In Re (#4 April 2018)

Piercing the Corporate Veil in Ukrainian Companies: not a Mirage

by Taras Dumych

When considering setting up or acquiring a company, a businessperson or an investor usually views this step as creating something separate from the founder or the acquirer. By holding a separate entity, one also envisages not just the separate personality of the company from its shareholder, whether the latter is an individual or another company, but also a separate liability shield between the companys liability and the liability of its shareholder. This perception is rightly based on the universal legal concept of a companys separate personality.

When it comes to Ukrainian companies, especially to the most common type of companies limited liability companies (LLC) and joint stock companies (JSC), the limited liability of their shareholders arises out of statutory law provisions. According to the Civil Code of Ukraine and the Joint Stock Companies Law, shareholders are not liable for the companys obligations, and the shareholders liability is limited to their contributions in the capital of the company in the case of an LLC1, or shares in the case of a JSC2.

The distinction of companies from their shareholders, and of companies liabilities from the liabilities of their shareholders, is called the corporate veil (or corporate shield). In United Kingdom company law, this principle originates from and was defined in the Companies Act 1862 and was first tested in the landmark House of Lords Salomon v. Salomon case.

Importantly, the corporate veil principle also has a reverse effect. Based on it, companies cannot be held accountable for the liabilities of their shareholders either.

However, there are instances when the corporate veil principle may be disregarded, and a companys shareholders may become personally responsible for the liabilities of the company. Being aware of how and in which situation the corporate veil principle cannot be applied, as well as the consequences thereof, is important for both foreign and Ukrainian investors and businesspersons.

In case of foreign investors and businesses, understanding this principle is important from the point of view of the potential liability of the Ukrainian counterparties with whom they do business (trade, financing, investing, joint venture, etc.). Whereas for Ukrainian businesspersons, it may be important not only from the point of view of their local counterparties, but also due to the increased activity of Ukrainian businesses in international trade as well as the use of foreign corporate structures (such as foreign holdings and trusts) in Ukrainian and international investment ventures.

What is piercing the corporate veil?

The situation when the corporate veil principle may be disregarded is called piercing the corporate veil. Sometimes the term lifting the corporate veil is also used to describe the same thing. In most cases, piercing the corporate veil is done by courts. However, in limited instances, regulatory authorities may also pierce the veil.

By making a decision to pierce the corporate veil, courts effectively decide to hold the company's shareholders personally liable for the actions of the company, the consequences of such actions and the companys debts and liabilities. In this regard, not all shareholders of a company can be exposed to such liability. Piercing the corporate veil may be applicable towards those shareholders effectively controlling the company and its affairs; although these would not necessarily be only majority shareholders. In addition, the companys executives and officers can also be subject to piercing the corporate veil and held responsible for the company's liabilities.

As a result of piercing of the corporate veil, the limited liability of shareholders in companies such as LLCs and JSCs is disregarded, and such liability effectively becomes joint and several for the shareholders that are subject to piercing the veil as well as for the company.

Piercing the corporate veil is an exceptional action undertaken by courts; and is something which they are often reluctant to do. When asked by a companys creditors or counterparties to take this action, courts require valid arguments and strong facts that can justify doing this.

Despite being an exceptional type of remedy, the court practice of piercing the corporate veil has been well developed in common law countries. As to civil law countries, they have also started implementing and applying this concept in their laws and court practice.

Instances when piercing the corporate veil can be granted

The practice of common law courts has been to establish the instances when courts grant piercing the corporate veil. In doing so, the main factor for the courts is to look into the substance of the situation that led to the companys liability and to determine the role of the company's shareholders and executives in that situation.

Those instances when (1) there is no real separation between the company and its shareholders, (2) when the company was an instrument for fraudulent actions or misrepresentation, or (3) when certain corporate formalities were not followed with respect to the company, are the ones in which courts are likely to grant piercing the corporate veil.

The first instance for piercing the corporate veil is based on the so-called alter ego doctrine. Under this doctrine, when a company is used by its shareholders for their personal business in such a way that there is no real separation between the decision-making in the company and the personal decision-making of the shareholders, the courts are allowed to pierce the corporate veil.

In establishing whether a company is merely an alter ego of its shareholders the courts look into the details of the companys corporate governance and the role of its executives; in particular if the directors are pure nominees following the instructions of the companys shareholders, or if the directors are independent executives. A situation when there is no separation between the companys business and the shareholders, for example, if payments on behalf of or for the company are conducted via the shareholder's bank account, would allow a court to rely on the alter ego argument.

The second instance is based on the so-called façade test. When a court determines that the company was incorporated or used in order for shareholders to avoid their personal liability for their fraudulent actions or misrepresentation and which resulted in losses for the companys creditors or the impossibility for the creditors to enforce their rights, piercing the corporate veil would likely become an available remedy for creditors.

For the purpose of the façade test, providing strong evidence and establishing the nexus between the fraud or other wrongdoing and the companys shareholders, would be critical for creditors to convince the court that the liability for these actions must be borne by the shareholders rather than by the company. This may be particularly important when the company is short of or has no assets to satisfy the creditors claims, while the shareholders of the company possess sufficient assets or have improperly benefited and enriched themselves at the expense of the companys creditors. The latter includes the case when the companys assets had been pledged towards the shareholders and thus are formally secure from third party claims.

When it comes to the third instance, courts may look into the formalities affecting the business of the company. For example, if the company is undercapitalized for the type of business it is engaged in or for the amount of liabilities accepted by the company before its creditors, or the company is subject to negative equity, the courts may use these facts as grounds for piercing the corporate veil.

The same relates to the situation when a company is part of a group of companies. If the business of this group is organized in such a way that the company, as a subsidiary, is suffering losses, including, for example, by serving as a cost center, while the parent company of this subsidiary is a profit center, a court may likely pierce the corporate veil of the subsidiary and hold the parent company liable for the subsidiarys debts.

Piercing the corporate veil by courts may take place in commercial litigations as well as in insolvency proceedings. When it comes to insolvency proceedings, Ukrainian insolvency law provides an example of the implementation of corporate veil piercing into Ukrainian law:
In case of the insolvency of the debtor due to the fault of its shareholders or other persons, including the chief executive of the debtor, or persons that can direct the activity of the debtor, the shareholders of the debtor as well as other persons can be made responsible for the liabilities of the debtor3.

Another example of the implementation of the piercing the corporate veil principle into Ukrainian law is the liability of key shareholders and executives of Ukrainian banks: the persons associated with the bank [which, among others, include direct and indirect key shareholders, bank controllers and top executives] may be held responsible for the liabilities of the bank, which arose due to the actions of such persons as well as in the cases when such persons benefited from these actions, and for this purpose these persons shall bear joint and several liability4.

Conclusions

Although courts may be reluctant to instantly grant piercing of the corporate veil and those cases when it is allowed are rather limited, businesspersons and investors should be aware of the possibility. It would not be improper to assert that Ukrainian courts would apply a rather formalistic approach to piercing the corporate veil, and do this only in those instances directly provided for by law (including the instances outlined above). While the courts in other countries, especially common law countries, will most likely handle the issue less formalistically, and look into the substance, rather than the form.

One could ask the question as to why there should be concern about non-Ukrainian law and non-Ukrainian court practice at all, and why this issue should be considered in cases when the liabilities of a Ukrainian company and its shareholders are at stake? The answer to this lies in the internationalization of Ukrainian business.

As Ukrainian businesses become more and more internationalized, including in the areas of international trade, financing, capital markets, private equity and venture capital investments, multijurisdictional corporate structuring and holding assets abroad, Ukrainian businesses and investors submit themselves and get access to the jurisdiction of foreign courts. A foreign court jurisdiction may arise either out of the agreements whereby disputes between the parties are to be resolved in foreign courts or arbitral tribunals or out of foreign laws that specifically grant jurisdiction to foreign courts despite the parties (such as respondents) not being located in foreign countries.

Furthermore, taking into account the fact that the principle of piercing the corporate veil is provided for in Ukrainian law (as shown in the examples of bankruptcy law and banking law provisions), the argument that the application of this principle is against public policy in Ukraine cannot be a winning one. As a result, the enforcement of a foreign court decision or an arbitral award in Ukraine that would apply the piercing of corporate veil principle should not be ruled out.

Therefore, piercing the corporate veil of a Ukrainian company, or a Ukrainian ultimate owner of a foreign company, or by a Ukrainian party in a situation when a foreign company and a foreign shareholder are on the other side, is not a mirage.

As piercing the corporate veil is very much a stick with two ends, the following recommendations on how to use this tool as a remedy, on the one hand, and how not to unnecessarily expose oneself to risk, on the other hand, will be helpful to businesses and investors.

How and when to pierce the veil?

Piercing the corporate veil should be considered if one has suffered from the fraudulent actions of a counterparty, rather than from a breach which can be considered as largely commercial and non-fraud related;

The company-wrongdoer is either a special purpose vehicle company or there are grounded concerns that it is a sham, and there is no possibility to receive remedy from that company without reaching out to its controlling shareholders and beneficiaries;

In case the company-wrongdoer is a party to an arbitration agreement (clause), initiating arbitration proceedings against this company should be considered, while further recognition and enforcement of an arbitral award at a later stage should be directed at the shareholder or beneficiary of the company. However, if there is a possibility and rationale to bring a lawsuit against the shareholder or beneficiary of the company in court, for example if the respondent or its assets are located in a country where a court would likely be willing to pierce the corporate veil, bringing a straight-forward lawsuit, and skipping the arbitration should be considered;

A party that is requesting piercing of the corporate veil must be prepared to submit evidence, which will be sufficient to convince the court that the actions the respondent is accused of are indeed fraudulent actions, rather than a commercial breach. Furthermore, proving that the respondent is in fact controlling the company (by being its controlling shareholder or beneficiary, or an executive) will be the essence.

What should one do to stay safe from the risk of piercing?

First of all a businessperson or a company must not get involved in fraudulent activities. Even if a party is in breach of its commercial obligations, trying to get rid of liability by committing fraud will not be helpful either to the companys or to its shareholders and executives business reputation. Neither does this guarantee that the wrongdoer will be able to avoid liability;

The corporate governance in a company or group of companies should be organized in accordance with the best standards, so that the company will be able to preserve its separate personality from its shareholder. Doing so will enable the shareholders to retain their limited liability over the obligations of the company;

The shareholders of the company should ensure that the company complies with all corporate formalities, such as adequate capital liquidity, at all times. In this way the company will be able to prove that it has sufficient assets to respect its obligations, and no further assets of its shareholder should be involved for this purpose.

Keeping in mind the possibility of piercing the corporate veil will allow good faith businesses and investors to effectively protect their rights and create a safer environment for both their transactions and investments.


1 Article 140 of the Civil Code of Ukraine.

2 Article 3 of the Joint Stock Companies Law.

3 Article 41 of the Law On the Recovery of the Solvency or Declaring a Debtor as Bankrupt.

4 Article 58 of the Banking and Banking Activity Law.

Taras Dumych, partner at Wolf Theiss

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