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A Review on the Regulation of Limited Liability

Implications for Reform


INTRODUCTION

The limited liability doctrine refers to the capping of the liabilities of members of
a company for the companys debts (Company Ord (Cap 32) s4(2) and s170(1))
as generally justified on economic basis. A related concept is the separate legal
entity doctrine as laid down under Salomon v Salomon [1897] AC 22. When the
aforesaid two doctrines are applied together, they can potentially be abused
which lead to unjust results to the companys creditors. The law has attempted
to correct such injustice through the doctrine of piercing the corporate veil - by
disregarding the separate entity of the company and imposing liability or
conferring rights of the company onto persons behind the company (e.g.
shareholders or directors).

Regulation of limited liability is a controversial subject. In the rest of this paper,
I will outline the current laws in Hong Kong on this subject, followed by a
discussion of the problems of the status quo and recommendations to address
the shortcomings. I will then conclude with a suggestion for the necessary
reforms.


CURRENT LAWS REGULATING LIMITED LIABILITY IN HONG KONG

Limited liability is mainly governed by common law together with some statutes
in Hong Kong.

Common Law
Common Law has pierced the corporate veil in the following scenarios

(1) Evading existing liabilities
Where a company is regarded as a sham or a mere device for evasion of an
existing legal obligation of another person or entity, the court will be ready to
pierce the corporate veil, as in Gilford Motor Co v Horne [1933] 1 Ch 935 and
Jones v Lipman [1962] 1 WLR 832. The same principle has been adopted in the
Hong Kong case of Liu Hon Ying v Hua Xin State Enterprise (Hong Kong) Ltd
[2003] 3 HKLRD 347. Nevertheless, avoiding contingent future liabilities is
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permissible

as ruled in China Ocean Shipping Co v Mitrans Shipping Co Ltd [1995]
HKCA 604.

(2) Fraud
Use of a company to perpetrate fraud could lead the court to pierce the
corporate veil to impose liability where necessary, as illustrated in HKSAR v
Leung Yat Ming [1999] 2 HKLRD 402, HKSAR v Sin Law Yuk Lin & Another [2002]
HKEC 378 English Judgment and in Re Darby [1911] 1 KB 95.

(3) Corporate Groups
The corporate veil between companies in a group would not be pierced merely
because of the fact that the companies belong to a group (see e.g. Woolfson v
Strathclyde Regional Council 1978 SC (HL) 90, 1978 SLT 159). The court may,
however, pierce the corporate veil of a group of companies when one or more of
the following principles are applicable:

Agency
Sometimes the corporate veil is pierced on the basis of agency between the
subsidiary and its parent holding company (see e.g. discussion by Krishnaprasad,
K. V., Agency, Limited Liability and the Corporate Veil (2011) Comp. Law 163).
In Smith Stone and Knight Ltd v City of Birmingham [1939] 4 All ER 116 the
significant factors were that the parent company did not transfer the business to
the wholly owned subsidiary and the subsidiary profits were treated as those of
the parent company. The mere fact that a company is under the practical
control of a person does not give rise to an agency (Salomon v Salomon [1897]
AC 22, Adams v Cape Industries Plc [1990] 2 WLR 748).

Single Economic Unit
This principle is illustrated in DHN Food distribution Ltd v Tower Hamlets London
Borough Council [1976] 1 WLR 852, in which Lord Denning referred the parent
company and two wholly owned subsidiaries as virtually the same as a
partnership and the three companies should be treated as one.

A mere facade
One test suggested for veil piercing is where there are special circumstances
alleging that the company is a mere facade concealing the true facts: see e.g.
aforementioned cases like Woolfson, Adams and DHN, and the case of Toptrans
v Delta Resources Co Inc [2005] 1 HKLRD 635 CFI.

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Note that justice may sometimes be considered as a factor in veil piercing rulings,
e.g. as in the case of DHN. Yet this factor is never solely decisive (Adams v
Cape Industries Plc [1990] 1 Ch 443 at 544; China Ocean Shipping Co v Mitrans
Shipping Co Ltd [1995] HKCA 604 at p.8).

Statutes
Limited liability is also governed by legislations. Examples are:

a. Company Ordinance (Cap 32)
Under s275, a person who is knowingly a party to carrying on the business with
intent to defraud any creditors, or for any fraudulent purpose, may be personally
liable with unlimited liability for the companys debts or other liabilities.

b. Transfer of Business (Protection of Creditors) Ordinance (Cap 49)
A transferee of a business will be liable for the debts and obligation of the
transferor arising out of the transferred business unless he is a bona fide
purchaser without notice of such liabilities (s3), or if he can rely on other
exemptions such as the limitation period of 1 year (s9) or other savings as
provided for in the Ordinance (s10). Thus, if a shareholder transfers a business
of his company to another company under his control, he will be deemed to have
constructive notice of the debts of the transferor and liability will likely be
imposed upon the transferee subject to the aforesaid exemptions.

c. Criminal Procedure Ordinance (Cap 221)
S101E provides that where a company has committed an offence under any
Ordinance with the consent or connivance of a director or other officer in the
management of the company (or any person purporting to act as such director
or officer), the director or other officer shall be guilty of the like offence (see R v
Mirchandani [1977] HKLRD 523). Thus a shareholder will be liable for the
statutory offences committed by the company if he is a director of the company
or the master-mind behind.

d. Inland Revenue Ordinance (Cap 112)
Where the Commissioner of Inland Revenue has reason to believe certain
transactions have the effect of evading tax, the corporate veil can be lifted (s61
and 61A).

RECENT DEVELOPMENT IN THE UK

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A new principle in piercing the corporate veil has emerged recently in the UK.
In Ben Hashem v Ali Shavif [2008] EWHC 2380 (Fam), Munby J (as he then was)
after reviewing the available authorities in which the court has been willing to
pierce the corporate veil concluded (at para 199 of his judgment) that the
wrongdoing must exist dehors the company. Here the phrase dehors the
company means something outside the ordinary business of the company. This
new principle was applied by Flaux J, albeit obiter, in Lindsay v OLaughnane
[2010] EWHC 529 QB at 134. Yet in Antonio Gramsci Shipping v Stepanovs
[2011] 1 Lloyds Rep 647 at para 15, the necessity of such condition for piercing
decision was doubted by Burton J when the sole purpose of the corporate
structure is to perpetrate fraud.

PROBLEMS IN THIS AREA OF LAW

Despite many economic benefits such as reducing agency cost (Easterbrook, F. E.
and Fischel, D. R., Limited liability and the corporation, (1985) 52 U. Chi. L. Rev.,
89, at 92), promotion of investment (Posner, R. A., The rights of creditors of
affiliated corporations (1976) 43 U. Chi. L. Rev., at 503) and free transfer of
shares (Clark, R. C., The regulation of financial holding companies (1979) 92(4)
Harv. L. Rev., at 825), limited liability has occasionally led to injustice to creditors
as discussed early on. Yet the way the court acts to correct such injustices via
veil piercing have also attracted criticism, which are summarised in the following
categories:

1. Lack of coherent principles
Courts often explain their decision to pierce by describing the company as a
mere sham or facade (Vandekerckhove, Karen, Piercing the Corporate Veil,
(2007 Kluwer The Netherlands), at para 3.6.8 and 3.7.6), or as the defendants
alter ego (Vandekerchhove, Karen, above, at para 3.7.4). Yet labelling using
such vague and confusing terms do not convey a clear legal reasoning for the
piercing decision.

For example, inWoolfson the court did not follow ruling in a previous similar case
of DHN and held that the corporate veil between the group of companies did not
fall within the facade exception but offered no guidance on what would be
within. It has been suggested that the underlying reasons for a UK judge to lift
the corporate veil are probably his subjective perception of fairness or policy,
which is therefore difficult to predict (Hicks, Andrew and Goo, S. H., Cases &
Materials on Company Law (6
th
ed 2008 OUP Oxford), p.103).
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The new and yet unsettled principle that the wrongdoing must exist dehors the
company in some recent UK cases, as discussed earlier, represents another
example of the lack of consistent principle in this area of law.

Situation in Hong Kong is no better. In Lee Sow Keng Janet v Kelly Mckenzie Ltd
[2004] 3 HKLRD 517 the defendants argument that the liquidator (but not the
plaintiff) would have the locus standi to sue was explicitly rejected by the Court
of Appeal, which regarded the defendant as a mere facade and affirmed the
lower courts piercing decision. However, in Horace Yao Yee Cheong & Ors v
Pearl Oriental Innovation Ltd [2010] HKEC 537 at para 16 and 37, the same
argument was accepted by the appeal court who commented the lower courts
finding of impropriety, wrongdoing, concealment, sham or fraud as lack of clear
guidance and overturned the lower courts piercing decision. Yet there is no
clear indication as to whether the ratio in Lee Sow Keng case has been overtaken
by the Horace Yao case as Lee Sow Keng was not considered in Horace Yao or
any subsequent cases.

The US courts in veil piercing cases have gone even further from the
instrumentality test (e.g. Powell rule, see Krendl, Cathy S. and Krendl, James R.,
Piercing the Corporate Veil: Focusing the Inquiry (1978) 55 Denver L.J. 1) to
adoption of a template approach by constructing a list of factors where prior
cases have been considered in piercing decisions (Gevurtz, Franklin A., Piercing
Piercing: An Attempt to Lift the Veil of Confusion Surrounding the Doctrine of
Piercing the Corporate Veil (1997) 76 Or. L. Rev., at p.875). The context of the
current case is then compared with the list and decision to pierce made if there
exists enough facts to fit the list. The major drawback of this template approach,
as commented by Gevurtz (above, at p. 857-858), is the indeterminacy as to how
many of the factors, if not all, must be proven before the piercing decision can
be affirm.

2. Differential treatment towards contract creditors and tort creditors
Many writers have advocated that courts should differentiate between piercing
claims raised by contract (voluntary) creditors and tort (involuntary) creditors of
the company. Such view is premised on the belief of freedom of contract
between the contract creditors and the limited company - if the contract
creditors so wish they can require a guarantee from the shareholders or charge a
higher interest rate to compensate for the risk exposure, and the court should be
slow to intervene in such veil piercing cases (Gevurtz, above, at p. 859). In
contrast, the tort claimants inability to self-protect ex ante against the insolvent
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company renders their judgment nugatory. Thus tort claimants warrant more
sympathy from the courts in veil piercing claims. Empirical evidences, as will be
discussed later, have refuted such theoretical ideology.

3. Differential treatment towards an individual controlling shareholder and a
corporation controlling shareholder
Some commentators have avowed that the courts should be more ready in
piercing the veil of a company whose controlling shareholder is another company
rather than an individual (e.g. Easterbrook and Fischel, above, at 110 111).
Others have argued that there should be no reason to distinguish between
individual and controlling shareholders (Gevurtz, above, at 897). Many others
assert that the courts ought to be more ready in lifting the veil of companies with
an individual controlling shareholder as the limited liability for closely held
companies increases the chances of risky behaviour (Andersen, Helen, Piercing
The Veil on Corporate Groups in Australia: The Case For Reform (2009), 33 Melb.
U. L. Rev. 333, at 346). Apparently there is no consensus in this academic
debate.

INSIGHTS FROM EMPIRICAL STUDIES

While there is considerable support from the literatures for the various schools of
thoughts discussed in last two paragraphs, I would argue that some of them
cannot stand in light of the available empirical studies on veil piercing. For
instance, Thompson based on a study of 1600 cases found that (Thompson,
Robert B., Piercing the Corporate Veil: An Empirical Study (1990-91) 76 Cornell
L Rev., 1036):
courts pierce less than in tort than in contract contexts (contrary to
the theoretical construct of the voluntary creditors);
piercing is more likely in cases involving individual shareholders rather
than corporation shareholder (contrary to the theoretical
counter-argument that courts should be more ready to pierce the veils
of corporation shareholders than individual shareholders);
likelihood of piercing increases as the number of shareholders
decreases;
misrepresentation and undercapitalization (or other frauds) do make a
difference, but is more pronounced in contract settings than in tort or
statutory settings;
piercing only occurs within corporate groups or in private companies
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but not in public companies;
reasoning of the courts in cases which piercing was effectuated varies
with the context.

Other empirical studies have affirmed the above results. (see e.g. Thompson,
Robert B., Piercing The Veil within Corporate Groups: Corporate Shareholders as
Mere Investors (1998-1999) 13 Conn. J. Int'l L. 379; Ramsay, Ian M. and Noakes,
David B., Piercing the Corporate Veil in Australia, (2001) 19 Com and Sec L. J.
250 271; Oh, Peter B., Veil-Piercing (2010-2011) 89 Tex L. Rev. 81). Matheson
in his independent empirical studies have provided additional insights (Matheson,
John H., The Modern Law of Corporate Groups: An Empirical Study of Piercing
the Corporate Veil in the Parent-Subsidiary Context (2008-2009) 87 N.C.L. Rev.
1091; Matheson, John H., Why Courts Pierce: An Empirical Study of Piercing the
Corporate Veil (2010) 7 Berkely Bus. L.J. 1):
appellate courts pierce twice as often as trial courts;
entity plaintiffs succeeded more than twice likely than individual
plaintiffs in piercing the subsidiarys veil.
although plaintiff category (i.e. individual or entity) and claim category
(tort, contract, etc) tell us when courts pierce, they do not explain why;
fraud, owner control and mixing of funds give the most significant and
predictive power on corporate veil piercing the presence or absence of
these factors alone is often deterministic of the piercing decision;


DISCUSSION BETWEEN THEORETICAL BELIEVES AND EMPIRICAL
FINDINGS

Although many theorists advocate that the courts should be more readily in
piercing the corporate veils in cases involving tort claimants than contract
claimants, and having corporate shareholders than individual shareholders, the
reverse is observed from the empirical findings. Apparently the doctrinal
analysis of the corporate veil piercing cannot give a satisfactory account of this
myth. Then how can it be explained?

I would like to offer an alternative explanation from a social jurisprudence
analysis. Galanter observed that the haves (those with richer resources and
competency in litigation) outperformed the have-nots (those underprivileged in
litigation), and concluded that legal reforms alone will not be a panacea in
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reducing the gap between the two classes of players (Galanter, Marc, Why the
Haves Come Out Ahead: Speculation on the Limits of Legal Changes (1974) 9
Law & Society Rev. 1). His observation has been affirmed by a number of
subsequent empirical studies (See the literature review discussed in He, Xin and
Su, Yang, Do the Haves come out again in Shanghai courts?, paper presented
at the 2
nd
Int Conference on the New Haven School (23-24 Nov 2010) in Hong
Kong).

In the context of Galanters theory individual/tort plaintiffs and individual
shareholders are generally classified as the have-nots whereas entity/contract
plaintiffs and corporation shareholders are regarded as the haves. This view is
consistent with the empirical finding that the appellate courts are more likely to
pierce the corporate veils than the first instant courts e.g. an individual/tort
claimant (have-not) who lost the veil piercing case in the first instant may not
have the necessary resource to appeal, especially if he is financed by legal aid in
the first place, where as an entity/contract plaintiff in general has better
resource to support an appeal to the appellate court which has a higher
tendency to pierce the corporate veils than the lower courts. Applying
Galanters theory, any legal reforms alone, including judicial activism in reducing
the comparative disadvantage of the have-nots will be limited in its effectiveness
(Galanter, above, at p.44-48).

Furthermore, I would argue that attention on the above myth in company law is
actually mis-focus of the issue. It is in effect an example of the inequality
between the haves and have-nots in a much wider context, in which an effectual
remedy is to convert the have-nots into the haves, e.g. by forming clusters of
self-help association such as labour unions (Galanter, above, at p.50-52).


RECOMMENDATIONS FOR REFORM

From the previous discussion, it follows that any reform on the regulations of the
limited liability, or the veil piercing doctrine should be focused on the lack of
coherent legal principles in adjudicating veil piercing cases of the status quo,
rather than attempting to balance the inequality between the haves and
have-nots. One possible reform is thus to codify the generally accepted legal
principles into statutes, such as by embracing them in the current statutes
regulating limited liabilities discussed early on. Cupuano, for example,
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identified (i) control; (ii) an act warranting the piercing of the veil; and (iii) mala
fides as the three general principles guiding veil piercing cases ( Cupuano,
Angelo, The Realists Guide to Piercing the Corporate Veil: Lessons from Hong
Kong and Singapore (2009) 14 Aus J. Corp Law 23), whereas only the third
principle is stipulated in our statutes as revealed from our earlier discussion on
statutes governing limited liability in Hong Kong. Another possibility is to fill the
loop-holes in the current law, such as a tort claimant can initiate an action for
compensation within 3 years for personal injury or 6 years otherwise (Limitation
Ord (Cap 347) s4 and 27) towards a corporate wrongdoer, whose window will be
curbed to only 1 year if the shareholder of that corporation transfer the business
to a third party (Transfer of Business (Protection of Creditors) Ord (Cap 40) s8).

In fact, similar codification reforms have been successfully introduced in some
other areas of the laws in Hong Kong, such as the codification of the common
law part-performance and resulting / constructive trust doctrines in the
Conveyances and Property Ordinance, codification of the common law nemo dat
rule and its exceptions in the Sales of Goods Ordinance, and the enactment of
the Misrepresentation Ordinance to enshrine common law principles on
misrepresentation in contract laws.

The major benefit of the proposed codification will be reduction in the
uncertainty in veil piercing rulings especially in the first instant courts. From
the empirical researches of Andersen and Thompson mentioned above, veil
piercing cases constitutes a highly litigious area in company law in the US.
Though I am unaware of any similar empirical data in Hong Kong, nonetheless
the proposed codification will result in saving of social resources in resolving
disputes in this area of claims. In addition, it will help deter corporate
mis-behaviours and decrease risk to creditors (both voluntary and involuntary)
and will thus be beneficial to the society at large.

CONCLUSIONS

Limited liability is a great privilege to shareholders of limited companies. Yet it
is a privilege which has to be exercised in a responsible manner. Currently it is
governed by common law via the doctrine of corporate veil piercing and by some
statutory provisions in Hong Kong. By referencing to literatures and empirical
studies I submit that current laws regulating the limited liabilities may lead to
uncertainty in judicial rulings. A proposed legal reform through codification of
the generally accepted legal principles in corporate veil piercing will address such
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shortcoming and be beneficial to the society.





Dr Roger So
Fellow, Cheung Kong Centre for Negotiation and Dispute Resolution,
Law School of Shantou University