Liability protection is one of the biggest advantages to incorporating a business. When forming a corporation, LLC, or similar entity, a “corporate veil” is formed that creates a separation between the entity and personal shareholder assets. In some instances, courts will pierce this protection and hold shareholders personally liable for the debts and liabilities of the corporation, if the shareholders are found guilty of having misused the corporation as their alter ego.
Many lawsuits apply the legal theory of the “alter ego” wherein the corporate entity is shown to be a sham and/or an alter ego of one or more individuals that have brought on injurious conduct and who essentially utilized the entity as a blanket to hide behind. Oftentimes this allegation comes into play when a corporation’s assets or insurance are inadequate to pay debts or claims. The shareholders can become personally liable.
In California, two requirements must be met to pierce the corporate veil:
1) Unity of Interests – the shareholders in question must have treated the corporation as their alter ego; and
2) Inequitable Result – the shareholders sanctioned fraud or injustices.
A step-by-step process is commonly used to examine and ultimately determine if alter ego liability is appropriate in a lawsuit. The landmark case of Associated Vendors Inc. v. Oakland Meat Packing, Co. spells out the steps to determine the severity of their actions:
1) Did the individual(s) act in bad faith?
2) Did the individuals contract with one another with the intent to avoid performance by using a corporate entity to shield against personal liability?
3) Did the individuals divert assets from a corporation by or to a stockholder, other person, or entity to the detriment of creditors?
4) Is the corporation dominated by a few key individuals?
5) Is the same office or business location used by the individuals and corporation?
6) Did the individuals and the corporation employ the same attorney?
7) Did the individuals use the entity to procure labor, services and merchandise for another person or entity?
8) Did the individuals fail to adequately capitalize the corporation?
9) Did the individuals fail to maintain minutes or adequate corporate records?
10) Will there be an inequitable result if the court fails to pierce?
A plaintiff has the burden of establishing alter-ego liability. Courts do not typically make a distinction between different forms of corporations, whether they are non-profit or for-profit, so alter-ego liability is evaluated equally.
If a corporation is properly created and maintained, shareholders will not be liable for corporate debts or exposed to lawsuits. Shareholders must uphold corporate formalities and avoid any misuse of corporate funds, property and means of manipulation.
The keys to making sure an entity stays separate from its shareholders are:
1) Documentation and Formalities: Ensure that all letterhead, business cards, and corporate signs include the words “Inc.” or “Incorporated”, for example. Shareholders who sign contracts or documents should sign them in a corporate capacity indicating their corporate position. Create by-laws, issue stock, maintain corporate minutes, have separate account books, file annual reports, and have regular board meetings with all directors.
2) Avoid Co-mingling: Never co-mingle corporate assets with those of the shareholders. Corporations should have their own separate bank account. If you borrow from or lend to the corporation, record an appropriate resolution, sign a promissory note, charge a fair market rate of interest, and make regular payments.
3) Capitalization: Capitalize the corporation sufficiently and purchase adequate liability insurance.
4) Employment Agreements: Establish one between you and the corporation.
5) Multiple Corporations: Avoid identical stock ownership of several corporations along with similar officers and directors. Use different business addresses, telephone numbers and employees.
This valuable advice is critical to minimize a corporation’s exposure to litigation and help them manage their operations. Small and big companies need to understand the importance of having a lawyer to help them with increasing complexities in today’s business environment.
The Law Offices of Spotora & Associates has decades of experience for both businesses and the shareholders that run them. Their services range from counseling individual and corporate clients domestically and internationally, to assisting in business management and maintaining corporate records.