Limiting Your Liability – Avoiding Piercing the Corporate Veil
When forming a corporation or other business entity, one of the benefits is that if the corporation is sued or creditors obtain a judgement against the corporation, then only the corporate assets are at risk and not your own assets. Former presidential candidate Mitt Romney once infamously reminded us that “corporations are people too”, and he was mostly right. Corporations are separate entities from the shareholders and officers and have the right to sue on their own or be sued individually. By being separate, the corporate officers and shareholders are generally not liable for corporate debt or contractual obligations. Similarly, members of a limited liability company (LLC) also enjoy liability protections and are generally not personally liable for LLC debt or obligations.
However, if you are a shareholder, director, or officer of a corporation, there are instances where your personal assets may not be protected, regardless of whether the corporate entity is the target of the lawsuit. In such cases, the party wishing to seize your personal assets attempts to “pierce the corporate veil,” or the protection that gave you personal immunity from the corporation’s obligations.
In civil suits against a corporation for damages where the plaintiff discovers that the corporation’s own assets may be insufficient to satisfy a judgement, the plaintiff may seek to go after the assets of the corporate owner or shareholder. If the plaintiff can prove that the corporate owners or shareholders acted in certain ways, then a court may allow the “corporate veil” or shield of immunity to be pierced or deemed unenforceable.
Doctrine of Alter Ego
Many of us have heard of the term “alter ego.” For example, Superman’s alter ego is mild-mannered reporter Clark Kent. Bruce Wayne is the alter ego of Batman. Although those cartoon characters acted for the forces of good and their alter egos were created to shield their actual identities for non-nefarious reasons, an individual can act as the alter ego of a corporation. But in this case, it is to cover up personal transactions in order to gain an unfair advantage by designating them as corporate conduct and using corporate immunity to shield that person’s personal assets.
Where an individual is deemed the corporation’s alter ego, the court will have decided that the person and the corporation are not separate entities and that allowing personal immunity would only accomplish a fraudulent purpose. In other words, the individual misused the corporate identity or ignored its form and disguised his or her own assets as the corporation’s.
Closely-held or family corporations may be especially at risk. If your business is incorporated, you must follow the formalities involved, including holding meetings, keeping the minutes of such meetings, and other requirements. If you fail to keep separate bank accounts, commingle funds, or use corporate funds for your own personal use, then any corporate transaction that fails or results in debt that cannot be paid potentially exposes your own personal assets.
Proving Alter Ego or Veil Piercing
Civil lawsuits concern causes of action that have certain elements, each of which must be proved by the plaintiff, in most cases, before a judgment and compensation may be awarded. If a party is asserting that an individual cannot hide or be shielded by corporate immunity regarding a particular transaction, the Wisconsin courts have imposed certain tests to determine if the corporate veil may be pierced. Generally, Wisconsin courts apply a three-part test:
Has there been a strong element of control or domination of the corporation by an individual?
For instance, has the corporation followed all formalities such as holding regular meetings, keeping records, and issuing yearly reports? What actions have been performed by the corporate officers in furtherance of the corporation’s goals, or are they officers in name only? Have dividends been paid out? Has any stock been issued? Has an individual or others siphoned off funds or commingled their funds with the corporation’s? If such actions are shown to have occurred, then the next prong of the three-part test must be met.
Has the control of the corporation by one individual caused harm or an injustice?
Relevant to this test is whether the corporation was adequately funded at its inception. If it was not adequately funded, this may be an indication that the corporation was created as a sham. It is not an indication of fraud if a corporation lacked sufficient assets or was undercapitalized when the act in question took place or when the debt was incurred. Courts will look at the nature of the corporate undertaking when it was founded and determine if it was adequately capitalized at that time. It may well have been a very small operation only requiring a small infusion of capital and has since substantially expanded. However, if the shareholders failed to provide new capital to the corporation when it was substantially expanding or when the nature of its business changed and its financial condition was suffering, this may indicate undercapitalization that can lead to an injustice. If such actions are shown to have occurred, then the next prong of the three-part test must be met.
Is there a “nexus” (i.e., connection) between the domination of the corporation and the injustice that led to the alleged injury?
An injustice may be money owed to a creditor that cannot be repaid because the corporation was undercapitalized at its inception. But this mere fact is not sufficient to show a nexus between the undercapitalization and the debt that is owed. The creditor must show that he or she detrimentally relied on the shareholder’s fraudulent representation that the corporation was adequately financed at the time the creditor provided the service or goods. If the creditor was aware that the corporation lacked sufficient assets or was struggling but nevertheless continued to conduct business to its detriment, the creditor may be estopped from asserting that it was undercapitalized.
If all three parts of this test are met, then a party may well pierce the corporate veil and may be allowed to hold that individual or others personally liable. This can be a difficult burden to meet. since a plaintiff does need to show all three parts of the test to demonstrate that the shareholder or officer intended from the corporation’s inception to undercapitalize it, never subsequently infused it with adequate capital, failed to follow corporate formalities, and that such actions resulted in an injustice. Essentially, a plaintiff must show that this individual had intended to use the corporate entity for unjust advantage from the start and that the plaintiff relied on that person’s misrepresentations of its financial status to provide whatever service or product to the plaintiff’s detriment.
Consumer Protection Violations and Piercing the Veil
Under recent court rulings by Wisconsin’s highest court, if you own an LLC or corporation involved in providing services or products to consumers, then any violation of consumer protection laws, particularly unfair business practices, may lead to corporate veil piercing. Unfair business acts are covered under laws promulgated by the Wisconsin Department of Agriculture, Trade and Consumer Protection (DATCP). In many family or small businesses, such as home improvement companies, a corporate officer may be the seller of the service or product or is not in a position where he or she can provide oversight of the business practices such as where the seller or agent personally meets with the consumer outside the office. If the agent made misrepresentations to the consumer, then that person may be held liable as well as any shareholder who was complicit. Liability would not extend to a shareholder who merely performed administrative tasks and was not in a position to prevent unfair dealings.
Other similar businesses such as gas stations, auto body shops, or mobile home operations are subject to regulations promulgated by the DATCP and any unfair business dealings or other consumer protection violations committed by a shareholder of his or her own volition could be held liable.
There are two main defenses to veil piercing: waiver and estoppel. For example, if a creditor knows that a company is undercapitalized, but fails to require a personal guaranty and continues to extend a credit, a court may find that the right pierce the corporate veil is waived. In such a situation, the creditor may also be precluded from piercing the corporate veil under the doctrine of estoppel. If a lender fails to require a personal guaranty, the lender risks the shareholder relying on lack of a personal guaranty.
What about an LLC?
Limited liability companies are a concept of recent vintage and designed to allow owners to forego many of the usual corporate formalities. Consequently, some observers feel it would be unjust to hold LLC officers and owners to the same standards. But if your business is an LLC, you are cautioned to follow normal corporate formalities such as holding regular meetings, maintaining records, issuing reports, and keeping separate accounts, all while not using the LLC as your own personal bank. This includes adequately capitalizing your LLC when formed and keeping it capitalized as it expands or changes its original purpose or business. LLC owners and officers should not misrepresent its capitalization to any potential creditor.
Other Acts of Personal Liability
In addition to veil piercing, there are other instances where a court will impose personal liability on a corporate shareholder or officer. Should a corporate officer or shareholder commit a tortious act, he or she can be held personally accountable so long as the act was not part of that person’s role as an officer or shareholder. This applies even if the person acted within the scope of his employment such as intentionally misrepresenting a material fact to a creditor or assaulting an employee at the office. Courts have ruled that this is not piercing the corporate veil, but it is merely holding an individual liable for their illegal actions.
Further, agents of a corporation face personal liability if they fail to disclose that they are acting on behalf of a corporation or the business’ corporate status unless that person knows that the agent is acting as such.
Finally, if the corporation is facing dissolution but the shareholders fail to act on dissolving it, they can be held personally liable for the corporate debts.
Take Your Corporate Identity Seriously
If you are a shareholder, owner, or officers of a corporation or LLC, you risk losing immunity from creditor lawsuits and being liable for the corporate debts if you fail to treat the corporation as a separate entity and to follow all the formalities involved in maintaining its separate identity. Keep Mitt Romney’s much aligned statement about corporations as people in mind when conducting corporate business, and treat your company as a distinct personality that needs to be “fed” and “nurtured” in its own right.
Rely on Professionals You Can Trust
As you can see, there are many potential mindfields in all stages of hiring. Putting in place a standard procedure and documenting your process can help avoid liability for you and your company. If you have any questions about this article or any other employment law issue, please contact us.
Disclaimer: The information contained in this post is for general informational purposes only and is not legal advice. Due to the rapidly changing nature of law, Schloemer Law Firm makes no warranty or guarantee concerning the accuracy or completeness of this content. You should consult with an attorney to review the current status of the law and how it applies to your unique circumstances before deciding to take—or refrain from taking—any action. If you need legal guidance, please contact us at 262-334-3471 or [email protected].