This is the second in a two-part series focusing on the legal concept of the “Corporate Veil,” with this second part addressing situations when a court of law will “pierce” the corporate veil. The first part in the series defined the corporate veil and explained how it serves to protect the shareholders’ personal assets.
Piercing The Corporate Veil, Part 2: Why Does It Happen?
This is the second in a two-part series focusing on the legal concept of the “Corporate Veil,” with this second part addressing situations when a court of law will “pierce” the corporate veil. The first part in the series defined the corporate veil and explained how it serves to protect the shareholders’ personal assets. The first part of the series can be read here.
In certain circumstances, a court of law will allow a corporation’s veil to be “pierced” such that the corporate veil will not protect shareholders’ personal assets from being used to satisfy the debts or obligations of the corporation. Like the notion of the corporate veil itself, the notion of piercing this corporate veil to reach personal assets has been applied to limited liability companies (LLCs) as well.
There are three general situations wherein a court will pierce the corporate veil: 1) alter ego; 2) undercapitalization; and 3) fraud.
An alter ego is defined as a second self that is both distinct from one’s original personality and also inherently connected to the first self. In Corporate Law, the concept of “alter ego” refers to a situation where a business owner or corporate shareholder does not respect corporate formalities and is essentially using the corporation as a means of protection externally while treating the corporation’s assets like his or her own internally. In these cases, there is no true separation between the company and its owners.
For example, where a corporate shareholder commingles personal and corporate funds, uses the corporate car as his own, and uses the corporate credit card to pay for personal purchases, a court will look to the corporate shareholder’s personal assets to satisfy the obligations where the corporation has failed to pay its bills.
Fundamentally, a court will not allow a corporate shareholder to expect creditors to respect the separate legal identity of the corporation for purposes of debt collection while the shareholder continues to treat the corporation as an alter ego.
Undercapitalization refers to a scenario where the corporate founders have not invested enough funds into the corporation at its formation to cover its reasonably foreseeable debts, liabilities, or other obligations. Similar to the problem with shareholders treating the corporation as merely an alter ego, a corporation that is capitalized inadequately from the outset is treated as though it was never truly intended to exist as its own separate entity.
For example, if a corporation were in the business of transporting and disposing of hazardous waste, failed to carry insurance, and started with an initial capitalization of $1,000, the founding shareholders could be found personally liable when someone is injured by a transport truck meltdown. In this case, the shareholders would have failed to invest enough capital to cover what were the reasonably foreseeable liabilities of the corporation when it was formed.
Where business owners commit wrongdoing by acting to intentionally misrepresent facts to those they transact business with, a court will not allow the owners to then stand behind the corporate veil and be absolved of personal liability for their misconduct.
For example, where business owners know that they will be unable to pay certain debts but make business deals anyways, borrow and lose money recklessly, or otherwise act in a dishonest manner, a court could certainly determine that the owners perpetrated a fraud in these transactions and dismiss any claim of limited liability on behalf of the owners.
Ultimately, it is important for corporate shareholders or LLC members to treat the business entity separately, to fund the business with enough capital to cover its prospective obligations, and to avoid entering into fraudulent business transactions in order to avoid having creditors come after personal assets.
ODGERS LAW GROUP specializes in corporate formation and can help you maintain limited liability while ensuring your personal assets remain protected. To learn more about how to limit your personal liability or to schedule your free consultation with Mr. Odgers, contact us by e-mail, call us at (858) 869-1114, or schedule your appointment online here.