HK company lawcorperation Veil

Veil of IncorporationObjectivesl To understand the separate legal principle and its implication to the development of economyl To appreciate the merits and demerits of the Salomon principlesl To understand the circumstances under which the veil of incorporation will be uplifted by courts and by statutes and the protection to creditors. A company is a legal device adopted to carry on a business or to carry out certain non-profit making activities. Once incorporated, a company is in law an independent person separate from its members and officers i.e. it has a separate personality from its members and officers.The principle of separate corporate personality prevents outsiders from taking action against the members and officers of a company personally even if they control and manage the business of the company. It therefore is being described as a veil of the company. However, statutes (e.g. the Companies Ordinance) and the courts will lift the veil of incorporation under specific circumstances.Separate Legal Entity Concept1. Separate Legal Entity/Corporate PersonalityA company is an association of its members. However, in law, a company is a legal person with a personality separate from its members. Where business is conducted in the name of the company, its business affairs are kept separate from the personal affairs of those human beings (e.g. directors, employees) who conduct it.Same as a natural person, a company has legal rights, obligations, duties and liabilities. A company can (through its agents e.g. directors) enter into contracts (e.g. employ people, buy and sell goods) in its own rights and in its name. It can own properties, take legal action, be sued, commit crimes and torts in its own name.It is due to the separate legal existence of the company that it is possible for the members to have limited liability i.e. once they have paid for their shares in full they cannot be required to contribute towards the payment of the companys debts if it cannot pay them from its assets. This is only possible because the companys debts are not the debts of the members. The company has an unlimited liability for its debts and must pay them so long as it has assets to do so. Corporate personality gives the company perpetual succession so that the death or bankruptcy of a member does not affect the continued existence of the company. The holding of property is made possible because the company can take ownership in its own name.Salomon v Salomon & Co Ltd 1897 AC. 22FactsMr. Salomon had, for more than 30 years, carried on a successful business as a sole trader in the manufacture of boots and shoes. In 1892, he sold his business to a private limited company entitled A. Salomon & Co Limited. He and his wife and children became members of the company. As partial consideration for the sale of the business, A. Salomon & Co Limited issued to Mr. Salomon new shares and mortgage debentures (i.e. debentures which were secured by a floating charge on its assets). After the sale of the business, Mr. Salomon continued to run the boot-making business in his capacity as a director of A. Salomon & Co Limited. He was entitled to receive debenture interests and dividends payable by A. Salomon & Co Limited in his capacity as a debenture holder and a member respectively.Due mainly to strikes by workers in the boot trade, A. Salomon & Co Limited fell on hard times and was put into liquidation. Its assets were insufficient to pay all its debts in full; however, it was able to repay Mr. Salomon (the secured creditor) if he can enforce the floating charge created in his favour. In that case, the unsecured creditors would get nothing. The liquidator (on behalf of the unsecured creditors) suggested to the court that A. Salomon & Co Limited was Mr. Salomon in another form, hence, he should not be paid in his capacity as a debenture holder. The liquidator wanted the court to ignore the fact that Mr. Salomon had sold his business to a separate person with the name A. Salomon & Co Limited. JudgementIt was held that once a company is legally incorporated, it must be treated like any other independent person with its rights and liabilities. The company is in law a different person altogether from the subscribers to the memorandum of association (i.e. the founder members of the company). Though the same person manages the business and receives theprofit of the business after the incorporation of the company, the company is in law a separate person from its members. Consequently, the business was owned by the company i.e. A. Salomon & Co. Limited and its debts were liabilities of the company. Although Mr. Salomon owned beneficially all the issued shares of the company, he could also be a secured creditor with enforceable rights against the company in that capacity.CommentThe court would not have ruled as it did if there had been fraud. There was no fraud in this case. There was no fraud on creditors because all the creditors of the old business had been paid off on the transfer of the business. The creditors of the new company knew that the members liability was limited to paying for their shares and they were not defrauded. The members of the new company were all members of Mr Solomans family and agreed to the price he was charging the company for the original business.Macaura v Northern Assurance Ltd 1925 A.C. 619 HLFactsMr. Macaura, the owner of a timber estate, sold all the timber to a company in which he owned almost all the shares. He was also the companys largest creditor. He insured the timber against fire by policy taken out in his own name. The timber was destroyed by fire and he sued the insurance company under the fire policy.JudgmentIt was held that in order to sue under a policy, the policy holder must have an insurable interest in the insured property i.e. the timber. Insurable interest is a legal or equitable interest in the insured property. After the sale of the timber to the company, the company is the owner of the timber, consequently, has a legal and equitable interest in the timber. Members and creditors of a company do not have legal or equitable interest in the property of the company, even though they may suffer indirectly from the destruction of the insured property. Accordingly, Mr. Macaura (being a member and a creditor) failed to claim under the fire policy as he did not have an insurable interest in the timber.Lee v Lees Air Farming Ltd 1961 AC 12FactsMr. Lee was the controlling shareholder and governing director of a company called Lees Air Farming Limited. He was also employed by the company as its chief pilot. To insure the company against liability to pay compensation to its employees in the event of an accident, he arranged for an insurance policy to be purchased in the name of the company. Subsequently, Mr. Lee was killed in an accident whilst flying an aeroplane belonging to the company. His wife claimed compensation under the insurance policy.JudgmentIt was held that Mr. Lee (the deceased) and the company were separate legal persons. Mr. Lee (a member and a director) could therefore enter into an employment contract with the company. It is a logical consequence of the decision in Salomons case that one person may function in dual capacities. It is possible for a person to be at the same time wholly in control of a company (as its principal shareholders and sole director) and a servant employed by that company. Accordingly, Mrs Lee can claim compensation under the insurance policy.Good Profit Development Ltd v Leung Hoi 1993 2 HKLR 176FactsThe defendant claimed that he had made an oral agreement with the directors and shareholders of the Plaintiff to buy out all of their shares in the Plaintiff (which owns a house). It was accepted that the Plaintiff was not a party to the agreement and that the directors had not acted as agents of the Plaintiff. The defendant alleged that either the Plaintiff was a trustee, holding the house on trust for the directors and shareholders, or that the Plaintiff was the alter ego” of the directors and shareholders.JudgmentIt was held that a company does not hold property as an agent or trustee of its members or directors. A company has a separate personality and is not the alter ego of its members. The agreement to purchase the shares in the Plaintiff had nothing to do with the Plaintiff itself, there being no privity of contract. The mere fact that the Plaintiffs only shareholders were also its directors and therefore had absolute control of the company did not, in itself, justify the lifting of the corporate veil.Lifting the Veil of Incorporation2.Lifting the Veil of Incorporation Under the concept of separate legal entity, the shareholders or directors of a company are protected by the corporate veil and are not liable for the acts done under the name of the company even though they are the decision makers or wrong doers in reality. However, the separate legal entity principle may produce unsatisfactory results in particular circumstances e.g. directors may avoid personal liability by making use of a company to defraud creditors. To solve this problem, statutes (e.g. the Companies Ordinance) and the courts recognize a number of exceptions to this principle. These exceptions are described as lifting the veil of incorporation. If the veil of incorporation is lifted, the members, officers etc and the company will be treated as the same person. Consequently the members and officers are personally liable to the debts and liabilities of the company even though the acts were done under the name of the company.Lifting the Veil of Incorporation by Court2.1 Lifting the Veil of Incorporation by the CourtsThe power of the court to ignore the rule of separate legal entity is a tactic that can be used to deal with the fraudulent use of the corporate entity and to counter sharp practice and illegality.2.1.1National Emergency In times of peace, the character of individual shareholders will not affect the character of a company. However, in times of war, it is illegal to trade with the enemy. The court may lift the veil of incorporation so as to impute to a company the same nationality as its members.Daimler Co. Ltd v Continental Tyre and Rubber Co. Ltd 1916 2 AC307FactsThe Continental Tyre and Rubber Co. Ltd (CTR) was a company incorporated in England. Its majority shareholders and directors are German residents. The Secretary, who held only one share, was a British resident and a British subject.JudgmentIt was held that in times of war, the court may lift the corporate veil of a company and look at the nationality of its members and directors to determine if a company is to be classified as an enemy. If the persons in de facto control of the companys affairs are residents in an enemy country, then the company (even though it was not formed under the law of an enemy country) may be classified as an enemy. In that case, persons dealing with the company are considered as trading with an enemy. CTR (even though it was registered in England) was therefore being classified as an enemy as its majority shareholders and directors were residents of an enemy country.2.1.2Where the company is formed principally for fraudulent purpose or as a sham to evade existing liability or to defeat the law Under Common Law, a company is an artificial person and has a separate corporate personality from its members. A company must be treated like any independent person with its own rights and liabilities distinct from those of its shareholders. However, the corporate veil may be lifted if there is a prima facie case that a defendant controlled the company, or that the company has been used for crime. The veil of incorporation may also be lifted to prevent the deliberate evasion of a contractual obligation.Secretary for Justice v Lee Chau Ping & Another 2000 1 HKLRD 49FactsThe defendant absconded after warrants of arrest were issued alleging that she had committed drug trafficking offences. Court orders were then made against the realizable property of the defendant i.e. the Hong Kong SAR Government will take over the realizable property of the defendant. JudgmentIt was held that the realizable property of the defendant included not only property held in the name of the defendant, but also those held by companies she controlled. Although a company is a separate legal entity from its members, the corporate veil could be lifted if there was a prima facie case that the defendant controlled the company, or that the company had been used for crime and the companys accounts benefited the defendant. Consequently, property held in the names of companies controlled by the defendant were realizable property of the defendant and should be taken over by the Government.Gilford Motor Co. Ltd v Horne 1933 Ch. 935FactsThe defendant, Mr. E. B. Horne, attempted to evade a covenant not to compete with the plaintiff (his former employer) by getting his wife (J. M. Horne) to form a companywiththe name J. M. Horne & Co. Ltd. The company carried on business in competition with the Plaintiff. Mr. Horne claimed that the company could not be bound by the covenant because it was a separate legal person from himself and not a party to the contract between himself and the plaintiff .JudgmentIt was held that the veil of incorporation should be lifted as the company was formed as a device to mask the effective carrying on of a business by Mr. Horne. The purpose of forming the company was to enable him, under what is a cloak or a sham, to carry on a business which the Plaintiff would object. The corporate structure could not be used to evade legitimate and legal contractual restraints. Accordingly, Mr. Horne was held to have breached the covenant and an injunction was granted against Mr. Horne and J. M. Horne & Co. Ltd.Yue Tai Plywood & Timber Co Ltd v Far East Wagner Construction Ltd & Another 2001 2 HKLRD 448FactsThe plaintiff supplied goods to 2 companies (D1 and D2) which it treated as one common entity. These 2 companies have common directors and shareholders, as well as sharing the same registered office and the same place of payment. On various dates between September, 1997 and April, 1998, the plaintiff sold and delivered goods to D1. In return, cheques drawn by D2 were given to the Plaintiff in purported payment of the outstanding amount. The cheques were dishounoured. It was pleaded that D1 and D2 were separate and distinct entities in law and that there had been no working or contractual link between the plaintiff and D2 , the second defendant.JudgmentIt was held that although D1 and D2 were obviously separate and distinct legal entitles, there was a deliberate and obvious blurring of the edges in the operation of transactions with the plaintiff. Directors of D2 had not taken any steps to deny or contradict the plaintiffs perception that D1 and D2 were a combined operation. D1 and D2 were inexorably linked. Hence, D2, the second defendant is liable to pay the plaintiff in respect of goods supplied to D1, the first defendant.Liu Hon Ying v Hua Xin State Enterprise (Hong Kong) Ltd & Another 2003 3 HKLRD 347Facts:C Limited, D Limited and E Limited all ran the same delivery business and had the same customers, the same offices, same staff and the same system of work, the same key equipment and same telephone and fax numbers. The ultimate controlling shareholder behind C Limited and D Limited gradually and continuously channeled the business of C Limited and D Limited to E Limited to evade the existing liabilities of C Limited.JudgmentThe veils of incorporation of C Limited and D Limited should be uplifted since using a corporate structure to evade legal obligations is objectionable. The court has the power to lift the corporate veil to overcome evasion so as to preserve legal obligations.China Ocean Shipping Co v Mitrans Shipping Co Ltd 1995 3 HKC 123FactsThe plaintiff chartered a ship to a company called Mitrans Maritime Panama SA (MMP) which carries cargo from China to North Korea. A dispute between the plaintiff and MMP was referred to arbitration. MMP failed to pay the award of US$150,000 to the plaintiff. The plaintiff claimed that the defendant was liable to pay since it controlled MMP and MMP acted as a faade for the defendant to evade their obligations.JudgmentIt was held that it was MPP which chartered the ship and that the plaintiffs claim should be struck out. The defendant had not evaded their legal obligations. They had simply used a corporate structure to avoid incurring obligations. The court is not entitled to lift the corporate veil merely because the corporate structure has been used to ensure that certain liabilities fall on another company within the group.2.1.3Group CompaniesTheseparate legal entity principle applies even where the companies are related as holding and subsidiary companies. Generally, the veil of incorporation will not be lifted to expose the holding company to liability on the ground that the holding company and the subsidiary are part of a group; or on the ground that a group of companies is to be considered a single economic entity. Hence, a holding company will not be liable to the debts of its subsidiary and vice versa. - Group of Companies means any 2 or more companies or bodies corporate one of which is the holding company of the other or others (section 2) - Section 2(4) provides that a company, S Ltd. is considered to be a subsidiary of H Ltd. if(a) H Ltd. is a member of S Ltd. and controls the composition of its board of directors; or (b) H Ltd. controls more than half the voting power of S Ltd.; or (c) H Ltd. holds more than half the issued share capital of S Ltd., excluding shares carrying no right to participate in surplus profits or capital; or (d) S Ltd. is a subsidiary of a company, which is itself a subsidiary of H Ltd.; S Ltd. is then a sub-subsidiary. Control over the composition of the board of directors is deemed to exist where: H Ltd. can appoint or remove all or a majority of the directors of S Ltd.without the consent or concurrence of any other person; or a person can only be appointed as a director of S Ltd. if H Ltd. can exercise a power in his favour; or a person becomes a director of S Ltd. automatically on appointment as a director of H Ltd. (s2(5). NoteFor the purpose of preparing group accounts commencing from 1st January, 2006, a new definition of the term “Subsidiary” will be adopted. The broader definition includes undertakings which are not body corporate i.e. partnerships and unincorporated associations.Generally speaking, each company within a group is separate and independent with its own separate identity. The principle of separate corporate personality protects the holding company from being held liable to its subsidiarys debts and liabilities and vice versa. It is legitimate to form group companies to avoid legal obligations but not to evade legal obligations. The separate legal entity principle may however enable crooks to escape liabilities through forming group companies. For example, the directors of a subsidiary may shift the assets of the company to its holding company and leave nothing for the creditors of the company. In specific circumstances e.g. where a subsidiary is acting merely as an agent of its principal i.e. the holding company, the courts may lift the corporate veil and treat the companies in a group as a single economic entity, so that the holding company may be held liable to the debts and liabilities of the subsidi