Many entrepreneurs create business entities to operate their businesses, to facilitate commercial ventures, and to shield themselves from personal liability. The business maintains a separate and distinct identity from that of its owners or related entities. However, the mere shell of a corporate structure is not always enough to avoid personal liability. Many of you have heard of the term “pierce the corporate veil” but haven’t thought any more about it. This blog post will discuss the five most common ways to pierce the corporate veil and shatter the façade of protection that the entity creates.
Before discussing the most important factors of veil piercing, it is important to understand what it means to pierce the corporate veil. Piercing the corporate veil is the legal jargon used to describe an action pursued against a company that ultimately leads to personal liability of the owners, shareholders, or members wherein the corporate structure is disregarded. This personal liability opens owners, shareholders, or members bank accounts, real and personal property interests, and investments to risk. Think of it this way – the corporate structure is the “veil” that provides protection and if that veil is pierced, there is no more protection.
Under Florida law, a party wishing to pierce the corporate veil must show that the corporation at issue is the mere instrumentality or alter ego of its shareholder(s) or its parent corporation, and that said shareholder or parent corporation engaged in improper conduct. Courts in Florida have enumerated a number of factors that may lead to piercing the corporate veil. While there is no set equation for the number of factors that must be present to pierce the veil (and in most cases there are three to five factors present), there are particular factors that raise red flags more so than others. A few worth noting are set forth as follows:
1. The existence of fraud, wrongdoing, or injustice to third parties.
Of all of the factors that courts look at, the existence of fraud, wrongdoing, or injustice is the biggest red flag when determining whether or not to pierce the corporate veil. In a majority of cases, the claimant is seeking to pierce the corporate veil because of the wrongdoing of the company or its owners. Consider the following: (1) Creditor of ABC Corp. receives a final judgment for money damages; (2) ABC Corp. cannot pay the judgment so it shuts down; (3) ABC Corp. transfers all of its assets to XYZ Corp. and XYZ Corp. operates a substantially similar business with the same assets and same employees. In this example, it is likely that ABC Corp. engaged in wrongful, potentially fraudulent actions, by shutting down its business and essentially reopening a new corporation of the same ilk. This is a classic example of a debtor attempting to defraud its creditor. As with any area of the law, it is never as clear cut as it seems and there are copious amounts of debtor defenses to the very serious allegations of fraud.
The wrongful conduct discussed above could lead to a shareholder’s personal liability for torts of its corporation. In Broward Marine, Inc. v. S/V Zeus, No. 05-23105CIVOSULLIVAN, 2010 WL 427496 (S.D. Fla. Feb. 1, 2010), the U.S. District Court for the Southern District of Florida pierced the corporate veil, finding that the corporation’s dominant shareholder should be personally liable for the torts of his corporation. In that case, the plaintiff sued the defendant yacht corporation for foreclosure of its mortgage on a yacht. Upon obtaining judgment against the yacht corporation, the plaintiff instituted proceedings supplementary after learning that the yacht corporation had transferred all of its assets, post-judgment, to other corporations controlled by the yacht corporation’s sole shareholder. Through the proceeding supplementary, the plaintiff sought to hold the transferee-corporation, and the sole shareholder, liable for the underlying judgment against the yacht corporation. Specifically, the Court found that the yacht corporation had transferred all of its assets, post-judgment, in order to hinder, delay, or defraud the Plaintiff. Resultantly, the yacht corporation had its veil pierced and its sole shareholder and one of his other closely-held corporations were found liable for the underlying judgment.
The takeaway here is to take an outsiders perspective on transactions and business decisions. If it appears to be fraudulent or even just questionable, the company should consult legal counsel to guide it through its decision-making process. There are many prophylactics that can be employed to make a superficially questionable transfer become an arm’s length transaction.
2. Failure to maintain the separate identities of the companies.
A familiar scene that may cause some scrutiny is where there are several related affiliates or multiple companies acting under the umbrella of one company and the failure to maintain separate identities of the companies. To narrow this down more, let’s use the example of when there is a parent company and a subsidiary company. The parent company operates and controls the subsidiary, provides all of the financing for the subsidiary, indicates the same officers, address, and corporate information, and files consolidated taxes with the subsidiary. See the red flags? The subsidiary can likely be accused of being the alter ego of the parent company.
This factual example is similar to Ocala Breeders’ Sales Co. v. Hialeah, Inc., 735 So. 2d 542 (Fla. 3d DCA 1999), where the court pierced the corporate veil to pursue the personal liability of corporate officers. Amongst the factors identified by the court, the court found that the following were indicia of a showing that the subsidiary was merely an instrumentality of the parent corporation: (1) the same person controlled both the parent and subsidiary; (2) they operated out of the same facilities as the parent; (3) the subsidiary’s contracts were performed by employees of the parent; (4) the subsidiary was never capitalized; and (5) the subsidiary shared bank accounts and financial obligations with the parent. The court also required a showing of improper conduct because “to pierce the corporate veil under Florida law, it must be shown not only that the wholly-owned subsidiary is a mere instrumentality of the parent corporation but also that the subsidiary was organized or used by the parent to mislead creditors or to perpetrate a fraud upon them.” Thus, the court held that a parent corporation defrauded the plaintiff when its subsidiary entered into a contract requiring it to make certain capital improvements and the subsidiary did not have the ability to fulfill the contract since it was never capitalized.
We know from case law that courts will carefully scrutinize the relationship of a parent corporation and its subsidiary. Thus, for companies who set up a corporate scheme with a parent company and one or multiple subsidiaries, the officers should ensure that the business of the separate entities is kept separate – separate bank accounts, separate contracts, etc.
3. Failure to maintain separate identities of the company and its owners or shareholders.
This factor is somewhat similar to number two listed above but instead of the intertwinement being with other companies, this is an intertwinement with the owners or shareholders of the company. The factual circumstances where this may arise are where the owners create a corporation or LLC but continue to operate out of individual checking accounts, fail to recognize corporate formalities, and use the company’s assets as if they were individual assets.
Again, the business tip is to ensure distinctness in the company and the owners. Owners, shareholders, and officers should avoid commingling funds and must treat assets of the business separate from personal assets.
4. Failure to adequately capitalize the company.
The issue of adequately capitalizing a company is never enough, in and of itself, to pierce the corporate veil by itself. Practically speaking, business owners are not punished by the court system for not making enough money or running a business haphazardly. However, a commonality amongst cases is the undercapitalization of the business. Courts will look to the assets of the company to determine if the company’s level of assets available to creditors is fair. The measure of assets is directly correlated to the business purpose so businesses are not all held to the same standard.
The tip for capitalizing a company is to ensure that when the company is opened, it has its own bank account with an adequate amount of money and/or assets to account for business operations. Owners cannot just open a business and use their personal account, with hopes of turning a profit and putting money back into the business. This behavior is too risky and jeopardizes your corporate liability shields.
5. Failure to follow corporate formalities
The final red flag that could lead to piercing the corporate veil is the failure to follow corporate formalities. Again, business owners are not necessarily punished because they fail to observe every corporate formality. In cases where formalities are not properly followed, courts have held that the legal liability protection of the shareholders was effectively waived and the personal assets of the owners could be reached by the claimant. This is most often seen in smaller, family owned businesses, which tend to be less meticulous in maintaining the corporate records. Oftentimes, this is not a purposeful neglect of the formalities but merely a lack of resources and staff necessary to meet filing and compliance requirements.
Nevertheless, the takeaways from this factor are as follows: (1) based on the type of business created, whether it be a corporate, LLC, or otherwise, the owners or officers should be aware of the formalities that they must adhere to depending on the corporate structure; (2) the corporation or LLC should undertake necessary formalities, such as properly updating by-laws, maintaining stock or membership ledgers, holding initial and annual meetings of directors/managers and officers, and maintaining status with the State of Florida by filing an Annual Report; (3) the business activities should be documented and records should be adequately kept and stored; and (4) the parties with whom business is conducted should be aware of the corporate status of the company.
Taking the proper steps to insulate personal liability could make the difference between the effective creation of a corporate structure versus the daunting effects of personal liability. From the creation of the business to everyday business decisions, owners, officers, and shareholders should be mindful of the separate corporate structure and acting in a manner that maintains that distinctiveness.
If you wish for further counseling on how to avoid these potential pitfalls in corporate operations or are a creditor looking to pursue a debtor in an individual capacity, our firm is well versed in all areas of pertaining to piercing the corporate veil.