Seminar Paper, 2006, 27 Pages
I. FUNDAMENTALS OF THE CONCEPT
A. RATIONALE FOR VEIL-PIERCING
B. HISTORICAL DEVELOPMENT
C. DOCTRINES OF VEIL-PIERCING
1. Alter Ego Doctrine
2. Instrumentality Doctrine
3. Interchangeability of the Alter Ego and the Instrumentality Doctrines
4. Other Doctrines
D. PREREQUISITES FOR DISREGARDING THE CORPORATE ENTITY
1. Three Factor Test: Classic Piercing
2. Single Factor Tests: Emerging Doctrines
3. Role of Undercapitalization
II. APPLICATION OF THE CONCEPT
A. WALKOVSZKY V. CARLTON
B. DEWITT TRUCKERS V. FLEMMING
C. SEA-LAND SERVICES V. PEPPER SAUCE
D. KINNEY SHOE V. POLAN
III. LIMITED LIABILITY AND VEIL-PIERCING
A. ECONOMIC IMPLICATIONS OF LIMITED LIABILITY
B. VEIL-PIERCING IN DIFFERENT CONTEXTS OF LAW
1. Contract versus Tort
2. Individual versus Corporate Shareholder
IV. ALTERNATIVES TO THE PRESENT VEIL-PIERCING CONCEPT
A. REQUIREMENTS FOR AN IDEAL CONCEPT
B. COMPARISON BETWEEN THE PRESENT CONCEPT AND ALTERNATIVE APPROACHES
1. A Statutory Solution
2. Abolition of Veil-piercing
3. Regulations of Undercapitalization
Corporate law aims at protecting shareholders from being subject to personal liability for the risks of conducting business.1 The state created a corporate fiction which is a separate legal entity and distinctive from the shareholders and which offers the primary advantage of limited shareholder liability.2 The underlying notion is to encourage shareholders to provide capital and take on risky investments.3 In this way, the risk is shifted towards third parties and costs are externalized. Overall, this investor attitude encourages economic development. Hence, limited liability can be seen as the “cornerstone of capitalism”4. However, as moral hazard comes into play, the externalization costs might exceed the benefits and, thus, damage third parties. In order to promote justice, the presumption of limited liability must be occasionally rebutted and personal liability imposed on shareholders. This concept known as piercing the corporate veil will be elaborated on in detail in this paper. The doctrine is of crucial importance since it is the most litigated issue in corporate law.5 Regrettably, it is also among the most confusing areas of law.6“’Piercing’ seems to happen freakishly. Like lightening, it is rare, severe, and unprincipled.”7
The objective of this paper is to lift the confusion of the doctrine and answer the question whether piercing the corporate veil is a sound concept. Moreover, it will be analyzed whether it is the prevailing alternative in dealing with the moral hazard problem of limited liability. Therefore, Part I will start with an explanation of piercing and the historical development of the doctrine. Competing doctrines of piercing will be presented and form the basis for the subsequent analysis of the main requirements for piercing. To illustrate the application of the doctrine, Part II will discuss four landmark cases. In Part III, the interplay of limited liability and veil-piercing will be assessed in different contexts of law. Afterwards, Part IV will elaborate the suitability of the concept compared to different alternatives. Finally, a conclusion will be drawn and the initial question will be answered.
The scope of this paper is limited to contract and tort cases against corporations. Therefore, the topics of reverse piercing or piercing in other legal entities will not be addressed. Furthermore, procedural peculiarities will not be considered.
Since shareholders are generally not personally liable, creditors face an inherent risk in dealing with a corporation.8 However, the liability shield is not justified when the shareholders have excessively or improperly transferred the risk to creditors. Under these circumstances, courts have the possibility to disregard the corporate entity. Thereby, the courts balance two competing aspects. On the one hand, democratic and economic justifications for limited liability exist which courts are inclined to promote in order to stabilize the fiction of the corporation.9 Thus, courts have been fairly reluctant to pierce the veil. On the other hand, creditors and society should be protected from the harm done by corporations and their shareholders. This fairness argument induces courts to pierce in compelling cases.10 The aim of the imposed personal liability is to compensate the victim, to sanction the wrongdoer and to deter potential wrongdoers.
Mostly, creditors will attempt to pierce the veil when they are unable to collect their accounts receivable from the corporation but the personal assets of the dominant shareholder may satisfy the claim. In these cases, shareholders, as defendants, are alleged to be liable for the debt obligations of the corporation. Piercing is an equitable remedy which courts use to avoid injustice.11 This concept is the most severe form of shareholder liability.12
The term “piercing the corporate veil” was first mentioned by Wormser in 1912.13 He analyzed various situations where the concept of the corporate fiction should be ignored. Wormser generalized that “when the conception of corporate entity is employed to defraud creditors, to evade an existing obligation, to circumvent a statute, to achieve or perpetuate monopoly, or to protect knavery or crime, the courts will draw aside the web of entity, will regard the corporate company as an association of live, up-and-doing, men and women shareholders, and will do justice between real persons”14. Later, he concluded that the doctrine could not be precisely formulated since it could take on many different forms.15
The early piercing cases usually required some kind of fraud.16 With Simmons Creek Coal Co. v. Doran 17 and J.J. McCaskill Co. v. U.S 18, the piercing doctrine was expanded to cases not involving actual fraud. In U.S. v. Milwaukee Refrigerator Transit Co, the court formulated the kind of wrongdoing that would trigger piercing the corporate veil. “[W]hen the notion of legal entity is used to defeat public convenience, justify wrong, protect fraud or defend crime, the law will regard the corporation as an association of persons.”19 This early attempt concentrated mainly on the harm done. The relationship between the corporation and the plaintiff was neglected. Since this articulation was very broad and severe, scholars and courts were dissatisfied with this approach. Later in Berkey v. Third Avenue Railway Co. 20, Cardozo demurred at the broad metaphors used in this area of law. At the same time, he admitted that an accurate definition could not and should not be made due to fairness reasons.21
As a result of this dissatisfaction, new doctrines were articulated. In 1931, Powell made one of the biggest attempts to formulate a clear rule of piercing – the instrumentality doctrine.22 His approach originally dealt only with piercing within corporate groups but was over time extended to all corporations. Simultaneously, the alter ego doctrine emerged. With the development of both approaches, the focus shifted slowly from the harm done to the plaintiff towards the triangle relationship between the corporation, its shareholders and the plaintiff.23
In theory, the emerged doctrines of piercing apply to publicly-held and closely-held corpora-tions.24 In order to be pierced, shareholders have to dominate the corporation. Since publicly-held corporations have a large number of different shareholders, it is hard to show the required domination and establish a piercing case against them. Consequently, no case exists where the veil was pierced against shareholders of publicly-held corporations.25 Veil-piercing has only occurred against shareholders of closely-held corporations because the required separation of ownership and control is most likely not given in this kind of corporation.26
Today, the rulings of lifting the veil are discretionary. It is determined on a case-by-case basis as a result of a missing bright-line rule. “If there is one overriding principle in all piercing cases, it is that each one must be decided upon its own facts.”27 Thus, the application is highly fact specific and courts enjoy great latitude of judgment. Since the application of the doctrine differs depending on jurisdiction and of court, the whole area of law is unclear and confusing. Cardozo once said: “The whole problem . . . is still evolved in mist and metaphors”28. And this is still true today. That’s why scholars and courts are continuously trying to formulate new frameworks and guidelines for a perspicuous application of the doctrine. The criticisms are not directed towards the achieved result but rather towards the emergence of endless labels and metaphors used to describe the decisions.29
This approach consists of the following two prongs:
(1) “[T]here be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist and . . .
(2) if the acts are treated as those of the corporation alone, an inequitable result will fol-low.”30
Phrased differently, the alter ego doctrine requires a unity of interest and ownership and a morally culpable conduct. Additionally, a proximate cause is assumed. Albeit this causation requirement is not explicitly mentioned, the alter ego doctrine is in essence a three prong test.31 The fo- cus of attention in this analysis is on the evaluation of the independent existence of a corporation. More precisely, the test assesses whether the corporation forms a distinctive entity from its shareholders. If the separateness of the corporation has ceased, the test concludes that the corporation is an alter ego of the shareholders. The rationale behind this doctrine is of a punitive kind. If the shareholders themselves ignore the corporate fiction, the court will do so as well in order to protect creditors and society.32 This approach is, among others, applied in Delaware, California and New Jersey.33 Factors which support piercing pursuant to the alter ego doctrine are undercapitali-zation, failure to observe corporate records and formalities, non-payment or overpayment of dividends or large withdrawals of corporate assets (siphoning).34
Based on Powell’s elaboration in 1931, this doctrine comprehends the following three factors:
(1) “[T]he corporation is a mere instrumentality of the shareholder; . . .
(2) the shareholder exercised control over the corporation in such a way as to defraud or harm the plaintiff; . . .
(3) a refusal to disregard the corporate entity would subject the plaintiff to unjust lost.”35
Note that a mere majority or complete stock ownership is not sufficient for the first prong. Rather complete domination has to be observed.36 Powell named this prong “instrumentality rule” as the corporation has to be a mere dummy of the shareholder.37 Furthermore, the dominant shareholder has to misuse the corporation for his own purposes, for instance to commit fraud or violate a statute. If all three requirements of the doctrine are met, the debts of the submissive corporation are in fact liabilities of the shareholder.38 In essence, this test focuses on the degree of control and influence of shareholders. Gross undercapitalization or limited decision-making ability of the corporation are indicators of domination. In the parent/subsidiary context, which is the primary application area of this doctrine, decisive factors are common directors and officers of parent and subsidiary corporations, lack of business of the subsidiary with parties other than the parent cor- poration or complete financing of the subsidiary through the parental enterprise.39 Among others, courts in New York and Florida have applied this doctrine.40
With the elaboration on the alter ego and the instrumentality doctrines, the question arises whether both approaches are virtually interchangeable. Basically, both doctrines require three major factors. First, the corporation has no independent existence and rather is a mere alter ego or instrumentality of the shareholder. Second, the corporation has to be misused for a wrongful, fraudulent or inequitable purpose by the shareholder. Third, a causal link between the share-holder’s misconduct and the plaintiff’s loss has to exist. As a result, all three prongs apparently match. Thus, even if the doctrines are distinctively labeled and defined, they are in fact interchangeable and are often used by courts as substitutes.41 In William Passalacua Builders, Inc. 42, the plaintiff made two counts – one for applying the alter ego and the other for the instrumentality doctrine. Subsequently, the court apparently required the plaintiff to amend the counts to one single count as both doctrines are “virtually identical”43. Both approaches, as they are in essence the same, form the theoretical framework for classic piercing which requires the satisfaction of the three discussed prongs. However, not all courts and scholars agree on the substitution of these doctrines. For instance, Kohn persists on a distinction and refers to the difference “between saying that a corporation is the mere department or instrument of its shareholder and saying that a shareholder and his corporation are one”44. Other difficulties and critics arise because “alter ego” and “instrumentality” are loose buzzwords and labels. The metaphors are mostly used to describe the piercing decision. They do not state real factors that courts can look at in determining whether to pierce.45 In particular, the term “alter ego” has developed to a universal expression over time. Hence, courts refer to this term but it is often unclear whether they in fact apply the underlying doctrine. This is one reason why the piercing jurisprudence is irreproducible and often criti-cized.46
Opponents of the alter ego and the instrumentality doctrines have developed the “totality of circumstances” doctrine.47 In essence, it states that courts should analyze all relevant facts of the case and then balance them against the presumption of limited liability. Constantly, so-called laundry lists, which cover potential facts, are compiled in order to provide a guideline for piercing decisions. For instance, commingling of assets, lack of meetings and elections, undercapitali-zation and excessive withdrawals of funds on the part of the shareholders are frequently contemplated on such lists. In contrast to the classic piercing approach, this approach is broad and not clouded in any labels or metaphors. Indeed, it is too broad. Since every case depends eventually upon its own facts, no universally applicable rule can be derived. Therefore, it seems disproportionate to speak from the “totality of the circumstances” as a doctrine. It is a mere restatement of what courts usually do, namely subsuming the facts.
When the corporation is used to perpetuate a fraud, the veil will most likely be pierced. Some courts regard this circumstance as describing a separate form, the “sham to perpetuate a fraud” doctrine.48 The plaintiff is in fact not required to show actual fraud; a demonstration of constructive fraud is deemed to be sufficient. In Archer v. Griffith, the court distinguished both kinds of fraud: “Actual fraud usually involves dishonesty of purpose or intent to deceive, whereas constructive fraud is breach of some legal or equitable duty which, irrespective of moral guilt, law declares fraudulent because of its tendency to deceive others, to violate confidence, or to injure public interest.”49 This approach is the underlying justification for the emergence of so-called single factor piercing tests in the context of fraud.50 Single factor piercing will be discussed later in this paper. First the three essential prongs of classic piercing will be scrutinized.
1 See MODEL BUS. CORP. ACT § 6.22 (2002).
2 See Robert C. Downs, Piercing the Corporate Veil – Do Corporations Provide Limited Personal Liability?, 53 UMKC L. REV. 174, 174 (1985).
3 See David H. Barber, Piercing the Corporate Veil, 17 WILLAMETTE L. REV. 371, 371 (1981).
4 1 JAMES D. COX ET AL., CORPORATIONS § 7.7, at 7.11 (2002).
5 See Robert B. Thompson, Piercing the Corporate Veil: An Empirical Study, 76 CORNELL L. REV. 1036, 1036 (1991); A more recent empirical study is missing to support this fact.
6 See Frank H. Easterbrook & Daniel R. Fischel, Limited Liability and the Corporation, 52 U. CHI. L. REV. 89, 89 (1985).
7 See id.
8 See 45 AM. JUR. 3D Proof of Facts § 6 (2005).
9 Cf. Rebecca J. Huss, Revamping Veil Piercing for all Limited Liability Entities: Forcing the Common Law Doctrine into the Statutory Age, 70 U. CIN. L. REV. 95, 103 (2001).
10 See Barber, supra note 3, at 376.
11 See Franklin A. Gevurtz, Piercing Piercing: An Attempt to Lift the Veil of Confusion Surrounding the Doctrine of Piercing the Corporate Veil, 76 OR. L. REV. 853, 855 (1997).
12 See WILLIAM T. ALLEN & REINIER KRAAKMAN, COMMENTARIES AND CASES ON THE LAW OF BUSINESS ORGANIZATION 147 (2003).
13 See Maurice Wormser, Piercing the Veil of the Corporate Entity, 12 COLUM. L. REV. 496 (1912).
14 Id. at 517.
15 See MAURICE WORMSER, THE DISREGARD OF THE CORPORATE FICTION AND ALLIED CORPORATE PROBLEMS, 40 (1927).
16 E.g., Booth v. Bunce, 33 N.Y. 139 (1865).
17 Simmons Creek Coal Co. v. Doran, 142 U.S. 417 (1892).
18 J.J. McCaskill Co. v. U.S., 216 U.S. 504 (1910).
19 U.S. v. Milwaukee Refrigerator Transit Co., 142 F. 247, 255 (1905).
20 Berkey v. Third Ave. Ry. Co., 244 N.Y. 84 (1926).
21 See id. at 95.
22 For a more detailed elaboration see FREDERICK J. POWELL, PARENT AND SUBSIDIARY CORPORATIONS: LIABILITY OF A PARENT CORPORATION FOR THE OBLIGATIONS OF ITS SUBSIDIARY (1931).
23 See 45 AM. JUR. 3D Proof of Facts B (2005).
24 See Barber, supra note 3, at 372.
25 See id.
26 See Easterbrook & Fischel, supra note 6, at 110.
27 Mark A. Olthoff, Beyond the Form – Should the Corporate Veil be Pierced?, 64 UMKC L. REV. 311, 312 (1995).
28 Berkey v. Third Ave. Ry. Co., 244 N.Y. 84, 94 (1926).
29 See Robert B. Thompson, Piercing the Corporate Veil: An Empirical Study, 76 CORNELL L. REV. 1036, 1037 (1991).
30 Automotriz Del Golfo De Cal. S. A. De C. V. v. Resnick, 47 Cal. 2d 792, 796 (1957).
31 See 1 PHILLIP I. BLUMBERG ET AL., BLUMBERG ON CORPORATE GROUPS § 11.01[A], at 11-8 to -9 (2006).
32 See HENRY W. BALLANTINE, BALLANTINE ON CORPORATIONS 294 (rev. ed.1946).
33 See BLUMBERG, supra note 31, § 11.01[A], at 11-5.
34 See 45 AM. JUR. 3D Proof of Facts § 7 (2005).
35 White v. Winchester Land Dev. Corp., 584 S.W.2d 56, 61 (1979); s ee POWELL, supra note 22, at 4-6.
36 See Gevurtz, supra note 11, at 864.
37 POWELL, supra note 22, at 4.
38 Krivo Indus. Supply Co. v. National Distillers & Chem. Corp., 483 F.2d 1098, 1102-3 (1973).
39 See POWELL, supra note 22, at 4-6.
40 See BLUMBERG, supra note 31, § 11.01[A], at 11-4.
41 See Lori J. Lechner, The Fate of Shareholders of Closely Held Corporations in the Wake of Bily v. Arthur Young, 34 CAL. W. L. REV. 245, 261 (1997); BLUMBERG, supra note 31, § 11.01[E], at 11-23.
42 William Passalacqua Builders, Inc. v. Resnick Devs. S., Inc., 993 F.2d. 131 (1991).
43 Id. at 138.
44 Richard S. Kohn, Comment, Alternate Methods of Piercing the Corporate Veil in Contract and Tort Cases, 48 B.U.L. REV. 123, 137 (1968).
45 See MELVIN ARON EISENBERG, CORPORATIONS AND OTHER BUSINESS ORGANIZATIONS – CASES AND MATERIALS, 254 (8th unabr. 2000).
46 See BLUMBERG, supra note 31, § 11.01[A], at 11-7 to -8.
47 See 45 AM. JUR. 3D Proof of Facts § 9 (2005).
48 See Pace Corp. v. Jackson, 284 S.W.2d 340, 351 (1955); Castleberry v. Branscum, 721 S.W.2d 270, 272 (1986).
49 Archer v. Griffith, 390 S.W.2d 735, 740 (1965).
50 Cf. 45 AM. JUR. 3D Proof of Facts § 10 (2005).
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