Bedrock Principle: Shareholders have limited liability [except in cases where the Court permits piercing of the Corporate Veil (PCV) which only occurs in closely-held Corporations.
Generally, a corporate shareholder is not liable for the debts of a corporation, except when the court pierces or lifts the corporate veil and disregards the corporate entity, thus holding shareholders personally liable as justice requires.
It is easier to find liability in closely held corporations (those with few shareholders that make the decisions - that is, active shareholders).
The veil can be pierced for the following reasons:
1️⃣ Alter ego: Where the shareholders fail to treat the corporation as a separate entity, but more like an alter ego where corporate formalities are ignored and/or personal funds are commingled;
2️⃣ Undercapitalization: Where the shareholders’ monetary investment at the time of formation (and/or insurance coverage) is insufficient to cover foreseeable liabilities; some courts in close corporations look at future debts if foreseeable;
3️⃣ Fraud: Where a corporation is formed to commit fraud or as a mechanism for the shareholders to hide behind to avoid existing obligations; or
4️⃣ Estoppel: Where a shareholder represents that he will be personally liable for corporate debts.
The effect of piercing the corporate veil is that active shareholders will have personal joint + several liability.
💡 Issue-spotting tip: Where piercing or lifting the corporate veil is at issue, the facts often will also raise the issue of promoter liability for pre-incorporation contracts and breaches of fiduciary duties by directors.
This issue often arises in situations where there are few shareholders and courts are more likely to pierce the corporate veil for tortious acts and not for contract issues.
💡 Unlike a contract claimant, a tort victim did not voluntarily choose to transact with the Corporation and did not knowingly assume the risk of limited liability.
✅ Where either de facto Corporation or Corporation by Estoppel are indicated by the facts this may create a defence [Bail promoter out of a position of liability] for the promoter to avoid personal liability.
These 2 doctrines have been abolished in many states, but if they are available here is how they would work.
The “home" state where the corporation is incorporated as a domestic corporation determines which states laws apply to the internal affairs of the Corporation.
California is more liberal in allowing the corporate veil to be pierced than say Nevada where it is more difficult.
Factors that a court may consider when determining whether or not to pierce or lift the corporate veil include the following:
⚖️ Absence or inaccuracy of corporate records;
⚖️ Concealment or misrepresentation of members;
⚖️ Failure to maintain arm's length relationships with related entities;
⚖️ Failure to observe corporate formalities in terms of behavior and documentation;
⚖️ Intermingling of assets of the corporation and of the shareholder;
⚖️ Manipulation of assets or liabilities to concentrate the assets or liabilities;
⚖️ Non-functioning corporate officers and/or directors;
⚖️ Significant undercapitalization (or under insurance) of the business entity (capitalization + insurance requirements vary based on industry, location, and specific company circumstances);
⚖️ Siphoning of corporate funds by the dominant shareholder(s);
⚖️ Treatment by an individual of the assets of corporation as his/her own;
⚖️ Was the corporation being used as a "façade" for dominant shareholder(s) personal dealings; alter ego theory;
Important: Not all of these factors need to be met in order for the court to pierce the corporate veil.
Further, some courts might find that one factor is so compelling in a particular case that it will find the shareholders personally liable.
For example: many large corporations do not pay dividends, without any suggestion of corporate impropriety, but particularly for a small or close corporation the failure to pay dividends may suggest financial impropriety.
Example is where a parent Corporation forms a subsidiary to avoid its own obligations. The Court may allow the piercing of the Corporate Veil, so the plaintiff may sue the parent Corporation (go after the parent Corporation's assets).
When a corporation is deemed undercapitalized or insolvent, third-party or outside creditors may be paid off before the claim of a shareholder and esp. a shareholder with a controlling interest who makes a loan to his or her own corporation, thus subordinating the shareholder claims.
This FAQ was prepared by James D. Ford GAICD | Principal Solicitor, Blue Ocean Law Group℠.
This FAQ is intended for general interest + information only.
It is not legal advice, nor should it be relied upon or used as such.
We recommend you always consult a lawyer for legal advice specifically tailored to your needs & circumstances.