December 17 2007
This update addresses certain questions pertaining to the rights and liabilities to which a company and the persons associated with it are subject. The concept of corporate personality has long been a significant issue in the study of corporate law and commercial systems in general, and raises a number of concerns regarding how a company is to be treated in the eyes of the law.
This update deals with:
In order fully to understand and appreciate these issuess, the nature of a company must be understood. Although the legal definition is somewhat vague and ambiguous,(1) common parlance provides some idea of what a company is: a company is an artificial body - an association of persons too numerous to be a firm - which is united for profit.(2)
Legally, a sole proprietor cannot segregate his or her private means from those of his or her business. Consequently, in the event of a business-related crisis, financial or otherwise, debts relating to the sole proprietor’s business must be met from his or her private finances. Thus, some unfortunate miscalculation on part of his or her business may leave the sole proprietor and his or her family facing bankruptcy and it may not be worthwhile to continue in other commercial ventures.
In the case of a partnership, the position is even more precarious: a partner is not only responsible for his or her acts in the course of business, but also liable for the acts of his or her partner.(3) The partnership relationship is based on mutual confidence.(4) If a partner misuses this confidence, he or she may place the other partners in insurmountable difficulties, since a partner’s liability is unlimited.
Thus, the advantages of a company in this case are huge, particularly in relation to investment, technical expertise, limited liability and resources. However, one of the most coveted benefits to be gained from the formation of a company relates to the concept of the company as a legal person separate from its members.
When a company is registered it is clothed in a legal personality (5) and has almost the same rights and powers as a human being. Its existence is distinct and separate from that of its members. Members may change or die but the company continues to exist until it is wound up on grounds specified by the Companies Act - in other words, it has perpetual succession.(6) A company can:
Members can even contract with the company, acquire rights against it or incur liability in respect of it.(10) However, in respect of debts, creditors can take legal action only against the company, not against its members.(11) In addition, according to Section 34(2) of the act, on registration of the company the association of persons becomes a body corporate by the name contained in the memorandum.(12)
Bacha F Gudzar v The Commissioner of Income Tax, Bombay
In Bacha F Gudzar v The Commissioner of Income Tax, Bombay,(15) the plaintiff, Mrs Guzdar, received certain amounts as dividends in respect of shares held by her in a tea company. Under the Income Tax Act, agricultural income is exempt from payment of income tax. As the income of a tea company is partly agricultural, only 40% of the company’s income is treated as income from manufacture and sale and is therefore liable to tax. The plaintiff argued that the dividend income in her hands should be treated as agricultural income up to 60%, on the grounds that dividends received by the shareholders represented the income of the company.
It was held by the apex court that although the income in the hands of the company was partly agricultural, the same income when received by Guzdar as dividends could not be regarded as agricultural income. This judgment followed the principle that in the eyes of the law shareholders are not part holders of the undertaking - a shareholder is not the part owner of the company, but rather has certain rights in law to vote, attend meetings or receive dividends.
Thus, the law in both the United Kingdom and India is well settled that a company has a separate legal personality from its members. However, under special circumstances this disparity may be removed.
The advantages of incorporation are extended only to those wishing to make honest use of a company. In the case of dishonest and fraudulent use of the facility of incorporation, the law lifts the corporate veil and identifies the persons (ie, members) who are behind the scenes and responsible for the perpetration of fraud.(16) The term ‘lifting the corporate veil’ has been defined as “looking behind the company as a legal person, that is, disregarding the corporate entity and paying regard instead, to the realities behind the legal façade”.(17) As to when the corporate veil may be lifted, the Supreme Court in State of Uttar Pradesh v Renusagar Power Co observed that:
“The concept of lifting the corporate veil is a changing concept. The veil of corporate personality, even though not lifted sometimes, is becoming more and more transparent in modern jurisprudence... [I]n the expanding horizon of modern jurisprudence, lifting... the corporate veil is permissible; its frontiers are unlimited. But it must depend primarily upon the realities of the situation.”(18)
Similarly, in Life Insurance Corporation of India v Escorts Ltd the apex court identified the circumstances under which the corporate veil may be lifted.(19) The court observed that:
“While it was firmly established by Salomon v Salomon & Co Ltd that a company has an independent and legal personality distinct from the individuals who are its members, it has since been held that the corporate veil may be ignored and the individual members recognized for who they are in certain exceptional circumstances. Generally and broadly speaking, the corporate veil may be lifted where a statute itself contemplates lifting the veil, fraud or improper conduct is intended to be prevented, a taxing or beneficent statute is sought to be evaded or where associated companies are inextricably connected as to be, in reality, part of one concern. It is neither desirable nor necessary to enumerate the classes of case where lifting of the veil is permissible, since that must necessarily depend upon the relevant statutory or other provisions, the object sought to be achieved, the impugned conduct, the involvement of the element of public interest and the effect on parties who may be interested.”
There are some circumstances in which a company is not deemed as having a separate legal personality from its members.
For the protection of revenue
The court may not recognize the separate existence of the company where the sole purpose for which it appears to have been formed is tax evasion or circumvention of tax.(21) In the case of In re Dinshaw Maneckjee Petit Mr Maneckjee was a wealthy person with dividend and interest income(22) who wanted to avoid surtax. For this purpose, he formed four private companies, in all of which he was the majority shareholder. The companies made investments and whenever interest and dividends were received by the companies, he would apply for loans which were immediately granted and never repaid. It was held that the corporate veils of all these companies were to be lifted and the incomes of the companies to be treated as belonging to Maneckjee.
Where the company is acting as an agent of the shareholders
In a case where the company is acting as an agent of the shareholders, the shareholders will be liable for the company’s acts.(23) This position is based on Sections 222(24)and 223(25)of the Contract Act 1872.(26)There may be an express agreement to this effect or such an agreement may be implied from the facts of the particular case.
Where the company has been formed in order to avoid valid contractual obligations
In some cases the company has been formed in order to avoid valid contractual obligations. For example, in Gilford Motor Co v Horne the defendant sold his business to the plaintiff and agreed not to compete with him for a given number of years within reasonable local limits. The defendant, wishing to re-enter business, formed a private company with majority shareholdings in violation of the contractual obligation. The plaintiff initiated legal proceedings against him and the private company. The court granted an injunction restraining the defendant and his company from continuing on with the business.(27)
Where the company has been formed for a fraudulent purpose or is a sham
In Delhi Development Authority v Skipper Construction Company Pvt Ltd the company failed to pay the full purchase price of a plot to the Delhi Development Authority.(28) In addition, construction was started and space sold to various persons. The two sons of the director who had businesses in their own names claimed that they had separated from their father's business and the companies which they were running had nothing to do with his properties. However, they could not produce satisfactory proof in support of their claim. It was held that the transfer of the shareholding between the father and sons must be treated as a sham. The fact that the director and members of his family had created several corporate bodies did not prevent the court from treating all of them as one entity belonging to and controlled by the director and his family.
Where the holding company holds all the shares in a subsidiary company
In State of Uttar Pradesh v Renusagar Power Co it was held that in cases where the holding company holds all the shares in a subsidiary company, the corporate veil may be ignored.(29) However, it must be established that the holding company was created only for that purpose.
Where the number of members falls below the statutory minimum
If the number of members of a company falls below the minimum(30) laid down in Section 45 of the Companies Act and the company carries on its business for a period of more than six months while the number is reduced, individual members may be open to legal action by the creditors of the company.(31)The privileges of both limited liability and separate entity are lost and the creditors are permitted to look beyond the company to the shareholders for the satisfaction of their claims.
Where the prospectus of the company includes a fraudulent misrepresentation
In the case of a prospectus containing fraudulent misrepresentation of a material fact, Section 62(32)and 63(33) of the Companies Act make the promoters(34) and directors personally liable not only in terms of damages but also in terms of prosecution by a fine of up to Rs5,000 or two years' imprisonment or both.
Where a negotiable instrument is signed on behalf of the company without mentioning the name of the company
In such a case where a negotiable instrument is signed on behalf of the company without mentioning the name of the company, under Section 147(4)(c) the officer who signed the instrument is liable to the holder of the instrument, unless the company had already made the payment to that effect on the instrument.(35)
Holding and subsidiary companies
In the eyes of the law the holding company and its subsidiaries are separate legal entities. However, a subsidiary company may lose its separate identity to a certain extent if:
Investigation into related companies
Section 239 of the Companies Act provides that for the satisfactory completion of the investigation into the affairs of a company it is necessary for the inspector appointed to the investigation to look into the affairs of another related company in the same management or group.(38)
Investigation of ownership of company
The separate legal entity may be disregarded under Section 247 of the Companies Act.(39)This section authorizes the central government to appoint one or more inspectors to investigate and report on the membership of a company for the purpose of determining the persons with a financial interest in the company and control or material influence over its policy.
Winding-up of a company
Where in the course of the winding-up of a company it appears that any aspect of its business has been carried on with intent to defraud creditors or any other persons, or for any other fraudulent purpose, the court, on the application by the liquidator or any creditor or contributory, may declare that any persons who were knowingly party to the fraudulent action shall be personally responsible and liable without limit for any debts or liabilities of the company as the court may direct.(40)
In Santanu Ray v Union of India the Delhi High Court held that where a company had failed to pay proper excise duty, the individual directors could be served notices to show cause so that the adjudicating authorities could determine which of the directors was involved in evasion of the excise duty by fraud, concealment or wilful misstatement, suppression of facts or contravention by the provisions of the act or rules made thereunder.(41)
Where the company is used as a medium to avoid welfare legislation
The leading case on the exception of where the company is used as a medium to avoid welfare legislation is Workmen of Associated Rubber Industry Limited v Associated Rubber Industry Limited.(42)The annual bonus paid to the company's workmen depended on the amount of gross profit in that particular year. The company transferred part of its shareholding to a newly formed, wholly owned subsidiary company, thus reducing its own profits on paper. It was held that since the new company was incorporated only for the purpose of reducing the annual gross profits for the holding company, the workers would not benefit and hence, the corporate veil could be ignored.
Where a device of incorporation is used for an illegal or improper purpose
In PNB Finance Ltd v Shital Prasad Jain the respondent was a financial adviser to the public limited appellant company and was given a loan of Rs1.5 million by the company to purchase properties in Delhi.(43) The respondent diverted the amount to three companies floated by him and his son. The companies used the money to purchase the properties. The Delhi High Court restrained the respondent from alienating, transferring, disposing of or encumbering the properties in question.
Determination of technical competence of a company
In New Horizons Ltd v Union of India the Supreme Court held that the experience of the promoters could be considered the experience of the company in determining technical competence.(44)
Thus, the doctrine of lifting of the corporate veil can be applied in five kinds of situation, namely:(45)
Thus, despite the concept of a corporate body having a separate personality; there are also a number of exceptions to the rule whereby individual members of the company may be held liable for its actions.
In certain cases a company can be used as a façade or alias in order to carry on illegal activity. The question now arises as to whether a company is a legal person, whether the company is a citizen and, if so, whether it may be protected under Part III of the Constitution.
In order fully to understand and appreciate this much-debated issue,(46) the terms ‘person’ and ‘citizen’ must first be understood. The word ‘person’, while not defined in the Companies Act, is mentioned in the General Clauses Act 1897(47) and the Penal Code as including corporate bodies: it is a legal entity that is recognized by law as the subject of rights and duties.(48) Thus, it is well established that a company is held to be a ‘person’ in every sense of the term.
The answer to the question of whether a legal person such as a company is a citizen depends upon the meaning of the word ‘citizen’ in Part III of the Constitution, where it is not defined. Although the Constitution determines which persons are Indian citizens(49), Article 11 empowers Parliament to regulate by legislation questions relating to the acquisition and termination of citizenship and all related matters. In pursuance of that power, Parliament has enacted the Citizenship Act.(50)
While the Citizenship Act denies the status of natural personality to artificial persons such as companies,(51) the leading case on this issue is State Trading Corporation v Commercial Tax Officer.(52) The majority judgment, delivered by Chief Justice Sinha, held that the word ‘citizen’ is intended to refer only to natural persons and that a legal body such as a corporation cannot claim the status of a citizen for the purpose of invoking fundamental rights under Part II of the Constitution. This was also the opinion of the apex court in Tata E & L Co Ltd v State of Bihar, in which Chief Justice Gajendragadkar held that were Part III of the Constitution to apply to companies, lifting the corporate veil would be of no use, since the members of the company would be able to do indirectly what they could not have done directly. (53)
In addition, it was held in Heavy Engineering Mazdoor Union v State of Bihar that a company was not a citizen under the Constitution of India.(54) However, a company may claim the protection of the fundamental rights that are available to all persons, whether citizens or not. The fundamental rights of shareholders as citizens are not lost when they associate to form a company. When their fundamental rights are impaired by state action, their rights as shareholders are protected because such rights are equally and necessarily affected if the rights of the company are affected.(55)
Hence, the debate seems well settled: an artificial person cannot claim the protection of fundamental rights under Part III of the Constitution. However, a company is a ‘person’ in the general sense of the term and should be treated as such.
It has been established that while members of a company are not directly liable for its acts, there are circumstances under which the barrier that stands between the members and third parties may be broken down. It has also been established that although a company is a person (if not a natural person), it is not a citizen under the Constitution or Citizenship Act and thus cannot claim protection of its fundamental rights. With sweeping changes in the law relating to companies with regard to the 2003 amendment to the Companies Act, it is expected that this area of Indian jurisprudence will continue to expand and change.
For further information on this topic please contact Arjya B Majumdar at FoxMandal Little by telephone (+91 120 430 55 55) or by fax (+91 120 254 22 22) or by email (firstname.lastname@example.org).
"From the date of incorporation mentioned in the certificate of incorporation, such of the subscribers of the memorandum and other persons, as may from time to time be members of the company, shall be a body corporate by the name contained in the memorandum capable forthwith of exercising all the functions of an incorporated company, and having perpetual succession and a common seal, but with such liability on the part of the members to contribute to the assets of the company in the event of its being wound up as is mentioned in this act."
(16) The term ‘corporate veil’ has been defined as the assumption of law that the actions of the corporation are not the actions of the owners of the corporation, so that they are exempt from liability for the actions of the corporation. Aiyar, id, p207.
(24) Section 222 of the Contract Act reads as follows: "The employer of an agent is bound to indemnify him against the consequences of all lawful act done by such agent in exercise of the authority conferred upon him”.
“Where one person employs another to do an act and the agent does the act in good faith, the employer is liable to indemnify the agent against the consequences of that act, though it may cause an injury to the rights of third persons."
(26) They also derive more generally from the principles of respondeat superior (let the principal answer) and qui facit per alium facit per se (he who acts through another acts himself), Aiyar, id, p751.
“If at any time the number of members of a company is reduced, in the case of public company, below seven or in the case of a private company, below two and the company carries on business for more than six months while the number is so reduced, every person who is a member of the company during the time that it so carries on business after those six months and is cognizant of the fact that it is carrying on business with fewer than seven members or two members, as the case may be, shall be severally liable for the payment of the whole debts of the company contracted during that time, and may be severally sued therefore.”
“Subject to the provisions of this section, where a prospectus invites persons to subscribe for shares in or debentures of a company, the following persons shall be liable to pay compensation ... for any loss or damage he may have sustained by reason of any untrue statement included therein, that is to say: every person who is a director of the company at the time of the issue of the prospectus;... has authorized himself to be named and is named in the prospectus either as a director, or as having agreed to become a director, either immediately or after an interval of time;... is a promoter of the company; and... has authorized the issue of the prospectus."
“Where a prospectus issued after the commencement of this act includes any untrue statement, every person who authorized the issue of the prospectus shall be punishable with imprisonment for a term which may extend to two years, or with a fine which may extend to Rs5,000, or with both, unless he proves either that the statement was immaterial or that he had reasonable grounds to believe, and did up to the time of the issue of the prospectus believe, that the statement was true."
(34) Under Section 62(6a) of the act the term ‘promoter’ means a promoter who was a party to the preparation of the prospectus or of the portion thereof containing the untrue statement, but does not include any person by reason of acting in a professional capacity for persons engaged in procuring the formation of the company.
“If an officer of a company or any person on its behalf signs or authorizes to be signed on behalf of the company, any bill of exchange, hundi, promissory note, endorsement, cheque or order for money or goods wherein its name is not mentioned in the manner aforesaid... such officer or person shall be punishable with a fine which may extend to Rs500, and shall further be personally liable to the holder of the bill of exchange [etc]... for the amount thereof, unless it is duly paid by the company.”
“Where it appears to the central government desirable for a holding company or a holding company’s subsidiary to extend its financial year so that the subsidiary’s financial year may end with that of the holding company, and for that purpose to postpone the submission of the relevant accounts to a general meeting, the central government may, on the application or with the consent of the board of directors of the company whose financial year is to be extended, direct that in the case of that company, the submission of accounts to a general meeting, the holding of an annual general meeting or the making of an annual return, shall not be required to be submitted, held or made, earlier than the dates specified in the direction, notwithstanding anything to the contrary in this act or in any other act for the time being in force.”
“If an inspector appointed under Section 235 or 237 to investigate the affairs of a company thinks it necessary for the purposes of his investigation to investigate also the affairs of any other body corporate, which is, or has at any relevant time been the company’s subsidiary or holding company, or a subsidiary of its holding company, or a holding company of its subsidiary, any other body corporate, which is, or has at any relevant time been, managed by any person as managing director or as manager, who is, or was at the relevant time, either the managing director or the manager of the company, or any other body corporate which is, or has at any relevant time been, managed by the company or whose board of directors comprises of nominees of the company or is accustomed to act in accordance with the directions or instructions of the company, or any of the directors of the company, or any company, any of whose directorships is held by the employees or nominees of those having the control and management of the first mentioned company, or any person who is or has at any relevant time been the company’s managing director or manager.”
“Where it appears to the central government that there is good reason to do so, it may appoint one or more inspectors to investigate and report on the membership of any company and other matters relating to the company, for the purpose of determining the true persons who are or have been financially interested in the success or failure, whether real or apparent, of the company; or who are or have been able to control or materially influence the policy of the company.”
(46) On the one hand, the High Courts of Madras, Punjab, Allahbad and Calcutta have categorically held that a company cannot be deemed a citizen in Narasaraopeta Electric Corporation v State of Madras (AIR 1951 Mad 979); Jupiter General Ins Co v Rajagopalan (AIR 1952 Punj 9); AB Patrika Ltd v Board of H S & IE (AIR 1955 All 595) and Cherry Hosiery Mill v S K Ghose (AIR 1959 Cal 397). On the other hand, the High Courts of Rajasthan, Bombay, Assam and Kerala in M K Mills v State of Rajasthan (AIR 1953 Raj 88); State of Bombay v Chamarbaugwalia (AIR 1956 Bom 1); Assam Company v State of Assam (AIR 1953 Ass 177) and Reserve Bank of India v Palai Central Bank (AIR 1961 Ker 268) have held that a company is a citizen.
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Arjya B Majumdar