A key purpose in incorporating (or setting up a limited liability company) is to achieve protection for personal assets from third party claims. The corporate and limited liability structure allows a person to protect personal assets from claims of creditors, employees, and often tax agencies provided the claimant is not allowed to ignore the corporate structure by "piercing the corporate veil." Thus, business people can engage in relatively risky business activities knowing that while the business and its assets may be subject to claims, the personal assets owned by the shareholders are protected from those claims.
Indeed, corporations and limited liability entities file bankruptcy regularly while the owners, though losing whatever value may be in the company filing bankruptcy, retain all their personal assets since from the legal point of view the corporation or limited liability entity is a separate person and its insolvency does not allow the creditors to look to the owners for payment of obligations, UNLESS:
1. The owners have guaranteed in writing personally the particular obligation, or
2. The owners, themselves, have somehow incurred the obligation in their own name by signing the contract or personally incurring the obligation rather than on behalf of the corporation, or
3. The owners have violated a statute which consequently imposes personal liability (such as environmental pollution or tax evasion statutes) or
4. The court determines that for equitable reasons the entire limited liability structure should be ignored as if it never existed and allows the claimants to proceed directly against the owners.
This article shall concentrate on the fourth possibility, namely how and why the corporate (or limited liability company) protection is "pierced" by a third party claimant convincing a court that fairness requires imposition of personal liability on the owners. The article will discuss both the criteria the court will use-and how intelligent owners of business can avoid such dangers by appropriate defensive measures.
PIERCING THE VEIL: HOW AND WHY
In its simplest terms, the Court will allow piercing the veil if a fraud would be perpetrated on third parties by maintaining the corporate fiction intact. It is critical to note that we are not dealing with a question of whether it is "right" or "fair" that the third parties are confronting a corporation without assets-the right to file bankruptcy, the right to breach a contract is a long held right of the citizen and debtor’s prisons were specifically banned in the Constitution. One may not like a debtor who fails to pay, the effect on the claimant may be economically disastrous, but that, alone, does not create the criteria that would convince the court to ignore the corporate veil.
Courts are fully aware that reliance on the corporate protection is vital to the continued creation of risk capital and that the entire structure of American business would radically alter if business people could not rely on the protection of the corporate structure. For the court to ignore the structure, the claimant must usually demonstrate by a preponderance of the evidence that the owners failed to utilize the corporate structure properly in one or two vital areas: that the corporate assets were not appropriately isolated from the personal assets; and/or third parties were misled as to the existence of personal liability on the part of the owners.
(In this regard, piercing the corporate veil should not be confused with invalidating transfer of assets to owners or third parties which caused insolvency. If a claimant can demonstrate such transfers somehow defrauded the claimant, both the bankruptcy court and state courts can order the transfers voided and the assets returned. Piercing the corporate veil, on the other hand, invalidates the entire structure and imposes personal liability on the owners, a result much more far reaching than merely invalidating a transfer of a particular asset.)
CORPORATE STRUCTURE: THE FIRST DEFENSE
One trial counsel put it well: there is no better defense to an attempt to pierce the corporate veil than to walk in front of the jury box with a minute book in your hands showing ten years of corporate minutes, to open up the book and show resolutions made five years before the debt was incurred, and to slam the book down on the table and invite the jury to read through the minutes in the jury room.
The great advantage of corporations over limited liability companies is that they do have such obvious and material objects to show to a jury: such things as stock certificates, years of minutes in a bound book, corporate seal, and the like often convince a jury that a corporation is "real." While limited liability companies can also have minute books and the like, the simple fact is that most people create such alternatives to corporations precisely to avoid having to have formal meetings with minutes. Legally, a limited liability company has just as much limited liability as a corporation-realistically, it is harder to demonstrate to a jury the actual validity of a limited liability company unless such minutes are kept.
One incorporates for many reasons, not least of which is the limited liability. To create the structure and then not keep excellent written minutes, fully executed and placed in a formal minute book, is to give up a vital defense that may someday be greatly missed. Annual meetings of the board of directors and shareholders must occur and any important corporate decisions should also have a corporate meeting with full minutes. See article on this web site regarding corporate structure and formalities.
Even more vital is the segregation of bank and equivalent accounts and economic structure such that the owners do not mix or "commingle" their assets with those of the corporation. Undoubtedly the most common and disastrous error is having the corporation pay an individual expense without a Promissary Note from the owner to the corporation requiring repayment. A judge once quipped, "If you ignore the corporation when you want something, we will ignore the corporation when your creditors want something."
The corporation must have its own bank accounts, its own tax returns, and any transfer between the owners and the corporation or any payments of any kind to the owners must be scrupulously accounted for. If the corporation pays sums to an owner, it is either income in terms of dividends or salary, or a loan, in which case a written promissory note should be created...and the loans repaid with legal interest. If the corporation pays expenses of an owner, there must be a legitimate business purpose or it must be declared as income to the owner-and deductible by the corporation.
And all this is true whether or not the corporation is Subchapter S, whether or not there is a single owner, single director, single officer-indeed, the more a single person controls all corporate activities, the more vital it is that the corporation scrupulously apply corporate formalities to avoid efforts to pierce the veil if things go wrong with creditors.
A client once commented to the writer that he felt foolish holding formal meetings with himself, with making resolutions and carefully executing the minutes as President and Secretary. The reply is obvious: you will feel much more foolish if the jury determines that the corporate veil you relied upon should be ignored.
A common error of owners is to dislike withholding taxes on their own salaries to the extent that they pay themselves sums without withholding or use bonuses at the end of the year to make up for absurdly low salary. Remember: what may seem to save taxes for you now may cost you far more down the road when a clever attorney argues that one cannot ignore realities when it is to your benefit, then claim a corporate structure when things go wrong.
Isolated events, unless remarkable, will usually not result in piercing the corporate veil. Juries (and judges) look at the totality of the circumstances and use a rough criteria of fairness to determine if the corporate formalities were violated to an extent to make voiding the structure appropriate. Missing minutes for a year or two; not signing a relatively small promissory note; failing to perform in a fully formal manner at meetings-these, alone, will not void the structure usually. However, a long pattern of such conduct or a particularly grievous example can, alone, result in personal liability being imposed if the jury is aroused by a particularly attractive plaintiff.
For example, this writer witnessed a case in which an owner, just prior to closing the doors of his corporation and beginning a new business, simply "sold" all the assets of his old corporation to the new business at a very low price, then declared a dividend to himself from the old company, thereby pocketing the proceeds and promptly closed the doors of the old company to the dismay of many creditors. The plaintiff, an elderly lady who had loaned money to the first company, sued and claimed the transfer should be voided and personal liability imposed. The angry judge not only voided the transfer, but pierced the corporate veil, imposed personal liability (and all the other creditors promptly filed their own actions against him.) The defendant had kept good minutes for over five years, had signed all the papers properly as President-but the clear fraud perpetrated on creditors allowed the court to ignore the corporate structure.
What should he have done? Simple: use common sense. If one is selling assets, one must get fair market value and as the first step he should have obtained expert opinion as to true value and paid the full price or held a public sale-and sold to the highest bidder. Second, if insolvent he never should have declared a dividend to himself. The combination of self dealing and inappropriate dividend was enough to anger the court and destroy the corporate protection.
THE ELEMENT OF FRAUD AND MISREPRESENTATION
In most cases in which the court allows piercing the corporate veil we find much more than mere failure to keep good corporate records . There is usually a degree of duplicity and dishonesty that annoys the judge or jury. If one abuses the corporate structure for personal benefit and ignores the corporate formalities, yet seeks to rely on the corporate formalities to seek protection, one is risking exposure.
Common examples of situations that may allow the corporate protection to collapse are owners not making clear to third party creditors the corporate or limited liability nature of the entity, or making vague promises about making sure all creditors are paid. One example known to the writer was an owner who tried to assuage angry creditors during a period of time when he hoped to hold off suit until he finished a construction project, thus would be able to pocket the profits. The owner assured creditors that he was worth millions, had never left a creditor in the lurch, and that "they had his word" that payment would be coming no matter what. His stationary did not indicate the corporate nature of the business and he often told creditors that everything he had "was on the line" when it came to the business. Due to a long history unblemished by business failure, he had good credibility in his promises.
When he closed the doors six months later after pulling out payments to himself, the creditors were shocked and dismayed to discover that he was a corporation and that the corporate assets were nonexistent. They sought to pierce the corporate veil, citing his many examples of oral promises.
But the owner had been careful to put nothing in writing, denied making any oral assurances, pointed out that the sums he had paid himself were merely long overdue back pay, and protested that he was sorry the company had gone under but such was a risk of business all of us must take. He had minutes and corporate documents in perfect order and clearly had prepared carefully to avoid the claims of creditors.
While one of the creditors had been "smart" enough to tape record a telephone conversation in which the promises were made, such taping was illegal and not only could not be used but would have exposed the creditor to criminal liability if it was revealed to the court.
Ultimately this debtor succeeded in avoiding liability. The court stated that while the court suspected implicit misrepresentation, there was no hard proof and the plaintiff creditors had the burden of proof and had failed to meet it.
But the courts have consistently held that they will use a broad sense of fair play and common sense in evaluating wrongful conduct and allowing the collapse of the corporate protection and there is no precise criteria that assures protection.
DEFENSIVE STEPS
The chances of avoiding the successful avoidance of corporate protection are improved by following the simple steps below:
1. Keep your books and accounts in good order and never, never commingle. If you borrow money from the corporation, pay it back and charge yourself reasonable interest. Demonstrate any such borrowing with a written Promissory Note.
2. Keep your corporate records up to date. Invest in a minute book, invest in share certificates, and hold your annual meetings, keeping up to date and accurate minutes signed by the directors and officers.
3. Make sure the corporate status is indicated on all corporate stationary, business cards...and above all on credit applications. Avoid personal guaranties whenever you can and never promise to make good on corporate obligations-unless you are willing to do so personally.
4. If you are going out of business, get legal and tax advice early and do not pull money out for yourself prior to carefully running all such transfers by both the attorney and the CPA.
And if you are a creditor, the key is to obtain a personal guaranty from the owner or face the unpleasant fact that just because an owner is rich does not mean that his or her entity is; indeed, the owner may be rich precisely because he or she is aware of the reduction in risk available in using limited liability entities.
CONCLUSION
Most attempts to pierce the corporate veil fail. Courts are loathe to invalidate these useful business structures-remember, most judges have owned or do own corporations themselves! Nevertheless, if fraud or foolish greed can be proven by written records or account books, a prima facie case lies and the fact is that hundreds of such cases are pled each year-many ending with success.
It is an odd but true fact that sitting alone in a room and having a formal meeting with yourself or a family member, calling each other "director" or "Madam President" may be the most important meetings your business ever holds-IF you keep the minutes up and treat the corporate books and accountings in the pristine condition that they should be in. Remember, it is the smaller corporations that are usually the targets of attempts to pierce the veil-no one claims that General Motors is the "alter ego" of its president, but hundreds of cases plead precisely that each year in companies involving one to ten shareholders. The more informal you seem, the more formal you must be. And the fairer you treat your creditors, the less danger exists that you will spend the tens of thousands necessary to defend attempts to ignore the corporate protection that you now rely upon.