The Threat of Corporate Veil Piercing

August 2006

Entrepreneurs often wrongfully believe that once they incorporate they have no risk of personal liability for corporate obligations. In fact, incorporating a business is only one step in protecting personal assets from corporate creditors.

The corporate law concept of piercing the corporate veil describes a legal doctrine under which a court may hold a shareholder of a corporation personally liable for the debts of the corporation. This doctrine is also known as "disregarding the corporate entity.”

In order for a shareholder to avoid personal liability for debts and liabilities of the corporation, the shareholder must respect the corporate entity’s individuality. The corporation must run like the distinct entity that it is.

When evaluating whether a corporate veil may be pierced, courts generally look at:

• Corporate Formalities – Is the corporation maintaining bylaws, conducting shareholder meetings and board meetings, keeping minutes, preserving corporate records, and maintaining financial books and back-up documents?

• Commingling of Funds – Is the corporation keeping corporate finances and accounts strictly separate from shareholders’ finances and accounts?

• Individual Control - What amount of financial interest, ownership and control do the principals maintain over the corporation? Are there non-functioning officers or directors?

• Personal Use of Funds – Are shareholders siphoning money from the corporation for their personal use?

• Inadequate Capitalization or No Corporate Assets – Is the corporation undercapitalized at the time of transactions with creditors? Are there real corporate assets?

• Liability Transfer – Is the corporation used as a conduit to transfer or receive liability of another (usually a shareholder)?

The closely related determination of whether a parent corporation may be held liable for the acts of its subsidiary under the “alter ego” doctrine is generally based on whether the:

1. Parent corporation owns all or a majority of the capital stock of the subsidiary;

2. Parent and subsidiary corporations have common directors or officers;

3. Parent corporation finances the subsidiary;

4. Parent subscribes to all the capital stock of the subsidiary or otherwise causes its incorporation;

5. Subsidiary has grossly inadequate capital;

6. Parent corporation pays the salaries or expenses or losses of the subsidiary;

7. Subsidiary has substantially no business except with the parent corporation or no assets except those conveyed to it by the parent corporation;

8. In the papers of the parent corporation, and in the statement of its officers, the subsidiary is referred to as such or as a department or division; and

9. Directors or executives of the subsidiary as a separate and independent corporation are not observed.

Not all of the above factors are required to find parent corporation liability under a veil- piercing theory.

Corporate veil piercing and alter-ego analyses are fact specific It is important to consult with a qualified lawyer when evaluating the risk in each case.

This legal update is for informational purposes only as a service to clients and other friends, is not a complete summary of the rules relating to the subject matter discussed above, and is neither to be construed as legal advice nor intended as basis for decisions in specific situations. For more information about this subject matter or other recent developments, please contact the attorneys in our Colorado Corporate Law practice group or any other attorney in our firm with whom you normally consult by calling (303) 825-4200.