Liability of Corporate Shareholders: Piercing the Corporate Veil

Piercing the Corporate Veil

        One of the primary purposes of forming a corporation is to limit the liability of the firm’s owners, also known as the shareholders.[1] Since a corporation is a separate legal entity distinct from its owners, the corporation itself is liable for its debts.[2] Shareholders’ liability is usually limited to the amounts of their investments.[3] The insulation from corporate debts is known as the “corporate veil.” However, in limited circumstances, if the corporation is not properly operated, the corporate veil can be pierced. 

        This presentation will discuss the origins of “piercing the corporate veil,” as well as provide background on how the corporate veil can be pierced.

        While the piercing-the-corporate-veil concept originated from corporate law and has been primarily applied to corporations, the concept of veil piercing has been extended to other forms of business entities, such as Limited Liability Companies[4] and Limited Partnerships.[5] In determining whether to pierce a corporate veil, courts typically examine a variety of factors.  Some states have developed a two-prong test. The prongs are called the “formalities” prong and “fairness” prong respectively:

1. Is there a sufficient unity of interest and ownership between the corporation and its owners such that the separate entity status of the corporation should be disregarded?; and
2. Would it be inequitable to pierce the corporate veil? (the “fairness” prong).[6]

        An important factor taken into consideration when analyzing the formalities prong is whether the corporation is grossly undercapitalized for its purposes.[7] A corporation is undercapitalized when it does not have sufficient funds to properly operate and, therefore, is not really a separate entity that could stand on its own. Other factors used in the analysis include:

• failure to observe corporate formalities such as holding board and shareholder meetings,
• non-payment of dividends,
• the insolvency of the debtor corporation at the time,
• siphoning of funds of the corporation by the dominant stockholder,
• non-functioning of other officers or directors,
• absence of corporate records, and
• any indication that the corporation is merely a facade for the operations of the dominant stockholder or stockholders.[8]

        With respect to LLCs, courts typically consider the same “corporate” factors in determining whether to pierce the limited liability shield offered by the LLC form.[9]  For example, many courts have explicitly noted the similarity of the liability shield offered by the corporation and that offered by LLCs: In a recent case, the Second Circuit court of appeals stated: “Given the similar liability shields that are provided by corporations and LLCs to their respective owners, ‘[e]merging caselaw illustrates that situations that result in a piercing of the limited liability veil are similar to those [that warrant] piercing the corporate veil.’”[10]  However, because LLCs are not required to follow all of the same formalities that corporate statutes impose, somewhat less emphasis should be placed on the formalities prong in the LLC context.[11]

        As for limited partnerships, in some cases, courts have held that there is nothing in the nature of the partnership form or in the relevant statutes that would preclude application of the veil-piercing doctrine to limited partnerships.[12] Keep in mind that in a limited partnership, only the limited partner has limited liability. Piercing the veil in limited partnerships typically requires evidence that the limited partner participated in the control of the limited partnership's business by taking action not within normal roles of limited partners or that limited partners dominated the limited partnership or used the limited partnership to perpetrate a fraud, injustice, or otherwise circumvent the law.[13]

        In some cases however, courts have opted not to apply the veil-piercing doctrine to limited partnerships. Instead, they have focused on ordinary partnership principles to overcome the limited liability of limited partners.[14]  For example, Texas courts have cited the state’s limited partnership statutory provisions, which provide two circumstances in which a limited partner will be liable for debts of the limited partnership:

1. when the limited partner is also a general partner, or
2. the limited partner participates in the control of the business in contravention of the limited partnership statute.[15] 

        Absent those scenarios, Texas courts have declined to use veil-piercing doctrine to impose liability on a limited partner.

        Courts typically note that veil piercing is the exception rather than the rule, and that limited liability should only be disregarded in extreme cases.[16] Nonetheless, it is dangerous to assume that mere filing of incorporation papers with the state is sufficient to hide behind the corporate veil.

        Smaller or closely held businesses are inherently at greater risk of veil piercing, because the same people are often owners and officers, which makes it particularly difficult for courts to distinguish their separate roles. Consequently, smaller businesses can follow this non-exhaustive list of recommendations to prevent veil piercing:

• Follow all formalities mandated by an applicable state’s corporate law or similar statute
• Keep proper records, including all records about meetings
• Keep business finances separate from personal finances
• Be very explicit about instances when one is acting as an owner or as an officer
• Register in every state where the business is operating
• File a Doing Business As (DBA) for any variations of the official business name

        While it’s not always possible to predict with precision how a court will view a situation, employing these steps can help afford the liability protection that is a key reason for choosing a business form in the first place.

Footnotes:

[1] Richard A. Mann & Barry S. Roberts, Smith’s & Roberson’s Business Law 668-670 (15th ed. 2012).

[2] Id.

[3] Thomas K. Cheng, Form and Substance of the Doctrine of Piercing the Corporate Veil, 80 Miss. L.J. 497, 501 (2010) (“[Shareholder] exposure to corporate liabilities is confined to their equity investments in the firm.”).

[4] Miriam R. Albert, The New York LLC Act at Twenty: The New York LLC Act at Twenty: Is Piercing Still "Enveloped in the Midst of Metaphor"?, 31 Touro L. Rev. 411 (2015).

[5] See ex. Canter v. Lakewood of Voorhees, 420 N.J. Super. 508 (2011).

[6] Cheng, supra note 3, at 503.  California and Illinois, for example, both follow iterations of this two-prong test.

[7] Jonathan Macey & Joshua Mitts, Finding Order in the Morass: The Three Real Justifications for Piercing the Corporate Veil, 100 Cornell L. Rev. 99, 107 (2014).

[8] Id.

[9] See, e.g., Michaels v. Banks, 901 F. Supp. 2d 354, 357 (N.D.N.Y, 2012) (citing the two-prong test articulated by the 2nd Circuit in a prior case involving corporations, as well as another case involving LLCs, and also referring to an alternative test justifying veil piercing “upon a showing of fraud or upon complete control by the dominating [entity] that leads to a wrong against third parties); In re Brentwood Golf Club LLC, 329 B.R. 802 (Bankr. E.D. Mich. 2005) (discussing factors considered in prior cases involving corporations).

[10] NetJets Aviation, Inc. v. LHC Communs., LLC, 537 F.3d 168, 176 (2nd Cir. 2008) (citing J. Leet, J. Clarke, P. Nollkamper & P. Whynott, The Limited Liability Company § 11:130, at 11-7 (rev. ed. 2007)).

[11] Id. at 178 (but noting that failing to follow contracting formalities as between two LLCs with the same owner is akin to admitting that the two entities are in fact one and the same).  See also Allen Sparkman, Will Your Veil Be Pierced? How Strong Is Your Entity's Liability Shield? -- Piercing the Veil, Alter Ego, Ego, and Other Bases for Holding an Owner Liable for Debts of an Entity, 12 Hastings Bus. L.J. 349, 423-24 (2016) (noting that some LLC statutes explicitly state that failure to follow formalities alone does not justify veil piercing).

[12] See, e.g., Canter v. Lakewood of Voorhees, 420 N.J. Super. 508, 518 (2011) (citing In re Adelphia Communc'ns Corp., 376 B.R. 87, 93-94 (Bankr. S.D.N.Y. 2007)).

[13] See, e.g.,. id. at 519.

[14] See, e.g., Peterson Group, Inc. v. PLTQ Lotus Group, L.P., 417 S.W.3d 46, 56 (Tex. App. Houston 1st Dist., 2013) (noting that Texas courts have uniformly declined to apply veil-piercing or alter-ego principles to impose an entity’s liabilities on a limited partner).

[15] Id. at 57.

[16] Mobil Oil Corp. v. Linear Films, Inc., 718 F. Supp. 260, 270 (D. Del. 1989).