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"Piercing the corporate veil" is a metaphor for ignoring the limited liability of a corporation (or other entity; see below). When a corporate veil is pierced, the corporation's creditors can go after the assets of its shareholders.

If you own stock, that probably sounds rather scary. It comes up fairly often in court, too: piercing the corporate veil is the most common issue of corporate law to arise in litigation, which makes sense when you consider that an irate plaintiff will often want more money than the corporate defendant in question can pay, so they try to pierce the veil to get at the millionaire financier or the multinational parent company that's backing up Deadbeat, Inc.

What's also scary is that there are no hard and fast rules for determining when the corporate veil should be pierced. That's left largely to the determination of judges, who look at the totality of the circumstances to make their ruling, and choose to pierce the veil if it's necessary to prevent fraud or achieve equity.

Fortunately for businesspeople, courts usually respect limited liability and leave the veil intact. Here are some criteria that often factor in to that analysis:

Undercapitalization

"Undercapitalized" is a fancy legal way of saying "broke"—it means the company doesn't have enough capital to cover its likely economic needs. When a company is short on funds, it has to be much more careful about how it does its business; it can't enter contracts it has no way of paying, and it can't engage in risky business that could foreseeably cause excessive damage to others. Heading off into either territory opens up the risk of piercing.

Undercapitalization is the most common argument for veil piercing; if the corporation itself doesn't have enough money to cover its debts, the creditors are going to want their money from someone.

The argument is most common in tort cases, such as personal injury suits. In these cases, insurance policies are often counted as part of the corporation's capital, since a cab company with no money and a $10,000 insurance policy becomes a cab company with $10,000 after its driver runs somebody over.

Contract claims can also make use of an undercapitalization argument, but such cases are rare except when they involve fraud. Managers are unlikely to make deals that would stretch the company beyond what it can pay. Moreover, if a person provides money, goods or services to a corporation with no capital, many judges will say that they did so at their own risk, especially if they are a large firm or experienced businessperson who "should know better." (Moral: when making deals with an unfamiliar company, it's a good idea to take a look at their accounting books.)

The company as an alter ego

Judges often describe a pierced corporation as an "alter ego," or a "sham," or a "mere instrumentality" of the shareholders. (One of my professors in law school remarked that the word "mere" is a synonym for "bad.")

Shareholders can be personally liable for corporate debts if they take certain voluntary actions. For example, they might have to co-sign a loan to the corporation if its assets aren't enough for the bank's tastes. Or a shareholder might put their own name on a promissory note from the corporation, making the note collectible from either party. None of these cases are really about "piercing the corporate veil," since the shareholder has gone around the veil and willingly opened themselves up to liability.

The sorts of actions that lead to alter ego judgments have more to do with domination and control. If one person or a small group (say, an elevator load or less) own the corporation, dominate its affairs and control its actions, they start to open themselves to personal liability. This isn't enough in itself (thankfully, since many companies are owned and run by small groups); something more is necessary. Maybe the shareholders are using the business for personal ends: intermingling business and personal funds, for instance, or leading their customers and vendors to believe that they're personally involved in a transaction, rather than acting as an agent of the company.

The company as part of a larger enterprise

Another idea of "mere instrumentality" comes up in the "enterprise entity" argument. Some businesses are divided into a number of small corporations for no clear reason other than escaping liability. In these cases, the liability can be extended to other components of the business.

This doesn't apply to all cases. For example, American Airlines and American Eagle, both airlines, are separate companies but wholly owned by another company, AMR Corporation. These are unlikely to fall victim to the enterprise entity argument: they have lots of assets and lots of insurance, for starters, but they engage in their own operations on an independent basis, and their operations are different enough (flying big airplanes versus flying small airplanes) to warrant an inference that there's more involved in the split than just escaping liability.

A more appropriate example (and the one that appears in textbooks) is the taxicab industry in New York City. Many cabs are owned by tiny corporations, which exist solely to hold the title, loans, and insurance for one or two cabs (they might also own the medallion, which is likely to be more valuable than the cab itself, but that can be leased from someone else). The dispatchers and drivers are separate from the company that actually owns the cab. A single person or group might own a number of these little corporations, and in those cases it makes more legal sense to spread liability among the entire business regardless of how many corporate tiers comprise it. (In practice, of course, none of these companies are likely to have much capital, so you're probably better off taking your insurance payment and running. Assuming you still have two feet.)

Disregard of formalities

When you form a corporation, the law requires you to do a lot of housekeeping work. There have to be shareholder meetings, board meetings, minutes, bylaws, and all sorts of nonsense that the owners don't care about, but that the lawyer insists on. The lawyer insists on these formalities for good reason: many judges will look to the corporation's respect for formalities as a criterion in determining whether or not to pierce the veil.

The reason for this is somewhat theoretical. A corporation is created by law, and it exists so long as the law allows it to exist. If the shareholders don't follow the law in running the corporation, its limited liability, one of the main benefits it receives under the law, ought to be impaired. So the argument goes. More practically, a disregard for formalities can also indicate that the company is being used as an alter ego of the shareholders.

Some state laws also provide for direct shareholder or director liability if the corporation violates the law. For instance, in New York, the largest shareholders of a close corporation are personally liable for any wages unpaid by the corporation, and the treasurer or CFO is personally liable for any unpaid sales or income taxes.

Outright fraud

Unscrupulous shareholders will sometimes lie, cheat and steal through their corporation. A typical example is "stripping" the assets of the corporation through generous dividends, leaving it with no money to pay its bills. Or, they might cook the books to mislead others into thinking that the company has more money than it actually has. Or, they might create a tiny corporation with few assets and slip it into a contract when the other party is thinking they're dealing with another, bigger corporation.

In all of these cases, veil piercing is usually only one means to achieve an end. There are other laws, like common law conversion, securities laws and the Uniform Fraudulent Transfers Act, that will also protect creditors and perhaps even subject the crooked businessperson to criminal charges. But veil piercing is another avenue open to those who want their money back, and judges will often be more than happy to oblige if some form of dastardly activity can be proven.

Piercing other entities

Limited liability companies, more commonly known as "LLCs," are similar enough to corporations that many courts have been willing to pierce their veils as well.

Piercing a limited liability partnership (LLP) is a bit trickier. Partners in LLPs are generally liable for any torts they commit. The tougher issue involves huge LLPs, like accounting firms, and whether the assets of partners can be used to satisfy the demands of the many people screwed over by the firm. The ongoing litigation against Arthur Andersen and other big LLPs may shed more light on this issue in the near future.


Random notes:
  1. Benjamin Cardozo, one of the most respected judges in American history, once complained that the issue of piercing the corporate veil was "enveloped in the mists of metaphor." This is one of the few instances when Cardozo made me laugh out loud.
  2. "Piercing the corporate veil" sounds vaguely dirty, doesn't it?

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