Bypassing the Corporate Barrier: A Guide
In the dynamic business landscape of California, corporations and their subsidiaries play a significant role. However, the state's courts are vigilant in ensuring that these entities maintain their separate identities and are not used as personal instruments of their owners.
When deciding to pierce the corporate veil, California courts consider several key factors, as outlined in the landmark case of Associated Vendors, Inc. v. Oakland Meat Co. (1st Dist. 1962). The primary factors include:
- Failure to maintain corporate formalities: Courts examine whether the corporation keeps proper records, holds board meetings, and follows other statutory requirements. Ignoring these formalities may suggest that the corporation is not a separate entity but an alter ego of the owners.
- Commingling of assets and business operations: If a corporation's funds or assets are mixed with those of the shareholders or used interchangeably, this supports veil piercing.
- Undercapitalization: Inadequate capitalization may indicate that the corporation is a mere shell or facade.
- Control and domination: Courts consider whether the dominant shareholder exercises control over the corporation to such an extent that it has no independent existence and is used to commit fraud or injustice.
- Fraud or unjust result: The alter ego doctrine is founded on equitable principles to prevent injustice. Courts require evidence that the corporate form was used to perpetrate fraud or wrongful acts, not merely to skirt regulatory requirements.
- Tracing harm to control and fraud: Recent rulings emphasize that plaintiffs must show a direct link between the individual's control over the corporation, fraudulent conduct, and the injury suffered. Mere injustice or breach of contract is insufficient for veil piercing.
A holding company can help consolidate power and reduce costs by owning multiple subsidiaries. However, the agency theory requires a plaintiff to prove that the subsidiary was acting on behalf of the parent as its agent, with the parent exercising total control over the subsidiary.
Creditors may ask the court to disregard the corporate status of a subsidiary and pierce the corporate veil to hold the parent company liable. This can occur in a parent/subsidiary context and when the corporation only has one individual shareholder and no subsidiaries.
It's essential to note that incorporation offers shareholders protection from personal liability. To avoid personal liability for the debts of a company or a subsidiary, proper capitalization, insurance, compliance with corporate formalities, separate tax returns, avoiding mixing personal and company funds, and maintaining an adequate debt/equity ratio are recommended.
In California, courts pierce the corporate veil in approximately 50.86% of cases, according to a recent study. This underscores the importance of adhering to corporate formalities and maintaining separate identities for corporations and their subsidiaries.
Incorporating in California may benefit a business as it will be governed by the state's laws. International companies may also benefit from letting their subsidiaries do the work in the United States to avoid significant expenses of being haled into remote U.S. courts.
However, these benefits should not encourage disregard for corporate formalities or the mixing of personal and corporate funds. The alter ego theory is a powerful tool for California courts to ensure that corporations maintain their separate identities and are not used as personal instruments of their owners.
When considering the implications of the alter ego theory, one should be mindful of maintaining distinct business entities. Failure to do so could result in courts piercing the corporate veil, treating a corporation as an extension of its owners, given the intermingling of assets and business operations or the disregard for corporate formalities. On the other hand, proper adherence to corporate formalities can help ensure the protection of personal liability for shareholders and keep businesses separate from their owners in California's business landscape, where corporations and their subsidiaries play a significant role.
