Piercing the Corporate Veil

Piercing the Corporate Veil and Directors’ Liability

This Article discusses an increasingly pertinent question; namely the extent to which the UAE law recognises a Limited Liability Company’s (“LLC”) separate legal personality and the circumstances under which the “corporate veil” of an LLC may be lifted.   

In common law jurisdictions, the concept of the “corporate veil” is longstanding. It is a recognised fundamental rule that a company has a separate legal personality; its assets and liabilities are separate from the assets and liabilities of its shareholders. The lifting/ piercing of the veil refers to a situation when the separation of the personality of a company and its shareholders is not maintained.

Being a civil law jurisdiction, concepts relating to limitation of liability and separate legal personality of legal entities in the UAE are codified within statutes and regulations as opposed to originating from judicial precedents.

This Article deals in turn with:

(i)            the doctrine of separate legal personality of an LLC and the circumstances under which the courts in the UAE may seek to “pierce the corporate veil” and make shareholders directly liable for the liabilities of the LLC; and

(ii)          the potential liability that may arise in connection with the failure by directors’ to adequately discharge their duties.

Each in the context of the recent UAE Federal Law No. 2 of 2015 concerning Commercial Companies (“CCL”) as enacted towards the end of 2015.

It is of note that the CCL was implemented towards the end of 2015 as a long awaited update of the previous companies law in the UAE. As such, the provisions therein dealing with separate legal personality and limitation of liability of UAE companies as yet have a relatively short history and are largely untested before the UAE Courts.

It is not clear how these provisions will be interpreted and implemented by the UAE Courts in practice. Interpretation and application may also vary from Judge to Judge and over time in light of the broad judicial discretion exercisable by UAE Courts. It is, therefore, not possible to comment definitively on the likely practical effects and consequences of the CCL and those provisions relating to piercing the corporate veil as will be  interpreted by the UAE Courts.

1. Is an LLC a separate legal personality from its Shareholders?

The CCL provides that a LLC is a separate legal personality from its owners and is potentially capable of suing and being sued and of holding property in its own name.

Specifically, Article 21 of the CCL sets out that a Company created under the CCL:

“shall become a corporate person as of the date of the registration thereof in the Commercial Register at the competent authority. (emphasis added)” 

1. Can the Shareholders of an LLC hiding “behind the veil” of the Company be sued?

Article 71(1) of the CCL defines an LLC as a:

“company in which the number of partners are no less than two and no more than 50  partners and the liability of each partner shall only be in proportion to his share in  the capital. (emphasis added)”

Article 71(2) of the CCL goes on to state that:

“the owner of the company capital shall not be liable for its [the Company’s]  obligations unless to the amount of capital that appears in the memorandum of association thereof and the provisions of the limited liability company, as stipulated by this Law, shall apply to such person, providing that there shall be no conflict with its [the Company’s] nature.”

The legal provisions set out above demonstrate that on a strict application of the law, the shareholders of an LLC cannot be held liable for the acts or omissions of the entity in which they hold shares beyond their shareholding. Thus, in principle, the corporate veil cannot be pierced and the Shareholders of an LLC cannot be sued. However, this is subject to certain exceptions.

1. Under what circumstances can shareholders be liable for acts or omissions of the corporate entity/entities in the UAE?

It is possible in certain circumstances for the separation of the personality of a Company and its shareholders to be disregarded. The exceptions may be classified into three categories.

Firstly, the statutory exceptions: the CCL itself provides for a number of specific exceptions in relation to LLCs:

-   Article 30 of the CCL provides that creditors of a LLC may claim the return of any amounts paid in the form of distributions or dividends if such distributions or dividends were made in contravention to the provisions of the CCL.

-   Article 75 of the CCL provides that if, at any time after incorporation of a LLC, the number of partners exceeds the statutory limit (50 partners), the competent authority will issue a rectification notice. If the company does not rectify its position within six months subsequent to the date of the notice, the company shall be deemed dissolved and partners shall be personally and jointly liable for the debts and liabilities incurred by the company from the date the statutory limit was exceeded.

-   Article 78 of the CCL provides that if a partner in a LLC presents a share in kind, such partner shall be liable towards third parties for the accuracy of the estimate of the value of such share in kind. If it is established that the share was valued at more than its real value, the contributor of the share must pay the difference in cash to the company and the founding members shall be jointly liable with their private assets for the payment of this difference.

-   Article 204 of the CCL provides that the creditors of a company have the right to sue company shareholders directly in their personal capacity to oblige them to pay up any unpaid amount due for their shares in the company. Although any defaulting shareholder is only liable to pay the unpaid balance of his shareholding participation in the company, the corporate veil is lifted in the sense that creditors have the right to pursue the shareholder directly in his personal capacity.

In addition to the statutory provisions set out above, there have been certain judicial decisions, prior to the enactment of the current version of the CCL, which examined instances when shareholders should be directly responsible for the liabilities of a company and should not be allowed to hide behind the separate corporate personality afforded by the CCL.

A 2011 case before the Dubai Court of First Instance sets out an example of the Courts treatment of the liability of shareholders. The Claimants were two U.S. based individuals who were induced by the shareholders of a UAE based investment company (the “Company”) to invest in a currency trading platform. At the end of May 2010, the shareholders of the Company issued a report falsely declaring a profit return of 34.28% on the Claimants’ money and induced the Claimants to transfer more funds in order to increase their investment returns. The Claimants, in reliance on the report, transferred additional funds to the Company. Shortly thereafter, the Claimants discovered the falsity of the claims made by the shareholders and discovered that the Company was not licensed to trade in currencies. The Claimants filed a claim against the Company and its shareholders claiming economic loss owing to the fraudulent misrepresentation by the Shareholders of the Company’s business activities.

The Court held that the shareholders were personally liable to the Claimants and that the losses suffered by the Claimants resulted from the shareholders’ false pretences. The Court further held that it was the shareholders and not the Company who had become enriched as a result of such misrepresentations.

Although the Court’s reasoning does not outline a principle of general application, it bears great similarity to the common law concept of tort of deceit; this is an established exception to the separate legal personality of a corporation whereby, as a general rule, the deceiving acts of the shareholders, if proven, are not attributable to the acts of the Company and therefore shareholders should be held personally liable for their deception.

The Court further imposed a positive obligation on a shareholder who was not active in the management of the Company, who ought to have been aware of the source, legality and purpose of the funds transferred to the Company and therefore found him jointly liable for having breached this obligation and enjoying the fruits of the active shareholders’ deceit.

This point is particularly important in the context of dormant shareholders since it suggests that constructive knowledge will be imputed in circumstances of deceit by another shareholder.

Similarly, the Dubai Court of Cassation, in cases No. 316/2003 and 69/2007, held that where a shareholder has exploited the principle of the independent liability of the company as a means to conceal fraudulent acts or misappropriation of the funds of the company in order to cause harm to his partners or creditors, the protection bestowed by law for a shareholder in an LLC will not be upheld. In these circumstances, it may be possible for a shareholder to be held liable in their personal capacity for such dispositions, and such liability will extend to their personal assets.

It may be seen from the above examples that the UAE courts will not be inclined to permit the concept of limited liability to protect shareholders from active and/or wilfully fraudulent behaviour from which they are unjustly enriched whilst simultaneously seeking the protection afforded by the limitation of liability and separate personality of the corporate form.

1. What is the position regarding Directors’ liability for breach of their duties?

In essence Directors are liable to the company, the shareholders and third parties for deception, fraudulent acts, misuse of authority, violation of law or the articles of association and for any losses arising from maladministration of the company including gross error. Any contracting out of this statutory liability will be void.

Article 84 and 162 of the CCL set out the position in relation to the liability of Directors.

Under Article 84, Directors will be liable:

“.... against the company, the partners and third parties for any fraudulent acts by such manager and shall also be liable for any losses or expenses incurred due to improper use of the power or the contravention of the provisions of any applicable law, the memorandum of association of the company or the contract appointing the manager or for any gross error by the manager”. 

Article 162 equivalently provides that:

“The Chairman and the Directors shall be jointly liable to indemnify the company, the shareholders and the third parties for the damage that arises from acts of fraud, misuse of power, and violation of the provisions of this Law or the Articles of Association of the company or an error in management. Every provision to the contrary shall be invalid.”

From the wording of Article(s) 84 and 162 read together, it is possible to infer a number of duties in which breach may result in personal liability for the Director. For example where a Director breaches:

(i)             a duty to act honestly;

(ii)            a duty not to abuse their powers;

(iii)           a duty to act in accordance with the Articles of Association and the law generally; and

(iv)          a duty to act in the best interests of the company and its shareholders,

it may be possible that personal liability may result in these circumstances..   

In relation to the extent to which “mismanagement” and “gross error” may result in personal liability for the Director, there is little by way of commentary or case law to clearly define where potential personal liability may flow in the event a Director neglects or mismanages tasks required under the CCL or the company’s Articles of Association. However, the general wording and potentially far-reaching effects of such provisions mean that a Director’s personal liability for mismanagement or neglect is a relevant consideration where allegations are made of a breach of duty.

It should be noted that, under Article 162 of the CCL, Directors are responsible jointly to the Company, the shareholders and third parties for any wrongful acts resulting from a unanimous decision of the Board. If, however, a Director records his objection to a wrongful decision taken by his fellow Directors in the minutes of a Directors meeting, he will not share responsibility for that decision. The absence of a Director from a meeting in which a wrongful decision was taken does not relieve him from liability unless he was not aware of the decision; or he was aware of the decision, but was unable to object to it; or he objected to the decision once he was made aware of it.

1. Who may bring proceedings against Directors?

Article 165 of the CCL sets out who has the right to bring an action against the Directors:

-    The Company has the initial right to bring an action against its Directors for the mistakes they commit in the management of the Company which results in damage to the shareholders. The resolution to initiate proceedings and to appoint a person to bring an action against a Director on the company’s behalf must be adopted by the shareholders in a general assembly.

-    A shareholder can bring an action against the Directors under Article 166, CCL in the following circumstances:

-    (i) where the Company fails to bring an action; and

-    (ii) the wrongful act carried out by the Directors has caused the shareholder a personal harm; and

-    (iii) the shareholder informs the Company of his intention to bring an action against the Directors.

-    A Company’s Memorandum and Articles of Association cannot exclude this statutory right.

-    If the Company is in liquidation, the right to bring an action against Directors will rest with the liquidator.

1. Are there exemptions to Directors’ liability?

Under the previous companies law in the UAE, exemption of liability provisions could be enshrined within the companies Memorandum of Association to indemnify Directors for personal losses deferred in connection with a breach of duties.

Article 24 of the CCL contains a restriction on companies exempting officers from liability and provides that any provision in the memorandum of association purporting to do so shall be void. 

It is not uncommon for companies in many jurisdictions to indemnify directors for personal losses deferred in connection with a breach of duties.  There is a risk (though this is not clear) that the provisions of Article 24 would prohibit the granting of such indemnities on the basis that they are “exemptions of liability”.

1. Conclusion

What can be seen from the above is that there exist circumstances where the corporate veil can be lifted, both pursuant to express statutory provisions and also where the Courts deem it equitable and appropriate to do so. In turn, this means that both shareholders and Directors are not immune from action. This is an important consideration to bear in mind given that litigation involving companies in the UAE is rife and in the event the corporate veil is lifted there is potential personal liability against Directors and shareholders which may have far reaching consequences.