Holes in the corporate veil: confronting the myth of reduced liability for small businesses and entrepreneurs under corporate forms.
Lahm, Robert J., Jr. ; Geho, Patrick R.
ABSTRACT
Entrepreneurship textbooks are devoid of some of the more complex
legal analysis that would lead would-be business founders to a more
informed understanding of the limitations of corporate forms in
affording protection from personal liability. Indeed, these texts may
have contributed to what amounts to a myth in causing entrepreneurs to
believe that they are personally separate and invulnerable, so long as
they have taken the step to incorporate, as compared to operating as an
individual under a sole proprietorship. The authors of this paper have
quoted the term "myth," because practicing corporate attorneys
and the plaintiffs they represent, the courts, and legal scholars are
keenly aware of ongoing efforts to devise strategies and methods to
pierce the corporate veil; of course, defendants also do become aware of
their vulnerabilities (but perhaps too late).
Despite such a legal landscape, our review of contemporary
entrepreneurship textbooks and the scholarly literature of
entrepreneurship undergirding these texts demonstrated a failure to
convey that increasingly, there are holes in the corporate veil. This
paper provides an overview of issues that merit consideration on the
topic of the corporate veil and veil piercing, and concludes with a
discussion of implications for entrepreneurship teaching, research, and
practice.
INTRODUCTION
"An important consideration in starting a business is whether
to form it as a corporation. Organizing a business as a corporation
offers many advantages. For example, the ability to sell stock can be a
significant help when raising capital" (Peckinpaugh, 2000).
"When presented with any kind of potentially devastating liability,
an attorney's instinctive response is to create a separate
corporation to 'shield' the rest of the corporate family, and
the individual assets of those who direct it" (Jackson, 2001). The
basis for this present paper is dispelling the "myth" (Graham,
2002) of the corporate veil, the affects of which are the mistaken
opinion that entity formation makes individuals bullet proof for all but
acts of fraud (Lowenstein, 1989; Prieston, 1999; Russell, 2004; Shub,
2006; Wagoner, 1996) and intentional acts of gross negligence (Bendremer, 2005; Hughes, 2004; Rolle, 2003).
The authors of this paper believe that this myth is due to a
paucity of coverage in entrepreneurship textbooks, and because a lack of
attention has been given to veil piercing in the scholarly literature of
entrepreneurship, which at least insofar as this topic is concerned
seems to exist in a relative vacuum, separate from legal scholarship.
This statement should not be interpreted as a criticism. Rather, we
recognize that entrepreneurship is a relatively new and emergent
scholarly discipline. Further, we think it is quite reasonable to posit
that perhaps other factors are in play, such as the widely disseminated
explanations regarding the benefits of forming a corporation that appear
in generalized business books, on web sites, and in articles
disseminated through the popular press and trade publications (sans any
adequate explanation to the effect that "there is always a
catch"--one must abide by certain rules and conditions in order to
pass the legal test of veil piercing).
"Most savvy business people are aware that corporations offer
some protection to officers, directors and shareholders from personal
liability. What many people may not know is that the corporate shield
from personal liability is not infallible" (Hughes, 2004). As
suggested by practicing attorney Stanford A. Graham, Esquire, "the
majority of veil piercing activity never makes it to the courtroom.
Rather, when business owners are threatened with litigation, and become
aware of their vulnerability to veil piercing, they pay expensive
settlements to avoid litigation" (Graham, 2002). Indeed,
"situations are often compromised because they are so expensive to
litigate" (Hays, 1998). Settlements under a threat of suits that
may involve veil piercing are also possible, and in these instances,
reporting may be obscured (Guglielmo, 1996).
Generally, piercing is a remedy to hold individuals accountable for
abuses of the corporate form, including hiding behind a corporate entity
in order to defraud creditors, investors or other claimants (Bainbridge,
2001; Caudill, 2003; Mirchandani, 1998; Russell, 2004; Wagoner, 1996).
"The [veil piercing] doctrine most often arises in connection
with plaintiffs' attempts to hold corporate shareholders liable for
the debts of the corporation" (Bendremer, 2005). As case law
indicates, being undercapitalized (and knowing so) is not reason to hide
behind the corporate veil when one defaults on a contract or other
obligation (Peckinpaugh, 2000). In instances such as these, the remedy
(on the part of a plaintiff) of veil piercing is apparent because the
business was undercapitalized to carry out the terms of the agreement
from the start.
However, veil piercing can become even more tumultuous, and
"the risk is much greater than most people realize" (Graham,
2002). The corporate veil will not protect a business when acts or
omissions will result in unfairness to the injured party: "The
determination of whether the doctrine applies centers on whether there
is an element of injustice..., fundamental unfairness, or inequity"
("State ex rel. Christensen v. Nugget Coal Co.," (1944).
Unfairness!!! To this we exclaim "holy cow," as the inclusion
of this descriptive term in the court's finding is very far
reaching, as most any plaintiff can assert unfairness.
For the reasons suggested above, we were compelled to offer this
first paper as a contribution to the scholarly literature of small
business and entrepreneurship (hereinafter our references to the
scholarly literature of small business and entrepreneurship will be
expressed simply as, "entrepreneurship" for purposes of
brevity and expediency).
REVIEW OF EXISTING LITERATURE ON "PIERCING THE CORPORATE
VEIL" WITHIN THE SCHOLARLY LITERATURE OF ENTREPRENEURSHIP
Vanderbilt University Professor of Law Robert Thompson (Robert B.
Thompson, 1995) is regarded to have provided an "exceptional
study" of veil piercing (Morrissey, 2007; Rapp, 2006). "Veil
piercing issues can also arise with regard to limited partnerships
('LPs') and limited liability partnerships ('LLPs').
Like LLCs, LPs and LLPs are unincorporated business entities"
(Bendremer, 2005). However, the need for this present paper became
evident after a series of searches in the scholarly entrepreneurship
literature revealed a dearth of research on the subject of the corporate
veil and veil piercing. Search attempts conducted on databases used by
ProQuest demonstrated that veil piercing was only covered within the
literature from within scholarly and professional legal and accountancy
contexts, typically associated with legal, finance or accounting
oriented journals.
With parameters for our searches set to identify only articles with
full-text availability and results in the citation and abstract, we
identified 155 articles in ProQuest databases originating from sources
that were not associated with the scholarly entrepreneurship literature.
Upon attempting to combine the term "corporate veil" with
others such as "corporate veil" AND
"entrepreneurship" we found only one result (from an
Australian journal published in 1992).
The popular business press produced some results in our ProQuest
searches (but upon examination, some of these were erroneous and
associated with other topics). Finally, we also examined several leading
entrepreneurship textbooks and found that forms themselves were
typically well covered, but emphasis on possible pitfalls and
vulnerabilities was not as well developed as probably should be
(Hisrich, Peters, & Shepherd, 2008; Kuratko & Hodgetts, 2007;
Price, 2005; Roberts, Stevenson, Sahlman, Marshall, & Hamermesh,
1998; Wickham, 2006; Zimmerer, Scarborough, & Wilson, 2008). We
presume that the paucity of results in the entrepreneurship scholarly
literature may partially or largely explain the scant coverage of issues
and consequences associated with veil piercing in contemporary
entrepreneurship texts. Many misconceptions (Mauldin & Wilder, 1997)
appear to exist.
Besides the general lack of coverage in entrepreneurship texts and
the scholarly entrepreneurship literature which undergirds those texts,
veil piercing is an evolutionary (Bendremer, 2005) topic within the
legal community. It has also "been one of the most hotly debated
concepts in business law" (Rapp, 2006), with "a long, if
controversial, history in the law of business" (Morrissey, 2007).
However, both the would-be and established entrepreneur may typically
fall under the false impression that the corporate form provides a
bullet-proof shield (Graham, 2002) of protection against personal
liability claims. "Statutes created the legal fiction of the
corporation being a completely separate entity which could act
independently from individual persons" (Eisenberg, 2005). Beyond
liability issues, other circumstances such as tax consequences dictate
that one should "frequently consider and reconsider the entity
options" that may be available (Massingill & Mares, 2007).
AN ABBREVIATED HISTORY OF THE CORPORATE FORM
The history of corporations is well covered elsewhere (Clemens,
1998; Morrissey, 2007; O'Kelley, 2006; Wells, 2007), and it is not
our purpose to retell that history in this present paper. However, a
brief review should serve to provide context for entrepreneurship
scholars who have not arrived here through education or practice with
specializations in management or corporate law. As outlined by Morrissey
(Morrissey, 2007):
The earliest corporations in British legal history were
ecclesiastical and other privileged organizations chartered by the
sovereign and allowed perpetual existence beyond the life-time of
their individual members. (30) In the new American Republic,
incorporation continued to require individual acts by legislatures,
(31) which were most often granted for special projects such as
creating canals, banks, (32) or roads. As the industrial revolution
began in earnest in the U.S. around 1825, businesses began to need
capital from widespread investors. At that time, corporate statutes
first started providing limited liability for shareholders (33) and
state legislatures created general laws allowing businesses to
incorporate by merely filing certain documents with designated
government officials. (34) Parliament passed the first Limited
Liability Act in 1855 (35) and by then limited liability had also
become a standard feature in the corporate codes of American
States. (36)
In the United States, the State of Wyoming passed the first LLC statute (in 1977), "but it was not until 1988 that LLCs received
considerable attention following an 1RS ruling clarifying that they
could be taxed like partnerships in spite of their limited liability
status" (Rapp, 2006). Indeed, "corporate law's most
dramatic revolution of the last quarter-century has been the emergence
of the Limited Liability Company (LLC) as the dominant business form for
small businesses" (Rapp, 2006). "Limited liability has always
been one of the major attractions of a business form for those engaged
in a closely held business" (Robert B. Thompson, 1997).
In terms of the present state of affairs in the corporate and legal
arena (and again, with no apparent acknowledgement in entrepreneurship
textbooks or scholarly literature), "veil piercing is the most
litigated area of American corporate law" (Rapp, 2006).
METHODS BY WHICH VEIL PIERCING MAY OCCUR
"Veil rules share a family resemblance with rules that forbid
conflicts of interest [i.e., "self-interested decision
making," also used here as an explanatory comment from elsewhere
within Vermeule]" (Vermeule, 2001). "The doctrine of veil
piercing has its origins in corporate jurisprudence and usually arises
in the corporate context" (Bendremer, 2005). "The doctrine
holds that in order to encourage investment, and to protect investors
from losing more than their initial investment, no liability should be
imposed upon shareholders beyond the corporate assets" (Rolle,
2003). However, as is the case for many rules, exceptions typically
follow.
The applied test for corporate veil-piercing is Van Dorn Co. v.
Future Chemical and Oil Corp., 753 F.2d 565 (7th Cir.1985). ("Van
Dorn Co. v. Future Chemical and Oil Co.," 1985). A corporate entity
will be disregarded and the veil of limited liability pierced when two
requirements are met: "(F)irst, there must be such unity of
interest and ownership that the separate personalities of the
corporation and the individual (or other corporation) no longer exist;
and second, circumstances must be such that adherence to the fiction of
separate corporate existence would sanction a fraud or promote
injustice." "Corporate veil piercing most often applies in
cases of (i) fraud; (ii) inadequate capitalization; (iii) failure to
adhere to corporate formalities; and (iv) abuse of the corporate entity
that results in complete dominance by the shareholder or
shareholders" (Bendremer, 2005).
"Normally when the [veil piercing] doctrine is used, it is
used to punish corporate directors for financial misconduct, but in the
wake of Enron and similar scandals, 'there's a general siege
on the walls of corporate immunity'" (Anonymous, 2006).
Although certainly not the first (and we presume not the last) corporate
scandal to occur, the Enron case has been exposed as a tragedy affecting
employees, shareholders and others, such as the Arthur Andersen accounting firm partners who became embroiled in the controversy
surrounding its demise (Pacelle & Dugan, 2002). In the latter
instance, this occurred when "Enron creditors, shareholders and
employees ... [sought] to recover the billions of dollars they have lost
from someone" (Pacelle & Dugan, 2002).
Among its other transgressions, "energy giant Enron Corp ...
gave gifts to non-profits associated with Enron board members"
(Klein, 2005). The issues were indeed systemic, as a culture of
corruption arose (Emshwiller & Smith, 2001). As suggested in a
Knight Ridder Tribune Business News editorial, ("Editorial: The
corporate veil," 2006):
American business leaders cannot have it both ways. They cannot
allege on the one hand that a corporation is like an individual
with all the rights of free speech and privacy accorded to
individuals and on the other hand attempt to conceal wrong-doing by
disclaiming knowledge, like the piano player in a house of
ill-repute who denies knowing anything about what's going on
upstairs. In the Enron trial, which began this week, Enron big-wigs
Kenneth Lay, company founder, and former CEO Jeffrey Skilling are
expected to defend themselves against felony charges with the
classical "barefoot boy on Wall Street" defense that "how wuz they
supposed to know" about all the cooking of corporate books and
other skullduggery that eventually brought the company to ruin.
"Exposure of Enron's frauds triggered a national debate
on the need for corporate reform" (Jones, 2004).
Of course, Enron was not the only scandal to shake investors'
confidence in capital markets. As allegations of fraud were brought
forward against other giants such as Worldcom, "Wall Street was
harboring a dirty little secret. Some of its highest paid investment
bankers were handing out hot IPO3 shares in return for kickbacks. Others
were offering favorable stock recommendations from their research
analysts [who suffered from numerous conflicts of interest]"
(Scianni, 2003). Collectively, these scandals led to the Sarbanes-Oxley
Act, which was signed into law by President Bush in July 2002 (Scianni,
2003).
Notwithstanding the above high profile instances of fraud and
scandalous behavior, smaller firms are more likely to make mistakes or
otherwise commit acts that lead to the use of the veil piercing remedy
on the part of plaintiffs (a discussion regarding prevention is provided
in a subsequent section of this paper). In some instances,
incorporations may occur in an effort to avoid preexisting personal
liability issues. For example, in a Norfolk Virginia case, the court
determined that two roofing contractors engaged in an effort to evade
personal liability by hiding behind a corporate shield (rather than
simply addressing problems by replacing or repairing defects in the roof
they constructed for a condominium complex): "the evidence supports
the conclusion that they simply determined to form ... [a corporation]
and, ultimately, to use that corporation to evade personal liability
while the condominium continued to be marketed with a known defective
roof" (S. Williams, 2003).
As was determined through a case decided by the Saint Louis County
trial court, the defendant, an orthopedic surgeon, "went to great
lengths to divert his earnings from his debtor into various
corporations" (Umbright, 2004). Among other things (e.g., shifting
monies to various trusts and corporations), he "had not received
any wages for his medical services ... because those wages were
transferred to his wife" (Umbright, 2004). Basically, "to
pierce the corporate veil of limited liability protecting a company and
establish a cause of action against its directors in their personal
capacity, there needs to be an assumption of responsibility"
(Mirchandani, 1998).
PREVENTING VEIL PIERCING
"Using a corporate form ordinarily will insulate the owners
from direct liability for the company's obligations, because the
corporation is considered to be a separate legal identity, independent
of its owners"(Peckinpaugh, 2000). However, and this is a
significant "however" often omitted in form or substantive
discussions within textbooks, the scholarly literature of
entrepreneurship, and in popular press outlets: this shield can only be
effective if certain conditions are met. These conditions vary somewhat
from state to state, and courts have interpreted cases based on what
typically entails extensive examination of whether or not veil piercing
is a justifiable remedy. In other words, "although using a
corporate form for doing business can provide many advantages, investors
who use this approach must be careful to follow the rules to maintain
those advantages" (Peckinpaugh, 2000).
Certain common principles to tend to apply to the concept of veil
piercing, regardless of venue (i.e., place where cases are decided). For
example, "one of the oldest ways to 'pierce the corporate
veil' is to show that a corporation was created for an illegal
purpose" (Jackson, 2001). Thus, as simplistic as it may sound (upon
knowing one of the most common sources of vulnerability), to prevent
veil piercing, corporations and individuals within them (or with whom
they have dealings), generally, should be careful not to commit any
illegal acts. As another example (fraud), "receiving
'insider" and other payments" (Turcotte, 2005) prior to
filing for bankruptcy protection would expose a corporation to a veil
piercing test. "Tort law in the United States has the same common
law foundations as tort law in most other nations" (Rolle, 2003)
and fraudulent behavior or negligence associated with illegal acts is
certainly suggestive of both litigation as well as what would likely
become a successful petition for relief through the veil piercing
doctrine.
Hence, one should also "avoid committing any torts. Examples
of tort claims are negligence and fraud, in contrast to contracts"
(Hughes, 2004). "In a tort case, liability links the defendant to
the plaintiff's injury" (Rolle, 2003). "Tort law provides
a structure to understand the separate 'wrongfulness' of
fraud, but in a way that also could suggest limits on recovery. By
recognizing lying as a wrong, law recognizes this conduct as an
inappropriate way of treating people that gives rise to an individual
right of redress" (R. B. Thompson, Spring 2006). "Tort law
encompasses several different categories of civil wrongs, which can
empower a judge or jury to impose monetary damages on a tortfeasor if he
is found to be liable for the given damages" (Rolle, 2003). For
example, "toxic tort law includes a smaller category of civil
wrongs, in which there has been some harm 'to persons, to property,
or to the environment'" (Rolle, 2003).
"The right to a law of redress has deep roots in
Anglo-American law" (Goldberg, 2005). According to Rolle (2003):
Many corporations are grateful for the protections they are granted
and try to set their subsidiaries up so as to avoid liability in
the event that any tort allegations arise based on their
subsidiaries' activities. The general rule in the United States is
that the parent will not be held responsible for the actions of its
subsidiary unless there is some evidence that the parent has
perpetrated some fraud. (301) This kind of fraud is not frequently
shown, but where "stock ownership has been resorted to ... for the
purpose ... of controlling a subsidiary company so that it may be
used as a mere agency or instrument of the owing company or
companies," then the veil may also be pierced. (302) When a court
finds that this kind of fraud has been committed, it then may
"pierce the corporate veil" and reach the assets of the parent.
(303) In rare cases, a parent corporation may also be held liable,
and lose the protection of the corporate veil, if the plaintiff can
show that the parent was directly involved in the day-to-day
activities of the subsidiary corporation. (304) This is not
technically considered piercing the veil, as the parent becomes
directly liable for its own actions in these cases, rather than
derivatively liable for the actions of its subsidiary. (305)
"The corporate shield hinges upon the legal fiction that a
corporation is a legal entity separate and apart from its owners,
officers and directors. To maintain this legal fiction, you must treat
the corporation like it is a separate entity" (Hughes, 2004). As a
matter of practical implications, small business owners are probably
particularly susceptible to mixing personal funds with corporate funds
(and both they and their small corporations may easily become
intertwined). It is imperative to maintain this separation, because once
evidence shows that for all intents and purposes a small business owner
is basically identifiable in transactions as one in the same as his or
her corporation, or vice versa, the protection of the shield is lost.
Another common way to create problems for a business is to fail to
acknowledge the corporate status both in terms of disclosure, but also
with respect to other formalities such as entering contracts. As Hughes
(2004) suggests:
You should properly identify the corporation at all times. For
example, business cards and advertising should include the proper
corporate name of your entity, including "Inc.", "Co.", "Corp.", or
other appropriate monikers denoting a corporation. Your letterhead
and stationary should include the same information. Last, but not
least, any contracts entered into by the corporation must have the
proper name including corporate designation. Signing a contract and
not including the right name [or your corporation as the party to
be bound by the agreement] is a very easy way to become personally
liable for all breaches of contract.
Formalities also include "'corporate governance'
rules [which] cover things such as board of directors meetings,
capitalization requirements and reporting requirements"
(Peckinpaugh, 2000).
In light of an increasingly litigious environment, more
organizations have recognized the need to take steps to protect their
interests against veil piercing: "The holding company structure
operates as an umbrella under which other companies ... exist"
(Gilpatrick, 2006). Conceptually, holding company configurations and
parent-subsidiary arrangements provide another layer of protection. As
suggested by Wortham (1998), the notion of formalities is applicable to
both small and larger organizations alike:
"Organization of a subsidiary should provide adequate
insulation if steps are taken to ensure that the 'corporate
veil' is not 'pierced' by lack of observance of corporate
formalities at the subsidiary level. [But] excessively close
arrangements (related to management and control) between a parent and
its subsidiary increase the likelihood that the subsidiary will be
viewed by courts as merely an agent or instrumentality of the
parent."
In other words, "conducting a similar business in a similar
location or having interlocking sets of officers, directors, and
ownership can create problems" (Hughes, 2004).
We conclude our discussion about veil piercing prevention methods
with an interesting quote which articulated the point of view held by
authors who are evidently in the trenches representing corporate
defendants. In an article entitled, Humanizing the deep pocket
corporation, T. B. Williams and Dominick (1995) observed:
Corporations are often perceived to be greedy, impersonal and
completely indifferent to the effects their activities have on
society. To overcome this prejudice ... [a corporate defense
attorney] must essentially draw the corporate veil, presenting the
corporation not as a faceless, single entity, but as a collection
of fair, responsible and conscientious individuals.
We find the above approach particularly compelling because it is
highly suggestive of a form of transparency that would normally be akin
to honesty and innocence on the part of a corporate defendant that had
behaved properly in the first place.
CONCLUSION AND IMPLICATIONS FOR ENTREPRENEURSHIP TEACHING,
RESEARCH, AND PRACTICE
The authors of this paper have sought to add an important and
needed contribution to the scholarly literature of entrepreneurship.
Those in favor of piercing the corporate veil are often (at least from
their own point of view) justified in their efforts. They also may be
formidable in their wherewithal (e.g., banks attempting to collect) and
commitment to doing so. Veil piercing efforts are driven not only by the
outcome of a single case, but also by the precedents that may be
established, which will influence future litigation.
Many contemporary business and entrepreneurship books identify
increasing globalization as a significant business trend (and even
without textbook knowledge, we would add that it would be difficult for
most individuals to remain unaware of this trend). However, particularly
as it pertains to veil piercing (which is recognized doctrine in many
nation-states), globalization has some additional implications. As
observed by McConnaughay (1995):
One of the few predictable consequences of the increasing
globalization of corporate conduct is a commensurate increase of
litigation in the United States (and presumably elsewhere)
involving corporate parties of multiple nationalities. Plaintiffs
from abroad increasingly will seek to impose liability on US
parents for the acts and obligations of their foreign subsidiaries,
while plaintiffs resident in the United States increasingly will
seek to impose liability on foreign parents for the acts and
obligations of their US subsidiaries. These efforts frequently will
involve the invocation of two related (and sometimes
interchangeable) doctrines:
* piercing the corporate veil to obtain jurisdiction over a foreign
corporate parent (or controlling shareholder); and
* piercing the corporate veil to impose liability on a corporate
parent (or controlling shareholder) for the acts or obligations
of its subsidiary.
Hence, changes in the environment foreshadow the likelihood of an
even greater risk that future entrepreneurs (presently students) may
encounter an even more complex morass of legal implications associated
with their choice(s) of corporate form.
Entrepreneurship educators who may be laypersons in the area of law
(as compared to practicing attorneys and legal scholars) may unwittingly
contribute to creating a false sense of security about protections
afforded under corporate forms in the course of providing instruction.
This of course suggests content that is not only presently inadequate,
but will be increasingly so in the future.
For the scholarly researcher in small business and entrepreneurship
disciplines, as we have found, this paper will represent one of the
first contributions of its kind to the literature. This suggests several
opportunities for future research. First, is the obvious task of making
further connections with the preexisting body of knowledge associated
with well established legal scholars and their research. Second, we
would suppose that small businesses and entrepreneurial firms may suffer
from unique challenges in lacking sufficient access to corporate
counsel, being more susceptible to mistakes and subsequent litigation,
and more likely to forego formalities that are precisely those that will
get them into real trouble. We expect this, but further research and
empirical testing would aid in both defining the situation as it now
exists (and subsequently addressing matters with practitioners and
students who are would-be entrepreneurs).
Finally, as we have indicated, veil piercing is an evolving area
and dynamic. Keeping up with changes and then correlating those changes
with the concurrently evolving discipline of entrepreneurship is also a
recommended course of action for any student, entrepreneurship educator,
researcher, or practitioner.
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