Disadvantages of Incorporation

Introduction :- Like there are advantages of incorporation of company, there are disadvantages of incorporation of company also like, Lifting the corporate veil, loss of personal ownership, loss of privacy, paperwork, legal formalities, etc which needs to be considered. Discussed below the disadvantages of incorporation of companies.

Lifting the Corporate veil (पडदा / बुरखा) :-

(Doctrine of Lifting of or Piercing (cut) the Corporate Veil)

Corporate Veil Meaning :- A Company is a person created by law, having a distinct entity. This principle is referred as Veil of Incorporation.

Misuse :- If the veil is used as a mask of fraud, then the courts will lift the veil and look at the person behind the company.

From the juristic point of view, a company is a legal person distinct from its members [Salomon v. Salomon and Co. Ltd.]. This principle may be referred to as the ‘Veil of incorporation’. The courts, in general, consider themselves bound by this principle. The effect of this Principle is that there is a fictional(काल्पनिक) veil between the company and its members. That is, the company has a corporate personality which is distinct from its members.

But, in a number of circumstances, the Court will pierce the corporate veil or will ignore the corporate veil to reach the person behind the veil or to reveal the true form and character of the concerned company. The rationale behind this is probably that the law will not allow the corporate form to be misused or abused. In those circumstances in which the Court feels that the corporate form is being misused, it will rip through the corporate veil and expose its true character and nature.

The circumstances under which the courts may lift the corporate veil may broadly be grouped under the following two heads :

A. Under statutory provisions

B. Under judicial interpretations.

A. UNDER STATUTORY PROVISIONS :- 

The veil of corporate personality may be lifted in certain cases or pierced as express provisions of the Act. In other words, the advantage of ‘distinct activity’ and ‘limited liability’ may not be allowed to be enjoyed in certain circumstances. Such cases are :

1. Misrepresentation in Prospectus (Secs 34 & 35) :-

In case of misrepresentation in a prospectus, every director, promoter and every other person, who authorizes such issue of prospectus, incurs liability towards those who subscribed for shares on the faith of untrue statement.

2. Failure to Return Application Money (Sec 39) :-  In case of issue of shares by a company to the public, if minimum subscription as stated in the prospectus has not been received within 30 days of the first issue of the prospectus the company must return the application money forthwith else the directors shall be personally liable to return the money along with prescribed interest.

 3. Misdescription of Name (Sec 12) :- Where an officer of a company signs on behalf of the company any contract, bill of exchange, hundi, promissory note, cheque or order for money, such person shall be personally liable to the holder if the name of the company is either not mentioned or is not properly mentioned

4. Holding Subsidiary Company :-  A holding company is required to disclose to its members the accounts of its subsidiaries. Every holding company shall attach to its balance sheet, copies of the balance sheet, profit and loss account, directors report and auditor’s report etc., in respect of each subsidiary company.

It amounts to lifting the corporate veil because in in the eyes of law a subsidiary is a separate legal person and through this mechanism their identity is known.

5. For Investigation of Ownership of Company (Sec 216) :-   Where it appears to the Central Government that there is a reason so to do, it may appoint one or more inspectors to investigate and report on matters relating to the company, and its membership for the purpose of determining the true persons—

(a) who are or have been financially interested in the success or failure, whether real or apparent, of the company; or

(b) who are or have been able to control or to materially influence the policy of the company.

Sometimes it becomes necessary to enquire into the ownership of shares and the extent of controlling interest as regards payment of taxes. The court has power to disregard corporate personality if it is used for tax evasion.

6. Fraudulent Conduct (Sec 339) :- If in the course of the winding up of a company, it appears that any business of the company has been carried on with intent to defraud creditors of the company or any other persons or for any fraudulent purpose, the Tribunal, on the application of the Official Liquidator, or the Company Liquidator or any creditor or contributory of the company, may, if it thinks it proper so to do, declare that any person, who is or has been a director, manager, or officer of the company or any persons who were knowingly parties to the carrying on of the business in the manner aforesaid shall be personally responsible, without any limitation of liability, for all or any of the debts or other liabilities of the company as the Tribunal may direct.

 Liability under this section may be imposed only if it is proved the business of the company has been carried on with a view to defraud its creditors.

7. Liability for Ultra Vires Acts :- Directors and other officers of a corporate will be personally liable for all those acts which they have done on behalf of company if the same are ultra vires the company.

8. Liability under other Statutes :- Besides the Companies Act, directors and other officers of the company may be held personally liable under the provisions of other statutes.

B. UNDER JUDICIAL INTERPRETATIONS :-

       Some of the cases where the veil of incorporation was lifted by judicial decisions may be discussed to form an idea as to the kind circumstances under which the face of corporate personality will be removed.

1. Protection of Revenue :-  If a company is being used for tax evasion or to avoid tax liabilities, the court readily disregard the corpoarate form of the business entity and lift the veil to see the human beings behind the corporate mask, as in Re. Dinshaw Maneckjee Petit (1927)

Sir Dinshaw Petit was a rich man having dividend and interest income. He was assessed for super-tax on an aggregate income of Rs. 11,35,302 arising in the previous year. He wanted to avoid income-tax. For this purpose, he had formed four private companies, in all of which he was the majority shareholder. The companies made investments and whenever interest and dividend income were received by the companies, he applied to the companies for loans, which were immediately granted, and he never repaid. In a legal proceeding the corporate veil of all the companies were lifted and the income of the companies treated as if they were ofSir Dinshaw Maneckjee Petit.

2. Prevention of Fraud or Improper Conduct :-

Where the medium of a company has been used for committing fraud or improper conduct courts have lifted the veil and looked at the realities of the situation. (Jones v. Lipman).

Gilford Motor Co V. Horne (1933) :-  Horne was appointed as a  managing director of the plaintiff company on the condition that “he shall not at any time while he shall hold office of a managing director or afterwards, solicit or entice away the customer of the company”. His employment was determined under an agreement. Shortly afterwards he opened a business in the name of a company which solicited the plaintiff’s customer.

It was held that, the defendant company ought to be restrained as well as the defendant Horne.

3. Determination of character (Trading with the enemy) :-

Company being an artificial person cannot be an enemy or friend. However, during war it may become necessary to lift the corporate veil and see the persons behind as to whether they are enemies or friends. It  is because, though a company enjoys a distinct entity, its affairs are essentially run by individuals (Daimler Co. Ltd. v. Continental Tyre & Rubber Co., 1916).

4. Formation of Subsidiaries to Act as an Agent :-

In Merchandise Transport Ltd v. British Transport Commission (1961), a transport company wanted to obtain licenses for its vehicles but it could not do so if it made the application in its own name. It therefore, formed a subsidiary company and the application for licenses was made in the name of the subsidiary. The vehicles transferred to the subsidiary, held, the parent and the subsidiary company were one commercial unit and the application for licenses was rejected.

5. In case of Economic Offences :-

In Santanu Ray v. Union of India (1988) it was held that in case of economic offences a court is entitled to lift the corporate entity and regard to the economic realities behind face.

6. Where Company is used to avoid Welfare Legislation :-

Where it was found that the sole purpose for the formation of the new company to use device  (idea) to reduce the amount to be paid by way of bonus to workman. Supreme Court upheld the piercing of the veil to look at the real transaction. (The Workman Employed inAssociated Rubber Industries Ltd, Bhavnagar v. The Associated Rubber Industries Ltd. Bhavnagar, 1986)

7. Government Company :-

A government company is, after all, a distinct entity in the eyes of the law. Even if the company holds majority of shares, company itself is not ‘government’. Justice Krishna Iyer took the view that, if the corporate veil of such a company is lifted, what lies behind the veil is the government, against whom writ petitions can be entertained. (Som Prakash Rekhi v. Union of India, 1981).

II) Cost :– The starting cost of incorporation comprises the fee needed to document our articles of incorporation, potential attorney or accountant fees, or the cost of using an incorporation administration to help us with completion and documenting the paperwork. There are additionally ongoing fees for keeping a corporation.

Even expenses involved in the incorporation of a company, in its day-to-day running and at the time of winding up are much greater than in the case of a partnership firm.

III) Formalities :-  Corporate law requires lot of formalities to be complied with.

Formalities start before the actual incorporation of a company, exist throught the life of company and continue even during its winding up.

IV) Ongoing Paperwork :-Most corporations are needed to document annual reports on the financial status of the company. The ongoing administrative work additionally incorporates tax returns, bookkeeping records, meeting minutes and any necessary licenses and allows for conducting business.

V) Loss of Privacy : In case of company, several documents including its accounts are to be filed with ROC and are open to public inspection resulting in loss of privacy after incorporation.

VI) Denial of fundamental rights :- Some of the fundamentl rights of the Constitution of India are available only to citizens of India (i.e. human beings).

But after the R.C. Cooper v. UOI, 1970, the corporation can claim their fundamental rights through their shareholder,  provided the shareholder is the citizen of India.

VII) Loss of Personal Ownership :– If a corporation is a stock corporation, an individual doesn’t sustain full control of the entity. The corporation is controlled by a board of directors who are nominated by the shareholders.