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A Corporation is a type of business organization convenient for growing business and increasing funds. A bonus of limited liability attracts entrepreneurs, because shareholders of a corporation are generally not liable for the corporate debts and, thus, do not put their personal assets at risk. However, this protection may be successfully challenged by creditors of the corporation.
Entrepreneurs have to be aware that the corporate veil may be “pierced” to them by court in certain cases, to make them personally liable for the company debts, or corporate assets may be used to pay off their personal liabilities (reverse piercing). It is important to be able to recognize and prevent those situations.
According to the empirical study conducted by R. Thompson in 1990 (see “Piercing the Corporate Veil: An Empirical Study,” 76 Cornell L. Rev. 1036, 1048-1049 (1991) piercing was granted in approximately 40 percent of all cases in which the issue was raised.
John H. Matheson in his publication “Why Courts Pierce: An Empirical Study of Piercing” (see Berkley Business Law Journal, V. 7, I. 1, (2010) analyzed every case involving piercing in the United States from January 1, 1990 to April 1, 2008. The summary shows that the percentage of cases when a corporate veil has been successfully pierced by court stays consistent compared to the results of the previous imperial study cited above.
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The concept of corporate veil piercing is highly correlated and interconnected with the doctrine of “alter ego.” As mentioned above, a company is considered to be an “alter ago” of its shareholders when used merely for transaction of their personal businesses for which they want to obtain protection from individual liability. It is one of the basis for corporate veil piercing. If corporate veil piercing occurs, the corporate entity will be disregarded and shareholders will be personally liable for the debts of the corporation.
To trigger the mechanism of piercing against a shareholder generally, a stock ownership has to be established as a threshold to proceed to further analysis of other factors. Actual control of the corporation can replace the stock ownership requirement in certain situations depending on laws of jurisdiction.
For example, California rules require for application of the “alter ago doctrine” and corporate veil piercing existence of “such a unity of interest and ownership that the individuality, or separateness, of the said person and corporation has ceased”.
In Riddle v. Leuschner, 51 Cal.2d 574, 335 P.2d 107, 111 (1959) the court underlined that “[i]f an individual's ownership is not established, the corporation's obligations cannot be imposed on him or her.” In Riddle, the court further wrote that “[t]he fact that Mrs. Leuschner had one share of ... stock is sufficient to hold her personally liable to creditors of that corporation provided that the alter ego doctrine is otherwise applicable.”
In Firstmark Capital Corp. v. Hempel Financial Corp. 859 F.2d 92 (9th Cir. 1988) Mr. Hempel owned 95% of the stock in Hempel Financial Corporation (“HFC”), and Mrs. Hempel had a community property interest in her husband's shares. Mr. Hempel was president and chief executive officer of the corporation; Mrs. Hempel held no corporate office. The court concluded that community property interest in a spouse’s stock holdings, “which arises under Cal.Civ.Code § 5105, is sufficient to satisfy the ownership requirement.”
However, under California rules, the satisfaction of ownership requirement is only a threshold that has to be breached in order to proceed to further analysis. In particular, the court analyzed whether an individual is the one who governed the corporation or who was an actor in the course of conduct that constituted the abuse of the corporate privilege. Id. at 95.
The court in Firstmark concluded that “[w]hile Mrs. Hempel was employed by the corporation, her employment was primarily in a clerical capacity, not in the management capacity.” The court concluded that she “merely passively enjoyed the benefits of the disregard of the corporate entity” and her participation in the conduct of HFC's affairs was insufficient to allow imposition of alter ego liability on her. Id.
To protect personal assets form business liabilities, investors have to ensure that the corporation is properly formed (formalities), and reasonably separated from the owner’s individual funds and affairs and other legal entities.
All the formalities are likely to be respected if the corporation has properly written formative documents and records that track the corporate decisions, business transactions and appropriation of funds. Separateness of entity may be questioned when its owner uses business funds, offices, tools, etc. for personal or family needs, or mixes personal and corporate assets. A Corporation has to be created for a lawful purpose and shall not be an “alter ago” of its owner maintained solely to shield his personal assets, or avoid existing liabilities of another entity.
In Automotriz Del Golfo De California S. A. De C. V. v. Resnick (1957) 47 Cal.2d 792, 796 [306 P.2d 1, 4] the court held, that “the failure to issue stock or to apply at any time for a permit, although not conclusive evidence, is an indication that defendants were doing business as individuals.”
Further, insufficient capitalization might be a trigger together with other factors, especially if capitalization is too low when compared with like businesses on the same market or if a statutory requirement has not been met.
Other than these fundamental factors, particular acts of shareholders may challenge corporate protection. For example, a shareholder may be personally liable if he personally guarantees the debt, or did not make it apparent and known to a creditor that he was acting as a representative of a corporation rather than in his personal capacity.
Laws regarding shareholder’s potential liabilities significantly differ in different jurisdictions, however, courts commonly consider injustice, unlawfulness, unfairness as an important factor for veil piercing.
A reverse situation is when investors accumulate and shield their assets inside of a business entity in order to protect it from their personal liability. A Corporation is not the best option to shield investment assets.
The main concern is that the corporate stock can be seized and its subsequent holder can exercise all the rights attached to the shares, vote on the meetings of shareholders and, thus, influence management of company and reach its assets. Moreover, a corporate veil may be pierced in a reversed way to make a company liable for personal debts of its owner.
A Corporation is generally not liable for the debts of its shareholders: creditors may only claim the portion of corporate stock sold to the debtor. However reverse piercing challenges this protection and may result in corporate liability for the debts of its shareholders.
The idea behind the reverse veil piercing doctrine and factors determinative for its application correlate highly with the veil piercing doctrine, however, its application raises more disputes and concerns.
For instance, in California, the reverse piercing doctrine did not receive recognition or support.
In Olympic Capital Corp. v. Newman (C.D. Cal. 1967) 276 F.Supp. 646, the Court stated that “[a]lter ego would appear to be limited to the situation where there is reason to disregard a corporate entity to reach individuals, it has no applicability in disregarding the existence of an individual to reach corporate assets.”
In general, courts consider different factors, inter allia, whether the shareholder retains possession and control over assets that were transferred to a corporation, whether the shareholder remains a true beneficiary of the assets. Similarly to the veil piercing doctrine, courts consider such factors as unity of interest, lack of formalities and injustice.
While a corporation provides fair protection to the personal assets of its shareholders from business liabilities, it is not the best option to hold and protect investment assets.
An LLC is a relatively new form of business organization. It attracts entrepreneurs with its flexibility and combination of features of corporation and partnership. An LLC requires fewer formalities for its operation than a corporation, and provides its members with the same limit of liability.
At the same time, an LLC provides fair protection to the investment assets accumulated in it. The default model of taxation for an LLC is partnership, which helps to avoid a problem of double taxation.
An important feature of an LLC is that management rights are separated from financial participation. An LLC may be members-managed or manager-managed and a manager doesn’t have to have any interest in an LLC (rules may vary in different jurisdictions). In most cases creditors can access financial rights of the debtor who is an LLC member but not managerial; thus, creditors are deprived from exercising control over assets of an LLC.
A charging order is a remedy available for creditors of LLC members and its understanding is important for asset protection planning. This remedy is available in most states, but its extent varies in different jurisdictions. Some states do not allow foreclosure on a member’s interest while other state’s creditors can force a sale.
A charging order granted by court entitles a creditor to receive distributions that an LLC member would be entitled to (to the extent ordered by court), but not to participate in management of an LLC or inspect its records. Courts have underlined in multiple decisions that a holder of a charging order receives economic rights only and is not entitled to become member or exercise management rights, unless otherwise provided in operating agreement. Since such holder cannot participate in management, he cannot influence an LLC’s decision to make distributions to its members, and, thus, may potentially find himself in a situation when an LLC decides not to make any distributions to its members in order to avoid paying debt to the entitled creditor.
This situation is resolved in several jurisdictions by allowing foreclosure on a lien and sale of a transferable interest. California law for example allows foreclosure and sale upon a showing that “distributions under a charging order will not pay the judgment debt within a reasonable time.” It explicitly states however that the purchaser of a transferable interest doesn’t become a member of an LLC, and that foreclosure may be prevented if debtor satisfies the judgment and pays his debt.
In jurisdictions that allow sale of a transferable interest, a useful tool to protect integrity of an LLC may be a carefully written operating agreement. An important feature of an LLC is that it is a very flexible and custom-made entity. Thus, rights and relationship between a creditor entitled in a charging order to receive member’s distributions and LLC and its other members will be determined according to provisions of LLC operating agreement. State laws or operating agreements may make the right of interest assignee to participate in management of an LLC conditioned on approval of all other members.
The policy behind limiting remedies available for creditors of an LLC member is to protect other LLC members and their investments, thus, investors have to be careful with operating single-member LLC because it creates a risk of lower protection. In particular, an assignee of an entire membership interest in a single-member LLC may become entitled to participate in management of an LLC.
In re Albright, 291 B.R. 538 (Bankr.D.Colo.2003), the Bankruptcy Court, held that where debtor was only member of Colorado LLC, “debtor's bankruptcy filing effectively assigned he entire membership interest in the LLC to Chapter 7 estate, and trustee obtained all of her rights, including right to control management of the LLC.”
In re Modanlo, 412 B.R. 715 (Bankr.D.Md.2006), likewise, the bankruptcy Court held that the Trustee had the power to place the single-member LLC into bankruptcy upon his appointment, and, “standing in the shoes of the Debtor and complying with the mandates of the Delaware Act, possesses both the economic and governance rights to participate in the management of [the LLC] that the Debtor himself enjoyed prior to his bankruptcy filing.”
For the purpose of asset protection planning it is important to be aware of different laws regulating a charging order as a remedy available for creditors in different states. Investors may face a situation when in the state of company formation foreclosure on transferable interest is not allowed, but in the state where creditors enforce the charging order this option is available, and thus, the transferable interest may be sold.
Finally, investors have to keep in mind that the LLC veil may be pierced analogously to corporate veil piercing discussed abode. Thus, members and managers of an LLC have to ensure reasonable compliance with the formalities and rules applicable to the company formation and operation.
Business owners need to be aware that the idea that courts rarely pierce the corporate veil is a drastic misconception and entrepreneurs are strongly advised to seek counsel to design a holistic strategy tailored to the entrepreneur's specific circumstances, rather than leverage merely a corporation to separate their personal assets from business and investment risks. Call our office right now at (800) 493-6304 to arrange a consultation.