If you have worked in the areas of structured finance or commercial real estate — even if you are not a lawyer — you may be familiar with the concept of “piercing the corporate veil.” You probably have used special purpose LLCs to limit the liability of individuals and to protect holding companies with substantial assets from the liabilities associated with a specific transaction. These structures are not without risk. You may have been advised that entities and individuals in the upper reaches of the structure chart may be exposed to the liabilities of their special purpose subsidiaries if a claimant is able to pierce the corporate veil. But beyond that the concept may remain a mystery.
In this article, we will examine the basic precepts of the legal doctrines underlying the concept of piercing the veil under both New York and Delaware law. The principles are very similar in both jurisdictions, and while we will be examining the law applicable to corporations in this article, the courts have applied these theories to limited liability companies as well.
Generally, courts understand that one of the primary functions of the corporate form is to limit liability, and so they are reluctanct to pierce the corporate veil. In fact, in a 2003 U.S. Supreme Court case, the court stated that “the doctrine of piercing the corporate veil is a rare exception that is (1) applied in the case of fraud or certain other exceptional circumstances, and (2) usually determined on a case-by-case basis.”
So when will courts pierce the veil and hold a parent company or the shareholders liable for the debts and obligations of the corporation? There are primarily two doctrines of law that courts in New York and Delaware will apply: the alter ego theory and the agency theory. We will look at each of these theories separately.
Alter Ego Theory
The alter ego theory derives its name from the idea that the courts will not respect the separateness of a corporation and its parent where the parent exerts such an inappropriate amount of control and dominance over the corporation that it becomes a mere shell or “alter ego” for the parent.
However, it is not enough that the shareholder or parent completely dominate the subsidiary corporation — the key is that there must be an “undue” or “inappropriate” level of control. In essence, this concept has led to the outcome that courts will generally require a showing of fraud or fundamental unfairness before they will pierce the corporate veil under the alter ego theory.
Thus, the theory has come to hinge more on the concept of wrongdoing and less on the theory of domination from which the doctrine gets its name. In both New York and Delaware, while a showing of complete control and domination by the parent over its subsidiary corporation is a necessary part of the analysis, such a showing alone will not suffice — the courts must also find some element of wrongdoing.
In New York, there is precedent that establishes that the corporate veil may not be pierced unless there is a showing that the abuse of the corporate form was used “to commit wrong, fraud or the breach of a legal duty, or a dishonest and unjust act.”
In Delaware, a finding of fraud was historically required in order to pierce the corporate veil. More recently the scope has been expanded beyond fraud to include the more general concept of fundamental unfairness. A 2004 decision allowed the veil to be pierced in order “to prevent fraud, illegality or injustice, or the adverse effects thereof.”
Even though a finding of complete domination alone is not enough to pierce the corporate veil, it is worthwhile to consider the factors the courts weigh in finding domination and control. By reducing the presence of these factors you can decrease the odds that you will fall prey to a veil-piercing attack.
The existence of the following factors will weigh in favor of a court finding undue domination and control:
- failure to observe corporate formalities (e.g. holding regular meetings, keeping minutes, maintaining separate books and records);
- insufficient capital;
- co-mingling of funds or other property;
- common ownership, officers, directors and employees;
- sharing offices, address and telephone numbers;
- very little discretion allowed to the subsidiary corporation;
- failure to conduct business at arms length between affiliates;
- subsidiary corporation is not an independent profit center; and
- debts of subsidiary corporation are paid or guaranteed by others.
The more you are able to reduce the presence of the foregoing elements the more likely you will be able to avoid a finding of undue domination and control; and, therefore, you will be better prepared to defend veil piercing claims brought against you under the theory of alter ego.
The second theory underlying attempts to pierce the corporate veil is known as the ”agency theory.” The agency theory differs substantially from the alter ego theory. Significantly, no finding of fraud or unfairness is required under the agency theory.
The theory derives from the general doctrine of agency where a principal, such as an employer, can be held liable for the acts of those that are authorized to act on its behalf — its agents — such as its employees.
In order for a principal to be liable for the act of its agent, the act must be within the scope of the authority granted by the principal to the agent. Such authority can be either ”actual” or ”apparent”. Actual authority exists where the principal communicates its delegation of authority to the agent and the agent accepts. Apparent authority can be found to exist even where there is no actual authority if some act of the principal makes it reasonable for a third party to infer the existence of an agency relationship.
In order to pierce the corporate veil under the agency theory, the degree of control exercised by the parent over the subsidiary is important, and the parent must be found to dominate the subsidiaries activities or to exercise “total control” over the subsidiary. Mere ownership of subsidiary’s stock and overlap in management is not enough.
The cases also indicate that there must be a connection between the agency relationship and the basis of the claim being made by the plaintiff — the agency arrangement must be relevant to the claim or the claim must ”arise out of” the arrangement.
While courts have recognized and applied the agency theory in the context of piercing the corporate veil, they have been reluctant to hold defendants liable under the agency theory, and there is little case law supporting such a finding. Therefore, it is difficult to determine just what sort of connection or relevance between the agency relationship and the claim would lead to a successful piercing of the corporate veil.
Because of this lack of case law, there is little basis for establishing a thorough method for mitigating the risks of falling victim to a veil-piercing claim under the agency theory. However, in order to help mitigate the risk of a successful veil-piercing claim based on the agency theory, it would be prudent to (1) have a subsidiary enter into its own contracts and (2) avoid having parent entities participate in negotiations of its subsidiaries. If the subsidiary remains the face of the negotiations and the parent’s involvement is limited, it will be more difficult for potential claimants to argue that the subsidiary was acting as the agent of the parent.