Maintaining Corporate Protection
Many businesses operate as corporations or limited liability companies in order to shield the owners’ personal assets from liability for the debts and obligations of the business. However, in order to keep that protection one must continue to observe the separate nature of the company or the owners could be personally liable for the debts and obligations of the company under the alter ego theory of liability.
A corporation or limited liability company is recognized under the law as a legal entity separate and apart from its owners. As such is the case, the company can enter into contracts and other business transactions in its own name, and only the company but not the owners of the company are liable for such obligations. This is a great benefit to the owners and allows them to enter into business transactions they might not otherwise undertake if they had to risk all their personal assets. This stimulates business and stimulates our economy.
There are some exceptions to the concept of “no personal liability” for the owners of the company. The first and most common is if the owners are required to provide a personal guarantee. In many business transactions, the owners of a company are required to provide a personal guarantee to provide additional assurances to the other party to the transaction that the obligation will be paid for. Most commonly a personal guarantee is required in conjunction with a lease or a loan from a bank. Also, in our industry many of the ISO types of relationships require a personal guarantee.
Another way the owners of the corporation or limited liability company might lose their protections and remain liable for obligations of the company is if they fail to observe the separate nature of the company. Unless all corporate formalities and requirements are adhered to, the owners may be personally liable under the “alter ego” theory of liability. In such cases, the corporate entity may be disregarded (the corporate veil “pierced”) and the owners held personally liable for company debts because of the manner in which they have dealt with the company.
There are two basic requirements to pierce the corporate veil: First, the owners sought to be held liable must have treated the company as their “alter ego,” rather than as a separate entity. The alter ego doctrine is usually applied where owners have not respected the company’s separate identity; for example, where the owners 1) fail to complete formation of the company; 2) use company assets as their own; 3) commingle company funds with their personal funds; 4) fail to adequately capitalize the company; or 5) fail to observe company formalities such as holding shareholder and board meetings and keeping corporate minutes.
Second, the ‘veil’ may be pierced if allowing the owners to escape personal liability for company debts would sanction a fraud or promote an injustice. Company creditors seeking to pierce the corporate veil must show the manner in which they were harmed by an owner’s abusive conduct toward the company or some other injustice or inequity that would result from recognition of the company entity under the circumstances.
In practice, however, the courts regard the alter ego doctrine as a drastic remedy and disregard the company form only reluctantly and cautiously. This is because alter ego liability is fundamentally at odds with the general rule that a “de jure” corporation (one which has met all the technical and legal requirements for proper formation) is a legal entity separate from its founders and owners; the law specifically permits owners to incorporate a business for the very purpose of shielding them from liabilities.
When the alter ego doctrine applies, a company’s owners are treated as partners and held jointly and severally liable for its debts. However, alter ego liability is limited to owners who influence and govern the company or who were actors in the course of conduct constituting the abuse of the corporate privilege.
I have had the opportunity to litigate this issue and found it very difficult to pierce the corporate veil. In practice, if just one thing is done wrong, like failing to keep up annual minutes in a corporation, that is not enough to pierce the corporate veil. There must usually be a number of the listed factors present before the owners will be held personally liable. For instance, if the owners failed to keep the required formal company records and then also used the company’s bank account to pay their personal mortgage, car payment and other personal expenses then the chances of having the company’s separate nature disregarded is much higher.
To avoid problems, the company should diligently adhere to all required formalities. A careful review by legal counsel as to whether a company is adhering to the requisite formalities is advisable in order to prevent personal owner liability.
The information contained herein is for informational purposes only and should not be relied upon in reaching a conclusion in a particular area. The legal principles discussed herein were accurate at the time this article was authored but are subject to change. Please consult an attorney before making a decision using only the information provided in this article.