1, Introduction
Company law is based on various concepts and principles, including the legal formation, governance, management, and dissolution of companies, as well as the rights and obligations of shareholders, directors, and other stakeholders. Some of the foundations company law is based on include limited liability, separate legal personality, corporate governance, fiduciary duties, and shareholder rights. These concepts and principles help to establish the legal framework for businesses to operate in and to ensure that they operate in a responsible and accountable manner.
Among the aforementioned foundations company law is based on, limited liability is a fundamental concept in company law that refers to the legal responsibility of company owners and shareholders for the company’s debts and obligations. Under this principle, the personal assets of the owners and shareholders are protected from the company’s financial liabilities, and they are only liable for the amount of money they have invested in the company. This means that if the company incurs debts or legal claims that exceed its assets, the creditors or claimants cannot go after the personal assets of the owners or shareholders to recover their losses. Limited liability provides a significant advantage to entrepreneurs and investors by limiting their exposure to financial risk, which encourages them to invest in and start new businesses. This concept has been a driving force behind the growth of the modern economy and has enabled the creation of many successful companies.
Although it’s commonly believed that limited liability provides complete protection, it has never been as absolute as it appears to be. In situations where a corporation is unable to pay its debts, creditors have the option to use a legal principle called “piercing the corporate veil” to hold a shareholder accountable for the corporation’s obligations. This principle was developed by the courts and serves as a safeguard against the principle of limited liability, preventing shareholders from misusing it for unlawful purposes.
The concept of piercing the corporate veil is a fundamental principle in corporate law that allows courts to disregard the corporate entity and hold its governors, shareholders or owners personally liable for the obligations of the corporation. This term paper will discuss the concept of piercing the corporate veil in the new commercial code (hereinafter referred to as “the NCC”) in detail, including the origins, evolution, and current status of the doctrine. The paper will further explore the legal standards for piercing the veil, the factors that courts consider in making this determination. The goal of this paper is to provide a general understanding of piercing the corporate veil under the NCC. its implications, and its importance in corporate law.
Why Pierce the “Corporate Veil?
It would be ideal to begin with the phrase “corporate veil” before diving into the subject matter because the word has been alien to the writer of this paper just before a couple of months ago. Black’s Law Dictionary provides the following definition:
“Mohammed Rezal salim, ‘Corporate insolvency: separate legal personality and directors’ duties to creditors’, Universiti Teknologi MARA Law Review, Vol. 2, No. 90, 2004, p.1” Cited in Endalew Lijalem Eniyew, The Doctrine of Piercing The Corporate Veil: Its Legal Significance and Practical Application in Ethiopia, Addis Ababa University School of Graduate Studies, LL.M Thesis, 2011, p.1 Chao Xi, Piercing the Corporate Veil in China: How Did We Get There?, Journal of Business Law, No. 5, p. 413, 2011, Available at SSRN: https://ssrn.com/abstract=1907079 Federal Negarit Gazette of the Federal Democratic Republic of Ethiopia, Commercial Code of Ethiopia Proclamation No. 1243/2021, 7th Year No. 23, Addis Ababa, 2021, hereinafter referred to as “the NCC” “Corporate Veil. (1927) The legal assumption that the acts of a corporation are not the actions of its shareholders, so that the shareholders are exempt from liability for the corporation’s actions.”
The dictionary further elaborates what “piercing” this corporate veil means as follows;
“Piercing the corporate veil. (1928) The judicial act of imposing personal liability on otherwise immune corporate officers, directors or shareholders for the corporation’s wrongful acts. – Also termed disregarding the corporate entity; veil-piercing.”
“In recent years, the issue of the misuse of corporate entities for illicit purposes has drawn increasing attention from policy makers and other authorities. While corporate entities have been credited for their immense contribution to rising prosperity in market-based economies, there has been growing concern that these vehicles may be misused for illicit purposes, such as money laundering, bribery and corruption, shielding assets from creditors, illicit tax practices, market fraud, and other illicit activities.”
The concept of limited liability, which is based on metaphysical ideas, overlooks the fact that people and physical objects are responsible for causing harm and creating liabilities in the real world. It’s misleading and unrealistic to shield the real causes of harm and liabilities from accountability behind a fictitious and an intangible idea like the corporate veil. Consequently, the unethical evasion of criminal or civil responsibility using limited liability has led courts to make exceptions and “pierce the corporate veil.”
Origins and Evolution of Piercing the Corporate Veil
The origins of this doctrine can be somehow debatable as the subject matter itself. “The legal separation between the company and its members and those with whom it deals is often
Garner, B. A. (ed.), Black's Law Dictionary, 9th ed, West Publishing Co., 2009, pp. 390-391 Garner, Note 4, p. 1264 Organization For Economic Co-Operation and Development - OECD, Behind the Corporate Veil: Using Corporate Entities For Illicit Purposes, 2001, p.3, Available at https://www.oecd.org/daf/ca/behindthecorporateveilusingcorporateentitiesforillicitpurposes.htm , last accessed on 3 February 2023 Angelo Capuano, The Realist's Guide to Piercing the Corporate Veil: Lessons from Hong Kong and Singapore, Australian Journal of Corporate Law, Vol. 23, No. 1, 2009, Available at SSRN: https://ssrn.com/abstract=1369110
described using the metaphor of a veil, or the veil of incorporation which is drawn between the company and all other legal entities.” This separation is generally accepted, as established in the Salomon case. However, exceptions to this principle of separate corporate identity have emerged through legal precedent and legislation, allowing for the “lifting” or “piercing” of the corporate veil in certain situations. This deviation from the seemingly untouchable principle of limited liability didn’t come to being overnight. Some traced back to the 19th century England when courts first began to recognize the concept of a corporation as a separate legal entity. Others claim that “It is fair to consider the United States as the origin of the doctrine of corporate veil piercing.” On the other hand, some wrote that the origins of corporate veil-piercing are unknown and they further elaborate that the reason is may be because shareholder liability has never been fully unrestricted. They further claim that throughout the history of limited liability, courts have overlooked the structure of corporations engaging in wrongful conduct in order to reach the personal assets of shareholders.
The evolution of piercing the corporate veil doctrine, in the early cases, courts did not explicitly recognize the concept of piercing the corporate veil but instead relied on the “alter ego” or “instrumentality” doctrine to impose liability on shareholders. Legal and historical texts show that courts focused on whether the shareholder exercised such control over the corporation that the corporation was merely a tool or instrument for the shareholder’s personal affairs. Black’s Law Dictionary defines Alter Ego and the Alter Ego Rule respectively as follows;
Lorraine Talbot, Critical Company Law, Routledge-Cavendish, United Kingdom, 2008, P.29 In the well-known case, Salomon v. A. Salomon & Co. Ltd., it was established, beyond doubt in England, that the company was to be treated as a person separate and distinct from its shareholders, including the principal shareholder and director. Talbot, Note 8, p. 29 Endalew Lijalem Eniyew, The Doctrine of Piercing The Corporate Veil: Its Legal And Judicial Recognition in Ethiopia, Mizan Law Review, Vol. 6 No. 1, 2012, P. 85 Karen Vandekerckhove, Piercing the Corporate Veil, European Company Law Series, Volume 1, Kluwer Law International, 2007, p. 28 Peter B. Oh, Veil-Piercing, Texas Law Review, Vol. 89, p. 81, 2010, University of Pittsburgh Legal Studies Research Paper No. 2010-06, p. 83Available at SSRN: https://ssrn.com/abstract=1557972 "Alter Ego. (1879) A corporation used by an individual in conducting personal business, the result being that a court may impose liability on the individual by piercing the corporate veil when fraud has been perpetrated on someone dealing with the corporation.”[ Garner, Note 4, p. 91] “Alter-ego rule. (1939) 1. Corporations. The doctrine that shareholders will be treated as the owners of a corporation's property, or as the real parties in interest, whenever it is necessary to do so to prevent fraud or to do justice.”
Until around mid-20th century, courts began to develop a more formalistic approach to piercing the corporate veil, focusing on whether the corporation had observed the formalities of corporate law, such as holding regular meetings, maintaining accurate records, and avoiding commingling of personal and corporate funds. This approach was criticized for being too rigid and formalistic, and it failed to capture the complex reality of corporate relationships.
The current concept of piercing the corporate veil doctrine emerged in the mid-20th century, and it is characterized by a more flexible and fact-specific approach to the doctrine. Courts of Western countries now consider a wide range of factors when determining whether to pierce the corporate veil, including the nature of the corporation’s business, the degree of shareholder control, and the degree of financial interdependence between the corporation and its owners.
Legal Standards for Piercing the Corporate Veil
For the purpose of comparison, the legal standards employed for piercing the corporate veil will be assessed as “general” and “Ethiopian” standards. By general, we are referring to the widely accepted standards, and we will look for local statutory justifications for the Ethiopian standards.
General Standards
The legal term “piercing the corporate veil” pertains to a situation where courts set aside the distinction between a corporation and its shareholders and hold a shareholder accountable for the corporation’s actions as if they were their own. This exception is established by the court and it is not always clear cut, leaving judges and litigants with limited direction in future cases.
Garner, Note 4, p. 91 Garner, Note 4, p. 91 Robert B. Thompson, Piercing the Corporate Veil: An Empirical Study , 76 Cornell Law Review, Volume 76, Issue 5 July 1991 1991, p.1036 (1991) Available at: http://scholarship.law.cornell.edu/clr/vol76/iss5/2
The concept of piercing the corporate veil is a topic of debate in legal theory and practice. On one hand, it can be necessary to align legal decisions with economic realities and provide creditors of a subsidiary with a way to seek compensation from the parent company. On the other hand, this approach appears to contradict the fundamental principle of corporate law that views a company as a distinct legal entity responsible only for its own debts.
It is crucial to understand that piercing the corporate veil is a means of redress and not an independent legal claim. It is not a distinct and separate legal cause of action, but rather a process to execute a pre-existing judgment. Therefore, if there is no pre-existing liability, there can be no grounds for piercing the limited liability protection of a company. Hence, it is presumable that there are legal standards for piercing the corporate veil of companies.
The legal standards for piercing the corporate veil vary from legal systems to legal systems and country to country. However, there are several general principles that are common to most jurisdictions. Generally, courts will only pierce the corporate veil when necessary to prevent fraud or to achieve equity. Courts will not pierce the veil simply because the corporation has become insolvent or unable to pay its debts. In the research finding that followed massive factual data collection, courts have given eighty-five reasons they employed to justify the piercing of the corporate veil and these were grouped into several major categories.
According to Thompson and other texts, courts will typically look at several factors to determine whether to pierce the corporate veil, including the following most common factors:
The Undercapitalization Theory: The undercapitalization theory is another legal standard that courts use to pierce the corporate veil. Under this theory, courts may pierce the corporate veil if the corporation is undercapitalized, and the shareholders failed to provide adequate capital to meet the corporation’s financial obligations. In applying this theory, courts consider the nature and extent of the corporation’s business, the amount of
Vandekerckhove, Note 12, p. xiii Herrick K. Lidstone, Piercing the Corporate and LLC Veil, 2020, p. 3. Available at SSRN: https://ssrn.com/abstract=2207735 , last accessed on 24 January 2023. Thompson, Note 14, pp. 1044-1045
capital that was required to conduct the corporation’s business, and the amount of capital that was actually provided by the shareholders.
- The Alter Ego Doctrine: Under the alter ego doctrine, courts may pierce the corporate veil if the corporation is a mere instrumentality or alter ego of its shareholders. The courts look at whether the corporation is being used to perpetuate fraud, to circumvent a legal obligation, or to achieve an inequitable result.
- The Single Business Enterprise Theory: The single business enterprise theory is another legal standard that courts use to pierce the corporate veil. Under this theory, courts may pierce the corporate veil if two or more corporations operate as a single business enterprise. In applying this theory, courts consider whether the corporations are interrelated and interconnected, whether they share common ownership and management, and whether they operate as a single economic unit.
- Failure to observe corporate formalities: If a corporation fails to observe corporate formalities, such as holding regular meetings, keeping accurate records, and avoiding commingling of funds, a court may be more likely to pierce the corporate veil.
- Dominance and control: If the shareholders exercise excessive control over the corporation, to the point where the corporation is merely a tool for the shareholders’ personal affairs, a court may be more likely to pierce the corporate veil.
- Fraud or Illegality/Misrepresentation: If the shareholders have made false representations about the corporation or its activities, this may also support piercing the corporate veil. For example, if the shareholders have represented that the corporation is financially stable and can pay its debts when it is not, this may suggest that the corporation is a mere instrumentality.
- Commingling of assets: If the shareholders have commingled their personal assets with the assets of the corporation, this may also support piercing the corporate veil. For example, if the shareholders have used the corporation’s bank account to pay their personal expenses, or if they have mixed personal funds with corporate funds, this may suggest that the corporation is a mere instrumentality.
In addition to the aforementioned reasons, in the United States, it is provided that under the Federal Bankruptcy Act, a bankruptcy court may disregard the corporate existence and pierce the corporate veil in order to reach a fair resolution of the corporation’s debts and protect the rights of certain creditors.
In summary, the standards for piercing the corporate veil can vary depending on the jurisdiction and the specific circumstances of the case. The authorities for piercing corporate veil are “incoherent and “unprincipled”, as quoted by Endalew, and he further quotes Rams and Noakes “[t]here is no common, unifying principle, which underlies the occasional decision of the courts (mainly common law courts) to pierce the corporate veil. Although an ad hoc explanation may be offered by a court which so decides, there is no principled approach to be derived from the authorities.” However, in general, courts will look at factors such as inadequate capitalization, failure to observe corporate formalities, dominance and control by shareholders, fraud or wrongdoing, misrepresentation, the alter ego doctrine, the single business enterprise theory, commingling of assets, inadequate separateness, and other relevant factors in determining whether to pierce the corporate veil.
Ethiopian Standards
In addition to the formerly existing two types of companies, Share Company and Private Limited Company, whose liabilities are met with asset of the company and by the individual contribution of each member respectively, the NCC has introduced a third type of company; the One Member Private Limited Company. By this virtue, the three types of companies have a legal personality that’ll enable them to enjoy the rights and protections that come from it, one of them being limited liability. However, the notion of limited liability under the Commercial Code, both
Angela Schneeman, The Law of Corporations and Other Business Organizations, Fifth Edition, Delmar Cengage Learning, 1993, P.257 Rams Ian M. and Noakes David B. (2001) ‘Piercing the corporate veil in Australia’, Company and Securities Law Journal, Vol.19, p. 4. Quoted in Endalew, Note 11, p. 86 NCC, Article 245 NCC, Article 495
he old and the new, too is not absolute. The law provides certain conditions and circumstances that’ll enable the piercing of the corporate veil.
Seifu Tekle Mariam’s groundbreaking research has revealed that in Ethiopian law, the only legal basis for piercing the corporate veil is in situations involving bankruptcy. Specifically, if a share company or private limited company is declared bankrupt and its assets are insufficient to cover its debts, a court may declare an individual bankrupt if they have conducted business on their own behalf, used company funds as if they were their own, and disguised their actions through the company’s activities. While this clause has broadened the scope of liability to any individual who meets the legal requirements, it does not specify the identities of these individuals. This assertion would be erroneous if we try to see it in light with the NCC.
Unlike the general standards to invoke the piercing of the corporate veil we’ve seen earlier, which can accommodate varieties of justifications under them, Endalew Lijalem puts forward seemingly narrow grounds under Ethiopian Commercial Code. He lists five grounds under which the corporate veil could be pierced under Ethiopian law; piercing the corporate veil in case of bankruptcy, piercing the corporate veil in case of failure of directors to discharge duties diligently, piercing the corporate veil upon reduction of members below the legal minimum, piercing the corporate veil in group companies and piercing the corporate veil in case of trade restraint. Endalew’s findings need to be updated in light of the provisions of the NCC.
Grounds of Piercing the Corporate Veil Under the New Commercial Code
The responsibility of lifting the corporate veil in Ethiopia, as in France, lies primarily with the legislative branch, meaning that the law permits the veil to be lifted and the courts have the authority to enforce it. However, the courts also hold some degree of power in this matter.
1, Bankruptcy
Seifu Tekle Mariam, Piercing the corporate veil: its application to private limited companies and share companies in Ethiopia, Senior Thesis, Quoted in Endalew, Note 1, pp. 3-4 cum. Article 1160 of the old Commercial Code Endalew, Note 11, pp. 98-106 Endalew, Note 1, p. 61
Bankruptcy procedure can play a critical role in piercing the corporate veil because it often brings to light the true nature of the relationship between the corporation and its owners or shareholders. Bankruptcy is a legal process in which a debtor’s assets are liquidated or reorganized in order to satisfy the claims of its creditors. When a corporation files for bankruptcy, its assets and liabilities become subject to the jurisdiction of the bankruptcy court, which has the power to oversee the liquidation or reorganization process, and to decide disputes between the debtor and its creditors.
In the context of bankruptcy, the piercing of the corporate veil may arise in several ways. For example, a creditor may seek to pierce the corporate veil in order to reach the personal assets of the managers or shareholders of the debtor corporation. The piercing of the corporate veil in bankruptcy can have significant implications for corporate law and practice. On the one hand, it can help to deter abusive practices by corporations and their owners or shareholders, and ensure that creditors are able to recover their debts.
Under the section that covers the management of PLCs, the provision of the NCC that talks about the liability of the manager. This provision reiterates that a manager can be held responsible for any harm caused to the company, shareholders, or third parties due to a breach of their legal or ethical obligations, regardless of any conflicting rules. It also states that in the event of bankruptcy, if the company’s assets are insufficient to cover its debts, the court may order the managers, including previous managers, to pay some or all of the debts if requested by the trustee in bankruptcy. The provision however clarifies that managers who can demonstrate that they acted with proper care and diligence are exempt from the provisions of the second statement.
The aforementioned provision of article 516 of the NCC can be dissected into three limbs and explained as follows;
i, Liability of the Manager for Breach of Duty
This provision makes the manager of a company personally liable for any damage caused by the breach of their duties under the law or the memorandum of association. The provision overrides any other provision that may suggest otherwise.
NCC, Article 516
The concept behind this provision is to ensure that managers act responsibly and diligently in carrying out their duties. It holds managers accountable for their actions and decisions, ensuring that they prioritize the interests of the company, shareholders, and third parties.
For instance, if the manager engages in fraudulent activities or misappropriates company funds, they can be held personally liable for the damages incurred by the company or third parties. This provision acts as a deterrent, discouraging managers from engaging in any unethical practices.
ii, Liability of the Manager in Bankruptcy
This provision provides for the possibility of the manager and previous managers of the company being held liable for the company’s debts in the event of bankruptcy. If the assets of the company are insufficient to pay off the debts, the court may order the managers to pay some or all of the debts.
The concept behind this provision is to ensure that managers act prudently and responsibly to avoid the company’s bankruptcy. It also ensures that creditors of the company are not unfairly disadvantaged in the event of bankruptcy.
If the manager engages in risky investment strategies or mismanages the company’s finances resulting in the company’s bankruptcy, for instance, the manager may be held personally liable for some or all of the company’s debts. This provision acts as a deterrent, encouraging managers to act responsibly in managing the company’s finances. While discussing about bankruptcy of a business organization, the following four points should be considered before deciding to make the manager liable;
A. Bankruptcy is a legal process that is designed to help struggling companies restructure their debt and get back on their feet. By filing for bankruptcy, the company can work with creditors to develop a plan for paying back debt over time, which can help to reduce the financial burden and provide a pathway for future success.
B. Bankruptcy can be a strategic move to protect the company’s assets and minimize losses. By filing for bankruptcy, the company can prevent creditors from seizing assets and selling them off to recoup their losses. This can help to preserve the company’s value and prevent a complete shutdown of operations.
C. Filing for bankruptcy can be an act of responsibility and accountability on the part of the company’s leadership. Rather than continuing to operate in a state of financial distress, which could ultimately result in greater losses for all stakeholders, filing for bankruptcy shows a willingness to confront the problem head-on and take steps to address it.
D. Finally, it is important to remember that bankruptcy is not a sign of failure. Many successful companies have gone through the bankruptcy process and emerged stronger on the other side. By taking action to address financial challenges, the company’s leadership is demonstrating their commitment to the company’s long-term success and the well-being of all stakeholders.
iii, Due Care and Diligence
This provision stipulates that the liability provisions under sub-Article (2) of this Article shall not apply to managers who have demonstrated that they have acted with due care and diligence. The concept behind this provision is to provide a defense for managers who have acted responsibly and diligently in carrying out their duties. If a manager can show that they acted in good faith and in the best interests of the company, they may not be held personally liable for any damages or debts incurred by the company.
For instance, if a manager can show that they made informed decisions based on accurate information and acted in good faith, they may not be held liable for the company’s debts in the event of bankruptcy. This provision encourages managers to act responsibly and diligently, while also providing them with a defense against personal liability.
2, Fraud or Illegality/Misrepresentation:
If the shareholders have made false representations about the corporation or its activities, this may also support piercing the corporate veil. For example, if the shareholders have represented that the corporation is financially stable and can pay its debts when it is not, this may suggest that the corporation is a mere instrumentality.
3, Commingling of Assets:
NCC, Art 295 (1) & (4)
Even though it is provided that the liabilities of a share company are met only by the assets of the company, there is an exception to it. If the shareholders mix personal assets with corporate assets or use corporate assets for personal use, this may suggest that they are not treating the corporation as a separate legal entity. If any shareholder with a decisive vote engages in commingling of assets, they shall be jointly and severally liable with the company.
4, Dominance and control:
If the shareholders exercise excessive control over the corporation, to the point where the corporation is merely a tool for the shareholders’ personal affairs, a court may be more likely to pierce the corporate veil. The NCC describes this situation if the shareholder “makes use of the assets of the company for himself or the benefit of a third party without making an arm’s length payment or without the knowledge or decision of an appropriate management body”
5, The Alter Ego:
Under the alter ego doctrine, courts may pierce the corporate veil if the corporation is a mere instrumentality or alter ego of its shareholders. The courts look at whether the corporation is being used to perpetuate fraud, to circumvent a legal obligation, or to achieve an inequitable result. The NCC describes this situation where the shareholder causes the payment of dividends in excess of that permitted under the law”.
There are other provisions of the NCC that deal with the doctrine of piercing the corporate veil of a company that will not be discussed here for plenty of reasons, and the above are just indicators of the situation.
NCC, Art 245 (1) NCC, Art 295 (2) NCC, Art 295 (5) NCC, Art 295 (6) The writer would like readers to refer the provisions of Articles 325, 329, 334, 495, 534/3/, 538, 539/3/, 540/5/, 541, 542 /1/, 543, 563 and 564(3), which are pertinent articles that deal with the doctrine.
