Ten (10) Key Considerations for Business Owners
Are you a business owner needing to protect your personal assets from liability? Are you considering investing, loaning money or providing services to a company? Are you engaged in businesses and deals that may lead to litigation? Given the current economic climate and anticipated financial hardships related to the pandemic, contractual defaults and insolvency will certainly increase.
If you are active in business, it is imperative to understand the concepts of “limited liability” and “piercing the corporate veil” to protect personal assets and/or enforce contracts and collect payment. Veil piercing is the most litigated issue in corporate law and can serve as a shield and a sword for savvy businesspersons.
This article is part one of a three-part series on veil piercing litigation for business owners. The following explains what veil piercing (a/k/a alter ego liability) is and highlights ten important facts to know. Part II provides practical considerations for companies to maintain limited liability and deter piercing claims. Part III discusses alternative claims to veil piercing that create third party liability such as successor liability, single enterprise theory, fraudulent transfer, and agency principles.
What is Veil Piercing?
Piercing the corporate veil is when a party to a lawsuit seeks to pierce a company’s limited liability protection to go after assets of the owners under a theory the owners (or affiliates) are an alter ego of the company, and thus holding them accountable for damages is fair.
For context: people form business entities to obtain limited liability protection over non-business assets. Thus, in the event of litigation such as breach of contract, partnership disputes, fraud, personal injury, etc., the liability is limited to the assets of the company, not the personal assets of the owners. However, the company may lack sufficient assets to pay damages. In that case, the claimant will want to go after the owners or affiliates (the alter egos) with assets to recover damages should it prevail.
Legal Requirements. There are two basic requirements for establishing alter ego:
(1) unity of interest, and
(2) resulting injustice.
This article focuses on California law, and each state has its own requirements for veil piercing and there is specific federal law as well. Generally, the elements of unity of interest and injustice are common themes across the board.
The first requirement- unity of interests- requires a finding of a unity of interest between the owners and the company such that separate personalities of the individuals and the entity do not exist. To establish unity of interests, California courts apply a multi-factor test analyzing certain facts such as: adequacy of capitalization, disregard of corporate formalities, commingling of funds and assets, transactions with insiders, issuance of stock, record keeping, diversion of assets, etc. No one factor is dispositive.
The second requirement- resulting injustice- requires a finding that to maintain the limited liability protection (hence, to deny piercing of the corporate veil), would sanction fraud or promote some form of injustice.
Why is Veil Piercing Important to Know?
Piercing the corporate veil is the most litigated issue in corporate law. If you own a business or actively engage in business deals (investing, lending, services, partnerships, joint ventures, etc.), chances are you will deal with veil piercing at some point- either as a plaintiff (creditor) or defendant.
Interestingly, courts view it as an extreme remedy to be used sparingly only when justice requires. Thus, there is a presumption against piercing in favor of respecting the corporate form. A study examining cases from 1996-2005 found that courts pierced the veil in 27% of cases nationwide. In California, veil piercing occurred in 33% of cases. An earlier study of 1600 veil piercing cases published in 1991 found the national rate at 40%, and California at 45%. So, the instances of veil piercing by the courts has decreased over the years.
While the percentage of successful veil piercing cases is relatively low and declining, the fact is that veil piercing is still highly litigated. Meaning the judicial policy disfavoring veil piercing does not prevent or deter creditors from pursuing alter ego liability claims.
So, while infrequently granted, it is frequently litigated and almost always threatened in pre-litigation discussions. Defending against alter ego liability is costly and given the subjective nature of the multi-factor test, the outcome is unpredictable. Therefore, it is essential to understand when one may be entitled to pierce and how to protect against potential claims of piercing. Some additional key points to know:
Ten (10) Key Considerations:
- Veil Piercing Laws of the Company’s State of Formation (Usually) Apply. Generally, the laws of the state of formation will dictate what state’s veil piercing law will apply. However, there are exceptions. For example, a recent California Court of Appeal case applied CA corporate veil piercing law to a Delaware LLC in a reverse veil piercing case. Notwithstanding the exceptions, certain states have veil piercing laws that make it harder to pierce, including Delaware, Wyoming, and South Dakota. Nevada is also protective of the corporate form and a good state for asset protection generally.
- Single-Member LLCs (SMLLCs) are More Susceptible to Veil Piercing. Alter ego liability relies on the concept that the entity and owners are one and the same. So at the outset, SMLLCs are perceptually more vulnerable to piercing claims. This is often true in practice, where corporate formalities may not be strictly followed, and comingling occurs more frequently. Since there is only one member, there is no need to track capital accounts. But remember, the litmus test is equity, i.e., some fraud or wrong doing.
- Unlike Corporations, LLCs are Subject to “Reverse” Veil Piercing Claims. “Reverse piercing” is generally when a creditor has a judgment against an individual and tries to go after the assets of a business owned by the individual. Creditors cannot go after a shareholder’s assets in a corporation. However, creditors may go after an LLC member’s interest in an LLC.
- No Limited Liability Protection for Personal Misconduct. Personal conduct is not protected by the corporate veil. Thus, intentional misconduct and other torts outside the capacity of the company are not protected, and the individual will be personally liable.
- Veil Piercing Applies to the Parent / Subsidiary Relationship. The law provides for parent / subsidiary business structures to aid in isolating liabilities in separate entities. Thus, sole ownership does not automatically create alter ego liability. Even instances where there are common personnel, shared offices, consolidated financials and shared manuals, a court may still not find an alter ego. A similar analysis applies to piercing a parent / subsidiary as piercing individuals and entities. In California, courts look for instances where the parent controlled the subsidiary in a manner that the sub was a “mere instrumentality” and used for an improper purpose, and it would be inequitable to uphold limited liability.
- There are Clear Ways to Prevent Piercing. Business owners must know how to protect and isolate their personal assets (or other business assets in the case of multiple business owners) from liability. This will be discussed in more detail in Part II. Generally, it is critical to ensure that your business entity is properly formed and registered in the states you are doing business. Ensure there is adequate capitalization, and that you follow proper corporate formalities. Do not comingle funds or assets of the owners or of affiliate businesses.
- You Can Take Preemptive Actions to Mitigate Risks of Default and Avoid Having to Pierce. Remember, piercing the veil is an extreme remedy and not often granted. Wise business best practice is to avoid situations for potential piercing litigation, which can be done via prudent due diligence and contractual protections. For example, search public records to identify red flags of the prospective partner, such as prior litigation, prior deals, reputation in the industry, etc. Contractually, get personal guarantees for the obligations and negotiate reasonable liquidated damages in the event of default. Identify specific assets (real property, intellectual property, receivables, etc.) as collateral and get security agreements on the collateral in the event of default. Ensure proper representations and warranties of ability to perform.
- Veil Piercing is an Equitable Claim, Not Legal Claim. Alter ego liability is an equitable remedy, not a cause of action. This is important because it goes to who decides. Since it is an equitable remedy, the judge decides, not a jury. Knowing this issue will be resolved by a judge versus a jury can have significant impacts on pre-litigation strategy considerations, demands and settlement negotiations.
- Similar Veil Piercing Analysis is Applied to Corporations and LLCs. While LLCs are newer corporate instruments, courts tend to apply similar alter ego principles to LLC and corporation, namely unity of interest and injustice.
- Fact Intensive — Subjective & Unpredictable. Because of the multi-factor test, the nature of all piercing cases is highly fact specific. No one factor is dispositive, and the determination is subjective and unpredictable.
The foregoing is not a comprehensive list of veil piercing issues, and each issue above arguably can justify a separate in-depth discussion. There are also more issues not covered. The point is veil piercing is important and common in business. If your business dealings anticipate or involve litigation and potential insolvency, you should consult with experienced corporate and litigation attorneys about viable strategies to protect third party assets (shield) and/or go after them to collect payment (sword).
[Shahrokh Sheik is a partner in the Los Angeles office of Weinberg Gonser. He regularly handles business and trademark litigation and outside general counsel matters.]