- Basics
- Reasons for piercing the veil
- Alter ego theory
- Agency theory
- Recommendations
Basics
One of the major advantages of incorporation is that it protects shareholders from personal liability. For that purpose, corporations can legally limit their liability exposure by creating corporate subsidiaries to conduct certain operations and take on debt. This way the subsidiary company protects the parent company from liability. Nevertheless, creditors can ask the court to disregard the corporate status of a subsidiary and “pierce the corporate veil” to hold the parent company liable beyond its capital contribution to the subsidiary. Corporate veil can be pierced in a parent/subsidiary context and also when the corporation only has one individual shareholder and no subsidiaries. In the latter case, you would be personally liable for the liabilities of your corporation. According to a recent study, California courts pierce the corporate veil in 50.86 percent of cases. Peter B. Oh, Veil-Piercing, 89 Tex. L. Rev. 81, 115 (2010).Reasons for piercing the veil
Usually plaintiffs try to pierce the corporate veil to get to the parent’s or your personal pockets when the corporation’s assets are insufficient or unreachable. The court may pierce the corporate veil either before or after rendering a judgment on the merits.In some cases the plaintiff may ask to pierce the corporate veil for the strategic purpose of acquiring a more convenient jurisdiction and/or jurisdiction with more favorable laws. This is often the case when the parent company is outside of the US and is doing business through a US subsidiary. In that case, a plaintiff who makes it to the discovery stage is entitled to oblige the defendant to produce massive amounts of documents and witnesses for both the defendant’s parent company and its subsidiaries. Plaintiffs are entitled to that at the discovery stage because the US has some of the most generous discovery laws in the world. This, of course, significantly increases the value of the plaintiff’s case and makes the defendant more likely to settle.
The basic task in trying to pierce the corporate veil is to prove that the company, even though a separately incorporated entity on paper, is not really separate from its owner(s) or parent company.
Alter ego theory
Alter ego theory of piercing the corporate veil basically means that the parent or owner dominated the subsidiary with disregard of corporate formalities for the separate identity, and injustice to the plaintiff is likely to result unless the corporate veil is pierced. When deciding whether to pierce the corporate veil, California courts look at the following factors, laid out in Associated Vendors, Inc. v. Oakland Meat Co., (1st Dist. 1962):(1) Commingling of funds and other assets, failure to segregate funds of the separate entities, and the unauthorized diversion of corporate funds or assets to other than corporate uses.
(2) The treatment by an individual of the assets of the corporation as his own.
(3) The failure to obtain authority to issue stock or to subscribe to or issue the same.
(4) The holding out by an individual that he is personally liable for the debts of the corporation.
(5) The failure to maintain minutes or adequate corporate records, and the confusion of the records of the separate entities.
(6) The identical equitable ownership in the two entities; the identification of the equitable owners thereof with the domination and control of the two entities; identification of the directors and officers of the two entities in the responsible supervision and management; sole ownership of all the stock in a corporation by one individual or the members of a family.
(7) The use of the same office or business location; the employment of the same employees and/or attorney.
(8) The failure to adequately capitalize a corporation; the total absence of corporate assets, and undercapitalization.
(9) The use of a corporation as a mere shell, instrumentality or conduit for a single venture or the business of an individual or another corporation.
(10) The concealment and misrepresentation of the identity of the responsible ownership, management and financial interest, or concealment of personal business activities.
(11) The disregard of legal formalities and the failure to maintain arm's-length relationships among related entities.
(12) The use of the corporate entity to procure labor, services or merchandise for another person or entity.
(13) The diversion of assets from a corporation by or to a stockholder or other person or entity, to the detriment of creditors, or the manipulation of assets and liabilities between entities so as to concentrate the assets in one and the liabilities in another.
(14) The contracting with another with intent to avoid performance by use of a corporate entity as a shield against personal liability, or the use of a corporation as a subterfuge of illegal transactions.
(15) The formation and use of a corporation to transfer to it the existing liability of another person or entity.
Agency theory
In order to prevail on the agency theory, a plaintiff must prove that the subsidiary was acting on behalf of the parent as its agent, while the parent exercised total control over the subsidiary. Ownership of subsidiary’s stock and overlap in management is usually insufficient to pierce the corporate veil on the agency theory.Plaintiff must show parent’s extraordinary control over the actions of the subsidiary. Such control and authority can either be actual or apparent. Actual authority exists when the parent specifically communicates the intent to control the subsidiary’s actions. Apparent authority can be established when some conduct by the parent company (not the subsidiary) gives the plaintiff good reasons to believe that the subsidiary is acting fully under the parent’s authority and control.
Recommendations
On order to avoid being personally liable for the debts of your company or a subsidiary of that company, you should:- Properly capitalize the business(es) and insure against foreseeable risks;
- Ensure compliance with corporate formalities;
- File separate tax returns;
- Avoid mixing personal and company funds;
- Avoid mixing parent’s and subsidiary’s funds;
- Parent must abstain from hiring and firing subsidiary’s personnel;
- Ensure that all loans and transactions between you and your company are reasonable;
- Maintain debt/equity ratio adequate for your industry;
Basically, the courts will be less likely to pierce the corporate will if you show that you were serious about maintaining corporate entities separate and provided adequate for your industry capitalization and insurance to guard against foreseeable risks.
International companies will benefit by avoiding contacts with the U.S. and letting their subsidiaries do the work in this country. This will help foreign business to avoid the significant expenses of being haled into the remote U.S. courts with their burdensome discovery rules.
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