Lifting the Corporate Veil

A basic principle in corporate law is the principle of separate legal personality, according to which the independent and separate existence of the company should be validated in relation to its shareholders and directors.

The exception to this rule is mainly manifested via the legal tool called “lifting the corporate veil”. This tool is intended for rare and exceptional cases where a proper response is required for an abuse of the principle of the company’s separate legal personality by a shareholder therein, and in order to prevent hiding behind the corporate veil in order to avoid obligations taken, all during an act of fraud or inappropriate behavior.

The Companies Act determines, defined and limited standards for those cases in which the corporate veil is lifted, in order to maintain the rule regarding the company’s separate liability. The question arises, whether the existence of an “employer-employee relationship” affects the flexibility of interpretation regarding the lifting of the corporate veil between the company’s shareholders and its employees?

Background

The provision in the law which determines the cases in which the veil between the company and its shareholder is to be lifted, is set in Article 6 of the Companies Act, 1999, according to which the court may attribute a company’s debt to a shareholder therein if under the circumstances it was found right and just to do so, in the exceptional cases in which using the separate personality is done in a way which deceives a person or deprives a company creditor or in a way which harms the company’s purpose and while taking an unreasonable risk as to the company’s capability to redeem its debts.

Whether it is an investor, a supplier, a funder or any other person bound by contract to the company, any factor engaging with the company in a transaction performs the engagement out of business considerations and out of calculating risk aginst possibility. In exceptional cases where the “legal corporate veil” is abused, the rules of lifting the corporate veil have been determined in order to defend those engaged.

In this matter, there should be a distinction between business creditors engaging with the company and employees employed therein, who are not regular engagers since they do not operate as business factors. On the contrary: the employees see their employer as a safe and solid support over time, and their dependency on the company is extremely high. Therefore, the employee is no longer a “voluntary” creditor.

The ruling has recognized the employee as a special engager towards whom there is an increased liability on the company’s behalf and that of the holders of controlling interest, whose origin is the duty of bona fide applied to the company as part of the contractual relationship with the employee[1].

The duty of bona fide and the duty of loyalty as a source for making the rules regarding lifting of the corporate veil more flexible

As stated above, as opposed to the group of engagers maintaining a business relationship with the company, the employees are classified as a special engager. The employment contract constitutes for the employees a work place, a source of livelihood and a safe and solid support over time. In exchange for the services they provide the company with, the employees put their trust in the company, rely on its stability and the security it induces upon them.

The special duty of loyalty originates not only in the provisions of the employment agreement, but is also derived from the increased duty of bona fide existing in employment relationships. Therefore, in order to examine the existence of the exception of “lifting the corporate veil” in employment relationships, we should take into consideration not only the typical general/business law should be examined, but also the implementing of this law and its implications on the relationships between an employing company and its employees[2].

It should be remembered that the legal action of employing employees is unlike purchasing equipment or engaging with a supplier or an outside contractor. By engaging with an employee, a special closeness is formed between the employer and the employee. This closeness originates in the contractual relationships and in the requirement of bona fide resulting therefrom. This closeness also, perhaps mostly, originates from the relationships of financial dependency of the employee in the employer. This closeness creates an increased liability and a special duty of loyalty in the relationships of the employer with and towards his employees.

In the case of Zilberstien[3] it was determined that the employer’s liability should be manifested in managing the business matters not just out of his personal interest but also out of viewing the interests of the employees depending on him. The ease in which business owners establish a business project and later shut it down while placing their employees – sometimes surprisingly – in a hopeless situation is intolerable and inappropriate. This liability should not stop at the foot of the corporate veil, and under the right circumstances the court shall defend the employees, lift the corporate veil and expose the real economic factor hiding behind the veil.

It should be remembered that financial difficulties which have caused the situation where there is no chance for redeeming the company’s rights towards its employees are not enough to lift the corporate veil. Only if the employee succeeds in proving that the company or its shareholders have not acted in bona fide or that they have acted out of a clear and explicit knowledge that there is no chance of fulfilling their obligations, will the court tend to lift the corporate veil[4].

Mixing properties

It has been ruled that in a case of “mixing properties” between the company and its shareholders a situation in which the company, especially a familial company which encounters financial difficulties, continues to employ an employee without paying his salary for a period of several months, is not to be tolerated. The duty of bona fide requires an adaptation of employing employees to the company’s financial capability, continuing to employ an employee knowing that the company is unable to pay him constitutes an abuse of the corporate veil.

In a case where establishing a new company in order to continue employing a failing employee in a way which in fact drains the company of its assets, there is a justification in the appropriate cases to lift the corporate veil[5].

However, the purpose at the basis of said “mixing of properties” should be examined. In cases where the purpose is consistent with the company’s benefit and that of its creditors, the corporate veil shall not be lifted. The same applies to cases where a director and a shareholder in the company help the company to fulfill its obligations towards its employees[6].

Fraud and the intention to deceive

Lifting the corporate veil shall be applied even in the case of not paying various social rights, especially when the matter regards not transferring money deducted from the employee’s salary towards executive insurance and training funds. Even when the shareholder has acted to obviate the company, smuggled the company’s assets, transferred money due to the company into his personal account and established a company dealing in similar business areas, a lifting of the corporate veil was performed[7]. Failure to transferring deductions from the employee’s salary to their destination is sufficient cause for lifting the corporate veil[8]. It has been determined that this conduct constitutes misappropriation regarding the employee’s money and a felony according to the Penal Code, 1977, and according to Article 26 of the Wage Protection Law and therefore this is a clear case of fraud which justifies lifting the corporate veil towards the shareholders.

Summary

“The rules of play” of corporate laws determine that a creditor’s conduct towards a corporation involves the risk of business failure while separating the corporation’s legal personality from that of its shareholders. When the creditors are the employees, this risk is insured in employee rights insurance during bankruptcy or liquidation, according to the National Insurance Institute Law. The possibility to personally sue a shareholder should exist, as stated, in exceptional cases where it is proven that the company’s separate legal personality was abused out of the intention of fraud.

However, it should be remembered that not every breach of the law constitutes an intention of deceit and fraud required in order to lift the corporate veil towards the shareholder. Not fulfilling part of the employee’s rights, by itself, and in the absence of proof regarding the intention of fraud towards the employee, does not establish a ruling regarding the abuse of the company’s separate legal personality[9]. Using the doctrine of lifting the corporate veil should be done sparingly, and only in those exceptional and extreme cases as determined in rulings.

In a series of verdicts the Labor courts implement the rules regarding the lifting of the corporate veil towards the shareholder in a corporation as determined in Article 6 of the Companies Act. However, it has been determined that referring to the status of employer-employee is interpreted differently than a pure business relationship between a funder, a supplier or any other contract engager and the company. In the area of labor laws, the determination as to when the corporation veil was abused by the shareholder or attributing the intention of fraud to the employer is always examined while taking into consideration the employer’s duties of loyalty and increased bona fide towards his employee.