Beware Your Alter Ego
This post discusses the alter ego doctrine, particularly as it is applied by courts in California.
The section references below has been updated to reflect California’s new LLC law that took effect on January 1, 2014 (see RULLCA Brings New LLC Laws to California in 2014).
Corporations have existed for centuries. One way they promote economic activity is by allowing stockholders to limit their personal liability for corporate debts to the amount of their individual investments in the corporation (“limited personal liability”).
Consequently, entrepreneurs often form new corporations to run their new businesses. But they should be careful. Sometimes courts ignore the corporate entity and hold an entrepreneur liable for all of the corporation’s debts!
This result often is called “piercing the corporate veil“. It also is referred to as the alter ego doctrine, on the theory that the corporation merely was the alter ego of the entrepreneur.
Alter ego typically arises when a plaintiff sues an insolvent corporation and needs another defendant – the entrepreneur – who can pay the hoped-for award of damages. California courts apply the doctrine when two criteria are satisfied.
- There is a unity of interest and ownership such that the entrepreneur and the corporation are no longer separate entities.
- Adhering to the fiction of a separate corporate entity would sanction a fraud or promote injustice.
Minifie v. Rowley (1921) 187 Cal. 481, 487.
In determining whether there is a unity of interest and ownership, courts look at such factors as:
- Whether corporate and individual funds were commingled.
- Whether corporate funds were used for personal purposes.
- Whether adequate corporate records and minutes were kept.
- Whether the corporation was merely a shell for the entrepreneur’s activities.
- Whether the corporation was severely undercapitalized.
Harris v. Curtis (1970) 8 Cal.App.3d 837, 840-41.
The last factor merits elaboration. Many new companies are underfinanced. However, if the invested capital “is illusory or trifling compared with the business to be done and the risk of loss,” the court may apply the alter ego doctrine. Harris at 842.
So if you plan to start a company and want to use a corporation to limit your personal liability, be sure to do the following.
- Hold personal assets separate from corporate assets.
- Keep up with all required corporate formalities.
- Provide enough capital to have a reasonable shot at satisfying the corporation’s business needs.
Note to LLC members: Corporations Code Section 17703.04(b) states that members of limited liability companies are subject to alter ego liability. However, failure to hold, or comply with formalities regarding, meetings of members or managers will not result in alter ego liability.
- Avoiding “Alter Ego” Problems: A To-Do List
- Corporate Suspension and Personal Liability are Two Different Things
Dana H. Shultz, Attorney at Law +1 510 547-0545 dana [at] danashultz [dot] com
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.
B. Keith Martin
7/21/2010 | 2:05 pm Permalink
With regard to your comment on my answer to the Q on piercing, plz read my answer a little more carefully. I said an “LLC provides a bit better protection that a corp” because of piercing “due to failure to comply with corporate procedures.” In the above you list lack of “adequate corporate records and minutes” as one factor courts consider.
While this sometimes seems like a makeweight for a court about to pierce a corp, the fact remains that LLC’s have no requirements for minutes to comply with. This must reduce their potential for piercing to at least a small extent. A couple of years ago I had a case on piercing LLC’s. Extensiver nationwide research at that time revealed no case where a court pierced an LLC. LLC’s are still young. As time passes such a case may appear, but I still will advise my clients that the risk is less for an LLC than for a corp for piercing.. Best practice of course is to capitalize well, have insurance and maintain separate books, whether a corp or an LLC.
7/21/2010 | 2:28 pm Permalink
@B. Keith Martin
Thanks for the comment and clarification.
11/21/2012 | 4:39 am Permalink
Came here from one of the answers you provided to one of the questions at onstartups. I’m not quite sure what the last paragraph means as I’m not a native English speaker but it seems to be mattering to me as I’m forming an LLC in DE. Can you let me know what it means in plain words? I lost sense of the sentence from “except as concerns”. Thanks!
11/21/2012 | 9:18 am Permalink
The last paragraph probably will not matter much to you, because it pertains to California LLCs, whereas yours will be a Delaware LLC. Its meaning is that failure to hold meetings of members or managers, or failure to comply with formal requirements for those meetings, will not be the basis for alter ego liability.
11/21/2012 | 11:26 pm Permalink
Thank you Dana!
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