Behind the Veil: How to Avoid Alter Ego Liability and Personal Risk in Business | Articles

When a business fails to meet its obligations (e.g., breaches a contract or commits a tort), injured parties may try to hold the business’ owners personally liable. One legal tool to get to the owners is the doctrine of alter ego liability, which allows courts to pierce the corporate veil and treat the business and its owners as one and the same. Piercing the veil, however, is not granted lightly—courts carefully scrutinize the facts, especially in cases involving tort claims versus contract claims.

This article explores the concept of alter ego liability, the factors courts consider, the distinctions between tort and contract cases, and the laws governing piercing the corporate veil in California, Texas, Florida, and New York.

What Is Alter Ego Liability?

Alter ego liability occurs when courts decide a corporation or limited liability company is not a distinct entity from its owners. Instead, the entity is being used improperly to shield the owners from personal liability. When this happens, courts can disregard the business’s protection exposing the owners to the entity’s debts or obligations.

Common factors courts evaluate include:

Commingling of Assets: Owners mix personal and business funds or use business accounts for personal expenses.
Failure to Follow Formalities: The business doesn’t maintain proper records, hold meetings, or comply with other governance requirements.
Undercapitalization: The business lacks sufficient funding to meet its obligations.
Fraud or Misrepresentation: Owners use the entity to perpetrate fraud or act in bad faith.

Tort Cases vs. Contract Cases: Key Differences

The nature of the underlying claim significantly impacts how courts evaluate alter ego liability.

Tort Cases: Focus on Misconduct

In tort cases, courts often focus on the business’s misconduct or negligence. Plaintiffs argue that the business was used to commit wrongful acts or shield owners from accountability.

Example:
A construction company with undertrained workers causes a severe on-site injury. The injured party sues for negligence and argues that the owners deliberately undercapitalized the business to avoid paying claims.

Key Factors:
Courts in tort cases scrutinize whether the business’s undercapitalization or lack of governance contributed to the harm. The focus is on preventing businesses from using the corporate shield to avoid accountability for wrongful acts.

Contract Cases: Focus on Voluntary Agreements

In contract cases, courts emphasize whether the owners used the entity to defraud or evade contractual obligations. Since contracts are voluntary, courts are generally more hesitant to pierce the veil unless there is clear evidence of fraud or abuse.

Example:
A vendor delivers $50,000 worth of goods to a restaurant, only to find that the restaurant has no assets because the owners siphoned off all profits. The vendor sues, alleging the owners never intended to pay and used the business to commit fraud.

Key Factors:
Courts consider whether the owners’ actions, such as misrepresentations or asset transfers, show bad faith. The bar for piercing the veil is higher in contract cases, as parties knowingly entered the agreement.

Piercing the Veil: LLCs vs. Corporations

The reasons for piercing the veil are similar for limited liability companies and corporations, but courts often scrutinize LLCs differently because they are less formal by design. LLC members might be tempted to be more casual about governance, such as skipping operating agreements or mixing finances; however, failing to adhere to basic governance principles can still lead to veil-piercing claims with severe financial consequences.

State-Specific Approaches

California

Key Statute: California courts analyze veil-piercing under common law, focusing on the unity of interest and inequitable results (Associated Vendors, Inc. v. Oakland Meat Co., Inc., 210 Cal.App.2d 825).
Application: Courts are more likely to pierce the veil in cases of fraud or severe undercapitalization.

Texas

Key Statute: Texas Business Organizations Code § 21.223 restricts veil-piercing except in cases of actual fraud.
Application: Plaintiffs must prove owners acted with the intent to defraud creditors or evade obligations.

Florida

Key Statute: Florida applies a three-part test requiring proof of improper conduct, control, and unjust loss to the plaintiff (Dania Jai-Alai Palace, Inc. v. Sykes, 450 So.2d 1114).
Application: Florida courts are cautious about piercing the veil, focusing on fraud and misuse.

New York

Key Statute: New York courts evaluate veil-piercing under a two-prong test, considering whether owners abused the corporate form and whether injustice would result (Morris v. New York State Dept. of Taxation and Finance, 623 N.E.2d 1157).
Application: Courts require clear evidence of fraud, undercapitalization, or improper conduct.

Practical Considerations for Businesses

To protect the corporate veil and avoid alter ego liability:

Maintain Proper Capitalization: Ensure the business has enough funding to meet its obligations.
Follow Governance Formalities: Hold meetings, maintain records, and comply with legal requirements.
Separate Finances: Keep personal and business accounts distinct.
Avoid Fraud or Misrepresentation: Act in good faith in all transactions and contracts.

Risks of an Alter Ego Finding

If the corporate veil is pierced, owners face:

Personal Liability: Owners may be held personally responsible for the business’s debts and obligations.
Loss of Credibility: Piercing the veil can damage business reputation and trust.
Financial Consequences: Owners may lose personal assets to satisfy judgments or debts.

Final Thoughts

Alter ego liability underscores the importance of treating business entities as distinct from their owners. Whether you operate a corporation or an LLC, adhering to governance principles and acting transparently are critical to maintaining the liability shield that protects your personal assets.

If you’re involved in a case where alter ego liability is an issue—whether as a business owner or plaintiff—consulting an attorney is essential. Understanding the factors courts consider and the nuances of state law can help you navigate these complex claims effectively.

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Mark Adams is a trial lawyer at JMBM who focuses his practice on business litigation including contracts, products liability, corporate and partnership disputes, and hospitality litigation. He has tried numerous cases in state courts, federal courts, and in domestic and international arbitrations. Contact Mark at MarkAdams@jmbm.com or (949) 623-7230.

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