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Corporate Veil Theory

Last updated date: 16th May 2024
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Introduction to Corporate Veil

Any established organization has a legal identity of its own, and which is separate even from the identity of its employees. As it’s obvious that a company itself isn’t a living body and thus, various members come together to work in the name and behalf of the company, living under a shadow/veil. This is simply termed as “Corporate Veil”.  Under certain urgent occasions and circumstances,  the corporate veil is removed and it’s known as the ‘piercing of the corporate veil’, which enables the company to check frauds committed by members. Thus, it’s necessary to know in detail what the corporate veil is.

What does Corporate Veil do?

The corporate veil is a legalized concept separating the actions of the organization from that of its shareholders.

It also safeguards the shareholders from being guilty of the actions of the company. The court has the right to determine the guilty party. This method exercised by the court is called “piercing the corporate veil in which the court can directly charge the investors of the company as responsible for debts or frauds and put aside the limited liability of the shareholders. The effectiveness of piercing the corporate veil can be mostly observed in closed and small corporations which have limited shareholders and assets. But, it is more convenient to abstain from uplifting this veil unless some serious breach of affairs and misconduct take place.

Factors determining the Piercing of Corporate Veil

  1. Fraud done to third parties- Piercing the corporate veil becomes necessary in dishonest practices like fraudulent activities.

  2. Inability to make separate identities among companies- Sometimes, when various small companies work under one big company, certain mishappenings occur. In such cases, the law allows the court to carefully inspect the relationship between the parent company and its subsidiaries.

  3. Not in conformity with the corporate guidelines- It is mandatory to follow the corporate rules and guidelines and the breach of it may result in waiving off of the limited liability protection to the shareholders.

  4. Inability to maintain separate identities with shareholders- This happens in case the name of the company merges with that of the shareholders or the owner.

  5. Inability to capitalize the economy successfully- If the business is found undercapitalized, the court can check the assets of the company to determine if creditors have their fair share of assets.

A company is a separate and distinct legal entity, separate from the identity of its members too. A company is not a living body hence the members work on behalf of the company behind the veil. This, in simple terms, is known as the ‘Corporate Veil’. 

There arise many circumstances where the corporate veil is removed which are known as the ‘piercing of the corporate veil’, to check any fraudulent activities conducted by the members. In this discussion, we will delve into the theory of Corporate Veil, so let us get started.

Corporate Veil

The corporate veil is a legal concept which separates the actions of an organization to the actions of the shareholder. Moreover, it protects the shareholders from being liable for the company’s actions. In this case a court can also determine whether they hold shareholders responsible for a company’s actions or not. Here comes the term of ‘Piercing the corporate veil’ which refers to a circumstance where courts set aside the limited liability of the shareholders and hold a company’s investors or directors personally liable for the organization’s fraudulent activities or failure in debts. Laws vary from state to state, but courts will generally abstain from piercing the corporate veil unless there have been signs of serious misconduct.

Piercing the Veil

The liability protection of a corporation is quite important, unfortunately, it is not always absolute. Piercing the corporate veil takes off the distinction between the owners and the business, the distinction is stripped away. The owners or the shareholders working on behalf of the company become personally responsible for the financial condition of the business, like as they would be if the company was a sole proprietorship.

Piercing of the corporate veil generally occurs when someone, like the creditor or a person who has been affected by a business, takes legal action. He would argue that the owners of the business should be held personally liable for the money that is at stake or frauded. The court will not easily agree to pierce the corporate veil in any random situations, since the entire purpose of creating the veil is to protect owners and allow the business to operate in its own independence. However, the court will pierce the corporate veil in situations where the owners, directors or shareholders commit frauds, fail to follow the corporate formalities or have acted inappropriately.

Piercing the Corporate Veil Factors

Though there is no definite set of the equation for the number of factors that must be validated to pierce the veil, there are particular factors that raise red marks, a few worth noting are mentioned below:

  1. The Existence of Fraud or Wrongdoing to the Third Parties

One of the biggest factors that the court condemns is the existence of fraud or wrongdoing to the third parties, the court pierces the corporate veil in this case. 

  1. Failure to Maintain the Separate Identities Among the Companies

A common scene that may cause some checking is where there are several related companies acting under the umbrella of one company and the failure to maintain separate identities of the companies.

  1. Failure to Maintain Separate Identities of the Company with its Owners or Shareholders.

This is the merging of the name of the company with the owners or shareholders of the company. 

  1. Inadequately Capitalize the Company

Courts will check the assets of the company to determine if the company’s quantum of assets available for the creditors is appropriate or not, whether it is a scene of undercapitalization.

  1. Not in Accordance with the Corporate Formalities

Another red flag that could lead to piercing the corporate veil is the failure to follow corporate formalities. In cases where formalities are not legally followed, courts have held that the liability protection of the shareholders will be waived off and the personal assets of the owners can be tied in this case.

Piercing the Corporate Veil Examples

Examples of the piercing of the corporate veil and its related circumstances are as follows-

  1. The creditor of ABC Corp. receives a final judgment for money damages. Here the veil is to be lifted.

  2. ABC Corp. cannot pay the judgment so it shuts down. This too leads to the piercing of the veil.

  3. ABC Corp. transfers all of its assets to XYZ Corp. and XYZ Corp. operates a similar business with the same assets and same employees, it is likely that ABC Corp. engaged in fraudulent actions, by shutting down its business and reopening a new corporation. This is a classic example of a debtor who attempts to defraud its creditor, here the court will pass the judgement in favor of lifting of the corporate veil.  

Corporate Veil Case

In Broward Marine Inc. v. S/V Zeus, the U.S. District Court of the Southern District of Florida pierced the corporate veil, they found that the corporation’s dominant shareholder should be personally liable for the torts of his corporation. In this case, the plaintiff sued the defendant yacht corporation for foreclosure of its mortgage on a yacht. Upon obtaining a judgment against the yacht corporation, the plaintiff instituted the proceedings after learning that the yacht corporation had transferred all of its assets, post-judgment, to other corporations controlled by the yacht corporation’s sole shareholder. 

Through the previous supplementary, the plaintiff sought to hold the transferee-corporation and the sole shareholder liable for the underlying judgment against the yacht corporation. Specifically, the Court found that the yacht corporation had transferred all of its assets to hinder or defraud the Plaintiff. In consequence, the yacht corporation had its veil pierced and its sole shareholder and one of his closely-held corporations were found liable for the underlying judgment.

The business thus maintains a separate and distinct identity from that of its owners. However this mere shell of a corporate structure is not always enough to avoid personal liability.

FAQs on Corporate Veil Theory

What is the necessity of piercing the veil?

The piercing of the corporate veil is necessary because-

  • It helps in limiting fraudulent activities in an organization and safeguarding the rights of the shareholders by giving them limited liability protection for unseen and non-preventable situations. 

  • It helps shareholders against intentional aims of fraud by creditors and other people. For eg: In bankruptcy cases, shareholders can transfer their assets in lieu of their limited liability protection.

  • It allows maintaining statutory consistency.

When can the corporate veil be pierced?

When the terms of the corporate veil are not met, it becomes a problematic situation. In case a fraud occurs, shareholders are held responsible for paying off the debts of the company. This creates financial and emotional burdens and trouble for the innocent co-owners. Thus, the corporate veil needs to be pierced in such cases to prevent innocent people and charging liability only on those who have directly participated in the fraud.

How to prevent the corporate veil from being lifted?

The company can save unnecessary trouble of getting charged, by taking certain preventive measures. This includes:-

  1. All the necessary Paperwork and Documentation must be done properly. 

  2. Illegal and fraudulent business undertakings must be avoided at all costs. 

  3. Shareholders should avoid offering business loans personally to the company’s owner.

  4. While entering into a contract with any shareholder, the organization should make the terms and conditions and engagement rules crustal clear.

What are the factors considered by the court while determining whether to pierce the corporate veil or not?

Some of the Factors considered by the court to determine the piercing of corporate veil includes-

  • Failed delivery of accurate reports or the absence of it.

  • Hiding information about or misrepresenting the members of the organization.

  • Inability to maintain a segregated identity with other related companies.

  • Mixing the assets of the company with that of the shareholder.

  • Non-functioning and incapable members/organizers.

How to find more information about Corporate Veil on the web?

To find reliable, accurate, and detailed information about the corporate veil and related topics, students are suggested to go through the Vedantu website/app. By enrolling as a student there, one can find various study materials and study through live classes where all doubts can be asked and cleared. It provides students with clear-cut examples and explanations regarding the concepts along with amazing quizzes. School students can refer to the website for better information.

Who can pierce the corporate veil?

The members of a company can create another company or subsidiary to avoid certain legal obligations. In such cases, piercing the corporate veil is done by the Courts to understand the real transactions.

Who is the creator of this corporate veil?

The veil is created by the law itself. The law applies to all the limited corporations in India.

Why is the piercing of the veil important?

The corporation is considered completely separate from the individuals who own and manage the business, the owners/managers cannot be held responsible for the company's actions, hence this veil is important.