Limited Liability Companies: Safety for Businessowners, When Done Right




Limited Liability Companies: Safety for Businessowners, When Done Right

Limited Liability Companies: Safety for Businessowners, When Done Right

By: Albert Gawer, Esq.

            Many people are broadly familiar with the concept that a company—if properly formed—is a “separate legal entity” or a “separate legal personality.” For businessowners, this concept is one worth being keenly aware of.

            Business entities are generally governed by the laws in the state they were formed. In New York State, a corporate entity—such as a limited liability company—is solely responsible for the liabilities or other obligations it incurs.  An important consequence of this legal principle is that the owner of a corporate entity is ordinarily not liable simply by virtue of being an owner.  

            A further legal doctrine, known commonly as “piercing the corporate veil” presents a limited exception to this general rule in New York and elsewhere.  Under that doctrine, if a court holds that an entity has effectively acted as an “alternate ego” for its owner, it may allow a party that’s suing to be awarded damages not only from the business’ assets, but also the owner’s personal assets.  Courts employ this as a method to prevent injustice—and to disregard a corporate entity’s separate legal existence when exceptional circumstances justify doing so to make an injured party whole.  

            As a common law doctrine—as opposed to a statutory imperative—whether to pierce a corporate veil or not is essentially within a court’s discretion.  Over time, however, courts in New York State have established well-recognized criteria, requiring a review of the specific circumstances of a case, to determine whether it is an appropriate remedy.  The criteria considered by New York State courts include whether:

1.         There has been a failure to adhere to a corporate entity’s formalities (such as failing to comply with statutory requirements to hold regular meetings);

2.         A corporate entity is inadequately capitalized;

3.         A businessowner treats a corporate entity as his or her own personal “piggybank”—using business and personal funds interchangeably (especially when this leads to the business being inadequately capitalized);

4.         A corporate entity’s assets or properties are used as though they were the personal property of the owner;

5.         A corporate entity owner has transferred substantially all of the business’ assets to him or herself (or another business entity) in anticipation of a lawsuit or legal liability; and

6.         There has been other self-dealing by an owner of the corporate entity.

           Courts do not strictly limit themselves to the above-listed factors alone; nor do they require any one particular factor, or even a specific combination thereof.  Instead, the test is one of balance—and considers whether, on the whole, circumstances exist to suggest that a business owner “abused the privilege of doing business in the corporate form,” in order to perpetrate a wrong or an injustice against a party such that the court, in equity, must intervene.[1]

            Stated another way, a corporate entity will generally be disregarded only to prevent fraud or illegality, or, to the extent necessary, to achieve equity.  And while piercing the corporate veil is discretionary, courts regard the step as an extraordinary remedy.  As such, they require that a party seeking such relief prove extreme circumstances justifying the doctrine’s use.  

            It should also be noted that federal courts have held that they are not required to follow the factors used by state courts when conducting an alternate ego test in an action brought pursuant to federal law.[2]  Nevertheless, there is substantial overlap between the factors considered by state courts (applying state law) and federal courts (applying federal law) when determining whether to pierce the veil of a corporate entity doing business in the State of New York.

            The Northern District of New York, for example, has considered twelve (12) factors in finding a case appropriate for veil-piercing, including:

(1) common ownership; (2) pervasive control; (3) confused intermingling of business activity and assets; (4) thin capitalization; (5) nonobservance of corporate formalities; (6) absence of corporate records; (7) non-payment of dividends; (8) insolvency at the time of the litigated transaction; (9) the siphoning away of corporate assets by the dominant shareholders; (10) the non-functioning of officers and directors; (11) the use of the corporation for transactions of the dominant shareholders; and (12) the use of the corporation in promoting fraud.[3]

The court has further noted that “[t]hese twelve factors are not of equal importance, and ‘the exercise is, of course, not one in counting’”—suggesting that the standard under federal law is again a balancing test, and not a checklist requiring all factors to be met.[4]

            Notably, an inability of a corporation to pay its debts is not enough on its own to pierce the corporate veil.  Similarly, the fact that corporate entities have overlapping directors or officers is not sufficient to establish a pervasive control of one entity by the other—particularly if the directors are clearly acting in separate capacities.   A corporate entity being capitalized sufficiently to conduct its operations will weigh against piercing the corporate veil.  And the general test—under both state and federal law—is whether a corporate entity is necessary to prevent fraud or illegality, or to achieve equity.

            While seemingly abstract, all of these considerations can have very real consequences for businessowners, potentially meaning the difference between keeping personal assets safe, or having them at risk when facing a lawsuit. As such, businessowners would be well-served by ensuring they are operating their business in a responsible, legitimate matter, which proper legal counsel can assist with.

[1] ABN AMRO Bank, N.V. v. MBIA Inc., 17 N.Y.3d 208, 222 [2011] [emphasis supplied].  

[2] See, e.g., In re G&L Packing Co., Inc., 41 BR 904 [N.D.N.Y. 1984].  Relevantly, anti-trust claims may be based on federal law such as the Sherman Antitrust Act or the Clayton Act.  In addition, many states have their own antitrust statutes.  New York’s antitrust statute, for example, the Donnelly Act, was enacted in 1899.  Known as “the Little Sherman Act,” its provisions are found in Article 22 of the New York General Business Law and broadly mirror the Sherman Act.

[3] Roundout Val. Cent. School Dist. v. Coneco Corp., 339 F. Supp. 2d 425, 441, 442 [N.D.N.Y. 2004].  

[4] Id. at 442

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