Piercing the corporate veil can lead to individual liability
Los Angeles business litigation attorneys often represent corporate clients in cases where the plaintiff alleges alter ego. The plaintiffs ostensibly seek to ‘pierce the corporate veil’ to go after the individuals because the corporation cannot pay its debts. This is called alter ego. Alter ego is a theory where the corporate entity is disregarded and the individuals (or other corporation) behind the corporation are held responsible for the corporation’s debts.
Alter Ego Discovery Before Establishing Liability?
Unscrupulous plaintiffs’ attorneys can misuse the alter ego theory in an effort to pressure a defendant into settling the case. The attorney can allege alter ego even in instances where there is absolutely no indication of alter ego. Because of the allegation of alter ego, the attorney can then propound discovery regarding all of the finances of the corporation and the individuals related to it. In other words, with no basis whatsoever to make the accusation, a plaintiff and his attorney may invade the financial privacy of a corporation and its owners under the guise of pursuing an alter ego theory.
Obviously a plaintiff who is allowed to engage in a fishing expedition regarding the finances of the defendant can learn a lot of information that the corporation understandably wants to keep confidential.
What is alter ego?
Let’s back up. What is alter ego and how does it work? Alter ego is an equitable doctrine that allows the court to examine certain factors in the relationship between an entity (corporation or limited liability company) and its owner or shareholders (which can also be another entity but is often the individual shareholders in the case of small corporations). Alter ego is common in
business litigation, including breach of contract and business fraud cases, but can also be used in run-of-the-mill liability cases.
How to Establish Alter Ego
In order to prevail in an alter ego lawsuit, the plaintiff must establish (1) there is such a unity of interest that the separate personalities of the corporations no longer exist, and (2) inequitable results will follow if the corporate separateness is respected.
Determining alter ego is a question of fact and involves a variety of factors. A prominent factor is the commingling of funds and other assets. In a small company this often involves an owner who does not respect the separateness of the corporation and instead uses its bank account as his or her own personal bank account to pay personal expenses. When there are multiple corporations or entities, commingling of funds can involve the failure to segregate the funds of the separate entities—using the money of one corporation to pay the debts of another. Overall these instances are referred to as the unauthorized diversion of corporate funds or assets to other than corporate assets. This includes the treatment of the corporate assets by an individual as assets of his or her own.
“Commingling” has a negative meaning. A corporation can loan money to another corporation and still avoid a finding of alter ego if the transactions are done at arms-length and market rate. The lesson for those with a corporation is to make sure that transfers of funds can be justified and are well-documented. However, the repeated use of a personal credit card for corporate debts or vice versa, even if the eventual accounting leads to repayments, may signal a failure to maintain the separateness of the entities.
In a related vein, a trial attorney alleging alter ego will pounce on the corporation that fails to maintain minutes and other adequate corporate records. Any confusion of records between entities or an entity and its shareholder or shareholders can be a factor in establishing alter ego. Has the company been maintaining minutes of the board meetings? Have there even been meetings? Are there cash withdrawals with no corresponding receipts showing a corporate expenditure? The courts will not find alter ego for mere incompetence or mismanagement so this is a weighing act.
A court will also look at domination and control of the corporation. Have significant actions been taken without full board approval? What is the actual decision making structure of the company? Are the directors and officers mere figureheads? A Limited Liability Company and a small family S-Corporation may have different requirements and standards regarding the formality of their structure and operation. For example the California Corporations Code provides that the failure of a close corporation to observe corporate formalities relating to the meetings of directors or shareholders in connection with the management of the corporation’s affairs pursuant to an agreement shall not be considered a factor tending to establish that the shareholders have personal liability for corporation obligations. Does that written agreement exist?
Another factor is whether the corporation is undercapitalized. There is no straight answer as to how much capitalization is sufficient capitalization when figuring out alter ego. For example, if a shareholder contributes enough money to a Limited Liability Company to finance the purchase of a building but not enough for future liabilities, is that sufficient capitalization? The court will take it into account along with all of the other factors but the plaintiff’s attorney will surely make that argument. Undercapitalization is assessed in light of a corporation’s prospective liabilities. Sufficient capitalization has been found where a corporation has consistently paid its bills on time over a two year period. It has also been found in situations where there was a small initial contribution but expenses have been paid and the shareholder has been able to withdraw substantial amounts over time. Of course undercapitalization has been found in those cases where the corporation is left with a deficit shortly after forming.
These factors are not all of the factors that a court may consider. Each case will be different. The established law says that no single factor is determinative and that the court must examine all of the factors together.
What Is The Inequitable Result Requirement for Alter Ego?
In alter ego lawsuits the court will often look to evidence of fraud or bad faith in establishing alter ego. However, proof of fraud is not required. Bad faith is also not required. The courts are looking to see if there will be an inequitable result, not necessarily that the party sued for alter ego acted with wrongful intent. “As the separate personality of the corporation is a statutory privilege, it must be used for legitimate business purposes and must not be perverted. When it is abused it will be disregarded.” Put another way “when a party seeks the benefits of the corporate form but shirks or ignores the corresponding burdens in a manner that unduly prejudices the interests of third parties, an unjust or inequitable result may be found regardless of wrongful intent.”
On the other hand “it is not sufficient to merely show that a creditor will remain unsatisfied if the corporate veil is not pierced…. In almost every instance where a plaintiff has attempted to invoke the doctrine he is an unsatisfied creditor, so such a rule would undermine the legitimate public policy of limited liability for corporations in the ordinary case.”
Business Attorneys’ Strategy In Alter Ego Cases
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business litigation attorney Los Angeles can never say for certain to a client that allegations of alter ego will be granted or denied. It is a balancing act. However, a business litigation attorney can state for certain that investigation into alter ego allegations can be a long, drawn out and intrusive process. The small corporation or limited liability company will want to consider whether laying bare all of its finances, sometimes to a competitor, make settlement more attractive.
A company’s attorney will also want to address this issue and begin an internal investigation right at the beginning of the case. Gathering the information and analyzing it can take a lot of time and manpower.
Laine T. Wagenseller is the founder of Wagenseller Law Firm in downtown Los Angeles. Mr. Wagenseller has handled many alter ego cases. For more articles on business litigation in Los Angeles, please visit www.wagensellerlaw.com. Mr. Wagenseller can be contacted at (213) 286-0371.