In this post, our Newport Beach corporate lawyers answer questions about the corporate veil and offer practical suggestions for protecting your personal assets from corporate liability.
What is the Corporate Veil?
“Corporate veil” is a phrase used to describe the legal concept that a corporate entity (such as a corporation or LLC) and its shareholders or members are to be treated separately and distinctly, especially for liability purposes. In fact, one of the main reasons for creating a corporate entity is to protect the shareholders, officers, and directors of the corporation from personal liability if the corporation is sued. Under the law, corporations and LLCs are treated as individuals if they are sued; accordingly, only corporate assets, as opposed to the personal assets of the people who control and operate the corporate entity, may be taken to satisfy the corporation’s debts or other obligations.
How Can the Corporate Veil Be “Pierced”?
In order to pierce the veil of a corporation or LLC, a court must find that (i) the entity was not operated in compliance with the formal rules established by state law; or (ii) the corporation was being used as a front for illegal or fraudulent behavior. Two theories commonly relied upon to pierce the corporate veil are Alter Ego and the Instrumentality Rule.
Under the Alter Ego rule, the courts require evidence that the entity was a façade for fraud or other irresponsible behavior by the people behind the scenes. This is often found where the entity is actually a “dummy corporation” or a “corporate shell.” In a common example of this situation, the officers and directors of a big corporation create a subsidiary and transfer all the debts and obligations of the big corporation to the subsidiary. However, the subsidiary has not been capitalized properly. When a creditor requests payment, it is not paid. If it sues the entity, there are not sufficient assets to pay the judgment.
The Instrumentality Rule looks to whether a parent corporation is just using a subsidiary to do all its dirty work while claiming its own officers, directors, and shareholders have limited liability and cannot be sued for wrongful acts perpetrated through the subsidiary.
What Can I Do to Protect Myself?
If you are a shareholder, officer, director, or member of a corporation or LLC, you can protect yourself by being aware of the behavior that prompts courts to seize the personal assets of individuals, like yourself, who own or manage an entity. Take these practical steps to help dissuade a court from piercing the corporate veil:
- Always adequately capitalize. If you are unable to invest enough into the entity initially, procure a business loan. In the alternative, ask others to invest in the entity and set them up as co-owners.
- Ask your Newport Beach corporate lawyer to explain all of the corporate formalities that must be followed. If your entity is a corporation, have your attorney draft bylaws and then make sure that the directors and officers follow those bylaws. Schedule necessary meetings and confirm that each year, the shareholders and the directors hold their annual meetings. Have a secretary appointed to take detailed notes, called “minutes,” of what took place at each meeting. Additionally, if any other meetings are scheduled, e.g., to accommodate voting on a matter, then detailed and accurate minutes need to be recorded at those meetings also.
- Update the bylaws for a corporation on a regular basis. For an LLC, draft an initial Operating Agreement, even if it is not required by your jurisdiction and routinely update the Operating Agreement.
- Never mix your personal assets with those of the corporation or LLC, even if you are the only shareholder, officer, or member of the entity. This includes not paying for personal items with the entity’s checking account, or depositing checks payable to the entity into your own checking account. If you do this, a court will be more likely to determine that you and the entity are one and the same, and it will be more willing to pierce the veil to access your personal assets.
- Never take assets from the corporation, whether money or property.
- Never tell someone that you will personally guarantee a debt for the entity.
- Identify the status of your entity, e.g., “Inc.” or “LLC,” on letterhead, business cards, email signatures, advertisements, etc. When you sign documents on behalf of your entity, use your title and the name of the entity along with “Inc.” or “LLC.” This differentiates you as an individual from the corporate entity and makes it clear that you are not one and the same.
- When issuing stock for a corporation, keep a stock transfer ledger. For LLCs, give owners membership certificates and then maintain a ledger that shows membership transfers.
- Keep copies of all corporate documents, including contracts, for a minimum of seven years.
If you have questions about the stability of your corporate structure, or other questions related to corporate liability, contact us by phone or email to schedule a free initial consultation with our experienced Newport Beach corporate lawyers.