Large firms today are rarely organized as a single legal entity, but rather as corporate groups with numerous subsidiaries that have separate legal personalities. A debate has long raged over how to treat the legal boundaries between companies belonging to a corporate group in administering bankruptcies, imposing liability for corporate torts, or determining how tax and jurisdictional rules should apply. Less discussed is how corporate law itself treats these boundaries when applying its regime of corporate governance and investor protection. Do corporate laws “pass through” and reach corporate subsidiaries – e.g., by allowing shareholders of a parent company to sue subsidiary directors, inspect subsidiary books and records, or approve major asset sales by subsidiaries? Or does corporate law instead uphold corporate separateness by strictly limiting shareholder rights to the particular entity in which investors hold shares?
In a Harvard Law Review article published half a century ago, Melvin Eisenberg warned that the emergence of corporate groups with mega-subsidiaries posed a significant threat to investor protection. If the legal separateness of subsidiaries were strictly upheld, shareholders of parent companies could not exercise their usual legal rights against major parts of the business, given that they do not hold shares in the subsidiaries. How have corporate laws around the world tackled this problem?
In a new working paper, I map corporate law’s treatment of entity boundaries within groups of companies in key jurisdictions over time. The paper reveals that the erasure of entity boundaries in the application of corporate law rules – which I term the rise of “entity transparency” – has gradually increased in jurisdictions as diverse as Brazil, France, Germany, India, Japan, the United Kingdom, and the United States. Moreover, the rise of entity transparency in corporate law has accelerated in the last few decades, with many jurisdictions adopting major reforms in this area well into the 21st century. While the problem identified by Eisenberg persisted in the United States through the 1990s, by 2020, courts and legislatures had largely addressed it. As of 2000, only one state allowed pass-through inspection rights in subsidiaries, and only seven states granted pass-through approval rights for substantial asset sales by subsidiaries. By 2020, the number of states with similar statutory provisions had more than quadrupled, with several others adopting a similar solution through caselaw.
Take Delaware law. Like other U.S. jurisdictions, Delaware has long recognized double derivative suits (i.e., the filing of a derivative suit by a shareholder of the parent company against directors of a corporate subsidiary). For instance, in its 1996 decision, Carlton Investments v. TLC Beatrice Int’l Holdings, Inc., the Delaware Court of Chancery agreed to process a quadruple derivative suit involving two separate levels of French wholly-owned subsidiaries by treating the French assets as beneficially held by the Delaware holding company.
But the embrace of entity transparency in other areas of Delaware corporate law is more recent. In response to the Enron debacle, section 220 of the Delaware General Corporation Law (DGCL) was amended in 2003 to allow parent company shareholders to inspect books and records of subsidiaries without showing fraud or abuse. Section 271 of the DGCL was amended in 2005 to clarify that the requirement of shareholder approval for a sale of all or substantially all of a company’s assets also applies to a sale by a wholly-owned subsidiary – a reform that followed the discussion in the Hollinger case and a similar shift toward entity transparency in this area by the Model Business Corporations Act (MBCA) in 1999.
Entity transparency also applies to Caremark claims, which often seek to hold directors of parent companies liable for failures of oversight over operations of a corporation’s subsidiaries. In a 2019 decision, Marchand v. Barnhill, the Delaware Supreme Court refused to dismiss a complaint against directors and officers for oversight failure in a food company that lead to a disastrous listeria outbreak – even though the operating company in the case was a limited partnership that was 69 percent owned by the holding company in which the plaintiffs held their shares. The opinion by Chief Justice Leo Strine relied on entity transparency and did not even bother with the issue of entity boundaries, except to observe in a footnote that “the Court of Chancery sensibly and properly collapsed the enterprise” in evaluating the case.
At the same time, there are relevant cross-country differences when it comes to the embrace of entity transparency. While we observe a general trend toward greater entity transparency in corporate law around the world, jurisdictions have diverged in their pace of adoption, thus producing overlooked gaps in investor protection. Although the United States and the United Kingdom lack a a specific statute on corporate groups and are assumed to adopt an “entity centric” approach to corporate law, these countries have led the way in increasing entity transparency in the field. In fact, accounting for pass-through shareholder rights reveals that the U.S. and the UK have a robust and dedicated corporate law regime for groups of companies, a conclusion that runs counter to depictions in the literature.
The study also finds a lack of direct correlation between a jurisdiction’s willingness to overcome entity boundaries for purposes of imposing liability on shareholders (veil piercing) and for purposes of extending the application of shareholder rights to controlled firms (“veil peeking”). The UK is a leader in entity transparency in corporate law but is comparatively reluctant to curtail shareholders’ limited liability. Brazil, by contrast, has aggressively weakened limited liability in corporate groups yet has been slower in embracing pass-through shareholder rights in various contexts.
Entity transparency also has interesting and potentially troubling implications for conflict of laws. The general conflict of law rule for corporate law is that the laws of the state of incorporation – be it determined by the principal place of business or by free choice – govern the internal affairs of the company. Entity transparency subverts the conflicts of law analysis because of its potential for extraterritorial application. Entity transparency leads to the application of the parent company’s governing laws to other related entities, which may be, and often are, governed by the laws of a different jurisdiction.
Recognizing the rise of entity transparency in corporate law also produces broader normative implications for other areas of law. First, it challenges the dogma of complete corporate separateness and corroborates the view that the degree of legal insulation provided by corporate personality is a matter of public policy, not a logical or doctrinal imperative. Second, and relatedly, the prevalence of entity transparency in corporate law helps debunk the oft-repeated notion that exceptions to corporate separateness invariably require extraordinary circumstances or explicit legislative authorization. Entity transparency in corporate law applies strictly and routinely; it does not require exceptional circumstances or abuse.
Neglecting the evolution toward entity transparency in corporate law has muddied doctrinal waters in corporate law and beyond. Several aspects of corporate law in various jurisdictions, as well as in other areas of law, have selectively adhered to the myth that overcoming corporate separateness requires exceptional circumstances or abuse. This view no longer corresponds to the content of corporate laws in a wide variety of contexts. In corporate law, as elsewhere, the degree of legal insulation afforded by corporate personhood is not a corollary of first principles, but the result of changing policy choices forged by economic and social needs. In corporate law itself, the case for entity transparency is particularly strong.
This post comes to us from Professor Mariana Pargendler at Fundação Getulio Vargas School of Law in São Paulo. It is based on her recent article, “The New Corporate Law of Corporate Groups,” available here.