I. Introduction
In the course of history, mankind has seen different forms of business organization. One of the earlier ones is the partnership. People coming together with a common goal can form a partnership. But time and practice has shown some problems and inconvenient applications of partnerships. A partnership hasn’t got a separate personality, which means that people entering transactions with a partnership, are actually entering into transactions with every single partner and not with the partnership. Therefore, third parties are supposed to claim the liability of the partners, in case they do not pay their debts or do not follow their obligations (because we are talking about the debts and obligations of the partners, not of the partnership). What should be clear is that the partnership hasn’t got a personality, so it isn’t possible to claim the liability of the partnership. This characteristic of partnerships makes it difficult to expand the business and brings other several consequences.
Finally, Capital Companies emerged and solved the problems resulting from partnerships. Capital companies introduced the principle of limited liability, which includes different advantages for the shareholders of the company. But as always experienced, rules providing advantages and protection can sometimes be used to take advantage of it in bad faith. In this case, the protection of the rule is used to harm others or to circle around the law. What will be pointed out in this paper is how the limited liability principle can be abused, in which circumstances it is abused, and how the judge acts when he/she is confronted with such abuse (this paper will rather be based on joint stock companies).
II. Short Definition of the Limited Liability Principle
Before starting to point out how the limited liability principle can be abused, it is important to understand the idea behind that principle. So, what means limited liability?
After the incorporation of a capital company, a separate personality emerges: the company as an independent legal person. It is independent from its members and is able to have its own rights and obligations. So unlike partnerships, capital corporations have a separate personality which also means that third parties are entering into transactions with the corporation, not with its shareholders. This leads us to the conclusion that the capital corporation is the only one who is liable for its own debts and obligations. Metaphorically we can say that the personality of the company puts a veil between the company and the shareholders so that third parties can only see the company as a contact person. This veil protects the personal property of the shareholders and makes sure that no one can claim the liability of the shareholders because of the debts of the company. Before the birth of the legal person, shareholders only contribute to the capital of the company, in order to be able to incorporate a corporation. So, the company has a constant amount of capital and over time it has its own assets, so third parties can only claim these properties because these are in the possession of the company. But if this is used up to the last remainder, third parties still can’t claim the liability of the shareholders. As we can see, this principle makes it possible for shareholders to be able to diversify their investments without risking all their property.
Now it is time to analyze how someone can abuse the advantages of this principle and what consequences can follow from his abuse, so that people will be able to invest with the confidence that they will not be personally in debt. This will undoubtedly lead to an economic model unique to developed and functioning countries, in which entry and exit are free. However, since this right given to the shareholders is also very open to abuse, the theory of lifting the veil of incorporation has been formed in doctrine and practice.
III. Piercing the Corporate Veil
After laying down the rule, it is time to mention the exception to the rule. The exception here is called ‘‘piercing the corporate veil “, which means that under certain circumstances the court can disregard the separate personality of the corporation which leads to the “lifting” of the corporate veil. Because of the lifted veil, claimants now can also see the shareholders as contact persons, next to the corporation. In this case, members of the company can’t benefit from the protection of the limited liability principle. Exceptionally, it is possible to make the shareholders personally liable for the debts and obligations of the company. The fact that the corporation has its own personality and has its own debts will be disregarded in order to make it possible for plaintiffs to claim the personal liability of the shareholders of the actually liable company.
It is very important to notice that this is a rare exception, and it can be referred to only in very rare situations, under very strict conditions. It is important to safeguard and maintain the limited liability principle because it is an important protection ensured by law which should save shareholders personal assets from claimants of the company. Only if it is urgently necessary and if the determined criteria are definitely met it is possible to lift the corporate veil.
As mentioned above, there are different criteria that should be met to put this exception into action. But we can’t speak about fixed and clear criteria, which are applicable in every single case. It is possible to observe that every state or every judicial system has its own and very different criteria and that some judges set up their own criteria. This is because we experienced “piercing the corporate veil” in case law and analyzing case law we can observe different criteria set by different judges according to their own legal opinions.
The necessity of this exception showed itself when shareholders began to use the corporate entity for their criminal purposes, for fraud, dishonesty, or other inappropriate conduct. In such situations, it isn’t fair to allow shareholders to hide behind the veil of the corporation. But after determining such a conduct it is the judge’s duty to analyze every fact of the case in order to decide to lift the veil. It isn’t enough to determine an inappropriate conduct, the judge must evaluate if every criterion is met and it is important that the judge complies with the high standards of these criteria, because piercing the corporate veil should be kept as an exception. After explaining the exception to the limited liability principle, it is important to understand under which circumstances it is possible to lift the corporate veil.
IV. Circumstances to Pierce the Corporate Veil
In Turkish law, Civil Code Article 2 plays an important role in determining the circumstances to pierce the corporate veil. In cases when shareholders acted in bad faith it is possible to say that lifting the corporate veil could be possible. The law doesn’t protect the abuse of rights.
But this abstract regulation isn’t enough to understand the circumstances in which piercing the corporate veil could be possible. Due to this it is necessary to concretize this matter, by looking into the case law and the doctrine.
One of the most important reasons to lift the veil is called fraud, which means for example transferring corporate assets to a shareholder with the purpose to defraud the creditors. Sometimes the assets of a company are transferred to another company, again with the same purpose. Shareholders try to “rescue” the assets of the company from creditors, by transferring them to another legal or real person who is actually not liable for these debts. In case the judge determines this fraudulent action, the shareholders will be personally liable. An example of this could be the Jones v. Lipman case (UK, 1962), where a British court decides for the first time to pierce the corporate veil. In this case, a part of the assets of the company was transferred to another company in order to hinder the creditor from getting the asset that should be handed over to him/her. The court figured out that the company which received the transferred asset was not formed for an economic purpose, it was formed with the sole purpose to receive this asset. The legal personality of the company which ensures its shareholders’ protection, was abused in bad faith and this led to the decision to lift the corporate veil.
Another reason to lift the veil can emerge when companies are dominated by a majority shareholder or a parent company. In a situation when the majority shareholder or the parent company abuses their dominant position (act in bad faith to hinder creditors), it is possible to hold them personally liable from the debts of the company.
The contribution to the capital plays also a role when we speak about piercing the corporate veil. When a company enters into transactions with third parties without paying the full amount of the capital, this means that the promised amount which is also stated in the Articles of Association doesn’t comply with the actually paid amount. And this leads to the conclusion that creditors who trusted in this promised amount were deceived by the shareholders. In such case, shareholders will be liable if the company isn’t able to pay its debts to the creditors. Another reason to lift the veil appears when the separate identities of the company and the shareholders is not maintained. In this situation it is difficult to distinguish between the assets of the company and the assets of the shareholders. This situation can arise when for example, some corporate formalities are not met or when the assets of the shareholders are used by the company like its own assets. This creates for third parties the faith that the company is the owner of these assets. In this case, the trust of third parties who enter into transactions with this company will be protected and lifting the veil to hold shareholders personally liable will be possible.
These were some very common reasons, which were seen in several countries, some of these are for example Turkey or some US states, like Georgia. But now it could be relevant to also mention some approaches or tests created by different judges in different countries. One of these is the Belvedere test created by the Ohio Supreme Court in 1993, which consists of three elements. These three elements must be met in order to pierce the corporate veil. The first element is the alter-ego requirement, which means that shareholders have almost complete control over the company so it isn’t possible to distinguish between the shareholders and the alter-ego of the company (no separate mind of the company). The second element is that the shareholders had the purpose to commit fraud or another inappropriate act (against creditors) by exercising such control over the company. The last element is that as a result of the fraudulent conduct of the shareholders, there must be damage to the creditor. These are the three elements the judge must determine in the case before deciding to pierce the veil. As we can see it doesn’t seem to be easy to lift the veil, all three conditions are meant to be met.
In the Laya v. Erin Homes case, judge McHugh (West Virginia) also determined a list of criteria which helped him to solve the case. In this list he also mentioned the fact of failing to maintain the separation of company assets and shareholders assets.
In the United States it is often requested from the court to pierce the company veil. The judges examine if the shareholders used the protection of the legal personality of the corporation in bad faith or not (together with other criteria).
Other examples could be added here but what is really important to notice is that almost in every case the judge is looking for fraudulent behavior and the use of the law in bad faith by the shareholders. This should be the most important reference point we should keep in our minds.
V. Conclusion
These were some examples that seemed to be important to mention. There are several other approaches and determinations of different judges and jurists in the doctrine of different countries. But what we can notice is that fraud or similar illegal conduct is always a component that is required in order to determine a necessity to pierce the corporate veil. Piercing the corporate veil is an exception that emerged to stop shareholders who act in bad faith and tryto escape from personal liability by hiding behind the veil of the company. In this writing, it was achieved to clearly point out that it is a very strict condition that shareholders whose personal liability is claimed, had to act in bad faith. Shareholders who had done everything to guarantee that the promises to creditors can be kept and that the debts could be paid, which means shareholders who acted in good faith, would not be personally liable. It is important to understand this principle as an exception which can’t be referred to in every case. There are strict criteria that should be met, and the judge is supposed to clearly analyze the case and decide whether all conditions exist to lift the corporate veil.
All in all, we can say that the limited liability principle has one exception that emerged out of the necessity to hinder shareholders’ fraudulent acts and conducts in bad faith against for example creditors and therefore we underline the fact that it is not a legal remedy that can be resorted to frequently.
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Sources:
- Howard Sher, Piercing the corporate veil, Hein Online
- Larry S. Bryant, Piercing the corporate veil, Hein Online
- Bruce W. McClain, Piercing the corporate veil, Hein Online
- Mehmet Mülazimoglu, Anonim Sirketler Hukukunda Sermayenin Korunmasi Ilkesi, S.280-284, Lexpera
- Sezi Demircark, Pay Sahiplerinin Sorumsuzlugu Prensibinin Istisnasi Olarak Tüzel Kisilik Perdesinin Kaldirilmasi
- Rekha Panchal, Piercing the Corporate Veil, Hein Online
