One of the biggest advantages to incorporating a business is that the principals of the corporation enjoy broad protection from being held personally responsible for the debts and liabilities of the corporation. That is, creditors can reach the corporation’s assets, but once those assets are exhausted they cannot ordinarily also reach the personal assets of the owners or shareholders of the corporation. Under some circumstances, those to whom the corporation is liable will attempt to “pierce the corporate veil”, the legal term used to describe an action to have the corporation set aside for purposes of the litigation such that personal liability attaches, and personal assets can be reached.
An action to pierce the corporate veil normally arises in civil litigation when the corporation is believed to have inadequate assets to cover its liabilities, and the plaintiff alleges that the corporation is actually a sham – that is, the corporation is not really a distinct individual, but is merely an extension or “alter ego” of its shareholders, being used to advance their private interests or to perpetrate a fraud.
As the precise facts and circumstances which can result in a piercing of the corporate veil will vary depending upon state law, and as this is a fact-dependent inquiry, it is important to consult with a qualified lawyer when evaluating whether the corporate veil may be pierced in any specific case. A corporation offers strong protection to its shareholders, and most efforts to pierce the corporate veil are rejected by the courts.
Generally, when evaluating if a corporation is in fact legitimate, or if the corporate veil should be pierced, courts look at the following factors:
- Corporate Formalities – Did the corporation follow proper procedure, for example in its formation and appointment of directors, issuance of stock, the holding of its annual meetings, the filing of annual reports with the state, and the maintenance of its own property, and financial books and accounts? Or were the procedures not followed, was the corporation dependent on property or assets of a shareholder which it did not technically own or control, or were the corporate finances commingled with those of its shareholders?
- Individual Control – What amount of financial interest, ownership and control did the principals maintain over the corporation?
- Personal Use – Did the principals use the corporation to advance personal purposes?
If the court examines those factors and concludes that there is such unity of interest between the corporation and its shareholders that they are inseparable, and it would be unjust to permit the corporate form to stand, a court will typically pierce the corporate veil.
A court may also pierce the corporate veil to prevent a fraud, where the corporation is found to be a “sham” meant to facilitate fraud against third parties. If the corporation was set up, for example, to shield its owners from liability over a fraudulent real estate deal, and the owners siphon out the corporate assets such that the corporation is unable to compensate the victims of the fraud, a court is likely to set aside the corporation and allow the victims to recover from the personal assets of the owners.
Silent fraud occurs when a defendant fails to disclose material facts. To establish this, plaintiff has the burden of proving each of the following elements by clear and convincing evidence:
- The defendant failed to disclose one or more material facts about the subject matter of the claim;
- The defendant had actual knowledge of the fact(s);
- The defendant’s failure to disclose the fact(s) caused the plaintiff to have a false impression;
- When the defendant failed to disclose the fact(s), the defendant knew the failure would create a false impression;
- When defendant failed to disclose the fact(s), defendant intended that plaintiff rely on the resulting false impression;
- The plaintiff relied on the false impression; and
- The plaintiff was damaged as a result of the reliance upon the false impression.
For example, where a defendant sells a plaintiff a car where the defendant knows the odometer had been rolled back, but the defendant does not mention to the plaintiff that the odometer is not accurate, the defendant knows that it is highly probable that the plaintiff would rely upon the mileage figure from the odometer in making the decision to purchase the car. It is likely that the defendant’s silence under these circumstances would support a subsequent action for silent fraud.
Even an innocent misrepresentation of a material fact may support a cause of action. Typically, to sustain a claim of innocent misrepresentation, a plaintiff must establish that:
- The defendant made a representation of one or more material facts;
- The representation was made in connection with the making of a contract between the plaintiff and defendant;
- The representation was false when it was made;
- The plaintiff would not have entered into the contract had the defendant not made the representation;
- The plaintiff suffered a loss as a result of entering into the contract; and
- The plaintiff’s loss benefited the defendant.
There may be circumstances where a plaintiff is unable to prove a defendant acted with the intent to defraud, but can nonetheless establish a cause of action for innocent misrepresentation. For example, the plaintiff may be unable to establish that the defendant knew or should have known that his representation of a particular material fact was false at the time it was made.
Under standard pleading practice, a lawyerly term for drafting a complaint for a lawsuit, a plaintiff can plead more than one theory of liability against a defendant, even where there is some inconsistency between the theories of liability. As even where fraud exists it can often be difficult to prove absent a confession by the defendant, innocent misrepresentation can provide a good alternative theory of the defendant’s liability – such that the defendant’s denial of knowledge in order to defeat the fraud claim may actually support the plaintiff’s alternative claim for innocent misrepresentation.