Limited liability of members in a corporation was created in order to encourage investors to fund the operations of a business while giving shareholders the ability to invest without fear of being held liable for the debts and obligations of the company.
One of the main reasons many form a corporation or limited liability company (LLC) is because they do not want to be held personally liable for business debts that they endure. However, if an owners, director, or majority shareholder uses that corporation as shield for personal debt, courts will hold the owners and shareholder personally liable by “piercing the corporate veil”.
As a result of limited liability, the corporation acts as a shield to protect individual shareholders from claimants and creditors seeking to satisfy a judgment against the corporation. Limited liability, however, is not absolute and the limited liability of shareholders in a corporation may be disregarded. Disregarding the independent and separate existence of the corporation is often referred to as "piercing the corporate veil."
This would occur if the owners, officers, directors, or shareholders do not have a real separation between the corporation and their personal obligations and use the corporations limited liability advantage to their own personal advantage.
If the court determines that the owners, directors, or shareholders are abusing the corporate status and shielding their personal liability with the corporate liability, the court will pierce the corporate veil and hold the owners, directors, or shareholders personally liable. This means that creditors that are owed debt can go after the owner’s, directors, and shareholders personal property to satisfy the debt.
Factors courts consider in determining whether to pierce the corporate veil:
- Alter Ego: The owners or directors fail to maintain a separation between the corporation and their personal financial affairs. This would be considered if the court determines that the owners and directors only use the corporation as an imitation or sham just to enjoy the limited liability status and they treat the corporate status as their own.
- Inadequate Capitalization: At the time of the formation of the corporation, there was insufficient capitalization that would usually be sufficient to cover prospective liabilities.
- Wrongful or Fraudulent Conduct: If the owners and directors used fraudulently borrowed corporate assets or entered into transactions dishonestly or entered into transactions to avoid personal liability with no intent to repay the future debt, then the limited liability would not apply and the wrongdoers will be personally liable for the transactions and debts incurred.
- Failure of Corporate Formalities: If the owners and shareholders failed to comply with corporate formalities, then it’s a possibility that there was no real intent to form a valid corporation and the corporation was made fraudulently to enjoy the limited liability status.
Factors for determining whether there is a unity of interest and ownership and whether the separateness has been blurred will vary. Typically, however, the following factors will be considered:
- Nature of the corporation ownership and control
- Creation and maintenance of corporate minutes and records
- Compliance with corporate formalities such as electing directors, issuing shares, acting through votes and resolutions
- Commingling of the funds of shareholders and the corporation
- Use of corporate funds for personal uses of shareholders
- Maintenance of separate offices and facilities
- Failure to comply with corporate formalities
Courts will generally not pierce the corporate veil unless the shareholder clearly used the limited liability protection provided by the corporation to engage in actions that were wrongful. If you would like to bring a legal action against a corporation, you should contact an experienced business lawyer for advice and assistance.