Can a Shareholder be Liable for Corporate Debt?

Although the personal liability of shareholders is generally limited to their investment in a corporation, there are circumstances under which corporate protection from personal liability can be set aside by the courts. The basis for setting aside such protection is known as the alter ego doctrine.

Under the doctrine of alter ego, the courts may disregard the concept that a corporation’s separate existence is distinct from that of its shareholders, and “pierce the corporate veil” thereby exposing the shareholders to personal liability for corporate debt.

There are two requirements that must be met in order for the courts to invoke the alter ego doctrine and create shareholder liability for corporate debt.

These requirements are, in the words of the Court of Appeal in California, “(1) that there be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist and (2) that, if the acts are treated as those of the corporation alone, an inequitable result will follow.”

In an action arising out of Alameda County some years ago, the Court of Appeal enumerated a number of circumstances under which a trial court could conclude that the disregard of a corporate entity would be appropriate. These factors were listed as follows:

1. Commingling of funds and other assets in the unauthorized diversion of corporate funds or assets to other than corporate uses.
   Translation: You pay your home mortgage, utility bills and gardener out of corporate funds.
2. The failure to obtain authority to issue stock or actually issue stock.
   Translation: You fail to file the appropriate notice with the Department of Corporations and also fail to prepare and sign the stock certificates.
3. The failure to maintain minutes or adequate corporate records.
   Translation: You haven’t held or prepared minutes for an annual meetings of shareholders and directors in a decade and haven’t documented any dealings which have occurred between shareholders and the corporation.
4. The failure to adequately capitalize a corporation.
   Translation: You formed your corporation with an initial capitalization of $12.
5. The diversion of assets from a corporation by or to a stockholder, to the detriment of creditors.
   Translation: You owe $175,000 to creditors; however, you purchased the corporate Lear jet for what you consider to be good and adequate consideration, namely, the sum of $5.
6. The use of a corporation as a subterfuge of illegal transactions.
   Translation: You take bets for the mob.

The Court of Appeal concluded in the above matter that “the purpose of the doctrine is not to protect every unsatisfied creditor, but rather to afford him protection, where some conduct amounting to bad faith makes it inequitable… for the… owner of a corporation to hide behind its corporate veil.”

Many owners of small businesses such as coin laundries, drycleaners, restaurants and clothing stores, form corporations, execute leases and purchase equipment under the name of the corporation and assume that they are protected against any personal liability. Although many pay attention to ongoing corporate responsibilities, others do not. Those who fail to do so occasionally become subject to personal liability.

You may have incorporated by the filing of Articles of Incorporation with the Secretary of State and received a minute book and stock certificate book from the attorney or agency that provided the service, but you have not necessarily complied with all of the requirements for corporate formation so as to protect you from personal liability.

Corporate obligations frequently overlooked at the time of incorporation include the following:

1. The requirement that an appropriate notice be filed regarding the issuance of stock with the California Department of Corporations.
2. The actual preparation and execution of stock certificates.
3. The filing of any necessary Fictitious Business Name Statement.
4. The preparation of minutes of the first meeting of the Board of Directors, which customarily includes many important start-up resolutions.

There are occasions when an individual will maintain two corporations, one with substantial assets and one that operates at the poverty level. The monied corporation will sometimes be deemed to be the alter ego of the impoverished corporation under the alter ego theory. Courts look to the following factors to make such a determination:

1. Whether there is identical, equitable ownership in the two entities.
2. Whether the same directors and officers of the two entities are responsible for supervision and management.
3. Whether there is sole ownership of all of the stock in a corporation by one individual or the members of a family.
4. Whether the corporations use the same office or business location.
5. Whether the corporations employ the same employees and attorney.

The moral of the story? Just because you own a minute book, stock certificate book and a corporate seal, doesn’t mean that your corporate responsibilities are satisfied. The involvement of an attorney at the time of incorporation and an annual corporate check-up by your lawyer may prove to be invaluable in protecting your assets, whether corporate or personal.

[This column is intended to provide general information only and is not intended to provide specific legal advice; if you have a specific question regarding the law, you should contact an attorney of your choice. Suggestions for topics to be discussed in this column are welcome.]

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