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Commercial Question

Drawing a veil over corporate behaviour

updated on 08 November 2011

Question

What is the corporate veil and can it be lifted?

Answer

Anyone who has studied company law will know that a company is a separate legal entity. ‘Separate' means that the company is neither the agent of a shareholder, nor can it legally be considered to be one and the same with other companies which are members of a corporate group. The case of Salomon v Salomon & Co Ltd (1897) established the fundamental concept that a shareholder is not liable to indemnify a company against claims by its creditors. The principle is the same whether there is one shareholder or many.

A company has its own rights and liabilities and these cannot be ascribed to its shareholders. Therefore a subsidiary company (even if its parent company holds most of its shares) will not be liable for the parent company's debt and vice versa. It does not matter if the parent company and its subsidiary share the same directors. The ‘veil' is a metaphor which represents the individual nature of each company.

So why has an established legal principle suddenly become a hot topic? Many companies which were previously able to meet their contractual commitments are now suffering because of the recession, which has forced them to renege or repudiate such contracts. The innocent party may then be left with a claim against a company with no assets or financial standing. However, a parent company or another member of the same group as the repudiating party may have sufficient assets to satisfy the innocent party's claim. The issue is whether these assets can be reached.

The recent outcome of Linsen International Limited & Ors v Humpuss Seatransport Pte Ltd & Ors (2011) brings this issue into focus. However, before we examine that decision, it is first necessary to establish what was the state of the law in relation to lifting/piercing the corporate veil prior to this judgment. There are two exceptions to the principle that a company is distinct from its shareholders: (i) where an agency relationship does in fact exist between the company and its shareholders, or (ii) where the corporate structure is merely a facade.

The second exception to the principle set out in Salomon is more pertinent to the case of Linsen v Humpuss. In such cases the company structure is a mere facade which conceals the true facts.

In Adams v Cape Industries Plc the Court of Appeal found that the veil should also be lifted when the corporate structure has been used to evade (i) limitations imposed on conduct by law, and (ii) such rights of relief which third parties already possess against the company.

The authorities on piercing the corporate veil were recently reviewed in Ben Hashem v Ali Shayis (2008). It was held that it will be necessary to show both control of the company by the wrong doer and improper use of the company as a device or facade to conceal the wrongdoing. A company may still be a facade even though it was not originally incorporated with deceptive intent - this is to be judged at the time of the relevant transaction. The court will pierce the corporate veil only so far as is necessary to resolve a particular wrongdoing. Therefore, creditors should identify the subsidiary with which they are dealing and be aware that the principle in Salomon will prevent claims against assets belonging to other members of the group. A frequently suggested means by which creditors can protect themselves is the use of guarantees from the asset-rich companies in the group or, alternatively and with less security, a letter of comfort.

Linsen v Humpuss

Background
In Linsen v Humpuss the claimants successfully applied for a freezing injunction against 12 defendant companies which were part of the same group, plus one defendant - Tommy Suharto - who was a controlling shareholder of the group's principal company. The judge who heard the initial application ruled that there was sufficient basis to argue that the corporate structure had been abused and that the corporate veil could be lifted to render the defendant group of companies liable.

The claimants were part of a group of companies which had ordered the manufacture of 12 ships. Seven were to be chartered to companies in the defendant's group and the claimants in this action owned four of the vessels. The first defendant, Humpuss Sea Transport Pte Ltd, time chartered the ships. The second defendant, PT Humpuss Intermoda Transportasi Tbk Ltd, guaranteed the first defendant's obligations under at least two of these charterparties. The vessels were delivered to the charterparties in the first half of 2009.

However, the sub-chartering of the vessels by the first defendant to third parties was made difficult by the freight market's collapse. The first defendant subsequently failed to pay hire for the ships and the claimants accepted this repudiation. The claimants were then left with a claim for outstanding hire and damages for repudiation which totalled $80 million. The claimants obtained arbitration awards in their favour which subsequently became judgments. They also obtained a judgment that the second defendant was liable under the guarantees, as well as a freezing injunction against the first and second defendants. Neither defendant had honoured these judgments at the time of the claimants' application to extend the freezing injunction to the remaining defendants.

The third defendant, Humpuss Transportasi Kimia, was 99% owned by the second defendant. Pursuant to a restructuring of the group which commenced in July 2009, the third defendant received assets previously owned by the first defendant or the other defendant subsidiaries. There was no evidence that the third defendant paid money to obtain these assets. The claimants contended that the restructuring of the defendants was an abuse of the corporate structure which entitled them to pierce the corporate veil - and that the third to thirteenth defendants should be liable under the original contracts. The defendants argued that the restructuring had come about due to the change of Indonesian law which required all activities in the Indonesian market to be carried out by national shipping companies with Indonesian flagged vessels.

Abuse of the corporate structure
At the return date hearing to consider whether the freezing injunction should be maintained, Mr Justice Flaux stated that the third to thirteenth defendants would only be liable if the claimants could reasonably demonstrate that the parties to the contracts or the contracts themselves were a sham and that the third to thirteenth defendants should be regarded as liable under the original contract. Flaux found that:

  • the use of one-ship owning companies was common in the shipping industry and it is usual for the corporate ship-owning group to share directors. However, this was not a reason to disregard each ship-owning company as a separate corporate entity within that structure;
  • intra-group financing is also normal, including the transfer of shareholdings - as is the administration of the group's finances by only one of its members on behalf of the other members;
  • that the 12th defendant, Tommy Suharto, was found guilty by the Indonesian Court of Corruption did not establish that he diverted funds and manipulated corporate structures; and
  • changes to the management by Suharto did not mean that he was controlling all of the companies in the group. There was no evidence that the new directors were merely puppets.

However, the transfer of assets by the first defendant to the third without any payment constituted "shams or facades designed to render enforcement against the first defendant more difficult". Flaux found that the corporate structure of the defendants had been misused between July 2009 and sometime in 2010 and there was justification for piercing the corporate veil between the first and third defendants.

The judge thought it was "just arguable" that the corporate veil could be lifted in relation to the sixth to eighth defendants, who had transferred the ownership of vessels to the third defendant upon the direction of the first and second. However, as these were simply shell companies, only extant to own one of the vessels concerned, they would not have had any useful assets left to satisfy the claimants.

On the other hand there was no evidence that the second defendant had sought to diminish its assets to avoid liability under the guarantees. There was no basis for piercing the corporate veil against the other defendants in relation to the second defendant's assets.  With regard to the fourth, fifth and 13th defendants, there was no evidence that they were directly involved in any wrongdoing as this was being orchestrated by the first and second defendants. Finally, Flaux concluded that there was insufficient evidence to demonstrate that the remaining defendants had been involved in any manipulation of the corporate structure.

Effect of piercing the veil
Flaux then considered whether the corporate veil could be pierced in such a manner as to go beyond merely unravelling sham transactions to render the defendants liable to the original charter parties and guarantees. The claimants relied upon Antonio Gramsci Shipping v Stepanovs (2011) to support the precedent for this, but Flaux distinguished this case from the matter presently before him. Here the contracts were initially signed in good faith and the corporate structure was not established to perpetrate the relevant fraud. By contrast, in Antonio Gramsci Shipping v Stepanovs there had been fraudulent misuse of the corporate structure from the outset. Flaux found no authority to support the claimants' argument and therefore ruled that abuse of the corporate structure long after the contracts were made could not justify the piercing of the corporate veil to make the third to thirteenth defendants liable as if they were parties to the original charter parties and guarantees. The freezing injunction against these particular defendants would be lifted.

Comment
The courts continue to adhere to the principle of Salomon. It is therefore impossible to extend a claim to other members of a corporate group if they cannot be seen to be the real parties to the contract in question. As such, if a defendant company no longer has sufficient assets to satisfy a claim then a claimant will be left bearing the loss – potentially causing the claimant serious financial difficulties given the current economic climate.

Deborah Laurent is a newly qualified solicitor at Ince & Co.