Separate Legal Entity Principle: Friction Between Company And Insolvency Laws

By Shivangi Pandia and Prateek Charan

Background

The word company has no technical meaning attached to it. It simply means a group of individuals who have come together for a common goal. The individuals may associate themselves either for an economic or for a non-economic cause. Chief Justice Marshall defines company to mean that a corporation is an artificial being, which is invisible, intangible, existing only in contemplation of law.[1] The words ‘intangible and invisible’ hold significance as they imply that a company is not a natural person, it has no existence of its own, the management is conferred with the power under the law to work, make a company, responsible for decision making and functioning of the company.

Principle of Separate Legal Entity

Unlike a partnership, a company has a separate legal entity apart from its members. It creates its own space in the eyes of law for determination of its own rights (contractual rights), and is also subjected to duties. A company has the right to sue for any loss it suffers.[2]

The principle of separate legal entity has been traditionally misused by the management of companies to extract money, acquire property and discharge their liability by doing illegal acts.  Such managements are aware that, as per the separate legal entity principle, any liability that arises from an act committed under the name of the company would be shifted to the company and that they shall not be liable for any illegal act committed. To fill this loophole, the concept of ‘Piercing of Corporate Veil’ has been introduced. In the case of Solomon v. Solomon Co. ltd.[3], the Hon’ble Court held that firstly – the company has a separate legal entity than its members; secondly – the principle of piercing of corporate veil may be utilized for looking at who the actual decision makers of the company are. 

Conflict With Insolvency Laws  

Insolvency can be described as a state where an individual, company or other organization cannot meet its financial obligations to pay debts as they become due. The provisions of the Insolvency and Bankruptcy Code [“the Code”] deal with sickness, application for revival, determination of liability of assets and if a revival is not possible, then liquidation process of the company through National Company Law Tribunal [“NCLT”].

Insolvency law is positioned at the interface of economics and law and is an important part of a well governed polity and efficient economy.  A well devised regime of laws governing the transactions would bring back the public trust and enhance the willingness of people to lend money to businessmen, minimize the costs incurred by the vulnerable creditors like the employees and promote cash flow in the economy and help businesses bloom. The creditors providing financial aid to the company or investing money into the company must not be left at the dead end to claim their money in case the company becomes insolvent.

Why Does Friction Arise?

The Code consists of provisions for dealing with the procedure when a company becomes insolvent. The directors of the company earlier used to adopt tactics like doing business with an intent to defraud the customers. Such acts include willful participation in conducting the business in wrongful manner, participate with the knowledge of fraudulent intent or purpose, not conducting the necessary due diligence to take action at the onset of financial distress. The directors after committing such acts, save themselves under the cloak of limited liability to get away with their actions. They would call for winding up and leave the creditors without any remedy. The Code provides that the winding up must be done only when the company is suffering losses not because of the fraudulent conduct of its debtors.

The Code further provides that when it is found that the directors carried the business with an intent to defraud the creditors and the persons who were knowingly party to such transactions, shall be held personally responsible without a limitation on liability for all or any debts. 

Treatment of Corporate Groups 

Implementation problems may arise while dealing with the insolvency of a company which forms part of a conglomerate of companies, as a holding, subsidiary or closely held limited liability company. This is a common practice for the commercial ventures to operate through groups of companies to, firstly- transfer extra profit earned to these subsidiaries and not enter into the books of accounts, hence the dividend to be paid to the shareholders of the existing company reduces and the profit is retained by the company; secondly- for each of these companies to have a separate legal entity, thus under the guise of the principle the management of the company may extract money, acquire property and discharge their liability by shifting the liability onto the company. Assets could be transferred from one enterprise to another without any proper book keeping. These intragroup transactions become unascertainable and so forth. The result of this is, it becomes difficult to determine which entity owes to which creditor and how much.

Abuse of Separate Legal Entity Principle  

Generally, legal systems tend to adhere to the concept of the corporate form pertaining to separate personality and limited liability to be the default rules while treating companies. The practical reality is that the enterprise groups may comprise of separate entities, but there may exist a close relationship among them and the group may act as one. 

Now when the companies grow around the group structure, the Solomon principle may be violated. Every company would be having its own constitution, its own board of directors, registered office, its own company secretary and financial statements, all of which must be audited.  However the practical reality is that the enterprise groups may comprise of separate entities, but there may exist close relationship among them and the group may act as one, there may be the case when the treasury of all the companies would be at hands of one company and the money of rest is being swept into the bank accounts of that one company. In such instances, how would a creditor get back his money or how would he make the company own up to the liability?

Fraudulent Conduct

Wrongful trading happens when – firstly – there has been a net deficiency of assets, and  liquidator must check the books of accounts and other documents to establish the fact; secondly- there must have been reasonable prospects that the company would avoid going into solvency or liquidation; thirdly- the person who is found guilty was in a fiduciary relationship i.e., if he is  a director. 

Section 66 of the Insolvency and Bankruptcy Code with fraudulent and wrongful trading. Wherein the director of the company having knowledge of the fraudulent and wrongful conduct still aids the same and does not take any necessary steps to control or regulate it, with the intention to defraud customers, he can be held liable.

Look Back Period 

The liquidator of the company has the power to ‘claw back’ and hold directors responsible for their action even before liquidation. Keeping in mind the maxims, “once a fraud, always a fraud” and “fraud vitiates every transaction into which it enters”, the primary reason of not having a look back period is that if any person has acted intentionally or dishonestly against the interest of creditors, he should not be allowed to get away by using the defense of lapse of time. 

Section 66 (2) of IBC deals with duties and liabilities of directors. Director being in a fiduciary relationship ‘due diligence’ is expected out of his code of conduct and if it is found that he did not exercise his due diligence in reducing the loss or the fraudulent transactions he shall be made liable.

Conclusion

Separate legal entity principles must be used only for the continuity and succession of the company, the meaning implies that the company having an entity apart from its members and directors. The directors must not use it for saving themselves from tax, paying of dividend or escaping liability from their fraudulent acts and subsequently calling for winding up. The Code provides that during winding up of the company, general rule is that the assets of the company shall be used for payment of creditors as per their liability, but if it is found that the inability to pay debt or loss occurred are due to the fraudulent acts of director, he is personally made liable to compensate. The friction is needed to stop the fraudulent conduct and to compensate creditors.

The provisions for fraudulent trading and wrongful trading are some of the most important provisions that have been added into the insolvency laws. With the increasing number of white-collar crimes, we need more stringent laws and provisions to regulate them.

The authors are pursuing their third year of law degree from the National Law University, Nagpur.

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[1]  Hobby Lobby, 134 S. Ct. at 2794.

[2] Floating Services Ltd v. M.V. San Francesco Dipalola, 762 SCL Guj. 52 (2004).

[3] Solomon v. Solomon Co. Ltd, 33 All. ER (1895-99).