is usually an absence of all the formalities that are to be completed by a corporation followed by a large transfer of funds from shareholder to company or vice- versa and an overlap between the positions of shareholder and director/manager. If a case has a lot of these irregularities, then the veil can be lifted. But the alter ego test or the aspect of total control is not enough.
Fraud Test
Apart from dominating the company, the shareholder must also have committed some fraud by taking unfair advantage of their position. This may include misrepresentation of identity. The shareholder may take a loan on behalf of the company but may falsely represent to the creditor that he was taking the loan for himself. An agency-based approach has also been applied which asks the question: Was the company acting as an agent of the primary shareholder? Both the conditions of fraud and alter ego need to be satisfied for the veil to be lifted.
Criticisms
Control is enough
When looking at the circumstances for when the veil can be lifted, courts often apply a twofold system. The alter ago test and the fraud test. But the courts only list the veil in case of abuse or fraud. When the fact that one individual is in control of the entire company of board of directors is enough to hold them accountable to the creditors. When a person has enough control to choose who goes on the board of directors, it is safe to presume that the profit being pursued by the company are at the complete discretion of this one individual. Yet plaintiffs must prove an additional element of fraud to claim compensation from the court when the fact that this one person is in control of everything, should be enough to find them liable. The second criteria in the test is not only unnecessary but makes it harder for plaintiffs to prove their case.
Innocent shareholders affected
In the case of forward lifting of veil, finding one shareholder responsible for their abuse of power in the company is actually helpful for the other shareholders involved. But the same principle does not hold true in revere lifting of corporate veil. Under this approach all shareholders get bunched together in one category and must pay for the personal liabilities of one individual even if they are not involved in the alleged fraud. Even if all shareholders do not directly have to pay for the deed of one, they still suffer indirectly as the company name and reputation gets affected by getting dragged into the fraud of one individual. The collective company resources also suffer as the creditor is now entitled to compensation from them. This goes directly against the concept of limited liability which promises to protect members from harm larger than the proportion of their contribution to the company capital. This violation of the protections offered by limited liability makes shareholders a lot more vulnerable.
The Insolvency Problem
The doctrine of reverse lifting was introduced in the Indian jurisprudence through the case Standard Chartered Bank v Directorate Of Enforcement. But despite being introduced in India, an inherent flaw in the application of reverse lifting of veil in India is that there no proper framework that supports those who are not involved in the fraud but are being directly affected by the lifting of the veil. As per S53 of the Insolvency and Bankruptcy Code, the creditors of the individual shareholder will have priority over the creditors and sureties of the company. This means that in case of reverse lifting of veil, the creditors of the shareholder who has been found guilty of fraud will be paid before the creditors of the corporation as a whole. This puts creditors of the company at a major disadvantage. This means even the biggest creditors will be at the same level of priority as the creditors of the shareholder. The company owners could even plan to get the veil lifted to evade their creditors.
Alternative Remedies Exist
Perhaps the biggest flaw with courts reverse lifting the veil is that alternative remedies exist. It has been established through cases like William Schwab v. Damenti’s Inc., that the option of reverse lifting should be exercised only when all other plausible options have been exhausted. The creditor does not have to sue the corporation to get compensation from the shareholder in the first place. The plaintiff can directly sue the shareholder in a personal capacity for offences like active concealment and misrepresentation. If we change the current model of vicarious liability to direct liability from a personal misconduct standard, then we can directly sue the person and check the individual offence committed by them. This model would actually uphold the concept of separate legal entity a lot better than the reverse piercing doctrine. This model of personal liability will work best in situations where liabilities have been taken by those in close control of the company. The inquiry should be directed at the personal conduct of these individuals. This will save innocent shareholders from being held liable.
Hybrid Model- The Identity Test
We have seen why the Alter Ego test and the Fraud test is problematic and inefficient as a criterion for determining when to lift the veil. The practice of veil lifting is contrary to the ideas of limited liability and puts innocent shareholders in jeopardy. Both these problems can be addressed by the Identity test. Under this test we look at the degree of identity between the shareholder and the company. Those seeking the lifting of the veil must satisfy the court that the degree of identity enjoyed by the shareholder to the company is high and that they can exert a lot of control and influence on the actions of the company. This will help the courts to cater to the subjective nature of most shareholder-company relationships. This will also ensure that the other shareholders who enjoy a lower degree of identity with the company are not held liable needlessly. Establishing the factor of control here is enough to lift the veil. Plaintiff won’t have to further establish fraud as a means of claiming compensation.
Conclusion
In cases of lifting the courts have shown a lack of logical reasoning and instead have depended on vague labels like “alter ego” and “lack of separation”. These outdated terms cannot cater to the complex nature of modern-day capitalism and company dynamics. There is a lack of clarity overall with regards to the doctrine of reverse lifting as the doctrine exists mostly in case laws and not in a concrete statute. This makes it harder for Judges to adjudicate cases and they limit their judgements to the question of equity and not the larger questions of personal liabilities of shareholders in society. The doctrine is deeply flawed and inherently contrary to many well settled principles of company law like limited liability. There needs to be major re hauling of the theory itself. We need a doctrine that can effectively prevent the situations that perpetuate domination and fraud in companies instead of finding a remedy later on. The hybrid model may be that effective alternative, but we need to solidify and regulate this model through proper laws and interpretation in courts.
Notes:
All Answers ltd, ‘Salomon v Salomon – Case Summary’ (Lawteacher.net, October 2022) <https://www.lawteacher.net/cases/salomon-v-salomon.php?vref=1> accessed 29 October 2022
Chandra I, “Reverse Piercing of Corporate Veil” (Manupatra online September 20, 2022) < https://articles.manupatra.com/article-details/REVERSE-PIERCING-OF-CORPORATE-VEIL-HOW-DOES-IT-SUPPORT-THE-PRESENT-INSOLVENCY> accessed October 29, 2022
Chakraborty D, “Doctrine of ‘Reverse’ Piercing and the Jurisprudence of Indian Courts” (IndiaCorpLaw July 22, 2018)<https://indiacorplaw.in/2018/07/doctrine-reverse-piercing-jurisprudence-indian-courts.html#:~:text=The%20%27reverse%27%20piercing%20of%20corporate,for%20debts%20of%20the%20shareholders.> accessed October 29, 2022
Chandra M, “The Emerging Theory of Reverse Piercing of Corporate Veil: Its …” (Law Journals May 3, 2022) <https://www.lawjournals.net/article/view/112/4-2-15> accessed October 29, 2022
Zaist v. Olson [1967] 227 A.2d 552, 558
Lidstone HK, “Piercing the Corporate and LLC Veil” (SSRN January 27, 2013) <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2207735> accessed October 29, 2022
Standard Chartered Bank And ors v Directorate Of Enforcement And ors [2006] AIR 2005 SC 2622
Sharma R and Pal V, “The Curious Case of Reverse Corporate Veil Piercing and the IBC” (Corporate Restructuring and Insolvency July 1, 2022) <https://rmlnlulawreview.com/2022/07/01/reversecorporateveilpiercing-and-ibc/> accessed October 29, 2022
William G. Schwab v. Damenti’s Inc and Ors. [2009] 405 B.R. 555
Bainbridge SM, “Abolishing Veil Piercing” (SSRN September 1, 2000) <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=236967> accessed October 29, 2022
Khurshid R, “Reverse Piercing of Corporate Veil: An Unemployed Phenomenon in India” (Corporate Law Reporter July 12, 2017) <http://corporatelawreporter.com/2017/07/12/reverse-piercing-of-corporate-veil-an-unemployed-phenomenon-in-india/> accessed October 29, 2022
Chandra M, “The Emerging Theory of Reverse Piercing of Corporate Veil: Its …” (Law Journals May 3, 2022) <https://www.lawjournals.net/article/view/112/4-2-15> accessed October 29, 2022
Mujih E, “Piercing the Corporate Veil: Where Is the Reverse Gear?” (London Met Repository April 1, 2017) <http://repository.londonmet.ac.uk/4909/> accessed October 29, 2022
Author Bio
