Introduction:
An essential and valuable aspect of limited liability entities is that the owners and fiduciaries of the entity are not usually liable for the debts and obligations of the entity. It was the invention of the concept of limited liability two hundred years ago that enabled the massive investment in business that helped fuel the modern economies. People could invest their monies and, while they risk the monies invested, they are not risking all their assets if the company fails.
Corporations, Limited Liability Companies and Limited Partnerships can provide owners with limited liability, and generally the owners are not answerable for the debts of the entity that they own.
Corporations are the most common form of limited liability company, and they are divided into public corporations, in which ownership is available on public stock exchanges, and private corporations in which shares are not publicly available. While the protection of limited liability is strong, the protection for owners of a corporation from liability is not absolute. There are times when the shareholders have committed acts that make them accountable for the corporation’s debts.
To impose personal liability on the owners, a plaintiff must pierce the so-called “corporate veil.” In California, this is done under what is called the Alter Ego Doctrine (the “Doctrine”). The Doctrine is used to make a corporation’s owner (its shareholders) liable when the shareholder improperly uses the corporate entity to commit acts which improperly harmed the corporation, or third persons dealing with the corporation.
This article shall discuss the Alter Ego Doctrine in California.
The Basic Law:
The Doctrine was first established in California in 1921 in Minifie v. Rowley, 87 Cal. 481, 202 P. 673, and is intended to prevent individuals or other corporations from misusing the corporate laws by the device of a sham corporate entity formed or used for the purpose of committing fraud or other misdeeds. Under the Doctrine, when the corporate form is used to perpetuate a fraud, circumvent a statute, or accomplish some other wrongful or inequitable purpose, the courts may disregard the corporate entity and hold its individual shareholders liable for the actions of the corporation. “The separate personality of the corporation is a statutory privilege, and it must be used for a legitimate business purpose and must not be perverted. When it is abused it will be disregarded and the corporation looked at as a collection or association of individuals.” (In re: International Cab Company, No. Dist Court, Bank 98-30535 WDM).
California courts developed a two-prong test for application of the Doctrine:
1. Unity of Interest. There must be such a unity of interest and ownership between the corporation and its equitable owner(s) that the separate personalities of the corporation and its shareholders do not truly exist.
2. Inequitable Result. There must be an inequitable result if the acts in question are treated as those of the corporation alone, or as more clearly in Robbins v. Blecher (1997) 52 Cal. App. 4th 886, the failure to disregard the corporate entity would sanction a fraud or promote injustice. See, Automotriz etc. De California v. Resnick (1957) 47 Cal. 2d 792, 796; Sonora Diamond Corp. v. Superior Court (2000) 83 Cal. App.4th 523, 539.
This is an equitable doctrine. Its purpose is to prevent injustice. As an equitable, fact-based remedy, the test is easy to state, but not easy to apply. Las Palmas Associates v Las Palmas Center Associates (1991, 2nd Dist.) 235 Cal App 3d 1220. The application of the Doctrine is done on a case-by-case basis, based on the facts. Most cases rely on the discretion of the trial court, and the appellate courts give them great deference. While the court must find both elements to apply the Doctrine, the reverse is not true. A finding of both elements does not require the application of the Doctrine. Associated Vendors, Inc., vs. Oakland Meat Company (1962) 210 Cal App. 2d 825. As an equitable remedy, there is no right to a jury trial. Dow Jones Co. v Avenel (1984, 1st Dist.) 151 Cal App 3d 144.
The First Prong: Unity of Interest
The Court in Arnold v Browne (1972) 27 Cal App 3d 386, 103 Cal Rptr 775 set forth a thorough list of factors tending to show a “unity of interest”:
1. Commingling of funds and assets.
2. Failure to segregate funds.
3. Diversion of funds or assets.
4. Treatment by shareholder of corporate assets as own.
5. Failure to maintain minutes.
6. Identical equitable ownership in two entities.
7. Officers and Directors of one entity same as controlled corporation.
8. Use of the same office or business location.
9. Employment of same employees.
10. Total absence of corporate assets.
11. Under-capitalization.
12. Use of Corporation as mere shell.
13. Instrumentality or conduit for single venture of another corporation.
14. Concealment or misrepresentation of the responsible ownership, management and financial interests.
15. Concealment or misrepresentation of personal business activities.
16. Disregard of legal formalities.
17. Failure to maintain arm’s length relationships among related equities.
18. The use of the corporate identity to procure labor, services or merchandise for another entity.
19. The Diversion of assets from a corporation by or to a stockholder or other person or entity to the detriment of creditors.
20. The manipulation of corporate assets and liabilities in entities so as to concentrate the assets in one and the liabilities in another.
21. The contracting with another with the intent to avoid performance by use of the corporation entity as a shield against personal liability.
22. The use of the corporation as subterfuge for illegal transactions.
23. The formation and use of a corporation to transfer to it the existing liability. In considering the factors on this list, appellate courts have held no one factor is conclusive. It is within the trial court's discretion to consider the presence or absence of any of these factors or other relevant circumstances.
The Second Prong: Demonstrable Inequitable Result
The Doctrine is about “doing justice.” Mesler v Bragg Management Co. (1985) 39 Cal 3d 290, 216 Cal Rptr 443. To prevail, a plaintiff must prove that respecting the corporate form will lead to an inequitable result. The remedy is used to prevent fraud or injustice, allowing the court to put substance over form: the substance and nature of the injury over th corporate form. NEC Electronics, Inc. v Hurt (1989, 6th Dist) 208 Cal App 3d 772, 256 Cal Rptr 441
Note that a plaintiff does not have to prove all the elements of fraud. A showing of bad faith is enough. Talbot v. Fresno-Pacific Corp., 181 Cal. App. 2d 425, 431. However, without a showing of wrongdoing, injustice, or violation of statute, a court cannot use the Doctrine as a remedy. Sonora Diamond Corp., v. Superior Court (2000) 83 Cal. App. 4th 523. A showing that the plaintiff is merely an unsatisfied creditor of a business venture that ultimately did not work out is not enough. Sonora Diamond Corp. v. Superior Court (2000) 83 Cal.App.4th 523, cited in Green v. UNITED FOOTBALL LEAGUE LLC (2016) Court of Appeal, 1st Appellate Dist., 1st Div. 201 (Not for Publication).
CONCLUSION:
1. The Doctrine is an exception, not readily used.
2. The Doctrine is an equitable remedy, designed to prevent injustice.
3. The Doctrine is a question of fact, not law.
4. Implementation of the Doctrine is on a case-by-case basis.
5. Both prongs of the test must be met: a) Unity of Interest, and b) Inequitable Result
6. Even if both prongs are met, the court is never required to use the Doctrine but has discretion to do so.
Piercing the veil is seldom easy. Remember, many judges own stock or interests in a limited liability entity and they are not anxious to see such protection taken lightly. However, we have found that if there is clear unfairness if the protection is given, that many triers of fact are inclined to take such corrective action. It is not merely that a creditor is not paid a debt…it must be that the reason the creditor is not paid is that the owners took some act that strikes that court as entirely improper and contrary to usual business practices.
As one Court commented to the other party in a case from a decade ago, “It’s not that you went broke and didn’t pay the plaintiff’s bill. It’s that you went broke while draining the company of its assets to your own benefit and lied about it. That’s just too much for me to stomach.”