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.