The shareholders of a corporation are generally not liable for the acts and obligations of the corporation. Exceptions are made, however. “Piercing the corporate veil” is a well-established legal remedy allowing recovery against the shareholders for a claim which is nominally only against the corporation. This doctrine exists because the separateness of the corporation is sometimes illusory.
The test for piercing the corporate veil is governed by the law of the state of the corporation’s organization irrespective of where its offices are or where the matter at issue arose. The cases boil down to situations where ownership and control are exercised so that the corporation isn’t really a separate economic entity; the owner and the corporation are a single enterprise. One court characterized the test in this way: “The corporation is really a dummy or sham for another dominating entity…a mere façade for the operation of the dominant shareholders.”
Since many closely held corporations are owned by a controlling shareholder, courts have insisted that theremust bemore than just control tomeet this test, and the burden of proof is on the party seeking to pierce the veil. Even in cases where piercing claims are approved, courts as they are summarizing the reasons for granting piercing, acknowledge that the fundamental legal rule is that shareholders are not liable for their corporations’ obligations.
Examples of evidence courts have used to support piercing claims are (i) the absence of corporate formalities (such as failure to hold stockholder or board meetings, or not maintaining stock records and minutes); (ii) inadequate capitalization; (iii) whether the corporation has become a personal pocketbook as funds are deposited in and withdrawn from it by a controlling shareholder in connection with personal wishes rather than corporate needs; (iv) commonality of owners, officers and directors; (v) sharing business and personal space, addresses and phone numbers; and (vi) use of corporate property for personal purposes without compensation.
Shareholders of a closely held corporation should take note. Scrupulous adherence to corporate formalities strengthens and reinforces the veil, increasing their protection against liability. But failure to strictly comply with corporate formalities alone is not enough to support piercing the veil. In fact, courts generally haven’t allowed piercing unless several of the elements noted above are present (they often appear together) and there is some fraudulent or illegal actions involved. “Fraud” for this purpose has been somewhat broadly interpreted and may include deceiving others about the corporation’s substance. Judge Posner of the Seventh Circuit Court of Appeals put it this way in a recent case:
“If there is no substance at all to a corporation, so that it cannot be made to answer for any of its debts, no rational person would make a contract with it unless he were deceived… Had [the corporation] during its negotiations with the plaintiff said that in the event it broke its contract the plaintiff could forget about suing, because [the corporation] is a shell, the plaintiff would not have signed the contract without a guaranty by [the shareholder].”
Piercing the veil cases mostly arise in situations in which the corporation has defaulted on an obligation and is insolvent. (In rare situations, the veil is “reverse pierced’” so that a creditor of an insolvent shareholder can reach the assets of the shareholder’s controlled corporation.) A successful plaintiff usually is able to assert and prove that piercing the veil is essential to a just result. In reading appellate court opinions, one almost has the feeling that the court determined that the shareholder’s actions were so unfair to the plaintiff that the latter should be able to recover from the shareholder; the court then relied on facts such as the examples above for its decision. Courts largely agree that the mere existence of a separate legal entity with nothing else—a corporate shell—should not protect a shareholder from personal liability for his bad acts perpetrated through his puppet company.
The limited liability company is a relatively new and widely used type of legal entity. It has attributes of both a corporation and a partnership. By statute, the owners (or “members”) are insulated from liability for the actions of the LLC, similar to the treatment accorded to shareholders of a corporation. For income tax purposes, however, LLCs are regarded and governed according to rules more like those applicable to partnerships. There have been a number of cases in which courts have permitted piercing of a UCC veil relying on the same reasoning that applies to piercing the veil of a corporation. Courts also have permitted reverse piercing of the veil of an LLC to provide access to its assets for the obligation of an insolvent controlling member.
For the purpose of piercing the entity veil, however, there is an important distinction between corporations and LLCs: There are no statutory or customary requirements that an LLC have a board of directors or officers or that there be meetings or other formal acts of the members or the managers who serve as policymakers and executives. Thus the absence of organizational formalities is not a telling factor in determining the reality of an LLC’s independent economic existence.
Courts faced with a claim that the veil of a corporation or an LLC should be pierced to permit a creditor to proceed against the real, as opposed to the merely formal, economic participant in a transaction rely largely on the demands of justice. To justify their decisions courts use the facts at hand as noted above, especially including whether there has been an often broadly defined illegal or fraudulent act.