Piercing The Corporate Veil
When clients contact us about forming a new business entity – a new corporation, for example -- a common theme is their desire to “limit their liability.” They nod knowingly, confident in the Kevlar protection their shiny new corporation will afford. We often need to have a little heart-to-heart about the behaviors that business owners need to embrace on an on-going basis for that Kevlar to work its magic.
This article will focus on some of this advice, and highlight an Illinois case that provides wonderful instruction on how to ignore all the right behaviors. But before delving into the TLD Builders case, let’s set the table with some background. This discussion will focus on corporations, but with a little spit polish it would apply equally to limited liability companies and limited partnerships.
A corporation is a legal entity that has existence separate from its shareholders, directors, and officers. This legal separation of the business entity from its owners and managers means that these “insiders” are not liable for the corporation's debts and obligations – again, this limited liability usually drives the decision for many clients to incorporate their business in the first place.
However, this separation is not absolute and if the insiders are not careful, Illinois law provides creditors of a corporation with a mechanism to reach through the corporate entity and attach the personal assets of those shareholders to satisfy a claim. On certain occasions, other individuals who have exercised sufficient control or influence over the business entity have also been called upon to satisfy the debts of the corporation. A creditor’s action to sidestep the corporate entity in order to reach the shareholders’ personal assets is sometimes called “piercing the corporate veil.”
The scenarios that gives rise to this legal maneuvering seem to have familiar structure: a person or company who has done business with a corporation is due some money – perhaps as a result of a contract matter, a tort liability or some other claim. During the course of trying to be made whole, the creditor comes to learn that his or her likelihood of getting paid by the business is slim or nonexistent, since the company has few or no assets from which a claim can now be satisfied. The company may also be without typical insurance coverage that might otherwise have paid the claim.
In this kind of case, the frustrated creditor will often file a lawsuit against both the corporation and any individual parties that the creditor may believe have controlled the corporation or had some responsibility for the decisions made by the corporation. By naming these individuals as parties to the lawsuit, the court must make a decision whether to “pierce the corporate veil” and hold them personally responsible for the business obligation.
When deciding whether or not to pierce the corporate veil, Illinois courts usually apply a two-prong test. The courts consider: (1) the “unity of interest and ownership” between the corporation and its shareholder (the “alter ego” analysis), and (2) whether upholding the separate corporate existence (and allowing the shareholder to be protected behind the corporate shield) would have the effect of encouraging a fraud, promote rank injustice, or promote some inequitable consequences (the “preventing a fraud” analysis). Let’s look at each.
Alter Ego. In determining whether the first prong of the piercing-the-corporate-veil test is met – that is, the “alter-ego” test -- courts consider many factors, including these:
- Did the corporation have inadequate capitalization for the type of business it was engaged in?
- Did the corporation formally issue stock?
- Did the corporation observe customary corporate formalities – hold regular meetings and maintain regular minutes of those meetings?
- Was the debtor corporation insolvent - or nearly insolvent?
- Did the corporation have active, functioning officers or directors other than the shareholder being sued?
- Did the corporation maintain customary formal corporate records – stock certificates, corporate charter, etc.?
- Was there any commingling of corporate funds with personal funds?
- Did the insiders prefer themselves as creditors (i.e., pay themselves first)?
- Were there any diversions of corporate assets from the corporation by or to an insider or other person or entity to the detriment of creditors?
- Was, in fact, the corporation a mere façade for the operation of the dominant shareholders?
While no one factor is controlling, but where many of these are present, it is more likely than not that the corporate veil will be pierced.
Obviously, the corporation’s shareholders or other insiders want to avoid a court ruling to pierce the corporate veil. Ergo: embracing good business practices is critical, as is the careful observation of basic corporate formalities. This includes, for example, holding required shareholder and director meetings, maintaining appropriate record keeping, using the corporate name and appropriate officer designation on contracts, correspondence and other communications with the public. It’s mandatory that the business and the shareholders maintain a clear separation of corporate and personal assets (i.e., don’t pay your mortgage out of the business checkbook).
Preventing a Fraud on Creditors. With the second prong of the two-prong test, courts look for “some element of unfairness, something akin to fraud or deception, or the existence of a compelling public interest.” It is important to note that actual fraud is not required under this analysis. Rather, the shareholder may be found liable for corporate debts (or the “veil pierced”) to prevent injustice or inequitable consequences. An example of such a situation is when a corporation’s business activities lead to a lawsuit in which the possibility of a substantial judgment is evident and the corporation begins selling off or otherwise disposing of its assets to the detriment of the potential judgment creditor or creditors.
How Not To Do It. The language quoted in the paragraph above was pulled directly from a 2005 Illinois case (Fontana vs. TLD Builders, Inc.). The Fontana decision drew considerable attention when it was handed down, and because the topic of piercing the corporate veil comes up in our practice with some regularity, it’s worth a short review here.
Joe and Angela Fontana entered into a contract with TLD Builders Inc. to build a single family home for $1.5 million on a quiet street in Clarendon Hills. TLD breached the contract by failing to construct the home as required in the contract and by abandoning all work on the home in February 2001, leaving construction incomplete and home uninhabitable. After a trial, the court agreed with the Fontanas, and held that it would be too costly to complete the home, so the court ordered the unfinished home demolished. The court held that the Fontanas had been damaged in the amount of $1,272,000, and entered judgment in that amount against TLD and the owners of TID – Nick and Theresa DiCosola jointly and severally.
Nick DiCosola appealed the decision. He was unhappy that the judgment had been rendered against him personally since, he asserted, TLD was his wife’s company -- not his. The Fontanas had alleged that Nick DiCosola was the alter ego of TLD and that, after the lawsuit was filed, he deliberately caused TLD to cease its business operations so that it had no funds with which to compensate plaintiffs for their economic harm.
Theresa DiCosola was called to testify in the case. In a textbook case of a witness not being properly prepared, she admitted that she was the incorporator of TLD, but she couldn’t provide evidence that the corporation had any start-up capital. There was no evidence that she or Nick ever paid for the stock issued by the corporation – or if stock was even issued. As the nominal “owner” of the corporation, Theresa knew nothing about the corporation, she didn’t sign checks, she kept no records, and she didn’t know whether the corporation had ever earned any money.
But wait - it got better . . . Theresa also testified that she has never received a dividend from TLD, and was unaware if TLD had profits or losses in the years 1998 through 2002 –despite having signing TLD's income tax returns for those years. She also admitted that she had no idea where the company's assets of $1.8 million went after the lawsuit was filed. Finally, the company had almost no financial records, and almost no records of any payments that it made to vendors and subcontractors.
As a result, the trial court rightfully found that “Mr. DiCosola is the dominant force behind this corporation” and that the corporation “was little more than a shell which was established to shield him from liability.”
When the court in Fontana applied the two-prong case – it was an easy calculus: the court found no evidence of adequate capitalization; there was a failure to issue stock; there was a failure to observe corporate formalities; the company was largely insolvent; there was no evidence that Theresa functioned as a real officer or director; and there was an almost total absence of corporate records.
To underscore the point, the Fontana case involved a corporation that did everything the wrong way - inadequate capital; no formal business records; no consistent use of the corporate name and identity; no effort to follow customary corporate formalities; and there was evidence of commingling of personal and corporate funds. The result in this case was personal liability in excess of $1.2 million.
It is interesting to note that Nick DiCosola was found liable even though he wasn’t a shareholder. The classic piercing-the-corporate-veil case involves an action against the corporation’s shareholders. This case underscores that on occasions, even non-shareholders can be tagged with personal liability.
The lessons of this Illinois case should be stamped on the brain of all business owners: it is simply not enough to form a corporation - you must fund and operate the corporation properly, and treat it as a separate and independent entity. You must use the corporate checking account or credit card for corporate purposes only, and keep records of corporate expenses. You must keep your own affairs and accounts separate from those of the corporation. Finally, you must recognize that it may be improper to transfer funds to yourself or others to avoid paying your creditors.
Nothing contained in this article should be taken as legal advice for your specific situation. Consultation with competent counsel prior to implementing any legal strategy is highly recommended.