Do You Have An Alter Ego?

Piercing the Corporate Veil in California

Oftentimes a client will ask whether or not he will be held personally liable for the debts and liabilities of his business.  Even immediately after a flawless incorporation, a good attorney will refuse the simple yes or no answer and respond, “Maybe …”  Why?

The Rationale Behind Limited Liability

Ordinarily, a corporation is regarded as a legal entity, separate and distinct from its stockholders, officers, and directors, with separate and distinct liabilities and obligations.[1]  The corporation (or the limited liability company, or the limited liability partnership, etc.) is premised upon the belief that by providing investors with a shield against personal liability, those investors are more likely to start a business or invest in an on-going concern.  This capital placed into the marketplace will in turn benefit the economy, and then, society at large.

Limits to Limited Liability

Now, if the business is a legitimate one, the premise works rather well.  However, if the business is a risky and/or dangerous endeavor, it seems unfair to allow the investor to gain all the rewards but take on so little of the risks involved.  In these situations, courts will disregard the corporate form and “pierce the corporate veil” of limited liability.  The investor, shareholder, member, or partner will then be held liable for the debts and liabilities of the enterprise.  As stated by the California Court of Appeal, “Under the alter ego doctrine, then, when the corporate form is used to perpetrate a fraud, circumvent a statute, or accomplish some other wrongful or inequitable purpose, the courts will ignore the corporate entity and deem the corporation's acts to be those of the persons or organizations actually controlling the corporation, in most instances the equitable owners.”[2]

The Test

In California, the courts have adopted what is known as the traditional two-part test in determining whether the corporate form should be disregarded and the owners held personally liable.  In order for the corporate form to be disregarded, the court must find that “(1) that there be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist and (2) that, if the acts are treated as those of the corporation alone, an inequitable result will follow..”[3]

Unfortunately, the “test” raises more questions than it provides answers.  The courts have, however, formulated a list of factors to be considered in determining whether to disregard the corporate form:

• 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;
• the treatment by an individual of the assets of the corporation as his own;
• the failure to obtain authority to issue stock or to subscribe to or issue the same;
• the holding out by an individual that he is personally liable for the debts of the corporation;
• the failure to maintain minutes or adequate corporate records, and the confusion of the records of the separate entities;
• 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 of the stock in a corporation by one individual or the members of a family;
• the use of the same office or business location;
• the employment of the same employees and/or attorney;
• the failure to adequately capitalize a corporation;
• the total absence of corporate assets, and undercapitalization;
• 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;
• the concealment and misrepresentation of the identity of the responsible ownership, management and financial interest, or concealment of personal business activities;
• the disregard of legal formalities and the failure to maintain arm's length relationships among related entities;
• the use of the corporate entity to procure labor, services or merchandise for another person or entity;
• 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;
• 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;
• and the formation and use of a corporation to transfer to it the existing liability of another person or entity.[4]

Generally, a court will find several of the above factors to be present prior to disregarding the corporate form.

Undercapitalization

One of the factors most prominent in the courts’ analysis is whether or not the investor provided the business with sufficient capital at formation.  At times, courts have hinted that undercapitalization alone is sufficient to warrant piercing the corporate veil.[5]  However, courts have denied alter ego liability in some cases where the party contracting with the corporation had knowledge of the corporation’s limited financial resources.[6]

It is important to distinguish an initially undercapitalized business from a failing business.  A business bereft of funds due to poor management and not under-funding at formation does not mean the business is undercapitalized for the purposes of corporate veil piercing liability.

Parent Corporations and Subsidiary Corporations

In the context of parent and subsidiary corporations, a certain degree of control must be found prior to piercing the corporate veil.  Generally, “a parent corporation is not liable for the contracts or torts of its subsidiary, even if wholly owned, unless the parent controls the subsidiary to such a degree as to render the latter a mere instrumentality of the former.”[7]

In one case, the court refused to disregard the corporate veil even though (1) 100 percent of the subsidiary’s stock was owned by the parent corporation, (2) there was interlocking officers and directors, (3) both corporation’s minute and stock books were kept by the parent corporation’s secretary at the parent corporation’s New York corporate headquarters, (4) there were consolidated financial statements which included income from divisions and subsidiaries in the parent’s annual reports, and (5) the parent corporation had transferred personnel from one subsidiary to another.[8]

Conclusion

While the shield of limited liability provided by corporations, limited liability companies, and limited liability partnerships is not impenetrable, a limited liability structure is generally advisable for many businesses.  It is important, however, that a business receive informed legal advice at all stages of its development.  From formation to operations to transitions, the maxim is correct:  “an ounce of prevention is worth a pound of cure.”

Feel free to contact our office for assistance in properly forming, running, and growing your business.  In today’s litigious society, your business simply cannot afford not to get the best legal advice!