Starting And Managing Your Business101: Piercing the Corporate Liability Veil and the “Alter Ego Doctrine”

By: Richard E. Korb, attorney ©2011[1]

 “Piercing the corporate veil has become the most litigated issue in corporate law today.  In every case, the plaintiff’s intent is to acquire not only the company’s assets, but the owner’s personal assets as well.  And at least half of them will win.” -Wake Forest Law Review

“Piercing the corporate veil” is a judicial doctrine that allows for a corporation or limited liability company (LLC) to lose its limited liability protection. In other words, the individual owners, officers, or members become personally responsible for their company’s debts or other obligations arising from a lawsuit. In the event that a court rules the corporation has lost its liability protection, the guilty parties will have to pay the plaintiff from their personal assets as opposed to relying on the corporation’s assets. (This applies equally to non-profit and for-profit corporations.)

Context: In a lawsuit, the party suing (the plaintiff) claims to have incurred a loss as the result of the defendant’s actions. The plaintiff seeks monetary reparations in a court of law for the damages done by the defendant. If the defendant is a corporation or limited liability company, then there is a kind of shield protecting the assets of the individual owners, members, and/or officers in the event of a lawsuit. This ‘shield’ is the legal division or ‘separateness’ existing between the owner and the company, and is created by incorporating the business (e.g., starting an incorporation) or through LLC formation. It is this legal separateness that provides limited liability protection to the owners. So in most situations, only the assets of the corporation can be recovered by the injured plaintiff, not those of the corporation’s owners.

Thus, if a plaintiff files a lawsuit against a business only to discover that the business has lost its assets, the damages will go uncompensated. But this is where piercing the corporate veil comes into play—because there are certain circumstances under which a plaintiff might still be able to gain access to the personal assets of the responsible parties. The corporate shield between business and owner can be ‘pierced’ by a court of law, thereby allowing the plaintiff to sue the owner or officers personally.

There are several potential reasons for a court choosing to pierce the corporate veil:

The corporation’s legal identity may be disregarded if, for example, the owners or officers have acted illegally, such as being discovered to have committed fraud or intentional misconduct.

Piercing the corporate veil can also occur when the corporation has neglected to observe corporate formalities, which is a common reason why a court might disregard an entity’s limited liability protection.

The Alter Ego Doctrine

Piercing the corporate veil can occur if the company is found to be an alter ego for the owners. The alter ego doctrine is the technical term for when a corporation or LLC is determined to be the alter ego of its owners. In other words, the court decides that the owners have failed to maintain a proper separation between their identities and that of the company, and as a result, are liable to pay the company’s debts from their personal assets. For example, the owner might have been paying personal bills through the company’s bank account, which is called commingling assets.

Another aspect of the alter ego/piercing the corporate veil doctrine exists when the court has learned that the company being sued is merely a ‘dummy corporation,’ or alter ego of either a “parent corporation” or the owner, which has been deliberately under-funded in order to protect the owner or parent corporation from exactly such a lawsuit. In this situation, the corporation may have transferred debts to its subsidiary while withholding the funds necessary for paying those debts; which is called under-capitalization. Thus, the company (being sued by the plaintiff) literally does not have the money to recompense them, which may spur the court into forcing the individual owners to reimburse the plaintiff instead.

Under-capitalization isn’t always a deliberate ploy; sometimes the business simply does not have enough capital to keep up with operational expenses, or perhaps lacks the capital to meet the demands of the market. Poor financial planning and economic recessions are both reasons that might result in under-capitalization. Other causes include inadequate insurance to cover perceivable risks or failure to secure a critical bank loan. An under-capitalized business not only runs the risk of bankruptcy, but also the risk of losing its limited liability protection. Thus, adequate capitalization will help ensure personal and corporate separateness, and help avoid a commingling of personal and corporate finances.

To prevent the risk of losing their limited liability status, LLC’s should draft an Operating Agreement, and adhere to it.  Similarly, a corporation should adhere to its by-laws and comply with other requirements of corporate governance such as holding annual board meetings with directors and shareholders or members, keeping detailed minutes of decisions made during meetings, and drafting appropriate corporate resolutions. All companies should

also be sure to obtain liability insurance as soon as the business is established.

Procedure Under California Law

In California, courts must first prove the legal entity to be an alter ego of the guilty party in order to take away its limited liability protection, and there are several requirements to doing so. The theories behind piercing the corporate veil rest largely upon three ideas: wrongful conduct (as mentioned above), proximate cause (such that the corporation is clearly the cause of the injury to the plaintiff), and unity of interest. Proving a unity of interest between the corporation and individual officer or owner means that legal separateness has not been maintained, to the extent that the separate entities of company and shareholder no longer appear to exist. Taken together, these are referred to as the ‘totality of circumstances,’ and provide, not a hard and fast rule, but general guidelines upon which the court will draw.

Notwithstanding the general guidelines above, the 1962 case of Associated Vendors Inc. v. Oakland Meat Packing, Co. led to the establishment of several concrete factors which are applied in California courts to determine whether an alter ego is in effect. These factors include pertinent questions such as:

1. Did the individual defendant(s) act in bad faith?
2. Did the individuals collaborate together with the intent to use a corporate entity as a shield against personal liability?
3. Did the individuals divert assets from a corporation to a stockholder or other person or entity to the detriment of creditors?
4. Was the corporation dominated by a few key individuals?
5. Did the individuals and corporation use the same office or business location?
6. Did the individuals and the corporation employ the same attorney?
7. Did the individuals use the business to procure labor, services and merchandise for another person or business?
8. Did the individuals fail to provide adequate funds to the corporation (e.g., under-capitalization)?
9. Did the individuals fail to maintain minutes (during business meetings) or adequate corporate records?
10. Will there be an inequitable result (for the plaintiff) if the court fails to pierce the veil?

Several of these factors, such as maintaining minutes and keeping accurate corporate records, fall into the category of corporate formalities. Failure to observe corporate formalities, together with abuse of legal separateness, are two common instances that might lead a court to pierce the veil of a business or LLC. Factors like these are often more likely to be disregarded among closely held companies (also called close corporations), which makes them more vulnerable to a piercing of the corporate veil. Thus, in smaller corporations with fewer owners, it is even more important to make sure you are strictly abiding by the requirements of corporate governance.

In California, the plaintiff must also prove that there will be an inequitable result if the case treats the defendant as merely a corporate entity, which would otherwise allow owners to stand behind the corporate shield to avoid personal liability for their debts. Defining “inequitable” has proven a difficult issue in California courts, as it is a fairly equivocal term.

“Inequitable” certainly does not imply that every unsatisfied creditor will be able to invoke the alter ego doctrine. Rather, the plaintiff must prove that the defendant has acted in bad faith, and has abused the corporate shield. To prove that there would be an inequitable result, it must be apparent that it would “sanction a fraud or promote injustice” (Webber v. Inland Empire Investments, Inc.) not to disregard a business’s limited liability protection.

While business incorporation and LLC formation can provide productive and necessary limited liability protection to a company’s owners, members, and/or shareholders, the legal doctrines discussed (piercing the corporate veil and the alter ego doctrine) ensure that such protection is not abused.

If you believe you have done business with a company that has acted illegally, and that you may have recourse against the personal assets of the guilty individuals, or if you are an owner or officer in a company and anticipate a law suit against you and/or your company, it is advisable to seek the advice of an experienced attorney. Should you desire a consultation with an experienced business and trial attorney familiar with these issues, please contact Richard E. Korb for a consultation at (510) 524-0903.