Christian Blume -December 21, 2018
Many business owners and entrepreneurs have likely heard the term ‘piercing the corporate veil’, but don’t understand the meaning, and how to take steps to avoid the ‘piercing.’
Generally, when we talk about piercing the corporate veil, it is holding shareholders (in the case of a corporation), directors, officers or employees liable for the debt of a corporation. These owners can be individuals or even parent corporations/LLCs. Why might a creditor want to go after the individuals or another corporate entity? The entity may not have the resources to cover the liability, and the creditor is seeking money from someone with ‘deeper pockets.’
Piercing the corporate veil is considered an equitable remedy and a means to impose liability from an underlying claim, such as a breach of contract. To pierce the corporate veil, Illinois courts require a creditor demonstrate: (1) a unity of interest and ownership, such that the separate personalities of the corporation and the individual do not exist; and (2) circumstances must exist such that adherence to the fiction of a separate corporate existence would sanction a fraud, promote injustice, or promote inequitable consequences.
In Fontana v. TLD Builders, the Illinois 2nd District Appellate Court delineated the following (11) factors, ‘badges of fraud’, to determine whether the unity of interest and ownership has been met, and are insightful as to whether the second-element of the two prong test is met. Corporations should do their best to avoid these mistake.
inadequate capitalization: when the corporation’s ratio of capital to its obligations and business operations is too low.
failure to issue stock: corporations have the power to issue shares of stock, as per the articles of incorporation. However, a failure to issue those authorized shares demonstrates a unity of ownership and may support a piercing of the corporate veil.
failure to observe corporate formalities: not holding regular director and shareholder meetings, keeping minutes at corporate meetings, maintaining corporate records, or updating filings with the secretary of state.
non-payment of dividends: not all corporations pay dividends, and many don’t necessarily have to. However, if dividend payments are required or appropriate based on the circumstances, then they should be paid to the shareholders.
insolvency of the debtor corporation: if the corporation is regularly unable to satisfy its debts when becoming due.
non-functioning of the other officers or directors: if only one of the named officers or directors, when there are multiple listed officers or directors, exercises complete control over the corporation, this demonstrates that the corporation may be in-effect the alter-ego of that individual and not a distinct entity.
absence of corporate records: corporations are required to keep correct and complete books and records, and minutes of the proceedings of its shareholders and directors. Additionally, a record of a corporation’s shareholders must be kept, including the names and addresses, and the number of shares and class of shares held by each shareholder.
commingling of funds: when personal funds are used to pay corporate liabilities, corporate funds are used to pay personal expenses, or when one corporate entity pays the liabilities of another. This can be avoided by maintaining separate and distinct bank accounts for the business entity, and not using one account to pay for the liability of another. This practice may also help in maintaining accurate accounting.
diversion of assets from the corporation by or to a stockholder or other person or entity to the detriment of creditors: when the corporation transfers assets or money, to shareholders or third-parties to prevent creditors from collecting. Additionally, these transfers may violate Illinois Uniform Fraudulent Transfer Act (740 ILCS 160).
failure to maintain arm’s-length relationships among related entities: when lawyers use the term “arm’s-length relationship”, it is typically in reference to a more formal relationship, where each party is independent, well informed, and looking out for their own interest. The opposite would be an “arm-in-arm relationship,” one in which the parties are more intimate, closely related, or familial. An example of this would be a corporation leasing office space/commercial space from another closely held entity below market rent and without any formal leases, or without periodic rental payments.
whether, in fact, the corporation is a mere facade for the operation of the dominant stockholders: when the corporation is set-up as a ‘sham’ or ‘dummy’ corporation. While it is good practice to avoid as many of these mistakes as possible, there is no concrete formula that courts use to determine whether to pierce the corporate veil, and each is determined based on the particular facts.