Veil Piercing and Corporate Substance

The idea of corporate substance is essential to corporate law.  Professors inform students in corporation class they must endeavor to give their corporate clients "substance" lest courts be given the opening to pierce the corporate veil.   Unfortunately there is a dearth of scholarship defining and developing this concept, despite its obvious importance.  While this post will hardly provide the depth needed for a true analysis, it will provide some insight on the exact nature of this idea.

Depending on your view, a corporation is either a privilege granted by the state (an older, more traditional view) or a nexus of contracts (from a law and economics analysis).  But regardless, it's an artificial construct with no physical existence.  At the same time, a corporation is allowed to perform many of the acts of an individual such as sign contracts, sue and be sued, hold property, transact business and the like. Del. Code Ann. tit. 8 Section 122.  This leads to the question of how exactly do we prove the corporation not only exists, but is in fact a unique entity with a separate existence? Or, to put it more existentially, how to we demonstrate it is "alive" or has "substance?" 

This is usually demonstrated by establishing a paper trail -- meeting minutes, a sales records, contracts and the like.  This leads to point number 1: the paper trail must exist and it must be documented.  Ideally, each fiscal year of a corporation's life can be placed into a folder (most likely electronic in nature) that includes contracts, payments, meeting minutes etc... outlining what exactly has occurred.  The folder should be readily available and easy to access. 

But there is an important corollary to rule number 1: the existence must demonstrate uniqueness, which is defined as, "existing as the only one or as the sole example; single; solitary in type or characteristics."  While this is easily accomplished with a larger publicly traded or private company it can run into trouble with smaller, closely held family businesses.  As an example, take the generic company Acme Corp.; Mr. Smith is the president, and Mrs. Smith is the treasurer.  The company has made two questionable purchases: high-end cars for its executives as a perk and property in a known vacation spot like Colorado in the name of "entertaining potential clients."  Has the company purchased these for legitimate corporate reasons or has the Smith family used the company to make personal purchases disguised as company purchases?

Enter the concept of "alter ego" from veil piercing doctrine.  According to Ballentine's Law Dictionary, an alter ego is literally "the other self."  Instead of the company being a separate and distinct legal entity, it's actually an extension of an individual or another company who are using the limited liability shield not to protect their investment (a primary reason for the shield) but instead for other, non-state sanctioned purposes such as fraud.  When the inter-mingling of personal and business substance is so inter-twined -- or when a company is not "unique" but a mere extension of an individual --  a court can "pierce the corporate veil" stripping the company of its limited liability shield thereby making the individual shareholders personally responsible for the corporation's debt. 

Depending on the jurisdiction, there are either two or three elements to veil piercing.  The three prong test is usually worded thusly: (1) a single individual or small group of individuals is in complete control of the company, (2) they use the corporation to commit some type of tort or breach of contract and (3) the tort or breach is the proximate cause of the plaintiff's harm.  The two prong test is phrased thusly: there is such unity of the interests between the individual and the corporation that the separateness of the corporation is erased and holding the "alter ego" as the only liable party would lead to an injustice.  There is a fair amount of overlap between the two tests.  In addition, veil piercing is not the cause of action but the equitable remedy; the plaintiff must allege an additional cause of action such as fraud or breach of contract.

The courts will look at many factors to consider piercing the veil, such as, "(1) majority ownership and pervasive control of the affairs of the corporation; (2) thin capitalization; (3) nonobservance of corporate formalities or absence of corporate records; (4) no payment of dividends; (5) nonfunctioning of officers and directors; (6) insolvency of the corporation at the time of the litigated transaction; (7) siphoning of corporate funds or intermingling of corporate and personal funds by the dominant shareholder(s); (8) use of the corporation for transactions of the dominant shareholder(s); and (9) use of the corporation in promoting fraud."  Pointer (U.S.A.), Inc. v. H & D Foods Corp., 60 F. Supp. 2d 282, 287 (S.D.N.Y. 1999).  There is no magical combination of factors for the court to use in arriving at its decision.  Instead, they weigh various elements in relation to the facts.

And this returns us to the concept of "substance."  A company that exhibits some of the factors listed in the previous paragraph and also engages in questionable behavior does not demonstrate that it has sufficient substance to be recognized at law.  In the alternative, it is not a unique entity with its own demonstrable personality, but instead an abuse of the limited liability granted by law.  As there is insufficient substance, a court can hold individual shareholders personally liable for corporate debts and obligations.