What is Piercing the Corporate veil?
In explaining what the term “piercing the corporate veil” means, we should start by looking at what the term corporate veil refers in order to get an idea of what we are piercing. One of the main reasons business entrepreneurs and owners choose to form corporations or limited liability companies (“LLC”), opposed to a partnership, is because those entity forms offer their shareholders and members limited liability.
Limited liability means that the individuals who created the entity will not be held personally liable if the business fails and cannot pay its creditors. Therefore, they are only liable up to the value of their individual stake in the entity. However, sometimes courts will decide to hold shareholders and members personally liable under certain circumstances where justice demands such an outcome.
When courts do this, it is called piercing the corporate veil.
Debts and Piercing the Corporate Veil?
Corporate veil cases share the same central theme of debts, with almost all arising in the context of an unpaid creditor attempting to persuade a court to pierce the corporate veil to recover money owed under a contract from the owners of a company.
Businesses will fail and dissolve the entity without enough assets to pay creditors. This is especially true for creditors with lower-ranking priority as well as creditors without a perfected security interest in the owed debt. Without a perfected security interest, the world is not on notice that the creditor has a security interest in the debtor’s assets.
For example, an individual or entity may attempt to sue to collect on a debt but is left with a notice that the company is defunct, without assets sufficient to cover any court judgment. Upon learning this, the creditor might be stunned because the company’s destitution leaves them with no way of getting paid for bills that can reach above six figures or more. The only option left for these creditors is to sue the business and pursue a piercing the corporate veil claim to recoup their lost money.
Creditors file these types of suits quite frequently, as corporate veil piercing is one of the most litigated issue in corporate law. As described in this article, the main reason people or entities may attempt to pierce the corporate veil is if the business itself does not have enough assets to cover the debt and is attempting to avoid paying its creditors.
Consequences of Piercing the Corporate Veil
As discussed before, when the metaphorical veil between the company and its owners is lifted, the owners become personally responsible for the company’s liabilities. These liabilities can include the company’s owed debts, unpaid loans or security interests, or ongoing and resolved legal claims.
Courts piercing the corporate veil can quickly turn into a frightening situation for owners. When they can’t repay these debts through their personal accounts, their home, cars, and other valuable assetshttps://www.investopedia.com/articles/pf/08/asset-protection-business.asp are at risk of being seized and sold to satisfy these debts. However, courts will only impose this potentially life-altering personal liability on the persons actually responsible for the corporation or LLC’s fraudulent actions. Innocent owners will not be held personally liable for the company’s debts. Guilty by association does not apply in veil piecing situations.
Who Can Pierce the Corporate Veil?
Generally, any person with an unpaid debt or other legal claims can bring suit against the corporation. Some claims involve tort creditors, which typically include people the company injured. Corporations can even bring veil-piercing claims against themselves for the benefit of their creditors in some states, like Oklahoma. Veil piercing cases are typically only brought against closely-held corporations, businesses only owned by a few individuals, particularly those with a single shareholder.
Test for Piercing the Corporate Veil
You might be wondering when how to actually pierce a corporate veil, especially if you are an unpaid creditor. Before getting to that million-dollar question, we must understand how courts handle this issue and what tests they use to determine these veil-piercing disputes. While courts generally view these case the same way, individual states have created their own tests.
A Colorado court ruled, in April 2020, that Colorado law allows horizontal veil piercing between entities that share a common ownership through another entity as well. Nonetheless, Colorado law generally states that the corporate veil can only be pierced in exceptional circumstances. In 2006, the Colorado Supreme Court laid out Colorado’s three-pronged test in order to pierce the corporate veil:
(1) the claimant must show that there is a unity of interest and a lack of respect for the separate identities of the corporation, where the corporation and the individual are essentially indistinct;
(2) determining whether adhering to the legal fiction of the entity would result in promoting injustice, fraud, or evasion of legal obligations; and
(3) whether piercing the veil and disregarding the corporate entity will lead to an equitable result.
In Florida, claimants must show that: (1) the corporation is only the alter ego of the shareholders, and (2) the shareholders engaged in improper conduct.
In Texas, the corporation must be one of three things: (1) the alter ego of its shareholders; (2) used to avoid legal limitations on persons or corporations; or (3) the corporation is a sham to perpetuate fraud.
Illinoishttps://www.isba.org/ibj/2000/07/theundercapitalizedcorporationandil#:~:text=In%20Illinois%2C%20courts%20have%20settled,no%20longer%20exist%3B%20and%20(2 follows a two-part test requiring: (1) a unity of interest and ownership that the separate personalities of the corporation and the parties who compose it no longer exist; and (2) circumstances promote discarding the fiction of the corporate entity to promote justice.
While each state does have its own test with different elements and legal jargon, all of the tests ask:
1) Whether the corporation is just a sham for its shareholders to use; and
2) Whether the privilege of incorporating has been abused in such a way that justice requires disregarding the corporate entity.
Courts will use a litany of factors to help them in this analysis, including:
- Whether the company engaged in fraudulent activities;
- If a small number of closely related people or one person controlled the company;
- Failure to issue stock;
- Compliance with corporate formalities;
- Adequate capitalization;
- Maintenance of annual meeting minutes;
- Commingling of personal and business finances or assets; and
- Failure to maintain an arms-length relationship among related entities.
This is not an exhaustive or exclusive list of the factors a court will consider. Remember, each state has different tests. Therefore, if you are involved in veil piercing litigation, you should consult with a knowledgeable law firm to understand past cases in your state dealing with the issue to find the complete set of factors a court will consider in a case.
Situations where Courts will Pierce the Veil
There are factual circumstances and scenarios where courts have determined to pierce the corporate veil.
First, when a business entity disregards corporate formalities. Disregarding corporate formalities would include failing to:
- adopting bylaws;
- enforcing bylaws;
- keeping accurate and detailed minutes of meetings; and/or
- hold annual meetings at all.
Second, when a business owner commingles personal and business assets, seemingly treating the business as an extension of their persona. This happens when:
- personal and corporate funds are repeatedly transferred into their respective accounts;
- the owner uses company property as their personal property; and/or
- when corporate credit cards are used to pay for personal purchases or bills.
Third, when shareholders intentionally undercapitalize a business entity, such as forming an entity in a line of business with funds not nearly sufficient to cover potential losses. Another example is when the company’s assets are intentionally moved out of a known creditor’s reach to prevent debts from being paid.
For instance, an Iowa court pierced the veil of an LLC that hatched eggs and grew chickens. An expert witness testified that such a business would usually be capitalized with at least $1 million at formation. However, the members failed to make any sensible capital projections and formed the LLC without nearly any capital. The members made the case against them worse by continuing to accept deliveries of eggs even after becoming aware that they could not pay for them.
In perhaps a more egregious example, an Alabama court pierced the veil of a solely owned corporation formed for constructing a house. The shareholder admitted that the corporation had no funds when the contract was executed, and she did not attempt to fund the project. Instead, she let a friend use the corporation’s bank account for personal purchases at jewelry and sporting goods stores, car services, restaurants, and more.
Any questions?
Contact the experienced lawyers at Newburn Law today so that we can answer any questions you might have.
