Corporations

PIERCING THE CORPORATE VEIL

When a corporation is a sham, engages in FRAUD or other wrongful acts, or is used solely for the personal benefit of its directors, officers, or shareholders, courts may disregard the separate corporate existence and impose personal liability on the directors, officers, or shareholders. In other words, courts may pierce the "veil" that the law uses to divide the corporation (and its liabilities and assets) from the people behind the corporation. The veil creates a separate, legally recognized corporate entity and shields the people behind the corporation from personal liability.

In these cases, courts look beyond the form to the substance of the corporation's actions. The facts of a particular case must show some misuse of the corporate privilege or show a reason to cut back or limit the corporate privilege to prevent fraud, MISREPRESENTATION, or illegality or to achieve EQUITY or fairness.

Courts traditionally require fraud, illegality, or misrepresentation before they will pierce the corporate veil. Courts also may ignore the corporate existence where the controlling shareholder or shareholders use the corporation as merely their instrumentality or alter ego, where the corporation is undercapitalized, and where the corporation ignores the formalities required by law or commingles its assets with those of a controlling shareholder or shareholders. In addition, courts may refuse to recognize a separate corporate existence when doing so would violate a clearly defined statutory policy.

Courts may pierce the corporate veil in taxation or BANKRUPTCY cases, in addition to cases involving plaintiffs with contract or TORT claims. Federal law in this area is usually similar to state law.

The instrumentality and alter ego doctrines used by courts are practically indistinguishable. Courts following the instrumentality doctrine concentrate on finding three factors: (1) the people behind the corporation dominate the corporation's finances and business practices so much that the corporate entity has no separate will or existence; (2) the control has resulted in a fraud or wrong, or a dishonest or unjust act; and (3) the control and harm directly caused the plaintiff's injury or unjust loss.

The alter ego doctrine allows courts to pierce the corporate veil when two factors exist: (1) the shareholder or shareholders disregard the separate corporate entity and use the corporation as a tool for personal business, merging their separate entities with that of the corporation and making the corporation merely their alter ego; and (2) recognizing the corporation and shareholders as separate entities would give court approval to fraud or cause an unfair result.

It may appear that a corporation owned by one or two persons or a single family would almost automatically lose its separate legal existence under these doctrines, but this is not necessarily so. A sole owner of a business, for example, can incorporate herself or himself, or the business; issue all shares to herself or himself; and set up dummy directors to follow the necessary corporate formalities. However, the sole shareholder may lose the protection of limited liability—just as any other corporation would—if the corporate affairs and assets are confused or commingled with personal affairs and assets, if the sole shareholder abuses her or his control, or if the sole shareholder ignores the necessary corporate formalities.

When courts ponder piercing the corporate veil, they consider undercapitalization to exist when a corporation's assets or the value it receives for issuing shares or bonds is disproportionately small considering the nature of the business and the risks of engaging in that business. Courts assess undercapitalization by examining the capitalization at the time the corporation was formed or entered a new business. For example, if a corporation that faces or may face obligations to creditors and potential lawsuits has received only a token or minimal amount for its shares, or has siphoned off its assets through dividends or salaries, courts may find undercapitalization. Such corporations are called shells or shams designed to take advantage of limited liability protections while not exposing to a risk of loss any of the profits or assets they gained by incorporating.

The undercapitalization doctrine especially comes into play when courts must determine who should bear a loss—a corporation's shareholders or a third person. This determination usually depends on whether the claim involves a contract or a tort (civil wrong or injury). In contract cases, the third party usually has had some earlier dealings with the corporation and should know that the corporation is a shell. So, unless there has been deception, courts typically find that the third party assumes the risk and should suffer the loss. In tort cases, the third party normally has not dealt voluntarily with the corporation. Courts thus must decide whether the owners of the business can shift the risk of loss or injury off themselves and onto the innocent general public simply by creating a marginally financed corporation to conduct their business.

Courts may disregard the separate corporate existence when a corporation fails to follow the formalities required by corporation statutes. Courts often cite the lack of corporate formalities in finding that a corporation has become the alter ego or instrumentality of the controlling shareholder or shareholders. For example, a court may justify piercing the corporate veil if a corporation began to conduct business before its incorporation was completed; failed to hold shareholders' and directors' meetings; failed to file an ANNUAL REPORT or tax return; or directed the corporation's business receipts straight to the controlling shareholder's or shareholders' personal accounts.

Courts also may ignore the corporate existence when a corporation's funds or assets are commingled with the controlling shareholder's or shareholders' funds or assets. For example, they may pierce the corporate veil when no sharp distinction is drawn between corporate and PERSONAL PROPERTY; corporate money has been used to pay personal debts without the appropriate accounting, and vice versa; the controlling shareholder's or shareholders' personal assets have been depreciated along with corporate assets; or the controlling shareholder or shareholders have endorsed company checks in their own name.

Many times, a controlling shareholder is itself a corporation: the controlling shareholder is the parent corporation, and the controlled corporation is a subsidiary. In some circumstances courts may pierce the corporate veil protecting the parent and hold the parent liable for the subsidiary's obligations. This happens where the subsidiary loses its independent existence because the parent dominates the subsidiary's affairs by participating in day-to-day operations, resolving important policy decisions, making business decisions without consulting the subsidiary's directors or officers, and issuing instructions directly to the subsidiary's employees or instructing its own employees to conduct the subsidiary's business.

Courts also hold the parent liable where the parent runs the subsidiary in an unfair manner by allocating profits to the parent and losses to the subsidiary; the parent represents the subsidiary as a division or branch rather than as a subsidiary; the subsidiary does not follow its own corporate formalities; or the parent and subsidiary are engaged in essentially the same business, and the subsidiary is undercapitalized.

A final scenario in which courts may pierce the corporate veil involves an enterprise entity, which is a single business enterprise divided into separate corporations. For example, a taxicab enterprise may consist of five corporations with two taxis each, a corporation for the dispatching unit, and a corporation for the parking garage. All the corporations, though separate, essentially engage in a single business—providing taxi service.

Courts often harbor suspicions that such arrangements are made in an attempt to minimize each corporation's assets that would be subject to claims by creditors or injured persons. Courts often will, in essence, put the corporations together as a single entity and make that entity liable to a creditor or injured person, perhaps because treating them as separate entities is unfair to those who believe they really form a single unit.