Is Your Corporation or LLC In Order?

In these challenging times for businesses, plaintiffs will want to rely on the alter ego doctrine to pierce corporate veils, making shareholders personally liable for corporate debts. The primary reason shareholders form corporations is to shield themselves from personal liability. However, the corporate shield that protects shareholders from personal liability is not absolute. Therefore, shareholders must understand the circumstances under which a court will deem a corporation the alter ego of its shareholders and thus remove the veil of personal protection.

• The doctrine applies not only to corporations, but also to limited liability companies.
• To establish alter ego, a plaintiff must prove both of the following: (1) that there is a unity of interest between the corporation and its shareholders, such that they have no practical separate existence, and (2) that an inequitable result or injustice will occur if the corporation alone is held responsible.
• Courts consider a number of factors to determine whether there is a unity of interest by answering the following questions: Have funds and other assets been commingled? Have corporate assets been diverted to a shareholder or related person? Has the corporation failed to comply with corporate formalities such as annual meetings? Does the corporation occupy the same office or location as a shareholder? Have the shareholders adequately capitalized the corporation? And has the corporation failed to maintain arm’s length relationships with its shareholders? Even if the court finds a unity of interest between the corporation and its shareholders, it will not pierce the corporate veil unless it also finds that it would be unjust to protect the shareholders.
• A court will not pierce the corporate veil and hold the shareholders personally liable simply because the corporation is insolvent. To establish an inequitable result or injustice, a plaintiff must prove that the corporation committed wrongdoing or bad faith, which makes it unjust for the shareholders to hide behind the corporate shield.
• A plaintiff may raise the alter ego doctrine either in its complaint or after the court has entered a judgment against a corporate defendant. But to add an individual defendant (shareholder) after the court has entered judgment against a corporate defendant, a plaintiff must prove that the individual defendant controlled the litigation that resulted in the judgment. This means some active defense of the lawsuit by the individual defendant such as paying for the defense, hiring the attorney, or controlling the course of litigation. The reason for this requirement is to protect the individual defendant’s right to its day in court.
• California does not recognize reverse alter ego. Reverse alter ego is when a creditor is permitted to use corporate assets to satisfy a judgment against an individual shareholder. The lack of reverse alter ego in California means that corporate investors do not have to worry that shareholder debts will be satisfied with corporate assets.