The act of incorporation of a company has the effect of making the company recognized as a legal entity, which is separate from its shareholders or owners. The reason behind incorporating a company is to protect its owners from being negatively affected by the affairs of a company. Incorporation prevents the shareholders of a company or its personnel from being held liable by law for any complaint lodged against the company. Therefore, incorporated companies are, in fact, artificial persons who have the ability to act just like a natural person would in terms of entering into contracts and being held legally responsible to pay an agreed form of compensation whenever the company acts in a manner contrary to the provisions of contracts it has entered into.
However, on certain occasions a court of law may view both the owners and directors of a company and the company itself as the same legal entity. When a court regards both the directors of a company and the company itself as the same entity, the court is said to have lifted the veil of incorporation of the company. In most cases, a court lifts the veil of incorporation of a company when the company is under investigation to find out whether it has acted in a manner that is contrary to some form of law.
Reasons that may cause a court of law to lift the veil of incorporation of a company:
1) If a company obtains credit when it has already been declared bankrupt
There are a number of reasons that may cause a court of law to make the directors of a company become liable to bear the burden of liability of the company. The first reason that may lead a court of law to lift the veil of incorporation of a company is when a company’s directors contract to obtain a credit from a third party when the company has already been declared bankrupt. This means that any liability that arises from a claim for reimbursement of a loan advanced by a creditor to a company and accepted by the company directors will be deemed payable by the company’s directors. The court takes action to pass the liability from the company to the company’s directors, since it holds them responsible for adding on to the company’s debt when the company had already been declared unable to clear its outstanding debts. Thus, the liability for any loans taken by a company after it has been declared bankrupt will fall on the company’s directors instead of the company, which is also a legal person, thus resulting in the lifting of the veil of incorporation of the company.
2) If a company begins to trade before obtaining a trading certificate
The second way, which may prompt a court of law to lift the veil of incorporation of a company is when a company begins trading before obtaining a trading certificate. The act of a company’s directors to commence transactions with third parties before obtaining a trading certificate will cause a court of law to deem the directors of the company liable for any claims lodged by third parties against the company for indemnification or payment of damages. The court takes this action, because the company is not deemed to have the capacity to enter into a contract, if it has not obtained a certificate of trading, i.e. it is the directors who bind themselves to the contract and not the company. This, therefore, is another example of a case, whereby a court of law shifts the burden of liability from the company, which exists as a legal person and instead places the liability to pay the concerned third parties on the company’s directors for failing to comply with their obligations.
3) When a negotiable instrument is signed without the disclosure of the company’s name
A company’s veil of incorporation may also be lifted by a court of law whenever a claim is lodged by a third party for compensation for any loss or damage incurred after an officer of a company signs a negotiable instrument without mentioning or using the company’s name. Whenever an officer of a company signs any negotiable instrument on behalf of a company but fails to mention or include the name of the company in the document, the specific officer who signs the negotiable instrument will be deemed liable for any claims made against the company for an amount equivalent to the amount signed on the negotiable instrument. The court takes the action of placing liability on the company's officer that signed the instrument, since his/her non-disclosure that he/she was working for the company meant that it is not the company that entered into a contract with the third party, but the company's officer. Thus, the fact that a court of law will instruct the person who signed for the negotiable instrument to be liable to pay for claims that arise from the holder of the instrument shows how the veil of incorporation of the company has been lifted.
4) When companies are bound into contracts by disqualified directors
Companies will also not be liable to pay for claims made by third parties in situations where a company was bound into a contract because of the actions of a disqualified director, who purported to work on behalf of the company. Cases may arise where a person continues to take part in the management of a company in spite of the fact that the same individual(s) has been disqualified from managing or acting as a company’s director. In case an individual binds a company into a contract despite the fact that the same individual has been disqualified from managing the company, the disqualified director will be deemed liable to pay any claim of the other party to the contract. The court, therefore, passes any claim for damages from being a liability to be incurred by the company to a liability that will be borne by the disqualified director, thus resulting in the lifting of the company’s veil of incorporation.
5) When it is considered just and equitable to wind up a company
Whenever a petition is presented with the aim of winding up a company on just and equitable grounds, the veil of incorporation of a company is lifted to allow for investigations or examinations aimed at determining whether a company met all the necessary requirements at the time it was being established. If it is determined that the there was an anomaly or a requirement that a company did not meet when it was being established, any liability that the company has will be passed on to the owners of the company.
There are several conditions that make it just and equitable to wind up a company. For example, if a company’s substratum disappears, a claim may be presented by a shareholder to wind up the company. A petition may also be presented to wind up a company on just and equitable grounds, if there is an illegality in the objects of a company or fraud has been committed in the running of the company. Another situation that may result in a petition to wind up a company on just and equitable grounds is when the management of a company has come to a deadlock that cannot be resolved in any other way, apart from the winding up of the company. Minority shareholders may also prove that majority shareholders are guilty of oppressing them, thereby resulting in the winding up of a company on just and equitable grounds.
It comes as a result of the process of examining the above causes of the dissolution of a company on just and equitable grounds that cause a company’s veil of incorporation to be lifted. During investigation, there is no separate identity between the directors of a company and the company itself. Any fault found in the company’s operations is deemed as having been committed by the company’s directors. Therefore, the court passes any liability that arises from any fault found in the company’s operations after investigation is launched into the activities of the company’s directors instead of the company itself.
6) When the company engages in fraudulent trading
If a company is found guilty of engaging in any business or entering into any contract with the intention of defrauding its creditors or any other person, then the specific persons who had full knowledge of the existence fraudulent dealings by the company are deemed liable to pay an amount that the court instructs them to pay. Whenever the court finds that the directors of a company had full knowledge and intention to defraud a third party, the courts sets a reasonable amount as damages which it instructs the fraudulent individuals of the company to pay to the defrauded party. Similarly, whenever a court finds out that an individual in a company, e.g. a manager, director or officer, has enriched himself unjustly, any claim made to for damages by a third party is passed on from the company itself to the guilty company employee. A court of law, therefore, lifts the veil of incorporation whenever an individual in the company defrauds other third parties, so as punish the guilty party with the burden of compensating the third parties for the loss they have incurred, while at the same time protecting a company from incurring the compensation expense.
7) When the company enters into wrongful trading
The court has the power to lift the veil of incorporation of a company by requiring a former director of a company to contribute to the assets of the company, of which he was once a director, if the company becomes insolvent and goes into liquidation. A court of law may pass a declaration that requires a former director of a company to contribute to the assets of a company, if the court ascertains that during his/her tenure the director could have reasonably foreseen that the company would become insolvent at some time in the future. The court passes this declaration if the former company's director could have reasonably foreseen the company’s insolvency but failed to so, which played a role in the ineffective management and subsequent liquidation of the company. The fact that a former director of a company can be asked to contribute to a company’s assets from his personal property, while in fact he/she initially had limited liability, shows how the court lifts the veil of incorporation of the insolvent company.
8) When a phoenix company is created
A phoenix company refers to a newly created company that has been named similarly to an insolvent company. A court prohibits any individual who was the a director of an insolvent company to form and name a similar company before a period of twelve months elapses to the commencement of the liquidation. The law also adds that an individual shall also be considered jointly liable for the debts of the insolvent company, if he/she becomes or shows the intent to become a director of a company after being instructed to do so by a former director of an insolvent company. A court of law will deem a similar company that was created before the lapse of a period of twelve months a part of the insolvent company. Directors of the new company will thus be called upon to contribute to the assets of the insolvent company if they were former company directors of the old company.
9) When it is determined that a company’s directors have been committing unfair prejudice
On some occasions, a company’s shareholders may feel that the managers or directors are running matters of the company in a manner that is unfairly prejudicial to their interests. If the shareholders feel that their interests are not been handled fairly by the company’s directors, they may petition the court to investigate the activities of the directors. In the same way, minority interest owners of a subsidiary company may petition a court of law to investigate the directors of the holding company, if they feel that the holding company is managing the affairs of their company group prejudicially.
If a court investigation concluded that the managers or directors of a company are guilty of managing the company’s affairs prejudicially, the court may lift the veil of incorporation of the company and require the prejudicial directors to pay damages to the shareholders or minority interest holders who have incurred any form of loss arising from the prejudicial management of the company’s directors. The act of the court to require the company directors to compensate shareholders or minority interest holders represents the lifting of the veil of incorporation of the company.
10) When there is a reduction in the company’s membership to a number that is below the statutory minimum
A court of law may also require the members of a company to have unlimited liability in relation to the payment of a company’s debts, if a company continues to engage in normal business operations for a period of six months after its membership falls below the required statutory minimum. The minimum statutory number of members in a public company is 7, while for a private company thisnumber stands at 2.
If it so happens that a company enters into a debt agreement after expiration of a period of six months while the total number of members in the company remains below the statutory minimum, all the members of the company who were aware that the company contracted while their number was below the statutory minimum will have an unlimited liability in the payment of all claims made to the company with respect to all the transactions entered into by the company after a period of six months.
A court of law will deem the outstanding members of the company as having an unlimited liability because they entered into a contract when their company had not met all the requirements needed by law to recognize an entity as a company. The court will, therefore, deem that the contract was entered into by individuals, and not the company. The fact that the burden of payment is shifted from the company to its specific members shows how the veil of incorporation is lifted by a court.
11) When a court finds a company to be guilty of evading tax.
The veil of incorporation of a company may also be lifted if a company is found guilty of evading its obligation to pay taxes to the relevant tax authority of the land. Some companies may try to outwit the tax authority to pay a reduced amount of corporate tax by using tactics, such as mergers or failure to record some of their incomes. If the tax authority taxing the company suspects that the company has been evading tax, it may institute investigations to establish whether the company has been paying the correct amount of taxes. Since it is a company’s directors who are supposed to oversee that a correct amount of tax is paid to a taxing authority, they shall be investigated to determine whether they have been discharging their obligations appropriately in terms of running their company. If found guilty of tax evasion by a court of law, both the company’s directors and the company itself shall be equally investigated as per the current legislation. The act of a court of law to view both a company and its directors equally represents the lifting of the veil of incorporation of the company.
12) When there is a holding and subsidiary company relationship
A situation may arise whereby one company may decide to buy a part of another company. The occurrence of such an action where one company buys part of another will result in some activities of the two companies being conducted jointly, even though the two companies were two separate legal entities before one bought the other. The company that has a majority of shares is called a holding company. The company that has a smaller number of shares is called a subsidiary company. The act of a holding company purchasing a huge part of another company’s shares forms a holding and subsidiary relationship. Once the holding and subsidiary relationship is formed, many people dealing with the company e.g. debtors, creditors or clients of the company, may be unaware of the fact that the actual company that they are dealing with is in fact two separate entities that are carrying out business as one entity.
If a law suit is lodged against either a holding or subsidiary company, a court of law will view both a holding company and a subsidiary company as being responsible for the payment of damages or the sum of money charged on the group company by the court. Even though the holding company will contribute a bigger amount of money than the subsidiary company in an attempt to pay the sum charged, the fact that emerges is that the actions of one company affect the other company legally. The court will expect both companies to contribute some portion of the total money it instructs both companies to pay. The veil of incorporation of both the holding and subsidiary company is said to be lifted by the court, since the two companies become one and are liable to pay for each other’s debts and earn each other’s profit, even though both the holding company and the subsidiary company started as separate legal entities during their original formation.
13) When a court discovers that an individual is using the veil of incorporation to evade personal or statutory obligations
A court may also decide to lift the veil of incorporation of a company by treating both an individual and a company as the same person legally, if an individual tries to evade his/her personal and statutory obligations. For example, a company's employee may be asked to sign an agreement, in which he accepts not to solicit the company’s customers to purchase goods or obtain services from a business he/she shall establish upon his/her retirement from the company that employs him/her currently.
If an employee agrees to sign an agreement, which prevents him from soliciting his/her former employer’s customers, the law cannot allow him to establish a similar to that of his employer, which he/she will, use to solicit and earn from his former employer’s customers. If the employer sues his former employee for acting against the provisions of the contract he signed, the court may issue an injunction against both the employee and his business. The court of law pierced the veil of incorporation of the employee’s business by treating both the employee and his business as the same person instead of two separate entities when it issued an injunction to prevent the continuation of the business and the soliciting acts of the employee.
14) When a court of law discovers that a business has been using its corporate structure to hide its criminal activities.
It has been observed that some companies may tend to use the corporate veil to conceal the operation of illegal business activities within their companies. On suspicion that a company may be using the corporate veil to conduct illegal businesses, an investigation may be launched into the business to determine whether the directors of a company in question are indeed using the corporate veil to conduct illegal business activities. If a court of law determines that it is indeed true that a company’s directors have been conducting illegal business activities under the cover of the company’s corporate veil, the court may decide to treat the property of the company as realizable. The veil of incorporation will, therefore, be lifted by the fact that the illegal activities of the company’s directors will make the company’s property vulnerable to realization. The illegal actions of company directors will, therefore, affect the company’s property even though both the company and its directors are two different corporate entities.
15) When a company is found to be guilty of committing a tortuous liability
A court of law may also lift a company’s veil of incorporation if its directors commit a tort on a third party, which causes the third party to incur some form of loss. A tort is any action done by one party that causes the infringement of the rights of another. Whenever the managers or directors of a company run the business in a manner that is likely to cause the infringement of the rights of another party, the party whose rights have been infringed may claim for compensation of the damages he/she has experienced.
For example, a company’s directors may hide under the veil incorporation and conduct the affairs of their business in a manner that inconveniences other parties e.g. a bar that pollutes the environment because of the noise made by its patrons and music played inside the bar. Parties who fill that the noise from the bar is inconveniencing them may seek a court order to stop the operations of the bar. If a court of law finds out that the bar is infringing on the rights of the members of the neighboring community, it may order the owners of the bar to start making some form of compensation to the members of the neighboring community. The noise from the patrons of the bar is a tort committed on the members living next to the bar. The action of the court to instruct the owners of the bar who, are a separate legal entity, to pay for the noise being made from the operation of the bar shows how a tortuous activity can result in the lifting of the veil of incorporation.
From the above discussion, we realize that a company is an artificial person that can exist and operate on its own. However, the occurrence of some events may cause the parties running the companies to be considered the same person as the company, thus resulting in the lifting of the veil of incorporation.