Legal Regulation Of Incorporation Process

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Introduction

Incorporation is the legal process used to form a company or corporate entity. The resultant legal body is a company that splits the assets and income of the business from its proprietors and stakeholders. Corporations can be formed in almost any country in the world and are usually known as such by using words like ‘Inc.’ and ‘Limited (Ltd.)’ in their titles. It is the method of establishing legal separation between a corporate entity and its shareholders. Business incorporation, as described above, is a vague umbrella concept that encompasses a range of legal structuring choices for your business. The business structure can be changed as it grows old or matures.

Benefits of incorporation:

1. Limited liability:

Limited liability of the owner is one of the biggest advantages of incorporation. A corporation can own properties in its name, continue operations, incur liabilities, sued or be sued. A company is liable for its own obligations due to separate legal entity and it ensures that a company’s creditors can only receive compensation from the company’s assets and not from the owner’s personal assets. This means that the business owners can continue doing business without risking their personal assets such as homes, cars, savings, or other personal property. On the other side, holders of a sole ownership and corporation bear unlimited liability for both business and personal property. (3)

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2. Easy access to capital:

As corporations can issue shares, so it’s easy for them to raise funds or capital for the business as compared to unincorporated businesses. For example, banks would prefer to give loans to incorporated businesses rather than to unincorporated businesses so corporations can raise capital through different kinds of sources. Therefore, easy access to capital facilitates the growth and development of business. (3)

3. Boosts the reputation of the company:

As suppliers, customers and business associates often perceive incorporated firms more stable than incorporated firms, therefore, by having “Inc.” or “Corp.” after a business’ name transmits durability, credibility, stability and communicates commitment to business venture’s current accomplishment.

4. Perpetual existence:

Incorporated firms have the most durable legal business framework because an incorporated firm can do business forever, irrespective of what happens to its owners, directors, executives, employees and investors. This means that incorporated firms are able to avoid the legal entanglements that might be experienced in other forms of business ventures.

Veil of Incorporation

The limited liability of owners is the biggest advantage of incorporating a business. In the case of an incorporated business, owners of a company are not responsible corporate debt/liabilities. So creditors can’t have no authority to take over owners’ personal assets to recover money owed by the company. An owner can’t be sued personally for what other people like employees, etc., do on behalf of the company. Therefore, this limited personal liability is called corporate veil.

Salomon v. Salomon is one of the landmark cases related to this concept. In this case, Salomon had a leather and boot manufacturing business and he was a sole trader. He sold his business to a newly incorporated company, Salomon Company Ltd. Salomon and 6 members of his family were given one share each in the company after incorporation. As part of the purchase cost, a debenture backed by a floating charge was generated in favor of Salomon. The remaining amount of the purchase price was given to Salomon in the form of 20,001 shares in the newly formed corporation. Although the business was solvent and profitable upon incorporation, a period of depression in trade and a succession of strikes within the industry resulted in financial problems. As a result of defaulting on debt, the company entered liquidation. Since, the debenture’s redemption would have culminated in a lack of funds to compensate certain lenders, the liquidator tried to have the debenture revoked on the basis that the company’s actions contributed to deception against its creditors. Although as per the law, Salomon & Company Ltd. was a separate legal entity to Mr. Salomon. However, it was further claimed that the incorporated company was not a real entity, but was constituted as a pure agent of Salomon.

Two other cases similar to Salomon v. Salomon are as follows:

  • In Macaura v. Northern Assurance (1925), Mr. Macaura held a certain quantity of timber and sold it to Irish Canadian Sawmills Ltd., of which he was the sole owner. He was the unsecured creditor, as well. He got a fire insurance policy from Northern Assurance in his own name and not in company’s name. Two weeks later, a fire broke out and Northern Assurance rejected Macaura’s demand for claim due to the fact that the company has a distinct personality from Macaura and policy was in Macaura’s name. The Court held that the Northern Assurance wasn’t liable to pay Macaura.
  • In Lee v. Lee’s Air Farming Company Ltd. (1961), Mr. Lee owned all the shares in Lee’s Air Farming Company Ltd. At the same time, he worked as a chief pilot and died in a plane crash. Mrs. Lee wanted compensation for her husband’s death under the Workers’ Compensation Act, 1922. The court stated that Mrs. Lee would receive the compensation for Lee’s death as Mr. Lee and the company were different legal entities and it was okay for Mr. Lee to have legal relations with this own company.

Above mentioned are some of the cases where the corporate veil should have been pierced but it didn’t happen due to obvious reasons.

The main idea behind the corporate veil is that a company has actually a separate legal personality from a legal and accounting point of view. If there is no clear distinction between what an owner and its company is doing, the corporate veil can be lifted/pierced either by courts or under statute.

Piercing/Lifting the Veil of Incorporation:

As stated above, a corporation is generally treated as a separate legal person who is solely responsible for the debts it incurs and the lone recipient of the credit it is owed. Common law countries usually follow this distinct personality rule, but in exceptional situations, the corporate cover can be ‘pierced’ or ‘lifted’. The corporate veil can be lifted/pierced either by courts or under statute.

Lifting the veil under statute:

The corporate mask can be broken under statute law and the company’s representatives and executives are held personally accountable. Some of the provisions under which corporate veil can be pierced are as follows:

  • Non-obtainment of a trade certificate
  • Non-use of company name
  • Fraudulent trading
  • Reckless trading

Lifting the veil by courts:

Due to certain cases, a corporate veil can be lifted by the courts and hold the company’s owner liable for the company’s debts. In one of the following contexts, the corporate veil can be lifted:

  • Piercing the veil between the directors and the shareholders;
  • Piercing the veil between a group of companies;
  • Totally disregarding the company where it was incorporated to defraud others.

In certain cases, the conditions in which the courts look behind the veil are listed below:

  • “Human characteristics”;
  • “Fraud”;
  • “Avoidance of legal duty”;
  • “Agency”;
  • “Single economic entity”.

Below mentioned are some of real-life cases which helps in describing the whole concept behind lifting of corporate veil by courts:

  • In Firestone Tyre & Rubber Co. v Llewellin (1957), in order to manufacture and sell tyres, an American company, Akron, established a wholly-owned subsidiary in Brentford, England. Akron operated this division and was responsible for acquiring the orders. Contract between the parent and the subsidiary specified that the sales price/profit ratio would be transferred back to Akron by the subsidiary having received the costs plus a 5% fee. Upon assessment of Akron’s UK tax on profits, it claimed that it is a separate legal entity from the UK subsidiary company. However, by piercing the corporate veil, the Court held that the UK branch had operated as Akron’s agent and thus, Akron was responsible for paying tax on all UK income.
  • In Power Supermarkets Limited v Crumlin Investments Limited & Dunnes Stores (Crumlin) Limited (1981), a shopping center was built and leased to the plaintiff by Crumlin Investments. And, in one of the terms of the lease, it was mentioned that no other lease would be given to another occupant in the retail or food industry or above a zone of more than 3000 square feet. As the shopping center was not a success, it was offered for sale. Cornelscourt Shopping Centre Ltd., A company owned by the Dunnes Stores Company, eventually acquired it. Then, the Dunnes Stores Company sent Crumlin Investments a freehold interest in Dunnes Stores (Crumlin) Ltd., enabling the Dunnes Group to function in the center as a superstore. However, the Court held that the Dunnes Group should be treated as a single economic entity and therefore, the restrictive agreement should be binding on Dunnes Stores (Crumlin) Ltd. even though it was not a contractual party to it.
  • In Creasey v Breachwood Motors Ltd. (1993), Mr. Creasey was sacked from his post of General Manager at a garage owned by Breachwood Welwyn Ltd. and he claimed that this constituted wrongful dismissal. Breachwood Welwyn Ltd. stopped its operations and transferred the whole business to Breachwood Motors Ltd. Other lenders’ dues were settled but no cash was kept aside for Creasey against Breachwood Welwyn Ltd. Creasey sought and was successful in upholding the judgement against Breachwood Motors Ltd. The court stated that the proprietors used a “phoenix company” to defraud an employee of his legal rights.
  • In Gencor ACP Ltd. v Dalby (2000), Mr. Dalby was a director of the ACP group including Gencor ACP Ltd. All the capital and resources were dishonestly diverted to his Virgin Islands Company. He even paid his school-going son a salary of £24,000 for work. Gencor ACP Ltd. wanted him to repay the money with his company. The court stated that the benefits must be returned to Gencor ACP Ltd. by Dalby and his offshore company. Both Dalby and his company were found responsible for diverting capital and resources and it was reasonable to pierce the corporate veil of the Virgin Islands Company as it was directly controlled by Dalby and essentially operated as his offshore bank account. Also, the salary given to his son was considered illegal because it was an unauthorized salary increase.
  • In Prest v Petrodel Resources Ltd. (2013), Michael and Yasmin Prest, a couple had divorced in 2011. The appeal involved a number of companies, known as the Petrodel Company, which was considered to be wholly owned and controlled by Mr. Prest by the trial judge, Moylan J. Initially, the businesses were included as supplementary claimants to the ancillary compensation claim of Mrs. Prest, as they were the legal owners of various properties, including the family home. The matter was first discussed in the High Court, then, Court of Appeal and then, the decision was finally taken by the Supreme Court. The Supreme Court pierced the corporate veil and stated that Mr. Prest tried to hide his net worth for his personal interests in order to evade taxes.

Conclusion

“Limited liability of companies has been a means of incentivizing and encouraging entrepreneurs to overcome aversion to risk and to make investments in business ventures that might be beneficial to the economy at large. It is clear that limited liability could potentially be open to abuse…. the courts are rightly hesitant to apply this doctrine: much of the beneficial effect of limited liability would be compromised if veil-piercing occurred on a regular basis.” – The Company Law Review Group, Report on Protection of Employees and Unsecured Creditors (2017), p 19.

I agree with the above said statement. The courts should avoid lifting/piercing the veil of incorporation regularly because then there won’t be any confidentiality, which is one the most important privileges of incorporating a company. However, lifting the veil is necessary in order to avoid or minimize risks of fraud. Courts should lift/pierce the corporate veil only when the plaintiff has a proper evidence against the defendant of misusing the right of limited liability and is absolutely needed to lift the veil.

References:

  1. https://www.investopedia.com/terms/i/incorporate.asp
  2. https://smallbiztrends.com/2010/04/forming-a-business-structure-is-incorporation-right-for-you.html
  3. https://www.calcpa.org/public-resources/ask-a-cpa/small-business-entity-structure/entity-choice/five-advantages-to-incorporating-your-business
  4. https://bizfluent.com/about-4727895-what-veil-incorporation.html
  5. https://www.cpaireland.ie/CPAIreland/media/Education-Training/Study%20Support%20Resources/2019%20Articles/P1CLPulling-Back-the-Curtains-Separate-Legal-Personality-and-Lifting-the-Veil.pdf
  6. https://www.revolvy.com/page/Macaura-v-Northern-Assurance-Co-Ltd
  7. https://www.revolvy.com/page/Lee-v-Lee%27s-Air-Farming-Ltd
  8. https://en.wikipedia.org/wiki/Piercing_the_corporate_veil
  9. https://poseidon01.ssrn.com/delivery.php?ID=850020098089104067004031113087024120028037009079051031109073109074027018000111013026118058007012054120046023083064090102071100007085094078038075064125000115019071096073022024030006003024012008090110023102071115002074067093123121098080092111001080025116&EXT=pdf
  10. “An Introduction to Business Law”- Vaeni Mac Donnell
  11. https://www.revolvy.com/page/Creasey-v-Breachwood-Motors-Ltd
  12. https://www.revolvy.com/page/Gencor-ACP-Ltd-v-Dalby
  13. https://aran.library.nuigalway.ie/bitstream/handle/10379/5360/Family_Law_and_the_Corporate_Veil_prepublication_version.pdf?sequence=5&isAllowed=y
  14. http://www.clrg.org/publications/clrg%20adhoc%20committee%20report.pdf
  15. https://corpgov.law.harvard.edu/2014/03/27/the-three-justifications-for-piercing-the-corporate-veil/

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