February 6, 2008

Piercing the Corporate Veil

Paul Battista, Esq.

Many advantages can be elicited by the creation of an entity through which a business is conducted.  One of the most attractive features of an entity such as a corporation or a limited liability company is that the owners of the entities are protected from personal liability for the debts, obligations or liabilities of a business.  In general, the owner’s liability is limited to the amount they invested in the entity.   However, this protection is limited by the right of creditors to sue the owners by claiming that these individuals should be held personally liable for a judgment obtained against the entity.  Commonly referred to as the “piercing the corporate veil” or “alter ego” theory, it is widely believed to be the most litigated issue in corporate law.  Most alter ego claims arise from transactions between private parties, but the government can also utilize the doctrine.  For example, the Internal Revenue Service pursues “alter ego liens” because a federal tax lien can attach to all property, and rights to property, of a taxpayer.

In California, a member of a limited liability company shall be subject to liability under the common law governing alter ego liability, and shall also be personally liable …for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort or otherwise, under the same or similar circumstances and to the same extent as a shareholder of a corporation may be personally liable for any debt, obligation or liability of the corporation.  Beverly-Killea Limited Liability Company Act, section 17101 (b).

Regardless of which type of entity is pursued (corporation or limited liability company), the general rules governing the application of this doctrine are well established in California.  There are two elements that an alter ego plaintiff must prove:

1)      That “there is such a unity of interest between the entity and another person or entity that they have no separate existence”;  and

2)      That an inequitable result would follow if the entity alone is held liable for the contract or tort.

In discussing the doctrine of alter ego, the California Supreme Court has held that “there is no litmus test to determine when the corporate veil will be pierced; rather, the result will depend on the circumstances of each case.” (Mesler v. Bragg Management Co., 39 Cal 3d 290, 216 Cal Rptr. 443 (485).

A review of the cases which have discussed the alter ego issues reveals that the court will consider a variety of factors in making its decision.  Those factors include, but are not limited to, the following:

(a) Commingling of funds and other assets;

(b) Failure to segregate funds of separate entities;

(c) Unauthorized diversion of entity funds or assets to other than the entity’s uses;

(d) The treatment by an individual of the assets of the entity as his or her own;

(e) The failure to obtain authority to issue stock or membership interests;

(f) The failure to maintain adequate entity records;

(g) The use of the same office or business location for two or more entities;

(h) The employment of the same employees for two or more entities;

(i) The failure to adequately capitalize an entity;

(j) The total absence of entity assets;

(k) The use of the entity as a mere shell, instrumentality or conduit;

(l) The disregard of legal formalities;

(m) The failure to maintain arm’s length relationship among related entities; and,

(n) The contracting with another to avoid performance by using the entity against personal liability (i.e. as subterfuge).

The court, in Associated Vendors v. Oakland Meat Co., Inc. (210 Cal.App.2d. 825, 840), stated that it is important to note that a “perusal of the cases reveals that in all instances several of the factors (are) present.”  Although a court will examine all of the factors in an alter ego claim, in California the factor most often found as the key factor in piercing the corporate veil is the undercapitalization of a company.  Undercapitalization can be obvious when, for example, a company holds no capital upon formation and continues to have no capital during the time it is conducting business. The courts will, however, also review the amount of capital a company holds in relation to the business of the company.  The theory underlying this inquiry is that the owners of a company should in good faith put at risk the amount of capital necessary to meet prospective liabilities of its endeavors, and if the court finds that the amount of capital contributed by the owners is illusory or trifling compared with the business to be done and the risk of loss, then it will find grounds to pierce the corporate veil and hold the owners personally liable for a judgment.

Limited liability protection provided by entities such as corporations and limited liability companies has been cited as essential for the growth of the economy because it allows owners to engage in economic risks that are quantifiable and circumscribed. The doctrine of piercing the corporate veil, however, attaches personal liability to the owners of these entities under certain circumstances, and has been created by the courts as an equitable remedy to counterbalance the relatively few individuals who subvert the advantages of limited liability to evade rightful creditors, to perpetrate frauds or to promote injustices.

Legal Disclaimer: The information contained herein is general in nature. It is for informational purposes only and provides an overview of a few legal principles. The information provided is not guaranteed to be up to date or correct. The information contained in this blawg is not, nor is it intended to be, legal advice. It should not be relied upon in making specific legal decisions, but you should consult an attorney regarding your specific situation. Receiving this transmission and/or reading the information in this transmission does not establish an attorney-client relationship. A written, signed retainer agreement is required for representation.

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