Veil Piercing: Some Practical Guidelines
BY PAUL L. CRISWELL
The legal maneuver known as "piercing the corporate veil," where a court lets creditors pursue stockholders for a corporation's debts, can send shivers up investors' spines everywhere.
Normally, corporation laws of every state confine debts to the corporation: stockholders, including corporate parents, usually are not personally liable for a corporation's debts and obligations.
Sometimes, though, a creditor can persuade a court to "pierce through" the corporate form and hold shareholders responsible for the actions of the corporation. That is, based on the facts and circumstances of a particular case, a creditor or other litigant may successfully argue that it is unfair or inappropriate to allow investors to get off Scot-free.
The stockholders' chief defense against such an attack is the public policy basis for having corporations in the first place: To insulate investors from personal liability lets companies raise investment capital in order better to conduct business, and thus the so-called "veil" forms a key underpinning of our economy. Because this argument is a powerful one, courts tend to pierce the corporate veil only in limited circumstances.
When courts conclude from the facts of a case that they ought in fairness to pierce a veil, they usually articulate their reasoning with a conclusory-and not very helpful-label: They may find behavior that disregarded the "separateness" of the corporation and its shareholders and created a single identity in the minds of observers; a corporation was the mere "alter ego" of its investor; a parent exercised "complete domination" over its subsidiary; or the corporation was the "mere instrumentality" of its shareholders.
Here are some recent veil piercings:
- A party to a contract concealed the fact that there was a separate corporation, only to finally execute the contract in the corporate name, depriving the victim of the concealing party's personal obligation to see the contract through;
- Two corporations (or a corporation and an investor) shared the same facility, used the same assets, paid bills from the same bank account and appointed the same officers-i.e., two entities conducted their operations as one;
- A subsidiary was routinely described as a "division;"
- The corporate form was used to evade a strong public policy such as environmental protection, tax collection or the payment of wages.
Conversely, under ordinary circumstances stockholders-individuals as well as corporate parents-may rest easy provided that the corporation follows some guidelines that may be loosely summarized as: (1) observe corporate formalities, (2) maintain in the corporation sufficient capital that it can operate (but not to cover every potential liability) and (3) don't fool people into thinking that they are dealing directly with the shareholders or a parent.
Here are the guidelines:
- Observe Formalities.
- File corporate form and especially annual reports timely (the latter being only formality required of an LLC, and thus especially important for it);
- Conduct board and shareholder meetings even if only by written consent;
- Issue stock to investor companies;
- Approve or ratify important decisions in board minutes.
- Open separate bank accounts and use the corporate account to pay corporate bills.
- Pay subsidiary employees with subsidiary checks, even if it's the same bank and payroll service.
- Do not commingle funds! Keep formal records of funds transfers to and from the corporation.
- Maintain Adequate Capitalization.
- Upon formation, estimate what money the company will need and either put it in at the outset or lay out a plan for investing or obtaining it.
- Put some of the investors' money or property at risk-do not capitalize solely through loans and services-courts may believe that you put nothing at risk, and so the corporation is a sham to avoid liability.
- Buy insurance coverage commensurate with the foreseeable risks that the company may face. (But it is not necessary to insure against every conceivable risk.)
- Pay particular attention where the corporation will conduct some high-risk activity or activity with a high profile or a strong public interest.
- Funds Transfers:
- Do not take money out of the subsidiary if the effect is to render it insolvent. (This is often a violation of corporate law also.) An improper withdrawal could be a dividend, a loan repayment or even a one-sided contract.
- Do not remove large sums in anticipation of a large liability. I.e., if you must remove profits, subject to tax considerations, do so regularly so that the parent is not in a situation where it might lose everything if it doesn't make a huge dividend payment just before someone files a lawsuit.
- Avoid Misrepresentation.
- If the parent (or investor) intends to guarantee a debt, do so formally. Otherwise, do not represent or even intimate that the parent may step in if the corporation cannot meet its obligations.
- Do not indicate or imply that the other party is really doing business with an entire corporate group (e.g. Smith Co. a member of the Smith Family of Companies.)
- See 1.b) above.
- Use separate stationery and maintain different Web sites for parents and subsidiaries.
- Brand parents and subsidiaries differently with different trademarks and service marks.
Comment: To avoid personal liability, make sure that any privately held corporation in which you are an investor: 1. observes corporate formalities, 2. is adequately capitalized, and 3. has officers that consistently inform third parties that they are dealing with a corporation.
© ASSOCIATION OF INDEPENDENT GENERAL COUNSEL 2005; (all rights reserved). This article is not intended as legal advice. Consult a qualified attorney for assistance concerning a specific issue or problem.