Why Form A Corporation – Business Essay

Nowadays more and more businesses have formed into corporation. There is no doubt about the advantages of corporation, such as easier rise capital, no limited number of members, unlimited life…One of the most popular advantages of corporate is the unlimited

liability for shareholders and management and sometimes it is described as “corporate veil”. This veil keeps shareholders and managers from liabilities and sometimes responsibilities.

To further understand the meaning of corporate veil, we need to trace back to Europe where corporate entities began to develop. The earliest idea of corporate is invented by Roman. As the development of commence and law system, corporation is given legal personality, which means that corporation is treated as an artificial entity. Corporation can held assets, borrow money in the title of corporation and sue or be sued. Thompson in the Cornell Law Review:
“As a general principle, corporations are recognized as legal entities separate from their shareholders, officers and directors. Corporate obligations remain the liability of the entity and not of the shareholders, directors, or officers who own and/or act for the entity.”

This idea of separated entity was carried out for pure convenience so that companies can have the function of holding monies, entering into contracts and appearing in court. However, this idea gives a veil to shareholders and managers and protect them form liabilities. This is why corporation is sued or sue, rather then the broad managers.

In practical, there are several disputes over the “veil”. Sometime the “veil” is misused. For the sake of justices, courts may lift the veil and look at what is inside the veil; shareholders and managers are no longer protected or covered by the veil. As it is defined in some articles, “piercing of the veil is an allegorical term which purports to describe how courts can search behind the corporate entity and, if necessary, to hold individuals personally liable for wrongs, thereby preventing operators and owners from claiming immunity as separate entities from the company”. This power is given by communal law and Corporate Act.

Advantages of corporate veil:
There are several advantages of limited liability. According to Ramsay, lan and Noakes, David article , we can derive three main advantages of limited liability. Firstly, the limited liability reduces shareholders incentive to monitor on corporations’ daily business. Because shareholders only liable up to the price of shares they purchase, they will have less incentive to monitor the operation of business than someone may take his private assets to cover company’s debt. Further more, limited liability makes shareholders less risky so that increases shareholders’ willingness to invest in companies and also reduce the administration expenses for company due to less monitor by shareholders.

Secondly, limited liability keeps companies’ wealth and managements work efficient. This can be explained by free transfer shares. If we assume there is an absence of limited liability, when we transfer shares from one to another, the price of share would consist with two elements. One part would affect by the company’s wealth, and the other one would depend on other shareholders’ wealth due to the unlimited liability. In fact, the concept of limited liability increases the liquidity of shares and promotes free transfer. As a result, when managers run a company in inefficient condition, shareholders will sell out their shares. This action would contribute to the possibility of a takeover by another entity and replace the older management with a more efficient one. This is how the limited liability keeps companies’ wealth and managements work efficient.

Thirdly, limited liability indicates a solution to reduce risk for both shareholders and finance managers. As well know, for the sake of reducing risk investors usually invest in different companies’ share. This consistence of different investment is called portfolio. I would say the foundation of operating a portfolio is the concept of limited liability. If the liability is unlimited, any failure in one of the investments could sacrifice gains on others and might even require investor’s personal assets. In this point of view, on the contract of reducing risk, invest in a portfolio actually increase the risk of investors. Consequently, investors would like to reduce the number of different shares they invest and only hold shares which they are confident.

Last but not list, this could be the most arguable one. Limited liability prevents insolvent trading. When directors realize there is a situation of insolvent occurred. Because fear of personal responsible for debt, directors might make decision to continuing to trade rather then the proper action, apply for bankrupt ion. However some people argued that as well as the concept of limited liability prevent insolvent trading, it is main reason to cause company being insolvent because managers don’t take personal responsibility for their decisions. I do not agree with this point of view. Also management might not take personal responsibility for their decisions as I described before if the management act in a very poor way, shareholders would sell out their shares and a takeover would occurred and replace the current management with a more efficient one. On the other hand, mangers or directors are not always protected by the veil in any situations. Sometimes, the court might deicide to lift of the veil or sometime called piercing the veil; make directors or managers to take personal responsible for their action. I would emphasis on this issue later.

Disadvantages of corporate veil:
As I mentioned above, there are several advantage for corporate veil and it well explains why corporate veil exist and accepted by public. However, in practical, as well as the concept of limited liability improves or promotes the business, it also causes a lot of troubles.

First of all, limited liability shields shareholders and managements from company’s debt. If the company goes bankrupted, shareholders could claim for the protection of limited liability and them only loss the money up to the amount they bought shares. Creditors can not ask shareholders to cover company’s debt by shareholders private assets. When such issue occurred, on the one hand, shareholders and managers are protected, on the other hand, creditors are sacrificed.

The other disadvantage of corporate veil is that it encourages managers to take risky action. When we first look at this, it seems like to be a advantage of corporate veil. From managers or directors point of view, because limited liability shields them from company debt, they can concentrate on their work and give less attention about ongoing risks. However, this could be a disadvantage for company, if managers or director pay less attention to the ongoing plans or actions; this could make the company more risky. When a project gives higher return and reasonable greater risk, managers or directors of company with limited liability would more tend to chose high return and high risk for the sake of profit maximization.

The concept of limited liability also contributes to another problem. As we know, limited liability keeps managers and directors from company debt, in fact creditors are sacrificed. Sometimes one company’s insolvency could cause a chain effect..

Why lift the veil:
The word lifting or piercing the veil is quite a new word for public. “The narrowest definition of piercing the veil is for a court to ignore the corporate veil in order to find the shareholders liable for some wrongdoing committed on behalf of the company. An alternative, and wider, definition would be one where a court examines what is occurring within the company entity in order to make a decision as to the behavior or relationship of the controllers, rather than just assuming separateness of the company form its owners and controllers.” According to the definition of lifting or piercing of the veil, court sometimes would ignore the concept of separate entity for company. “A successful piercing of the veil by a third party means that individuals cannot claim the protection of the separate company entity or the limited liability of a shareholder. They may be held personally responsible for the actions of that company.”

As it is well known, limited liability works as foundation of company law, why both common law and corporations Act give court power to ignore it? The concept of limited was development as requires arose. However, it is far from perfect. It actually works as the designers expected, at the same time it was also misused for some illegal purpose. For the sake of providing justice, court sometimes may lift the veil.

Is the veil misused:
Dose misusing of corporate veil triggers court to carry out actions such as lifting or piercing the veil? To answer this question, we should first look at if the veil is misused. The purpose of developing corporate veil was to protect management and shareholders from companies’ debt. Corporate were treated as a separate entity, corporate should sue of sued instant of management. However, is it fair or right to protect managers or shareholders from any debts or responsibility? I would like to introduce some cases from our life to prove the veil sometime is misused.

“Artedomus Pty Ltd (Artedomus) was formed in 1998 to import from Italy marble and other stone products for retail to the prestigious end of the building industry. The evidence showed that the company expended money and time to travel to Italy and source its stone products from little known quarries in remote regions of Italy. In particular, Artedomus sourced a limestone known as Modica from the province of Ragusa, Sicily which it marketed as Isernia in Australia. Artedomus had an exclusive contractual agreement with its Italian supplier and, over time, Isernia became the company’s largest selling product.

The deliberate change of the stone’s name was designed to serve a strategic purpose, namely, to avoid revealing its place of origin and to keep competitors at bay. The evidence showed that considerable efforts were made by Artedomus to conceal the source of Isernia and that secrecy in that regard was of real value to the company. Precautions taken to ensure this outcome included instructing the employees not to disclose the source of products nor the name of the supplier to clients or persons in the stone industry.”

Before we look at the court’s decisions, according to the concept of corporate veil, company is treated as a separated entity. The company should be sued instant of management. However, due to the nature figure as an artificial entity, the actual decisions are carried out by directors or managers. In this case, if we fulfill the concept of corporate veil, directors and managers and other relevant staffs would be shielded from their responsibility, and this is not the purpose of carrying out the concept. We would say in this case, the veil is misused.

The above case is only one situation of misusing corporate veil. In our normal life, there are lots of cases that the corporate is misused. For the sake of justice, courts will lift the veil and look at what happed inside the veil.

Does this achieve “justice”:
The purpose of lifting the corporate veil is to provide “justice”. First we should understand what justice is. “As Lord Denning, one of England’s greatest judges, suggested:
‘It is not a product of intellect but of spirit. The nearest we can go to defining justice is to say that it is what right-minded members of the community-those who have the right spirit within them-believe to be fair.’” According to this definition, we can derive that the concept of corporate veil provides justice. Some people may argue that the concept of separate entity sacrifice creditors. This is unfair. I would say this is true, but the concept achieves a majority people’s justice. “Yale Law Journal, Douglas and Shanks said:” limited liability is now accepted in theory and in practice. It is ingrained in our economic and legal systems. The social and economic order is arranged accordingly. Our philosophy accepts it. It is legitimate for a man or group of men to stake only a part of their fortune on an enterprise”.

One question would come to our mind. If the concept of corporate veil provides justice, will the action of breaking or ignoring the concept provide justice? I have no argument about the idea that it is reasonable for a man or group of people such as shareholders only loss limited fortune when the company goes insolvency. Back to the case I introduced above, Artedomus Pty Ltd was considered as conducting a fraud. I would say neither makes all shareholders responsible nor shield all managements from wrongdoing provide justice in this case. “The court actually decided that Mr Savini and Mr Del Casale, employees and directors of Artedomus, breathed their equitable duties of confidentiality to Artedomus.” Court lifted the veil and made some individuals responsible for their wrongdoing instant of claim all shareholders are responsible or shield everyone from their wrongdoing. We can conclude that the action of lifting or piercing the veil do provide justices.

When should the veil be lift:
As I introduced before, the concept limited liability for companies has played the role of fundamental for setting up our economic orders. For that reason, courts are reluctant to ignore the concept of separate entity and make shareholders responsible for company’s debt. Although both Corporate Act and Common law give courts power to lift the veil, they set up little rules to indicate in what circumstance courts would ignore the veil. As an article says: “Australia’s view of veil piercing could be summarized as: (1) an acceptance of the Salomon principle; (2) a reluctance to pierce; (3) actual piercing as the need arises; (4) no predictable set of principles by which the courts will or will not pierce.” However, if we analyses cases that make court take action to lift the veil, they dose give us some idea about in what circumstances courts would like to lift the veil.

When then company is operated by a shadow director. “A shadow director is a person in accordance with whose directions or instructions the directors of the company are accustomed to act.” Further more, shadow director could be a nature person also could be a parent company.

When the company carry out a fraud or try to avoid legal obligations, court would tend to lift the veil and make individual responsible for their action. Like the case we introduce previously, Artedomus Pty Ltd is considered as fraud and court decided to lift the veil.

In circumstances that courts recognize the veil is abused, such as parent company use subsidiaries or individual use the veil as sham. Courts would like to lift the veil and make individuals responsible to creditors and claim their personal assets to cover the debt.

Anything should be down to improve it:
Although there are some disadvantages of corporate veil, the action of lifting the veil dose play a role to overcome it and exam weather the veil is misused. However, as the action of lifting the veil still under develops, there are some improvements I would like to state in my essay.

Firstly, courts should clearly indicate in what circumstance court would lift the veil. In fact, companies have no idea when the court will take an action. It is better to make it clear to companies what is forbidden and what should subject to.

Another improvement is to encourage the development of Deed. A deed is set up by a group of voluntary companies for the sake of protect creditors right. Members of Deed will be responsible for others’ debt when one of the members becomes unable to cover his debt. This approach protects creditors’ right and avoids the chain effect. However, due to some reasons, the number of joined companies is always low roughly about 10% of total number of companies in Australia. Further research should be taken about how to improve current situation.