My Company is Supposed to Limit my Liability, Right?

That depends. When a business fails to meet its obligations like by breaching a contract or committing a tort (e.g. like injuring someone), injured parties may try to hold the business’ owners personally liable. The most common legal tool to get to the owners’ assets is the doctrine of “alter ego” liability. This doctrine allows courts to pierce the corporate veil and treat the business and its owners as one and the same – “alter egos.” Get it? Piercing the corporate veil, however, is not granted lightly—courts carefully scrutinize the facts and do so differently in cases involving tort claims versus cases involving contract disputes.

So, What Is Alter Ego Liability?

Is your company "real?" Or just a reflection of you?

Alter ego liability occurs when courts decide a corporation or limited liability company is not a distinct entity from its owners (e.g. If the company is not a “real” company, but rather is just an owner’s personal piggy bank or “insulator” from bad acts). Basically, if the entity is being used improperly to shield the owners from personal liability, and it’s not a “real” company, then the courts can disregard the business’s protection and expose the owners to the entity’s debts or obligations.

Here are Some Common Factors that Courts will Consider:

1.      Commingling of Assets: Owners mix personal and business funds or use business accounts for personal expenses (e.g. An owner purchases a company vehicle and treats it like a personal vehicle);

2.      Failure to Follow Formalities: The business doesn’t have a company records book, proper governance documents (e.g. Bylaws for a corporation or an Operating Agreement for an LLC), maintain proper minutes/resolutions, hold meetings, or comply with other governance requirements;

3.      Undercapitalization: The business lacks sufficient funding to meet its obligations (e.g. The owners pull out too much money leaving the business with too little operating funds); or

4.      Fraud or Misrepresentation: Owners use the entity to perpetrate fraud or act in bad faith (e.g. The owners take out a business loan and use the proceeds to pay off personal debt and then attempt to avoid the loan by claiming the business is failing and can’t pay it back…)

Good faith means no tricky business!

Are Tort or Injury-based Cases Handled Differently than Contract/Agreement Type Cases?

Certainly! The nature of the underlying claim significantly impacts how courts evaluate alter ego liability.

Tort Cases: Focus on Misconduct

In tort cases, courts often focus on the business owners’ misconduct or negligence. Plaintiffs or Claimants will argue that the business was used to commit wrongful acts or shield owners from accountability.

For Example: A construction company with undertrained workers causes a bridge to collapse. The injured party sues for negligence and argues that the owners deliberately ignored safety concerns, failed to train their workers, and then undercapitalized the business to avoid paying claims.

Courts in tort or injury type cases scrutinize whether the business’s undercapitalization or lack proper precaution or of proper governance contributed to the harm. The focus is on preventing businesses from using the corporate shield to avoid accountability for wrongful acts.

Contract Cases: Focus on Voluntary Agreements

In contract cases, courts emphasize whether the owners used the company to defraud or evade contractual obligations. Since contracts are voluntary, courts are generally more hesitant to pierce the veil unless there is clear evidence of fraud or abuse.

For Example: A vendor delivers $50,000 worth of goods to a restaurant, only to find that the restaurant has no assets because the owners siphoned off all available cash. The vendor sues, alleging the owners never intended to pay and so are liable because they used the business to commit fraud.

Courts consider whether the owners’ actions, such as misrepresentations or asset transfers, show bad faith. In any event, the bar for piercing the veil is higher in contract cases, as parties knowingly entered the agreement.

Is There a Difference for LLCs vs. Corporations?

The reasons for piercing the veil are similar for limited liability companies and corporations, but courts often scrutinize LLCs differently because they are less formal by design. Historically, LLC members are often tempted to be more casual about governance, such as skipping formal documentation like operating agreements or mixing business finances with personal finances. In either case, failing to adhere to basic governance principles can lead to veil-piercing claims with severe financial consequences…and that goes for shareholders in a corporation too.

Here are Some Regional Differences:

Different regions address the problem differently.

11^th Circuit (Alabama, Florida, Georgia) Courts are cautious about piercing the corporate veil unless fraud and misuse or misappropriate occurs. (See Dania Jai-Alai Palace v. Sykes, 450 So.2d 1114)

9^th Circuit (Alaska, Arizona, California, Hawaii, Idaho, Nevada, Oregon, Washington, etc.) Courts are more likely to focus on fraud or severe undercapitalization. (See Associated Vendors v. Oakland Meat, 210 Cal.App.2^nd 825)

5^th Circuit (Louisiana, Mississippi,Texas) Courts generally require plaintiffs to prove owners acted with the requisite “mens rea” (intent) to defraud creditors or evade other obligations. (See TX Bus. Org. Code § 21.223)

2^nd Circuit ( Connecticut, New York, Vermont) Courts generally require clear evidence of fraud, undercapitalization or improper/negligent conduct. (See Morris v. New York State Dpt. Tax, 623 N.E.2d 1157.)

Key Takeaways to Protect the Corporate Veil and Avoid Alter Ego Liability:

Shields are good.

1.      Maintain Proper Capitalization: Ensure the business has enough funding to meet its obligations! (If you are paying, nobody will have an issue.)

2.      Follow Governance Formalities: Have formal documentation, Hold meetings, Maintain records, and Comply with legal requirements. (It’s difficult to call it an alter ego if it has all the earmarks of a “real” company.)

3.      Separate Finances: Keep personal and business accounts distinct. (If you don’t commingle your money with company money, it’s difficult for someone to claim the company is your own personal piggy bank.)

4.      Obviously…Avoid Fraud or Misrepresentation: Act in good faith in all transactions and contracts. (You might be tempted, but that’s a very slippery slope with only one ending.)

In conclusion, do not take the risk of an alter ego finding. If the corporate veil is pierced, you will face personal liability, loss of reputation (both personal and business), loss of credibility (this can cripple your ability to enter into new contracts, conduct business, get funding), and loss of personal assets (your accounts, residence, investment or recreational properties, business shares or interests, etc.) to cover your business liabilities. Get help to put the systems and formalities in place and maintain them. It’s a small price to pay for the security of your personal assets.

Curry Andrews, Attorney