Piercing The Corporate Veil
Although that may sound painful, piercing the corporate veil is often the last resort of a plaintiff in a lawsuit, to receive, for example, payment for goods or services provided.
A major advantage of incorporating a business is liability protection. Forming a corporation, LLC or similar entity creates what is called a corporate veil, a formal division between the entity and the personal assets of the shareholders of the corporation. If challenged in a lawsuit, IRS audit or other action, the veil of liability protection may be pierced and the shareholders may be held liable for the debts and/or liabilities of the corporation if it is found that the corporation did not follow proper corporate formalities.
The default rule in corporation law is that shareholders enjoy limited liability protection. A shareholder’s exposure to corporate liabilities is confined to their equity investments in the firm. They can lose no more than the value of their entire shareholding in the event of corporate failure. The basis of this limited liability is separate corporate personality – the notion that a corporation is entirely distinct from its shareholders in the eyes of the law. As long as a corporation is duly incorporated, it functions as a distinct legal entity, and its shareholders enjoy limited liability protection.
Many companies legitimately use the corporate structure to manage their operational risk by creating corporate subsidiaries to conduct their businesses, including contracting with customers, obtaining supplies, and incurring debt. This structure allows a parent company to shield itself from its subsidiary’s liabilities and limit its exposure to its capital contribution to the subsidiary.
The primary reason plaintiffs seek to pierce the corporate veil of a subsidiary is to reach the deep pockets. Because recovery against the subsidiary may be limited (due to a subsidiary only holding those assets required for its operations and any statutory capitalization requirements), a plaintiff may seek to pierce the corporate veil to reach the parent company’s assets.
Courts typically base their decision to pierce the corporate veil by considering the structural relationship between the parent company and the subsidiary. To make the subsidiary’s actions and jurisdictional contacts the responsibility of the parent company, a plaintiff must persuade the court that the parent company and the subsidiary are not truly separate companies. The two primary arguments used in these piercing claims are:
- The subsidiary is the parent company’s Alter Ego
- The subsidiary is the parent company’s Agent
To prevail under the Alter Ego theory, a plaintiff must prove that:
- The parent company completely dominated the subsidiary with disregard for its separate identity
- An injustice or other wrong to the plaintiff will likely result if the corporate veil is not pierced
Under the Agency theory, a plaintiff seeks to prove the subsidiary was acting as an agent of the parent company. The parent company’s liability is based on the concept that the principals are liable for actions taken by their agents within the scope of their authority. To prevail on an agency theory, a plaintiff must typically establish that:
- The parent company intended for the subsidiary (the alleged agent) to act on its behalf; and
- The subsidiary agreed to act as the parent company’s agent; and
- The parent company exercised total control over the subsidiary
In both situations, although the subsidiary exists as a separate entity from the parent, the parent company actually “calls the shots.” When used to deny (for example) vendors payment, it is an abuse of the concept of incorporation, and the parent company can become responsible for the liabilities of the subsidiary.
PROTECTING THE PARENT COMPANY
There are many steps a parent company can take to minimize the risk that a court will pierce the corporate veil of its subsidiary to reach the parent company’s assets.
The most important step is to properly capitalize and insure the subsidiary to substantially weaken the possibility that the plaintiff will suffer injustice if the corporate veil is not pierced. Courts are far less likely to permit a plaintiff to reach the assets of a parent company if the plaintiff can collect the full amount of money judgment against a properly capitalized and insured subsidiary.
In addition, too much control by the parent company over the day-to-day business decisions of its subsidiary has lead courts to refuse to dismiss the parent company as a defendant. Parent companies should avoid structuring their relationship with their subsidiaries in ways that permit them to exercise final decision making power or other undue influence on the routine business operations of their subsidiaries.
To ensure your corporation is separate and apart from its shareholders, make sure it has the following:
- Documentation and Formalities: Create By-Laws, issue stock, maintain an up-to-date minute book, have separate bank accounts, file annual reports, and have regular board meetings
- Employment Agreements: Have one for each officer and the corporation
- Capitalization: Appropriately capitalize the corporation and purchase liability insurance
- Avoid Co-mingling of Assets: Do not co-mingle corporate assets with those of shareholders; all corporate assets should be titled in the corporate name. Corporations should have their own bank accounts. If you borrow from, or lend to the corporation, record an appropriate Resolution, sign a promissory note, charge fair market rate interest, and make regular payments
- Multiple Corporations: Avoid identical stock ownership of several corporations. Avoid having similar officers and directors. Use different business addresses, telephone numbers and employees for each corporation