Beyond the Corporate Veil

PRE-CONTRACT:
At the time of the negotiation of a contract a party can insulate itself against the consequences of default by its contractual counterparty by obtaining a guarantee of performance from a third party of strong financial standing such as a parent company or a bank. Such guarantees are common place in certain transactions (such as ship building) but less common in others (such as chartering). Letters of comfort or memoranda of understanding differ from guarantees in that they are generally nonbinding and create no enforceable obligation.

POST-CONTRACT:
The principle of separate corporate personality remains intact and it is generally difficult for a claimant to seek to enforce a contractual claim against assets other than those owned directly by its contractual counterparty. There are however exceptions to this rule which need to be considered at the onset of any litigation where there is a concern as to the ability of the contractual counterparty to satisfy any judgment or award given against it. These exceptions can be divided into three categories:

• claims in respect of which the corporate form of the contractual counterparty can be ignored/by-passed (the fraud exception)
• claims which may be brought against assets owned by a party other than the contractual counterparty (sister-ship/associated-ship claims)
• claims in respect of which a parent company can be held liable for the debts of its subsidiary (claims for the tort of inducing a breach of contract and claims under section 213/4 of the Insolvency Act 1986)

Claims where the corporate form can be ignored/by-passed: the fraud exception
The courts have demonstrated that they are prepared to pierce the corporate veil in circumstances where the corporate structure is a mere façade conceiling the true facts. The scope of the exception is best illustrated by reference to the case of Jones v Lipman [1962] 1 WLR 832 in which Mr Lipman agreed to sell land to Mr Jones, but then reneged on the bargain. In an attempt to defeat Mr Jones’ right to specific performance, Mr Lipman formed a company and transferred the land to it. The court in disregard of the principle that a company is separate from its shareholders made an order for specific performance against both Mr Lipman and the company. It should be stressed that this exception is very difficult to prove and that the courts are generally extremely reluctant to accept arguments by a claimant to the effect that it may bring its claim against a party other than the company with which it contracted because the company form was used by that party as a façade to conceal the true facts.

Claims against assets owned by a party other than the contractual counterparty: sistership/ associated-ship claims
Sister-ship/associated ship arrest claims are an example of legislative intervention with a view to limiting the principle of corporate separation in order to justify piercing of the corporate veil.

The classic sister-ship arrest concept is enshrined in the 1952 Arrest Convention and applied in many jurisdictions worldwide, including England. The basic position is that a claimant will be able to arrest a ship other than that in respect of which the claim arose (the "offending ship") if (a) the party who would be legally liable for the claim was, when the cause of action arose, the owner or charterer of the offending ship; and (b) at the time when the arrest is made, the same person was the beneficial owner of all the shares in the other ship. In order to escape the net of sister-ship arrest many shipowners have structured the corporate ownership of their fleets so that each ship is owned by a separate entity. Without the commonality of ownership there can be no sister-ship arrest. Commonality of management will not suffice.

South Africa has enacted associated-ship arrest legislation which is designed to do away with the usefulness of single asset companies as a device to avoid liability for sister-ship arrest. The concept of an associated-ship arrest is wider than the concept of sister-ship arrest. It goes beyond the common ownership of ships and extends to situations where there is common control of the ship owning companies (i.e. where the other ship is in the same beneficial ownership as the offending ship). The test for beneficial ownership is the ability to control the ships. In this context common control refers to the type of control that a majority shareholder would exercise over the affairs of a company as opposed to the type of control a manager or charterer would exercise over a ship. (There are certain other jurisdictions, notably civil law jurisdictions such as France, with wide ship arrest laws which fall between the UK and the South African approaches).

Claims against parent companies:
Inducing a breach of contract
Where a party unlawfully and intentionally induces another party to break its contract with a third party, it will be liable, in tort, to the third party for its damages arising out of the breach.

This principle was used with success in Stocznia Gdanska v Latvian Shipping Company and Latreefers [2002] 2 Lloyd’s Rep. 436 where the claimants sought to establish liability against a parent company in circumstances where the contractual counterparty was an assetless single purpose company subsidiary of the parent. Latvian Shipping Co. (Latco) had formed a single purpose company (Latreefers) for the purposes of purchasing a number of reefer ships. When rates for the market collapsed Latco decided that it did not want to take delivery of the ships (except on substantially improved terms, which the yard, Stocznia Gdanska, were not prepared to meet). Latco therefore did not place Latreefers in funds to enable it to pay instalments due under the construction contracts. Unusually, Latco had not provided a parent company guarantee to cover Latreefer’s obligations. As Latreefers had little or no assets, any victory against Latreefers would have been a hollow victory with no financial benefit for the yard. For this reason, the yard sought to pin liability on the parent company, Latco, claiming that:

• Latco was liable for directly inducing Latreefers’ breach of contract; alternatively
• Latco had by unlawful means indirectly induced Latreefers to breach the contract.

The court held that the yard’s first argument failed as there had been no instruction by Latco to Latreefers to break the contract.

The court did however hold in favour of the yard on their second argument finding that the breach of Latreefers’ obligation to pay the instalments was indirectly induced by Latco in that Latco had failed to provide the necessary loan finance to Latreefers to enable them to pay the instalments. The court found the requisite unlawfulness was established as Latco had failed to provide the finance in breach of its contract with Latreefers’ directors which provided that "… the Managed Entity [Latreefers] will be kept in sufficient funds by [Latco] to honour its liability as and when they become due…".

Section 213 and 214 of the Insolvency Act 1986
If the contractual counterparty is an English company and it became insolvent and is subject to winding up proceedings then insolvency law provides that in certain circumstances a contribution may be sought from third parties. Section 213 and 214 of the Insolvency Act 1986 provide that:

• If the business of the company has been carried on with the intent to defraud creditors of the company the company liquidator may apply to the court for an order that any persons knowingly party to this (such as a parent company) are liable to make a contribution to the company’s assets.
• Directors (or "shadow" directors which may include a creditor bank or parent company) may be held liable where they allowed a company to incur liabilities to third parties and knew or should have known that there was no reasonable prospect of the company avoiding insolvent liquidation.

CONCLUSION
From the above it will be clear that under English law there are exceptions to the general rule of separate corporate personality which in certain limited circumstances may permit a claim to be brought instead against a parent company or another third party. However, these exceptions are limited and generally hard to prove.

It is therefore advisable that before concluding any significant contract, a party should satisfy itself of the financial standing of its proposed contractual counterparty and, if possible, should insist on the provision of an appropriate third party guarantee. It should be possible to get such a guarantee in the majority of cases at the stage of entering into a contract, before disputes arise and relations sour. And if it isn’t possible, then at least the parties enter into the agreement with their eyes open and aware of the potential risks.