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February 22, 2011
Veil-Piercing and Corporate Formalities
My Business Associations class has been discussing piercing the corporate veil. Every time I return to this material, I’m struck by how intellectually vacuous the doctrine in this area is.
Some of the factors courts consider in piercing have an obvious policy tie to the question at issue: whether the corporation’s creditors should be able to recover from one or more of the shareholders. Undercapitalization, for instance, can have an obvious effect on the corporation’s ability to pay creditors. There’s an argument that consensual creditors should protect themselves from any undercapitalization that exists at the time the debt is incurred, but at least there’s a tie between undercapitalization and harm to the creditors. The same thing can be said for transfers of funds from the corporation to the shareholder after the obligation is incurred. The harm to the creditors is obvious and, in the case of post-obligation transfers, the self-protection argument is more difficult.
The factor that doesn’t seem to make sense is failure to follow corporate formalities. In most cases, you cannot establish a causal link between the failure to follow corporate formalities and the creditor’s loss. The creditor’s position is no worse because, for instance, the corporation didn’t hold regular board meetings or keep minutes of those meetings.
I understand the penalty argument—if you want a corporation, you have to comply with the rules for operating one, or we will penalize you. But it’s a very uneven penalty. Successful corporations are never penalized, no matter how blatantly they fail to follow corporate formalities. They are able to pay their bills, so veil-piercing isn’t usually an issue. Only corporations that fail to follow corporate formalities and are not successful are penalized.
I think the drafters of the Revised Uniform Limited Liability Company Act (2006) got it right. The Act doesn’t exclude piercing entirely, but section 304(b) does provide that “The failure of a limited liability company to observe any particular formalities . . . is not a ground for imposing liability on the members or managers . . .”
-Steve Bradford
February 22, 2011 | Permalink
Comments
I totally agree with you analysis. I recently discussed piercing the corporate veil (in the US) at the Dutch corporate law weblog thedefiningtension and concluded - just like you - that the relationship between piercing and a failure to observe formalities makes no sense at all.
On undercapitalization, see: http://www.thedefiningtension.com/2010/12/no-200-a-bit-more-on-veil-piercing-.html
Posted by: Jaap Barneveld | Feb 22, 2011 12:09:13 PM
Regarding following corporate formalities, I always understood the rationale to be this: the question at hand when piercing the corporate veil really is whether the corporation is in truth a distinct legal entity separate from its owner(s). One practice that is common among properly structured companies is the observance of corporate formalities. For sham companies that are nothing more than an alter-ego of the owner(s), the opposite is often true. Bear in mind that following corporate formalities is only a factor in veil piercing - it's not dispositive. I think it's a fair factor to consider.
Posted by: Chris Clark | Feb 22, 2011 4:55:07 PM
That is a very good point. I never thought about the doctrine being unfair in that way.
Posted by: Jason Chan | Feb 22, 2011 7:45:34 PM
I agree with the general lack of a causal connection. In defense of including the factor, however, we might think that failure to follow formalities is indirect evidence that the owners are impermissibly taking money/assets out of the corporation, which would hurt creditors. After all, if one was trying to steal from the company to the detriment of creditors, you wouldn't want formal meetings, resolutions, documents, etc. creating any sort of paper trail. It is not conclusive, of course, but it may have evidentiary value.
Posted by: Douglas Moll | Feb 24, 2011 9:26:59 AM
Doug,
You're right, but I would rather force the plaintiff to prove that directly. And, in many of the cases where failure to follow formalities is cited, there's no claim of transfers out of the corporation.
Posted by: Steve Bradford | Feb 24, 2011 10:40:25 AM
