Execution of Award against Directors by lifting Corporate Veil - Written Arguments - Part 2

1. That the Decree Holder has filed Execution Petition No. ……. and has prayed for the execution of the Award dated ……….. passed by the Sole Arbitrator, Delhi in Arbitral Reference No. ………. filed by M/s. ……… against the Judgment Debtors, which has been decided in favour of M/s. …….., the Decree Holder. Shri ………., the Sole Proprietor of M/s. ………., is a senior citizen aged about 83 years, hence merits preferential attention by this Hon’ble Court.

2.  In this case, all the four Directors of ……….. PVT. LTD have also been arrayed as Defendants in their individual capacity in the Claim Petition dated ………. submitted before the Learned Arbitrator and the Award dated …………. has been passed against all the Defendants. Therefore, all the Defendants are jointly and severally liable to satisfy the Award, which is applied for being enforced as a decree as per section 36 of the Act. The Judgment Debtor Directors …………., all residing at …………, New Delhi, have not preferred any application under section 34 of the Act for setting aside the Award. Hence, the Award dated ……….. has already become final and binding on the individual Judgment Debtor Directors ………. at the expiry of three months from the date on which they had received the Award as provided in section 34(3) of the Act. As described in following paragraphs, the Judgment Debtor Directors are personally liable to make full payment as per the Award on the following grounds.

LIMITED LIABILITY

3. EFFECT OF INCORPORATION (Company as separate legal person): As per Section 9 of the Companies Act, 2013 (Section 34 of the Companies Act, 1956) one of the characteristics of a company is that it is an incorporated body of persons. It is constituted into a distinct and independent person in law and is endowed with special rights and privileges.   Its assets are separate and distinct from those of its members; it can sue and be sued exclusively for its own purpose; its creditors cannot obtain satisfaction from the assets of its members; the liability of the members or shareholders is limited to the capital invested by them; similarly the creditors or the members  have no right to the assets of the corporation (vide Salomon V. Salomon & Co. 1897 AC 22). This principle may be referred to as “the veil of incorporation”. The Courts in general consider themselves bound by this principle.  

4. In his book ‘Gower and Davies’ Principles of Modern Company Law’, 7th edition 2003, Prof. Gower has stated that the fundamental attribute of corporate personality is that the corporation is a legal entity distinct from its members vide Salomon v Salomon & Co, so long as the company is a going concern. Of course this decision does not mean that a promoter can with impunity defraud the company which he forms or defraud his existing creditors. Since the Salomon case, the complete separation of the company and its members has never been doubted. However, there are cases in which the legislature, and also the courts, have allowed the veil of incorporation to be lifted. 

5. The overall result of the broad recognition by the courts of the separate legal entity of the company and of the limited liability of its members and directors is to produce at first sight a legal regime which is very unfavourable to potential creditors of the company. For large lender, especially banks, there are a number of possibilities, to be used separately or cumulatively. Apart from charging higher interest rates on loans, such lender may seek to leap over the barrier created by the law of limited liability, by exacting as price of the loan to the company personal guarantees of its repayment from the directors and shareholders of the company, guarantees which may be secured on the personal assets of the individuals concerned. Instead of or in addition to obtaining personal security by contracting around limited liability, large lenders may seek to improve the priority of their claims by taking real security against company’s assets. However, these self-help remedies may not be practicable for trade creditors or employees. Unless and to the extent that they have a statutory preference, unsecured creditors are in the worst possible world. Limited liability normally stops them from suing the directors and shareholders, whilst the fixed and floating charges of the big lenders often soak up all the available assets of the company. For theses reasons, the Companies and Insolvency Acts are full of provisions whose purpose can not be completely understood except against the background of limited liability. These include the extensive publicity and disclosure obligations placed upon limited liability companies.

EVOLUTION OF CONCEPT and THE RATIONALE FOR LIMITED LIABILITY

6.  During the battle for legislative acceptance of the principle of limited liability in Europe in the middle of nineteenth century, the argument which seems to have weighed most heavily with the legislator was that limited liability would facilitate the investment by members of the public, who were not professional investors,  of their surplus funds in the many large capital projects which companies were being set up to carry out at that time, in particular the construction of a national network of railways. Members of the public, whose primary activity and expertise did not lie with the running of companies, would be much less likely to be willing to buy shares in such companies, if the full range of their personal assets were to be put at risk. They might be prepared to become lenders of money to such companies, but not necessarily to become shareholders, and it was the flexibility of investment of risk capital through shares which those companies sought. So limited liability facilitates the trading of the company’s shares at a uniform price on the public exchanges. The adverse effect of unlimited liability could be mitigated by making the shareholders liable only a proportionate basis (i.e. liability on the part of each investor only for his or her “share” of the company’s debts). Two things are apparent about these two rationales for limited liability. The first that they support limited liability for companies which have offered their shares to the public, but are hardly persuasive for companies which have not and do not plan to do so, i.e. all private companies (which constitute the overwhelming majority of companies on the register). Yet, a great deal of effort was made on the part of practitioners in Europe in the second half of the nineteenth century in securing the extension of limited liability to all companies, including the smallest, a goal achieved when the House of Lords handed down its decision in Salomon v Salomon & Co, and the legislature did not reverse that decision. That decision remained controversial {In (1944) 7 M.L.R. 54, Otto Kahn-Freund described it as “calamitous”}, but so entrenched in our law is the principle of limited liability for all companies, large or small, that nobody seriously advocates the reversal of Salomon v Salomon & Co.  

LIMITED LIABILITY IS NOT A MANDATORY RULE

7.  An alternative or supplementary way of looking at the limited liability departs from the fact that it is not a mandatory rule. The incorporators themselves may opt out of limited liability across-the-board, by forming an unlimited liability company. Alternatively, particular creditors may contract with the company and its shareholders on the basis that both will be liable on the obligations undertaken. Where the rationales for limited liability are most at question, in relations to groups and small companies, it is in fact common to contract out. Those setting up small companies, into which they are not willing to inject a significant amount of legal capital, will usually, find that a bank will not lend money to the company unless the shareholders give a personal guarantee of the loan to the company. In this way the personal assets of the shareholders become available to the bank if there is default on the loan and it is not confined to the assets of the company.

LEGAL RESPONSES TO LIMITED LIABILITY

8. The legislature has always made it an essential condition of the recognition of corporate personality with limited liability that it should be accompanied by wide publicity. Moving beyond disclosure, the most direct response to abuses of limited liability is to remove the veil of incorporation and make the shareholders (or directors) liable for the debts and other obligations of the company where abuse occurs. Finally, since limited liability restricts creditors’ claims to the company’s assets, a different attack on the problem would be to take steps to ensure that assets are not improperly removed from the company before those claims are made.

BREACH OF COMMERCIAL MORALITY

9. Breach of commercial morality has at its centre the idea of conducting business at the expense of its creditors. A leading example of such conduct was described by the Cork Committee in England in terms of a person who sets up an undercapitalized company, allows it to become insolvent, forms a new company (often with assets purchased at a discount from the liquidator of the old company), carries on trading much as before, and repeats the process perhaps several times, leaving each time a trail of unpaid creditors (Cork Committee, para. 1813. This is the so-called “Phoenix” syndrome). More generally, the courts have been alert to find unfairness where the directors have apparently attempted to trade on the backs of the company’s creditors (Re Keypak Homecare Ltd (1990) B.C.L.C. 440}.    

LEGAL CAPITAL

10. The value of the assets which the company receives in exchange for its shares may represent less than the total value of company’s assets. Even where the company has not yet begun to trade, it may have raised money from sources other than in exchange for its shares. For example, it may have borrowed money from a bank or a group of banks. The value of such loans does not count as its capital, however. This is because the aim of the definition of the capital of the company is to protect creditors as a class, and only assets contributed by shareholders do this effectively. This arises from the principle that in insolvency the creditors are paid before the shareholders. Thus assets contributed by shareholders go fully to satisfy the claims of the creditors before any return is made to the shareholders. What then are the rules about legal capital which company law lays down for the protection of creditors? Most obviously, the law requires the company to have a certain level of legal capital (means the capital contributed by shareholders) before it begins trading. Legal capital is also important in company accounts, because it provides a basis for measuring the success of the company from the shareholders’ point of view or for fixing the distribution of dividends.

11. LIFTING OR PIERCING THE CORPORATE VEIL: The human ingenuity, however, started using this veil of corporate personality blatantly as a cloak for fraud or improper conduct. Thus, it became necessary for the Courts to break through or lift the corporate veil or crack the shell of corporate personality and look at the persons behind the company who are the real beneficiary of the corporate fiction. And while by fiction of law a corporation is a distinct entity, yet in reality it is an association of persons who are in fact the beneficial owners of all the corporate property [vide Gallaghar vs Germania Brewing Co. (1893) 53 Minn. 214, 254, N.W. 1115].

12. PREVENTION OF FRAUD OR IMPROPER CONDUCT:

(a) The legal personality of a company may be disregarded in the interest of justice where the machinery of incorporation has been used for some fraudulent purpose like defrauding creditors. Prof. Gower observes in this regard that the veil of a corporate body will be lifted where the “corporate personality is being blatantly used as a cloak for fraud or improper conduct”.

(b)  Courts of law are permitted to lift the veil of corporate entity as contemplated in section 34, for the purpose of paying regard to the economic realities behind legal façade, such as, for tax evasion, for circumventing tax obligations or for perpetuating fraud {Juggilal Vs Income-tax Officer, AIR 1969 SC 392; (1969) 2 Comp LJ 188}. The purpose of lifting corporate veil by law in terms of section 34, is to go behind the corporate personality of the individual members or to ignore the separate personality of each company, in favour of the economic entity created by a group of associated companies, {New Horizons Ltd vs Union of India, (1995) 1 SCC 478; 1997 (89) Comp Cas 849}. Doctrine of lifting of corporate veil, as contemplated in section 34, can be made applicable in instant case, in view that the respondent Directors had been attempting to make use of personality of the company in furtherance of their dishonest and fraudulent design {Jai Narayan Parasrapuria vs Pushpa Devi Saraf, (2006) 7 SCC 756; 2006 (65) ALR 163}.

13.  When corporate veil can be pierced- Hon’ble Supreme Court in Kapila Hingorani v. State of Bihar, (2003) 116 Comp. Cas. 133 has observed that it is now well settled that the corporate veil can in certain situations be pierced or lifted. The principles behind the doctrine is a changing concept and it is expanding its horizon as it was held in State of U.P. and others v. Renusagar Power Company Ltd {1988 (4) SCC 59}. The corporate veil indisputably can be pierced when the corporate personality is found to be opposed to justice, convenience and interest of the revenue or workmen or against public interest.

14. CONCLUSION:  Dr. Avtar Singh in his book ‘Company Law’, 12th ed. 1999 at page 25, has stated -thus it is abundantly clear that incorporation does not cut off personal liability at all times and under all circumstances.  Honest enterprise, by means of companies is allowed; but the public are protected against kiting and humbuggery. The sanctity of a separate corporate identity is upheld only in so far as the entity is consonant with the underlying policies which give it life. ‘Those who enjoy the benefits of the machinery of incorporation have to assure a capital structure adequate to the size of the enterprise. They must not withdraw the corporate assets or mingle their own individual accounts with those of the corporation or represent to third parties that no difference exists between themselves and the company. The courts have at times seized upon these facts as evidence to justify the imposition of liability upon the shareholders’ (Judicial Supervision of One-man Corporation, 46 Harvard Law Review 1084).

PIERCING THE CORPORATE VEIL

15. Black’s Law Dictionary, ninth edition, 2009 at page 1264 has defined the term ‘Piercing the corporate veil’ as follows - the judicial act of imposing personal liability on otherwise immune corporate officers, directors, or shareholders for the corporation’s wrongful acts. 

“Courts sometimes apply common law principles to ‘pierce the corporate veil’ and hold shareholders personally liable for corporate debts or obligations. Unfortunately, despite the enormous volume of litigation in this area, the case law fails to articulate any sensible rationale or policy that explains when corporate existence should be disregarded. Indeed, courts are remarkably prone to rely on labels or characterizations of relationships (such as ‘alter ego’, ‘instrumentality’, or ’sham’) and the decisions offer little in the way of predictability or rational explanation of why enumerated factors should be decisive.”{Barry R. Furrow et al., Health Law # 5-4, at 182 (2nd ed. 2000}.

16. FACTUAL MATRIX OF PRESENT CASE: As per details given in Balance Sheet the paid up capital of ………. Private Limited is Rs. 2,00,000 (Rupees Two lacs only), whereas under the heading Schedule ‘J’ Current Liabilities, Sundry Creditors for Goods for Rs. Six Crore has been given. Therefore, it is evident that the directors of the company have deliberately allowed to escalate the Creditors for Goods up to Rs Six Crore, which is highly disproportionate to the company’s legal capital of Rs. two lacs only. This by itself is sufficient proof that the machinery of incorporation has been used by the directors for defrauding company’s creditors including M/s. ………, the Decree Holder. A copy of Balance Sheet is annexed hereto marked as Annexure-A.

17. AWARD DEEMED TO CONTAIN THE INGREDIENTS OF PIERCING THE CORPORATE VEIL BY IMPLICATION:

(a) In the instant case, Shri ………, the Sole Proprietor of M/s. ……………, in due course realized that while by fiction of law ………….. Private Limited is a distinct entity, yet in reality it is an association of persons comprising the Judgment Debtor Directors  who are in fact the beneficial owners of all the corporate property of this small private company. Therefore, Shri ………. had orally contracted with the company and its shareholders on the basis that both will be liable to repay each and every business debt due to M/s. ………… (this understanding hereafter referred to as “contract out”). It is pertinent to note here that, it is in fact widespread in the trade of ……….. to orally contract out from the limited liability of private companies. On the basis of this contract out, M/s. ………… has filed its claim petition before hon’ble Arbitrator against ……….. Private Limited and its four directors, who are also shareholders. The learned Arbitrator is quite familiar with the wholesale trade of ……….., hence keeping in mind this contract out has passed the award against all the Defendants. It is important to note here that in the award the narrative about piercing the corporate veil of …………. Private Limited has inadvertently gone astray, there being no occasion to discuss that concept, because all the Judgment Debtors deliberately chose not  to contest the claim preferred by M/s. ………….

(b) Hon’ble Supreme Court in A. Venkatasubbiah Naidu vs S. Chellappan and Ors {(2000) 7 SCC 695; AIR 2000 SC 3032; Date of Judgment: 19/09/2000} has observed as follows (SCC Para 15).

“……..What would be the position if a court which passed the order granting interim ex parte injunction did not record reasons thereof or did not require the applicant to perform the duties enumerated in clauses (a) & (b) of Rule 3 of Order 39. In our view such an Order can be deemed to contain such requirements at least by implication even if they are not stated in so many words.” (Emphasis supplied)

By drawing analogy from this logic, in the instant case, such a composite award, holding the company and its directors both liable to pay the business debts, can be deemed to contain the ingredients of piercing the corporate veil of ………….. Private Limited at least by implication even if they are not stated in so many words.

18.  Recently, the Decree holder on enquiry has come to know that …………… Private Limited has not filed Balance Sheets for ……with the Registrar of Companies, Delhi, thus it appears that it has committed deliberate non disclosure of documents, in violation of section 220 of the Companies Act, 1956, with a view to facilitate deliberate and forced bankruptcy of the company to avoid payment of this award.

ALL THE TESTS HAVE EVOLVED AS RULES OF INTERPRETATION ONLY AS A MATTER OF REASONABLENESS

19. A three judge bench of hon’ble Supreme Court in Society for Unaided Private Schools of Rajasthan v. Union of India {(2012) 6 SCC 1; Decided on 12.04.2012} has observed as follows (Para 30)

“As held by this Court in Glanrock Estate Private Limited v. State of Tamil Nadu [(2010) 10 SCC 96], Article 21 (right to life) remains the core of the Constitution around which Article 14, Article 19 and others revolve. In other words, all other fundamental rights in Part III would be dependent upon right to life in Article 21 as interpreted by this Court to include right to live with dignity, right to education, etc. At the end of the day, whether one adopts the pith and substance test or the nature and character of the legislation test or the effect test, one finds that all these tests have evolved as rules of interpretation only as a matter of reasonableness. They help us to correlate Article 21 with Article 14, Article 19 and, so on.” (Emphasis supplied)

FUNDAMENTAL RULES OF LAW SHOULD BE APPLIED HAVING REGARD TO EXIGENCIES OF SITUATION AND NOVELTY OF CIRCUMSTANCES IN ABSENCE OF PRECEDENTS

20.  Hon’ble Supreme Court in Jamal Uddin Ahmad v. Abu saleh Najmuddin, {(2003) 4 SCC 257; AIR 2003 SC 1917; Decided on 28.02.2003} has observed as follows (SCC Para 21)

“Herbert Broom states in the preface to his celebrated work on Legal Maxims.--"In the Legal Science, perhaps more frequently than in any other, reference must be made to first principles." The fundamentals or the first principles of law often articulated as the maxims are manifestly founded in reason, public convenience and necessity. Modern trend of introducing subtleties and distinctions, both in legal reasoning and in the application of legal principles, formerly unknown, have rendered an accurate acquaintance with the first principles more necessary rather than diminishing the values of simple fundamental rules. The fundamental rules are the basis of the law; may be either directly applied, or qualified or limited, according to the exigencies of the particular case and the novelty of the circumstances which present themselves.” (Emphasis supplied)

As described above, the sanctity of a separate corporate identity is upheld only in so far as the entity is consonant with the underlying policies which give it life. Those who enjoy the benefits of the machinery of incorporation have to assure a capital structure adequate to the size of the enterprise, and must not represent to third parties that no difference exists between themselves and the company. On the contrary, the Judgment Debtor directors have always represented to Shri ……….., the Sole Proprietor of M/s. …………. that no difference exists between themselves and the company and their dues would be paid as soon as possible. It is pertinent to note here that Shri ……….. has always extended credit to the company on the basis of creditworthiness of individual directors as represented by them from the beginning and it will be a travesty of justice if he is denied repayment of his hard earned money by this hon’ble court by invoking the doctrine of incorporation of company and holding that the company is constituted into a distinct and independent person in law and the directors are not personally liable for the debts of the company.

21. A PROPRIETARY CONCERN IS AN INDIVIDUAL TRADING UNDER A TRADE NAME: Hon’ble Supreme Court in Shankar Finance & Investments Vs State of Andhra Pradesh & Ors.{2008 (8) SCC 536: 2009 AIR (SC) 422; Date of Decision : 26-Jul-2008} has, inter alia, observed (in para 8) thus  “As contrasted from a company incorporated under the Companies Act, 1956 which is a legal entity distinct from its shareholders, a proprietary concern is not a legal entity distinct from its proprietor. A proprietary concern is nothing but an individual trading under a trade name.” It follows that M/s. ………, the Decree Holder, in law is its Sole Proprietor Shri ………… himself in his individual capacity. He is running long-sufferingly from pillar to post since last seven years after passing of Award in his favour.

22. In Olga Tellis v. Municipal Corporation of Greater Bombay [(1965) 3 SCC 545] the Constitution Bench of  Supreme Court had considered  the right  to  dwell  on pavements or  in slums by the indigent and  the  same was accepted as  a part of right to life enshrined under Article 21; their  ejectment   from the      place nearer  to their work would be  deprivation of  their right to  livelihood. They will be deprived of  their livelihood if they are evicted from their  slum  and  pavement dwellings.  Their  eviction tantamount to  deprivation  of their  life.  The  right  to livelihood is  a traditional  right to live, the easiest way of depriving  a person of his right to  life would  be  to deprive him  of his  means of  livelihood to  the  point  of abrogation. Such deprivation would not only denudes the life of its effective  content and meaningfulness but it would make  life impossible to live. The deprivation of right to life, therefore, must be consistent with  the  procedure established by law. (Emphasis supplied)

Due to these huge unpaid debts of Crores of Rupees, Shri …………. is forced to close his business. He is deprived of his  means of  livelihood since last eight years. Shri ………… is a senior citizen aged about 83 years and now completely exhausted hence, merits preferential attention by this Hon’ble Court.

23.  DENIAL OF BENEFIT UNDER A PARTICULAR LAW TO A PERSON WILL AMOUNT TO A VIOLATION OF HIS HUMAN RIGHTS: Recently, hon’ble Supreme Court in Remdeo Chauhan @ Rajnath Chauhan  Vs Bani Kant Das & Others  [JT 2010 (12) SC 516 = 2010(12) SCALE 184; Decided on 19.11.2010] has held, inter alia, as follows

“52. ……..The jurisdiction of NHRC thus stands enlarged by section 12(j) of the 1993 Act, to take necessary action for the protection of human rights. Such action would include inquiring into cases where a party has been denied the protection of any law to which he is entitled, whether by a private party, a public institution, the government or even the Courts of law. We are of the opinion that if a person is entitled to benefit under a particular law, and benefits under that law have been denied to him, it will amount to a violation of his human rights. (Emphasis supplied)

62. There is no doubt that the majority judgment of this court in the ADM Jabalpur case {(1976) 2 SCC 521} violated the fundamental rights of a large number of people in this country. Commenting on the majority judgment, Chief Justice Venkatachalliah in the Khanna Memorial Lecture delivered on 25.2.2009, observed that the same be `confined to the dustbin of history.' The  learned Chief Justice equated Justice Khanna's dissent with the celebrated dissent of Lord Atkins in Liversidge v. Sir John Anderson reported in (1942) AC 206.

63. In fact the dissent of Justice Khanna became the law of the land when, by virtue of the Forty Fourth Constitutional Amendment, Articles 20 and 21 were excluded from the purview of suspension during emergency.”

Therefore, it is a deep routed hard fact that Shri …………., the Sole Proprietor of M/s. …………, has always extended such a huge credit to this small private company on the basis of creditworthiness of  individual directors as represented by them from the very beginning. It would be in consonance with justice and fairness that this hon’ble court helps in repayment of his hard earned money by breaking through the corporate veil of this small private company and looking at the persons behind this small private company who are the real beneficiary of the corporate fiction. Having seized upon these facts as evidence to justify the imposition of liability upon the shareholders it would be apt for this hon’ble court to hold that incorporation does not cut off personal liability of the Judgment Debtor directors.  (END)

Author:

Narendra Sharma

Consultant (Business Laws)

E-mail: nkdewas@yahoo.co.in