Lifting the Corporate Veil

Section 3A: membership below the minimum

If at any time the number of members of a company is reduced, in the case of a public company, below seven, in the case of a private company, below two, and the company carries on business for more than six months while the number of members 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 cognisant of the fact that it is carrying on business with less 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 therefor.

Broken down, four conditions must all be satisfied:

1. Membership falls below seven (public) or below two (private).
2. The company carries on business in that state.
3. It does so for more than six months.
4. The member sought to be charged is cognisant of the fact, that is, knows about it.

Only then, and only for debts contracted after those six months, is the member severally liable, meaning a creditor can recover the whole debt from him alone.

Notice what is not affected. The company continues to exist and keeps its separate personality; section 3A takes away the members' limited liability, not the company's personality. That distinction is worth a sentence in an answer.

Section 7(5), (6) and (7): a company got by lying

Section 7 is the incorporation section. Its last three sub-sections deal with what happens when the company was obtained dishonestly, and they escalate.

Section 7(5). If any person furnishes false or incorrect particulars, or suppresses material information of which he is aware, in any document filed for registration, he shall be liable for action under section 447, which is the Act's fraud provision.

Section 7(6). Where, at any time after incorporation, it is proved that the company was got incorporated by false or incorrect information or representation, by suppressing a material fact, or by any fraudulent action, then the promoters, the persons named as the first directors, and the persons who made the declaration under section 7(1)(b) shall each be liable for action under section 447.

Section 7(7). This is the true veil-lifting provision, because it reaches the company itself. On an application, and on being satisfied that the situation warrants it, the Tribunal may:

• (a) pass such orders as it thinks fit for regulation of the management of the company, including changes in its memorandum and articles, in the public interest or in the interest of the company and its members and creditors;
• (b) direct that the liability of the members shall be unlimited;
• (c) direct removal of the name of the company from the register of companies;
• (d) pass an order for the winding up of the company; or
• (e) pass such other orders as it may deem fit.

Two safeguards in the proviso. Before making any such order the Tribunal must give the company a reasonable opportunity of being heard, and must take into consideration the transactions entered into by the company, including obligations contracted and any liability paid. The second one exists because innocent outsiders have usually dealt with the company by then.

Clause (b) is the striking one. The Tribunal can convert a limited company into an unlimited one by order, which is veil-lifting written into the statute.

Section 339: fraudulent conduct of business

This one operates in the course of winding up.

If in the course of the winding up of a company, it appears that any business of the company has been carried on with intent to defraud creditors of the company or any other persons or for any fraudulent purpose, the Tribunal, on the application of the Official Liquidator, or the Company Liquidator or any creditor or contributory of the company, may, if it thinks it proper so to do, declare that any person, who is or has been a director, manager, or officer of the company or any persons who were knowingly parties to the carrying on of the business in the manner aforesaid shall be personally responsible, without any limitation of liability, for all or any of the debts or other liabilities of the company as the Tribunal may direct.

Take the elements in order:

1. The company is being wound up. Section 339 cannot be used against a going concern.
2. Business was carried on with intent to defraud creditors or others, or for any fraudulent purpose.
3. Who can apply: the Official Liquidator, the Company Liquidator, any creditor, or any contributory.
4. Who can be made liable: a director, manager or officer, past or present, or any person who was knowingly a party to carrying on the business that way. Note that the last limb catches people who were never officers at all.
5. The consequence: personally responsible, without any limitation of liability, for such debts as the Tribunal directs.

The words "without any limitation of liability" are the point. Limited liability is simply switched off for that person.

Section 464: too many members outside a company

Section 464(1) forbids an association or partnership of more than the prescribed number of persons, formed to carry on business for gain, unless it is registered as a company or formed under some other law. The proviso caps the prescribable number at one hundred.

Section 464(2) exempts two cases: a Hindu undivided family carrying on business, and an association or partnership formed by professionals governed by special Acts, which is why very large firms of chartered accountants and advocates are lawful.

Section 464(3) is the veil-lifting part: every member of an association carrying on business in contravention shall be punishable with fine which may extend to one lakh rupees and shall also be personally liable for all liabilities incurred in such business.

A worked example

Sunil owes a decree of forty lakh rupees to a bank. Before the bank can execute, he forms Sunview Trading Private Limited, transfers his shop and his stock to it for a nominal price, takes ninety-nine of its hundred shares, and tells the bank the shop is no longer his.

What the bank cannot do. It cannot simply say "the company is Sunil". Section 9 stands, and Salomon's principle stands with it. The company owns the shop.

What the bank can do. It can ask a court to look through the arrangement, because the corporate form has been used for the single purpose of defeating an existing obligation, and that is the paradigm case for judicial lifting. It can point to the timing, the nominal price and the ninety-nine per cent shareholding as evidence of purpose.

And if the company is wound up, section 339 becomes available: the business was carried on with intent to defraud a creditor, and Sunil, as a director and as a person knowingly a party to it, may be declared personally responsible without any limitation of liability for the company's debts, on the application of the liquidator or of the bank itself as a creditor.

Change one fact. Suppose Sunil had formed the company two years before the loan and had run a genuine business through it. The bank's argument collapses, because there is nothing to look through. Incorporating to limit future risk is the whole purpose of company law; incorporating to escape a debt you already owe is not.

Distinctions that carry marks

What this does NOT mean

It does not mean the company disappears. In almost every instance the company continues; what changes is that a person behind it is also liable. Section 7(7)(c) and (d), removal from the register and winding up, are the exceptions.

It does not mean a court will lift the veil because the result seems unfair. Salomon's principle is the rule and lifting is the exception, and an examiner will expect you to say so before you list the exceptions.

It does not mean a one-member company is a sham. Section 3(1)(c) expressly allows a One Person Company, so having a single member is lawful and is not by itself a ground for lifting anything.

Limits and criticism

The judicial categories are criticised as vague. "Fraud" and "single economic unit" are not tests so much as labels applied after the decision has been made, and the same facts can be described either way. That vagueness is the reason the statutory instances matter: they tell a person in advance exactly when their limited liability is at risk.

The counter-argument is that a closed statutory list would be gamed within a year, and that the courts need a residual power precisely because dishonest people are inventive. An answer that sets out both sides is a better answer than one that recites categories.

Quick revision

• The rule is separate personality, section 9. Lifting is the exception.
• Judicial grounds: fraud or improper conduct, evasion of law or of a contract, enemy character, tax evasion, single economic unit.
• Section 3A: below seven or two members, business carried on more than six months, member aware, severally liable for debts of that period.
• Section 7(5): false particulars, action under section 447.
• Section 7(6): company got incorporated by fraud, promoters, first directors and declarants liable under section 447.
• Section 7(7): Tribunal may regulate management, make members' liability unlimited, strike off, wind up, or make any other order. Hearing first, and past transactions considered.
• Section 339: in winding up, business carried on to defraud, director, manager, officer or knowing party personally responsible without limit.
• Section 464: association above the prescribed number, capped at one hundred, fine up to one lakh rupees and personal liability. HUF and professionals exempt.

Test yourself

1. What is meant by lifting the corporate veil? Disregarding the separation between a company and the persons behind it, created by section 9, so as to fix those persons with liability or to look at their characteristics. It is an exception to the rule in Salomon.

2. Name five statutory instances under the Companies Act 2013. Section 3A, membership below the minimum for over six months; section 7(6), incorporation obtained by fraud; section 7(7), the Tribunal's power to make members' liability unlimited; section 339, fraudulent conduct of business in a winding up; section 464(3), association exceeding the prescribed number.

3. Under section 339, who may apply and against whom? The Official Liquidator, the Company Liquidator, any creditor or any contributory may apply. The declaration may be made against any past or present director, manager or officer, and against any person who was knowingly a party to carrying on the business with intent to defraud.

4. A public company has had five members for four months and is trading. Are the members personally liable? Not yet. Section 3A requires the business to be carried on for more than six months while the number is reduced. At four months the condition is not satisfied. Liability, if it comes, attaches only to debts contracted after the six months and only to members who are aware of the position.

5. What is the maximum number of persons who may carry on business in an unregistered association? Such number as may be prescribed, and the proviso to section 464(1) says the prescribed number shall not exceed one hundred. A Hindu undivided family, and an association of professionals governed by special Acts, are outside the section altogether.

6. Can the Tribunal make the members of a limited company unlimitedly liable? Yes, in one situation: section 7(7)(b), where the company was got incorporated by false or incorrect information, by suppression of a material fact, or by any fraudulent action. The company must first be heard, and the Tribunal must consider the transactions it has already entered into.