Corporate insulation and piercing the veil

“Virtue has a veil, vice a mask.” — Victor Hugo

Corporations insulate shareholders from liability for entity debts and obligations. That is the historical reason for the corporate form. Insulation is a vital element of a robust commercial system, permitting concentration of capital where funding can be provided without exposing investors to risk beyond specified investment.

Industrialized nations long recognized the need for such protection. New York State’s 1811 general incorporation statute, and Great Britain’s Limited Liability Act of 1855, led the way in creating almost impregnable walls protecting ownership from enterprise risk.

The important word in that last sentence is “almost.”

Major trading countries today permit piercing of the corporate veil, although they do so with different weighting of factors. In the United States, the legal issue is particularly confused, since piercing the veil typically is controlled by the law of the state of incorporation, and our states are inconsistent in defining the triggers for piercing.

Brief history

Business organizations providing protection against shareholder liability existed in Roman times, and in England starting in the 16th century as the Age of Exploration required concentration of capital for lengthy enterprises remote and perilous.

For a time, insulation from liability was obtained only by Royal Charter. Many opposed expanding the grant of corporate charters, claiming that limited liability would prove a shield for fraud.

Need for capital, and a sense that limited liability would permit the less wealthy to invest without fear of total ruin, led to the mid-19th century British adoption of shareholder insulation.

In America, similar trends of commercial pressure and social equality, as well as the desire to halt diversion of capital to European ventures, led to invention of various entities, including limited partnerships, business trusts and joint stock companies.

Obtaining charters from state legislatures proved easier than obtaining a Royal Charter, and states also enjoyed the taxing advantage of attracting limited liability entities.

The evolution of limited liability always was seen as a balancing of risk and benefit. In common law countries, that tension was mediated by the development of case law that attempted to define when liability insulation became so onerous as to justify its abandonment. The analysis assumed that legislatures could not have intended that shareholder insulation was so absolute as to permit fraud.

The tension was litigated through various courts, bringing us to today’s patchwork, in which states shuffle various factors to determine when the corporate veil will be pierced.

Delaware

American jurisdictions proclaim that piercing should be an extra-ordinary event, and state courts have considered similar lists of elements that justify piercing the veil:

• Is the enterprise under-capitalized either initially or in light of anticipated obligations;
• Are boards the same;
• Are officers the same;
• Do shareholder and company share premises;
• Do they not deal together at arm’s length;
• Does the shareholder completely dominate the other;
• Is there confusion in the marketplace over the entity being part of the shareholder;
• Were corporate formalities observed, including keeping of separate financial and corporate records;
• Did the shareholder regularly siphon off cash of the entity;
• Did the shareholder provide or arrange the entity’s capital in the form of loans so that the corporation was “thin”;
• Did the entities use separate attorneys and professionals;
• Were employees shared;
• Did the shareholder guarantee the debts of the entity; and
• Does the fact pattern smell of fraud or sharp practices by which a counterparty would be misled to economic disadvantage?

Delaware ignores most of these factors. Some of the factors are trivial, just make-weights to justify piercing. What corporate parent does not set up a subsidiary to do business in a particular location or vertical, or to effect an acquisition through a holding company subsidiary, and use the same lawyer, accountant and bank, and install its own board in the subsidiary? Or share employees as needed?

Corporate lawyers, aware of the factors to avoid so as to prevent piercing, eliminate as many as possible, but often ignore those that have business logic.

The argument that a claim for piercing the corporate veil should not be brought as a corporate action but should proceed in tort, in contract, or under the laws of fraud or agency, is logically defensible but ultimately irrelevant.

Many of these factors are irrelevant to injury to a third party. Who cares, for example, if the boards are the same? You care about whether you have been misled or cheated, victimized by a tort, or suffered a breach of contract.

The analysis also is confused by the concept of thin capitalization under the Internal Revenue Code. Insufficient capital, or the advancing of loans by a parent to a subsidiary in less than arm’s length fashion, can result in adverse tax consequences. Thin capital in the tax sense is not determinative of a piercing situation in corporate cases, but corporate lawyers may instinctively draw an analytical parallel between tax treatment and an entity liable to be pierced.

In Delaware, piercing the veil is almost impossible. Various factors may be discussed, but you do not pierce the veil unless there has been fraud. The plaintiff must show that the pierced entity is a sham designed to defraud investors and creditors.

Although the courts may discuss capitalization, solvency, corporate formalities, funds siphoning and domination by the shareholder, unless there is fraud there is no piercing.

One cited recent decision refused to effect piercing even though the defendant potentially made fraudulent statements, as such statements were not tied to the manipulation of the corporate form. Further, in Delaware, the piercing claim is heard by a judge, so consistency in result is almost a certainty.

It is not surprising that Delaware has such an approach; the state wants to attract corporate formations, whether opening for a new market or for acquiring through an acquisition subsidiary.

Further, private equity and venture funds are no doubt comforted in making investments in non-pierce-able Delaware entities, where such investors’ economic model may seek quickly to extract profit from the entities in which they invested.

I would be remiss not to mention the law in Massachusetts. The issue is regularly litigated and, while Massachusetts courts delineate 12 different factors for piercing, they often focus on whether there has been “abuse.”

However, the occasional decision may affix shareholder liability based only on some number of purely mechanical grounds, absent a finding of independent unfairness (see for example Caruccio v. Alves’ Boston TKD, LLC, Suffolk Superior Court, Sept. 13, 2018). Nowhere is there a clear statement of the equivalent of Delaware’s requirement of intended fraud for a piercing of the veil to take place.

Other systems

Piercing the veil is a corporate remedy for something that, fundamentally, is not a direct corporate problem. Piercing arises when a tort has occurred that could be remedied in tort, when a contract has been breached that could be remedied in a contract action, when a corporation has been party to a fraud, or when a corporation is a mere agent of shareholders.

Tort approaches seem to have hold in Canada, Singapore and Australia. Indeed, in Canada, proof to pierce must demonstrate action akin to tortious fraud. Commentators also have noted that you need not invent the concept of piercing when the common law concept of “joint tortfeasor” can hold a party directly liable for arranging a tortious act effected by another.

Of the major trading countries, commentary identifies only China as having a statutory, as opposed to a common law, standard for piercing the veil. China is also identified along with the United States as being most proactive in piercing. Article 20 of the Chinese 2005 Company Law states: “Any of the shareholders of a company who abuses the independent legal person status of the company and the limited liability of the shareholders to evade the payment of the company’s debts, thus seriously damaging the interests of the company’s creditors, shall bear joint liabilities for the debts of the company.” Commentary implies that the abuse requires “subjective intent.”

Though Chinese commentary further suggests that undercapitalization can itself constitute abuse, less than 1 percent of successful piercing cases reported in this September’s National University of Singapore Working Paper cited insufficient capital; major factors were commingling of funds, fraud or exercise of undue control over the entity being pierced.

Conclusion

The argument that a claim for piercing the corporate veil should not be brought as a corporate action but should proceed in tort, in contract, or under the laws of fraud or agency, is logically defensible but ultimately irrelevant. If these legal arguments are de facto applied in litigation framed as piercing the corporate veil, then we are talking about the same analysis with a different label.

After all, what if anything is the causal role of inadequate capital, congruent boards, executive commonality, commingling of assets, existence of insolvency, or many of the other common United States-cited factors?

Delaware has it right: not much.

The key issue is: Has someone been injured by being misled materially? Aside from outright fraud (including re-incorporation with intent to leave behind the creditors of the predecessor), these other factors do not matter.

If you are a shareholder in another business, but you do not confuse a counterparty into believing it is dealing with or relying on you, the shareholder, why should you not enjoy the insulation from flow-through liability afforded by the corporate form?

Stephen M. Honig practices at Duane Morris in Boston.