New England Biz Law Update
Even in good times, creditors habitually cast a wide net in search of cash to satisfy their claims. In today’s economic climate, cash-starved creditors are sure to “follow the money,” pursuing a well-heeled corporate relative of the debtor, whether they have viable claims against that entity or not.
For instance, where it has a direct claim against a subsidiary that is insolvent or nearly so, a savvy creditor and its attorney may also bring claims against a solvent parent company, affiliates or even individual officers or stockholders.
There are numerous legal theories on which such claims are based, including the commonly alleged (and less commonly proven) action to “pierce the corporate veil.”
Below is a discussion of the legal basis for piercing the corporate veil, as well as practical steps that corporations can take to avoid such collateral attacks.
These claims, even if they have little merit, are particularly vexing for corporations (or individual entrepreneurs) who have a stake in multiple entities, each with distinct — but perhaps complementary — lines of business.
Consider a real estate investment firm with five properties. Each property is held in a separate LLC or corporation, wholly or substantially owned by the parent. The parent also has an agreement with a management company that operates each property.
Each subsidiary may have a similar name, the same board of directors, the same investors or shareholders, and may share office space with each other and/or their parent; but the entire business structure was established to segregate the liabilities of each through the separate legal identities.
However, where such a setup can be undermined is in the day-to-day operation of the companies. The law, straightforward on its face, may be thorny to apply in the context of litigation.
12 factors
As a basic premise, in order to promote capital investment, corporations are generally regarded as legally separate, distinct from each other and from their respective stockholders. My Bread Baking Co. v. Cumberland Farms, Inc., 353 Mass. 614, 618 (1968).
The corporate form promotes innovation by protecting its shareholders from personal liability for the corporation’s debts. Even corporations in a similar business, with the same shareholders and with related governance structures, will be regarded as separate entities so long as the corporate principals treat them as such.
Therefore, the creditors of corporation A cannot sue corporation B when A becomes insolvent, unless the interrelation of A and B merit so-called “veil-piercing.”
Veil-piercing allows a court, as a matter of equity, to permit creditors to reach the assets of shareholders, or related corporations, on the ground that “justice” requires the legally separate companies and, at times their shareholders, be treated as one.
Courts are clear that the corporate veil should be pierced only in “rare particular situations to prevent gross inequity” and only when “an agency or similar relationship exists between the entities.” My Bread Baking Co. v. Cumberland Farms, Inc., 353 Mass. 614, 619-620 (1968). See also, Scott v. NG U.S. 1, Inc., 450 Mass. 760, 767 (2008).
“[C]ommon ownership of the stock of two or more corporations together with common management, standing alone, will not give rise to liability on the part of one corporation for the acts of another corporation or its employees[.]” My Bread Baking Co., 353 Mass. at 619.
More specifically, a corporate veil may be pierced only where “there is active and direct participation by the representatives of one corporation, apparently exercising some form of pervasive control, in the activities of another and there is some fraudulent or injurious consequence of the intercorporate relationship.” My Bread Baking Co., 353 Mass. at 619; Scott, 450 Mass. at 767.
The ultimate decision to disregard the settled expectations accompanying the corporate form requires a determination that the parent corporation directed and controlled the subsidiary and used it for an improper purpose, based on evaluative consideration of 12 factors:
(1) common ownership;
(2) pervasive control;
(3) confused intermingling of business activity assets or management;
(4) thin capitalization;
(5) non-observance of corporate formalities;
(6) absence of corporate records;
(7) no payment of dividends;
(8) insolvency at the time of the litigated transaction;
(9) siphoning away of corporate assets by the dominant shareholders;
(10) non-functioning of officers and directors;
(11) use of the corporation for transactions of the dominant shareholders; and
(12) use of the corporation in promoting fraud.
Evan v. Multicon Constr. Corp., 30 Mass. App. Ct. 728, 733, rev. denied, 410 Mass. 1104 (1991), citing Pepsi Bottling Co. v. Checkers, Inc., 754 F.2d 10, 16 (1985).
Massachusetts courts will refer to the 12 factors in order to determine whether “justice requires that the separate existence of the corporation be ignored.” Pepsi Bottling Co., 754 F.2d at 16.
Notably, a litigant seeking to pierce the corporate veil need not satisfy each factor. Instead, enough facts must be proved to show that the debtor corporation is being directed and controlled by another and used by it for an improper purpose. Scott, 450 Mass. at 768.
Guarding against veil-piercing claims
Given the fact-intensive nature of the veil-piercing analysis, it is difficult to dismiss such a claim early in the case, or even by a later dispositive motion. The result is expensive discovery for the solvent defendant, even though fighting with the creditor of another, although related, entity.
For many businesses, having to venture deep into the discovery process constitutes a loss in itself, even if ultimately they would be vindicated at trial. The cost in attorneys’ fees and lost employee and management time may not be worth the battle, often leading to settlement despite viable defenses, thus providing creditors with incentive to bring these claims, even if the merits are dubious.
In addition, while a business’s structure may have been established with the advice of counsel to segregate liabilities among the different entities, the veil-piercing analysis focuses on the actual operation of the businesses, and that is where companies can run into trouble.
Where closely related businesses operate from the same location and use the same employees, the distinct nature of each business may be unclear or unknown to lower-level employees, vendors or creditors, who view the whole operation as one and the same. Fortunately, there are relatively inexpensive steps companies can take to guard against a successful veil-piercing claim:
• Educate employees. If having separate corporate entities was important enough to warrant the effort in the first place, it is important enough to spend time once a year explaining to employees what each company does and why it is important that expenses be properly allocated, that the public be aware of the differences between the companies, etc. Unwitting and uninformed employees can be a gold mine for aggressive attorneys looking to show a vague relationship between a parent and a subsidiary.
• Be clear with the public. A company may have three business — Blue Industries, Blue Enterprises and Blue Development LLC and think of them as the “Blue Group of Companies.” There is nothing wrong with using a brand name to cross-sell. When it comes to making contracts with third parties, however, documents should be crystal clear about the contracting entity. Beware of boilerplate in contracts that purport to define the contracting company along the lines of “Blue Industries, together with its parents, subsidiaries, affiliates (collectively ‘Buyer’).” Unless the parents, subsidiaries and “affiliates” (a common term with no fixed meaning) want to be on the hook for the contract, defined terms should be strictly limited to the company entering into the contract.
• Keep expenses separate. Careful accounting can solve many problems. If four companies work out of the same space, and the office spends $800 a month on bottled water, those expenses should be allocated among the four in some reasonable manner.
• Document any resource sharing. Similar to the point about segregating expenses, if employees get a W-2 from Blue Enterprises, but also do work for Blue Industries and Blue Development, there should be a written agreement (a one-page term sheet should be sufficient) spelling out how Blue Enterprises is to be compensated for providing its employees’ time to its sister corporations. Accounting entries reflecting the arrangement should be clear as well.
• Keep good corporate records. The absence of such records is one of the veil-piercing factors; keeping them is easy and inexpensive and can make a world of difference when it comes to litigating a veil-piercing claim.
• Observe corporate formalities. Each entity should have annual meetings, take minutes, and make sure employees who hold corporate office know they are officers and have at least a minimal understanding of their role. Corporations that establish and maintain corporate formalities and that confirm their separate existence despite common control or ownership are less likely to be responsible for their sister corporation’s debt.
As noted above, “there is present in the cases which have looked through the corporate form an element of dubious manipulation and contrivance [and] finagling.” Scott, 450 Mass. at 768 (quoting, Evans, 30 Mass. App. Ct. at 736).
Nothing makes a corporation look like it is being manipulated more than the failure to comply with simple corporate formalities and lack of attention to detail in making accounting entries.
The court in My Bread Baking Co. noted that “failure (a) to make clear which corporation is taking action in a particular situation and the nature and extent of that action, or (b) to observe with care the formal barriers between the corporations with a proper segregation of their separate businesses … records, and finances” may result in veil-piercing to prevent gross inequity. 353 Mass. at 619.
The purpose of the veil-piercing doctrine is to protect third parties who, through no fault of their own, believe that several related entities are, in fact, a single enterprise.
When companies take care internally and externally to note their separate roles, it is much less likely that an outsider will be able to claim that he or she was misled.
In short, companies that operate in a manner consistent with their legal form are better able to avoid or defend against claims of veil-piercing. In these difficult times, when creditors are more aggressive than ever, a small investment of time and money in keeping the corporate books and records tidy can save a load of litigation trouble down the road.
Michael Marcucci is an associate in the litigation group at Hanify & King in Boston. He concentrates his practice on complex business litigation including matters involving securities, employment, breach of contract, breach of fiduciary duty and commercial claims. He can be contacted at [email protected].
