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Undercapitalization As an Independent Ground for Shareholder Liability: the Case for Corporate Stakeholders

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Undercapitalization As an Independent Ground for Shareholder Liability: the Case for Corporate Stakeholders UNDERCAPITALIZATION AS AN INDEPENDENT GROUND FOR SHAREHOLDER LIABILITY: THE CASE FOR CORPORATE STAKEHOLDERS By Lathia Stubbs Submitted in partial fulfilment of the requirements for the degree of Master of Laws at Dalhousie University Halifax, Nova Scotia August 2016 © Copyright by Lathia Stubbs 2016 Table of Contents Abstract .............................................................................................................................. iii Acknowledgments.............................................................................................................. iv Chapter 1 Introduction .........................................................................................................1 Chapter 2 The Doctrine of Limited Liability and Veil Piercing ..........................................7 Chapter 3 Early Rise of the Limited Liability Company ...................................................15 Chapter 4 A Need to Protect Corporate Stakeholders .......................................................29 4.1 Introduction ............................................................................................................29 4.2 The Shareholder Wealth Maximization Theory ....................................................32 4.3 The Incentive to Externalize Unnecessary Risks to Stakeholders .........................37 4.4 The Social, Moral, and Ethical Responsibility of Companies and Shareholders ..41 4.5 Types of Social Responsibilities ............................................................................51 4.5.1 Economic Responsibility ....................................................................... 51 4.5.2 Legal Responsibility .............................................................................. 53 4.5.3 Ethical and Philanthropic Responsibilities ............................................ 54 4.6 Liability for Corporate Wrongs .............................................................................55 4.7 Equitable Subordination for Undercapitalization ..................................................65 4.8 Conclusion .............................................................................................................69 Chapter 5 Justified or Unjustified: Undercapitalization as an Independent Factor for Corporate Veil Piercing?....................................................................................................71 5.1 Introduction ............................................................................................................71 5.2 What is Undercapitalization? .................................................................................73 5.3 How is Undercapitalization Measured? .................................................................78 5.4 The Critical Nature of Undercapitalization ............................................................85 5.5 Undercapitalization: The Underlying Problem ......................................................89 5.6 The Case for Independence: A Critical Analysis of the Undercapitalization Factor .....................................................................................................................91 5.7 Conclusion ...........................................................................................................113 Chapter 6 Tort Creditors vs Contract Creditors – Should It Matter for Veil Piercing? ...115 6.1 Introduction ..........................................................................................................115 6.2 Undercapitalization in Tort Cases ........................................................................116 6.3 Undercapitalization in Contract Cases .................................................................118 6.4 Conclusion ...........................................................................................................123 Chapter 7 Recommendations and Conclusion .................................................................125 Bibliography ....................................................................................................................129 ii Abstract This thesis defends the position that undercapitalization of private companies should be an independent basis for shareholder liability. The thesis examines the developments in the law by exploring the work of commentators, legal scholars, and judges on the importance of protecting corporate stakeholders against undercapitalized corporations. American courts have also dealt with the issue in a number of cases, the majority in which the courts have not considered undercapitalization to be an independent ground for shareholder liability. These cases are critically examined to determine the reasoning behind the courts’ decisions. Ultimately, this thesis concludes that the arguments in favour of undercapitalization as an independent factor for veil piercing are more persuasive than the arguments against this view. iii Acknowledgments I would like to thank my parents, Anthony and Sharon Stubbs for making this possible and for their never ending love and support as I pursued my LLM degree. I would also like to thank Professor Michael Deturbide and Professor Kim Brooks for their outstanding academic support, supervision, and guidance. Thirdly, I thank David Dzidzornu for dedicating his time to make this paper a success. Last but not least, I thank God for this blessing. iv Chapter 1 Introduction In the corporate and financial world, companies possess the legal capacity and privilege of a natural person, subject to the incorporating legislation.1 By law, when a company is born, it must possess a birth certificate (Certificate of Incorporation); and by law, when it dies, a death certificate (Certificate of Dissolution) must be made in its name. Like human beings, it enjoys its own separate legal personality and can sue and be sued in its own name. This widely accepted metaphorical principle is thought to have been established in the landmark case of Salomon v A. Salomon2 where the English Court of Appeal confirmed the separate legal personality of a company with the reasoning that a company is separate from its members. All the debts of a company are the responsibility of the company and not its shareholders, directors, or employers. As early as 1613, Lord Coke defined the corporation as an aggregate of many that is invisible, immortal, and rests on its intendment and consideration of the law.3 This well-known orthodox principle of corporate law has encouraged risky investments by shareholders. As a result, it has left many persons suffering at the ‘hands’ of corporations. However, no matter the extent of legal personality the law of most jurisdictions affords a company with, it cannot incorporate itself, nor operate under its own will. Who then should be responsible for the loss that stakeholders, such as judgment creditors, face, when they cannot receive compensation from the ‘hand’ of a corporation? 1 Canada Business Corporations Act, RSC 1985, c. C-44, s 15 (1) [CBCA]. 2 Salomon v Salomon [1897] AC 22, 66 L.J. Ch. 35 (HL (Eng)) [Salomon]. 3 Robert Hamilton, “The Corporate Entity” (1970) 49 Tex L Rev 979 at 980. 1 This thesis argues, that undercapitalization of private companies should be an independent ground for piercing the corporate veil. As it relates to private companies, undercapitalization has gained some judicial attention, particularly in American states. While US courts believe that undercapitalization is a significant factor to be considered in deciding whether to lift the veil of incorporation, the outcome of most cases concerning undercapitalization show that courts have given only limited scope to this factor, with no clear justification. Additionally, the cases also show inconsistencies in the judges’ decisions on the issue. There are very few Canadian commentaries on the undercapitalization issue. Because American law has often had influence on Canadian law, a number of American cases are examined.4 From an economic standpoint, limited liability has encouraged investment for many years and will inevitably continue to do so. This makes shareholders liable only for the amount they invest in a company, and their personal assets are protected. This statutory rule stretches back to Salomon5 and has been enshrined into the law of countries all over the world. It is, indeed, the orthodox foundation of company law in common law legal systems. This same rule, however, has also encouraged corporate abuse by investors. The ways in which investors have abused the privilege of limited liability are many. This thesis discusses one of those abuses, undercapitalization, which has become a critical issue for corporations today. As the cases discussed in this thesis will show, stakeholders have often 4 Ronald Podolny, Fixing What Aint Broke: In Defence of Canadian Poison Pill Regulation (2009) 67 U Toronto Fac L Rev 47, confirms this by when he highlighted that “developments in the US have influenced Canada…..Canadian courts and regulators are influenced by American ideas and frequently look south of the border before formulating a Canadian approach.” 5 Salomon, supra note 2. 2 suffered uncompensated losses as a result of shareholders’ refusal to adequately capitalize the companies they invest in. The underlying issue of this thesis is as follows. There are many instances in which private companies have been initially incorporated with capital that is totally inadequate for the nature of the business in question as the cases in chapter 5 of this
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