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To what extent are shareholders of the corporation personally liable for obligations of the corporation?
Generally, corporate shareholders are not liable for the debts or obligations of the corporation, including legal liability for torts or contract actions. Under certain circumstances, however, a court will disregard the corporate protections and hold shareholders personally liable. This situation arises when a plaintiff sues the corporate shareholder(s) alleging that the court should “pierce the corporate veil” of protection and hold shareholders liable for the corporate debts or obligations. This claim involves the “alter ego theory”. Under this theory, a plaintiff must demonstrate that the purpose of the business entity is not to carry on business as a separate entity; rather, the corporate entity is simply a shell and should be considered one in the same with the shareholders. That is, the corporation is the alter ego of the shareholders and the limited personal liability protections should be disregarded. The court will ask the following questions in evaluating whether to pierce the corporate veil:
Business Formalities – Did the business maintain formalities, such as organizational filings, meeting minutes, etc.?
- Example: I am an officer and director of ABC Corp. I fail to file my state registration documents. I also fail to keep track of corporate records. I do not have established bylaws, and I fail to adhere to default governance rules. All of these facts can demonstrate an intent to use the corporation as a shell entity for my personal business activity.
Business Assets – Did the business owners intermingle personal and business funds or other assets?
- Example: I pay my personal mortgage from the business bank account without noting whether the payment is a dividend or salary compensation. Also, I routinely pay corporate expenses from my personal bank account without noting that my payment is a capital contribution to the corporate entity. This can demonstrate the corporation is a shell.
Business Capitalization – Is the business adequately capitalized or does it have adequate liability protection in place?
- Example: As shareholder, director, and CEO, I routinely distribute any corporate profits to myself as a dividend. I leave very little funds in the corporation to finance operations. Further, I do not purchase liability insurance to cover potential legal liability, such as tort liability. If the court finds that the corporate entity form is intentionally underfunded, it may find that the entity is merely a shell for limited liability purposes.
Stakeholder Functions – Did business members comply with or routinely deviate from their roles and responsibilities?
- Example: I serve as director and officer. I make decisions as officer that should be reserved or the board of directors. I fail to submit major decisions to shareholder votes. This would show that I am not respecting corporate formalities and the entity form is a shell for my personal business activity.
A negative response in any or all of these situations could be grounds for the court to disregard the limited personal liability protections of the corporate entity.
Discussion: How do you feel about the limited personal liability of corporate shareholders? What do you think is the justification for affording such personal liability protection? Should a court have the ability to pierce the veil of liability protection? Why or why not? Can you think of any other questions that could be relevant in determining whether the corporation is simply the alter ego of its shareholders?
Practice Question: Clark is a shareholder of ABC Corp. ABC Corp is being sued for the actions of an employee. Identify the conditions under which Clark could be held personally liable for the judgment against the corporation.
As a general provision, shareholders cannot be held liable for the obligations and debts of the corporations. The liability of the shareholders for company debts is limited to the capital originally invested in the business. However, there are circumstances where the shareholders may be held liable for the debts, obligations or fraudulent activities of the corporation. This is known as “piercing the corporate veil”. Elements that may lead to piercing of the corporate veil include:
- Failure to keep personal assets separate from company assets;
- Failure to adequately capitalize the company;
- Failure to maintain liability insurance;
- Failure to observe corporate formalities.