Saturday, February 20, 2010

The Court of Appeal Reaffirms the Sanctity of the Corporate Form

Few issues have proved to be more controversial than the strength of the principle that the company is a separate legal entity. The exceptions to the principle – commonly referred to as “lifting” or “piercing” the corporate veil – are both statutory and judge-made. The statutory exceptions are, in the main, not controversial. However, while there is agreement that courts are entitled to lift the corporate veil under “certain circumstances”, it has proved difficult to define what these circumstances are. The modern economy makes this task even more onerous, with the rise of “group entities”, the ubiquitous “investment” company and so on.

In DHN Food Distributors v. Tower Hamlet, [1976] 1 WLR 852, Lord Denning MR preferred to “ignore the separate legal entities of various companies within a group, and to look instead at the economic entity of the whole group.” These observations were doubted in Woolfson v. Strathclyde, 1978 S.C. (H.L.) 90. In the famous judgment in Adams v. Cape Industries, the Court of Appeal effectively rejected the approach in DHN, and reiterated the importance of the corporate form. In particular, the Court regarded only “agency” and “fraud” as proper exceptions to the corporate veil, and held that there is no presumption that the existence of a “single economic unit” is a reason to ignore the corporate form. This was reiterated by the Court of Appeal in 2008, and this blog has discussed these controversies on several occasions.

Over the years, this issue arose in a variety of contexts, of which one of the most prominent was whether a controlling shareholder of a company can also be an “employee” of that company. To some extent, the question had been answered by the Privy Council in the leading case of Lee v. Lee Air Farming, [1961] AC 2, where the issue was whether Mr. Lee, the controlling shareholder, was also “employed” as a pilot by the company that he controlled. Since it is settled law that the “power to control” is an essential ingredient of an employer-employee relationship, it was thus argued that a controlling shareholder, whose contract cannot be terminated without his consent, or duties altered without his consent, is not an employee of the company. The Privy Council nevertheless held that he was an employee, since the principle that a company is a separate legal personality cannot be disregarded.

In this connection, a recent judgment of the Court of Appeal in Secretary of State v. Neufeld, [2009] BCC 687 is of enormous significance. The immediate context was employment legislation in the United Kingdom, which provides, under certain circumstances, that an “employee” of an insolvent company is entitled to recover his unpaid dues from the Government. Quite obviously, the purpose of this legislation was to extend support for employees whose means of livelihood is terminated by the unforeseen insolvency of a company, and not to compensate the shareholders of the company. In this context, the question of whether a controlling shareholder who also had a contract of employment with the company was covered became important. Relying on this reasoning, an Employment Tribunal held that Lee’s case (above) is not relevant to an employment protection context, and some courts accepted this view, while others differed.

In Neufeld, the Court of Appeal has rejected this reasoning and held that a controlling shareholder is entitled to take advantage of the employment legislation and claim compensation from the Government in his capacity as an employee. In a comprehensive and well-reasoned opinion, the Court has reviewed all the authorities on the corporate veil, and extracted the principles applicable to such questions. In brief, the Court held that the “economic interest” that the controlling shareholder has in the company is irrelevant. The following observations are apposite:

There is no reason in principle why someone who is a shareholder and director of a company cannot also be an employee of the company under a contract of employment. There is also no reason in principle why someone whose shareholding in the company gives him control of it—even total control (as in Lee's case)—cannot be an employee. In short, a person whose economic interest in a company and its business means that he is in practice properly to be regarded as their “owner” can also be an employee of the company. It will, in particular, be no answer to his claim to be such an employee to argue that: (i) the extent of his control of the company means that the control condition of a contract of employment cannot be satisfied; or (ii) that the practical control he has over his own destiny—including that he cannot be dismissed from his employment except with his consent—has the effect in law that he cannot be an employee at all.

The Court recognised that an exception to this principle is an instance where the so-called employment contract is a “sham” contract or not a “genuine” employment relationship. However, “sham” is a legal, not economic concept and only requires the Court to determine whether the legal substance of the relationship between the parties is what it purports to be. For example, if A and B enter into an agreement that is called a “Licence Agreement”, a Court is bound to examine whether the terms of the agreement are characteristic of a licence. However, the Court cannot look to whether in “economic reality” the party acquires something other than the rights of a licensee. In this instance, if the court finds that the contract is neither a sham and is a valid or true contract of employment, the employment legislation will apply.

This confirms that recent developments in English law are receding from any dilution of the sanctity of the corporate form, which is significant not just in employment law, but in taxation as well, as the ongoing Vodafone dispute illustrates.

1 comment:

Mihir Naniwadekar said...

The observations in the Neufeld decision – that what matters is the legal and not the economic substance – are arguably been read down (incorrectly) in a later decision. The following observations in Agahi v. Department of Employment may be relevant: “Mr Agahi also took considerably reduced sums by way of salary during other periods. It is difficult to conceive of genuine employees accepting such an arrangement on a prolonged basis. The fact that some payments were being made to the claimants out of other loans to the company also seems to me to be inconsistent with employee status. The provisions relating to holidays and holiday pay again did not reflect the reality of the situation. Mr Agahi regarded himself as entitled to time-off in lieu, for which there was no express provision…”

Overall, the Agahi decision again seems to confuse between 'legal' reality and 'economic' reality; contrary to the test of the Court of Appeal in Neufeld.