Piercing the Ownership Veil Over Private Limited Liability Companies

In this paper, I arrive at a fundamental question: Given the particular nature of property rights in shares held by members of private limited liability companies (PLLCs), who actually controls the company? Ultimately, this will help clarify how what I call the ‘taming process’ developed by legislatures by providing restrictions on transfer of shares affects the physiology and morphology of the governance structure (decision-making) of PLLCs (can managers or directors in these business organizations afford to think they do not know it better or cannot do it better?). I define the effective powers members have in the company as a result of their ownership rights, as opposed to the powers held by managers and directors as a result of their management duties. It is often the case that members have residual control of the company, whilst managers have actual control of it. Thus, in reality, the scope of the rights held by members is more limited. They are even more limited, perhaps, than what operating agreements foresee. It is in this context that I refer to the 'piercing of the ownership veil'. I use this expression to stress that in my view, some circumstances demand that courts ignore restrictions on transfer of shares. The expression is also used here to suggest court intervention to clarify ownership of property rights in the shares. Here, I shall attempt to show under what circumstances this should be done. The idea that there may be situations in which the ownership veil must be pierced rests on the principle ‘substance over form’, which maintains that the economic substance of transactions rather than just their legal form be disclosed. Managers add value to the company. They are independent in the way they operate, in spite of the fact that in PLLCs members typically can give legally binding instructions to managers. But at the end of the day, these managers are also employees. They must take a common-sense approach to their work, including the meeting of members' demands. For instance, in order to make the business more attractive, they must ensure that information flows quickly. Innovation and the pursuit of new technology must be foremost in the managers’ mind, and this is true whether the business is small or big. Members want the company to grow. Essentially, managers should have the will to take responsibility, the ability to take initiative, and the capacity to add value to the company. The company is an ecosystem wherein path-dependent legal solutions lead to a fuzzy definition of property rights. Piercing the ownership veil entails investigating the reality of the company’s governance and tracing the real ownership profile of the company. It means asking: who controls the company (i.e., managers or members) and how 'tamed' are shareholders’ property rights according to the consensual agreements into which members and other stakeholders have entered? Toward this goal, I examine the extent to which freedom of contract is likely to enhance the power held by managers or directors in the PLLCs, and how this can be reconciled with the ownership or property rights of the members. Interestingly, I shall see that freedom of contract is used in different ways. For instance, corporate law is much more prescriptive in the United States than in the United Kingdom. Comparison can also be made with other countries. For example, in the United Kingdom it seems that freedom of contract has been used to enhance the power of directors. In Italy, where the principle of free transferability of shares prevails, this has not happened to the same extent. Members who are often managers hold the major stake in the company. Below, I look at how the ‘taming’ of property rights in shares of PLLCs established by legislatures affects the governance structure of the PLLC. The structure of this paper is the following. Section 1 analyses the relationship between concentration of ownership and control, which is different in the PLLC and the publicly held company. In the PLLC, there is a high concentration of ownership and often no separation of ownership and control, at least to the extent there is in the publicly held company. The implication of this is the emergence of clashes of interests not only between managers and shareholders, but also between shareholders themselves. Section 2 explores the definition of fiduciary duties in selected jurisdictions, in particular the duties of loyalty and care, and the different ways they are materialized. This section also dwells on the concept of business judgment rule (BJR) and links it to the piercing of the ownership veil, and the process of decision-making in the company. Additionally, it suggests the application of the BJR to civil law countries, considering that this is a mechanism rooted in US law. The idea is that whenever the advantages of the business judgment are hindered by the actual exercise of control and its manipulation, courts should be able to pierce the ownership veil, and read beyond the contractual terms. Finally, this section typifies the situations in which the ownership veil could be pierced. Section 3 concludes by pointing in the direction of a general theory of fiduciary duties in Europe that does not neglect hybrid property rights.