Most of us believe that when we set up a corporation to conduct business, we’ve accomplished many positive things. One of these, in particular, is that we’ve shielded ourselves from personal liability for any of the company’s business obligations. Unfortunately, that may not always be the case.
Usually a corporation is treated as a separate legal entity, and the corporation is solely responsible for the debts that it incurs. However, whether your business is financially sound, or is having cash flow issues, individual owners are not immune from suit by an aggressive creditor, or some other party seeking to recover a claim for a variety of other reasons.
In such cases, a plaintiff may file suit against not only the corporation, but its owners, officers or directors. How and under what circumstances can this type of action be successful? When can you be personally responsible for the debts of your corporation?
Courts have developed a concept known as “piercing the corporate veil.” Essentially, it is a legal concept in which courts cast aside limited liability and hold a corporation’s shareholders or directors personally liable for the corporation’s actions or debts under a theory that the corporation is their “alter ego.” Veil piercing is most common in small, closely held companies.
In determining whether a corporate veil may be pierced, which can result in personal liability, courts will look to a number of key factors.
Undercapitalization. Was the corporation undercapitalized from the outset? Failing to sufficiently capitalize a newly formed company can not only lead to financial distress, but also leaves its shareholders susceptible to suit.
Failure to adhere to corporate formalities. Does the corporation have an operating agreement and/or corporate by-laws? Does it conduct regular board meetings and keep minutes? If it fails to do follow these and other simple rules, the risk of personal exposure is higher.
Substantial intermingling of corporate and personal affairs. Are there significant intercompany transfers, or are funds being paid out of the corporation that are clearly not business related? When business owners use their various corporations to shuttle funds back and forth between them, or they utilize their corporation as a personal piggy bank from which they can withdraw money at will, the corporate form will be disregarded.
Use of the corporate form to perpetuate a fraud. Does someone with whom you do business routinely appear to be starting up, then shutting down, his corporations? Clearly, where individuals set up companies solely and knowingly to shield themselves from liability, they will be found to take on the liabilities of the company.
Recently, veil piercing through an alter-ego theory was tested by two courts in Pennsylvania, with opposite results.
In Liberman v. Corporacion Experianca Unica, S.A., — F. Supp. 3d —-, 2016 WL 7450464 (E.D. Pa. Dec. 27, 2016), the U.S. District Court decided in favor of business owners where the plaintiff sought to pierce the corporate veil. There, the plaintiffs were not paid rental profits from their investment in a time share in Costa Rica. In their subsequent suit, the plaintiffs attempted to pierce the corporate veil in order to hold the defendants and defendants’ principal liable for all resulting damages.
The court rejected the plaintiffs’ arguments outright. First, the court drew a distinction between undercapitalization and underperformance, the latter of which does not lend to a successful veil piercing claim. Also, the court found that the need to borrow money at the beginning of a project was not evidence of undercapitalization and noted the absurd result that could stem from such a ruling.
The plaintiffs’ argument that the defendants failed to observe corporate formalities was also rejected. The court noted that each defendant maintained separate board meetings, shareholder meetings, insurance, tax returns, officers, title to assets, books and records and financial statements as evidence that the defendant corporations were all maintained as separate entities. Finally, in rejecting the plaintiffs’ contention that intermingling occurred, the court found that the fact that funds were being transferred and booked, between different companies actually supported the defendants case, because it was evidence of the maintenance of separate books and records. Importantly, the court stated that common ownership was not evidence of intermingling and did not support an alter ego theory of liability.
In stark contrast to the District Court’s decision in Liberman, the Superior Court of Pennsylvania upheld a verdict by the Court of Common Pleas to pierce the corporate veil in Power Line Packaging, Inc. v. Hermes Calgon/THG Acquisition LLC, 2017 WL 90617 (Pa. Super. Jan. 10, 2017). In Power Line, the plaintiff supplied a line of mists, lotions and shaving gels to the corporate defendants. When the corporate defendants failed to pay, the plaintiff sued them, as well as the defendants’ principals. After a non-jury trial, the Court of Common Pleas issued comprehensive findings, holding the defendants’ principals personally liable.
First, the Court found that the defendant corporations were undercapitalized in that they were never solvent and never had any substantial assets at any time.
In addition, unlike the defendants in Liberman, the Power Line corporate defendants held no board meetings, kept no minutes and had board members that never participated in the companies’ business affairs. Moreover, the corporate defendants distributed dividends to shareholders with absolute disregard of their investment in that corporation, or the corporation’s financial ability to pay a dividend. Thus, the court held, corporate formalities were not observed.
The Court also found that the defendants and their principals frequently comingled their assets, stating, in fact, that one principal operated under the assumption that all of the money in all of the companies belonged to him and could be used at his leisure.
Finally, the Court held that the principals of the defendants used the defendant corporations to perpetrate a fraud and render the defendant companies insolvent. The court highlighted multiple misrepresentations from the defendants to the plaintiff that caused the plaintiff to continue to do business with the defendants, at a substantial loss.
When conducting business, it is important to be mindful of the red flags that can result in personal liability for corporate debt. In order to minimize these risks, it’s helpful to have a sound business model at the outset, maintain accurate business and financial records and comply with the standards of conducting a business that have been discussed above. Flaster Greenberg’s attorneys provide advice and counseling on business formation and risk management, and when litigation is unavoidable, we represent our clients tenaciously to resolve the dispute as quickly and efficiently as possible. If you have questions about managing risk or ways to avoid personal liability for your business obligations, please contact Harry Giacometti or Damien Tancredi.