By guest blogger Jerry Chiang
When courts decide whether to pierce the corporate veil, their analysis is typically a three-step process: (1) whether the defendant-owner exerts sufficient control over the business entity, (2) whether there has been an abuse of corporate form, and (3) whether there is an injury to a third party.
There is no exact percentage of control or ownership that courts require for liability. This is a threshold question the plaintiffs have to answer satisfactorily before courts will consider the abuse of corporate form question.
Abuse of corporate form can come in many shapes, but the following are some of the common examples. Although some of these descriptions are based on corporations, the concepts apply equally to limited liability companies.
• Undercapitalization – This refers to a defendant-owner’s failure to endow the corporation or limited liability company, typically in the beginning stages, with sufficient, unencumbered capital to meet foreseeable business liabilities.
• Milking – Common practices of milking include paying excessive dividends, selling company assets to shareholders or third parties at reduced prices, paying unreasonable management fees, and diverting corporate funds to personal use.
• Commingling – Commingling typically occurs where the shareholder keeps one bank account for both personal and corporate funds. It is also typical to see a shareholder using the corporation’s assets for the shareholder’s personal purposes and other businesses without proper documentation.
• Misrepresentation/Holding Out – This describes a shareholder who represents to third parties that they are dealing with an individual, rather than a corporation.
• Failure to Observe Corporate Formalities – Examples of failing to observe corporate formalities include failure to (1) appoint the required number of officers, (2) issue stock, (3) file tax returns, (4) hold annual shareholders and board of directors meetings, (5) keep a minute book, (6) act through resolutions and (7) create a corporate bank account. Here is a useful discussion of LLC formalities.
If a defendant-owner has committed one or more of the above, a court is likely to find abuse of corporate form.
Once the first two prongs are met, courts determine whether the corporate form should be disregarded in order to prevent fraud or injury to a third party. In other words, there must be a causal relationship between the abuse of corporate form by the defendant-owner and the injury of the plaintiff seeking to pierce the corporate veil.