A longstanding precept of corporate law is that a corporation is a separate and distinct entity that is separate from its shareholders. In other words, shareholders are not typically held liable for actions of their corporations. However, certain actions taken by a shareholder may void the otherwise valid “veil” of a corporate shell, allowing a wronged party to “pierce” a corporation and seek redress from the shareholders. The Cornell Legal Information Institute (LII) explains that the term “piercing the corporate veils” refers to a scenario “in which courts put aside limited liability and hold a corporation’s shareholders or directors personally liable for the corporation’s actions or debts.” A piercing of the corporate veil happens most frequently in closely held corporations.
When Does “Piercing the Corporate Veil” Occur?
The Delaware legislature and courts are generally at the forefront of corporate law, with the area of “piercing the corporate veil” being no exception. Two key elements are usually present when a wronged party has successfully pierced a corporate veil:
- The failure to disregard the separateness of the corporate entity would sanction a fraud or promote injustice; and
- The corporation is simply an “alter ego” of its shareholder(s) and insufficient corporate separateness exists.
While the failure to observe corporate formalities by itself may not suffice to justify setting aside the corporate shell, evidence of fraud, deceit, or asset-stripping in addition to the failure to observe corporate formalities is generally enough.
How can Shareholders Avoid Liability When the Corporate Veil is Pierced?
In situations in which shareholders become at risk of personal liability for the wrongs of the corporation, is there a way to avoid liability? In other words, the question becomes: What should shareholders do to avoid potential liability for actions of their corporation? The following is a list of things every shareholder should take into account when there is a possibility of personal liability and a piercing of the corporate veil:
- Most importantly, do not take part in any actions that may be construed as fraudulent or deceitful;
- Adequately capitalize all entities to fund expected losses, especially on formation (in a holding company structure, make sure each entity can separately support their own business operations);
- Ensure each entity is solvent and able to pay its debts as they become due;
- In a holding company structure, limit parent company control over day-to-day operations (parent entities should avoid intrusive day-to-day control where little discretion is left with the subsidiary);
- Comply with basic corporate formalities, which means forming a board for each subsidiary, holding regular board meetings where the board considers substantive matters, holding annual meetings to elect officers and directors and avoid vacancies, avoiding overlap if possible of board members among parent and subsidiaries, and documenting the decision-making processes by keeping contemporaneous minutes of meetings and/or support for board action through written consent;
- Subsidiaries should compensate any parent or affiliate for use of assets or services through arms-length written agreements (e.g., IP license agreements, leases, or management service agreements);
- Maintain separate offices, telephone numbers, and listings if possible;
- Maintain separate bank accounts, leases, and title (if separate cash accounts are not feasible, studious separate accounting practices and documented credit facilities should be maintained);
- Maintain separate balance sheets and profit/loss statements, and have the ability to determine the value of assets, liabilities, revenues, and expenses for each entity;
- Ensure that the shareholders are not removing assets or funds without adequate consideration, or using the assets or funds as a personal bank account; and
- Maintain a separate employee handbook for each subsidiary, with each subsidiary employing its own employees if possible (each entity should also have the ability to hire and fire its own employees, and separate equity incentive plans by entity may be appropriate if there is evidence of separateness).
Rarely will an entity or a holding company structure with many entities be able to adhere to each of the aforementioned points. However, the more you can follow, the less likely you are to see a court set aside your corporate shell. Note that the concepts set forth above generally apply the limited liability companies as well, although the law is not as well-developed.
Contact a Corporate Law Attorney Near Me
Do you have questions about avoiding a situation in which the corporate veil may be pierced? An experienced corporate attorney at Accretive Law can speak with you today. Contact Accretive Law to learn more about how our corporate lawyers can assist your business.