A publication for Credit and Finance Professionals
Introduction to Piercing the Corporate Veil.
When a debtor corporation or other limited liability company stops paying its bills, it is common for the creditor to ask, “Can I collect from the owners of the company?” If the debt was incurred by a bona fide corporation acting in the ordinary course of business, the answer is usually “no.” But if there is abuse of the corporate privilege or evidence of fraudulent conduct, individuals may be personally liable for corporate debts.
Limited Liability is the reason why corporations exist in the first place. In order to enable business people to engage in commerce with an acceptable degree of financial risk, corporations and LLCs with “limited liability” were conceived. A creditor dealing with a corporation is on notice that the corporation is worth nothing except the extent of its assets.
Corporations are made of shareholders/investors, directors, and officers. The shareholders invest money in the company and elected directors who oversee company operations. Directors elect officers who operate the corporation on a day to day basis.
Corporations must conduct their business affairs in a lawful manner in order to enjoy the protection of limited liability. Many of the laws governing corporate affairs are found in a state’s corporations code, such as RCW 23B in Washington State. As long as the company follows these laws, neither shareholders, directors, or officers are personally liable for corporate debts. In other words, if the company runs out of money, debts remain unpaid. (When there is a risk that the company may not pay its bills, the prudent creditor obtains personal guarantees from interested parties.)
Personal liability can be imposed if company agents do not follow the rules. When a company does not follow corporate laws and procedures, creditors of the company might be able to impose liability for corporate debts on shareholders, directors, or officers. For example, if the company does not maintain any records, or if company employees use company money for personal debts, or if company officers freely mix their personal and company accounts, the law may “disregard” the corporate form and impose personal liability. Doing so is generally known as “piercing the corporate veil.”
If the company does not formally exist, company agents can be personally liable. If a company is not properly registered, either because registration has lapsed or if the company has never been registered in the first place, company agents or “promoters” can be personally liable for company debts. If a company officer enters into a contract, knowing that the company he owns or works for is not properly licensed or registered, he can be personally liable for any debts he incurs in the name of the corporation. Likewise, if a person enters into contracts in the name of a corporation which has not yet been created, he can also be personally responsible for debts incurred in the company name.
If company agents disregard the corporate entity, they can be personally liable. Sometimes, creditors will deal with “closely held” corporations, where a family or a single individual acts as shareholder, director, and officer combined. Under the “alter ego” theory, personal liability can be imposed when the corporate entity has been disregarded by the principals themselves to such an extent that the corporation has ceased to exist. If corporate records or formalities were not kept, or if the facts show an overt intention by the principal to disregard the corporate entity, personal liability can be imposed.
So long as shareholders of a corporation, who are also the corporation's officers and directors, conscientiously keep the affairs of the corporation separate from their personal affairs, and no fraud or injustice is perpetrated upon third persons who deal with the corporation, the corporation's separate entity should be respected.
Personal liability can be imposed for fraud. If a corporate agent participates in wrongful conduct or with knowledge approves of the conduct, then the agent can be liable for the penalties. If a company sends out false financial statements or brochures making false promises or if a company employee signs a check which the employee knows cannot be honored, company officers and other agents can be personally liable.
To the extent that there is proof that a corporate agent has committed fraud or misrepresented facts or otherwise manipulated the corporate form for the benefit of the stockholders and to the detriment of creditors, personal liability can be imposed on those responsible for the wrongful conduct.
Conclusion. When legitimate companies go out of business, creditors can be left holding the bag without any recourse against any individuals. But if company agents wrongfully abuse the corporate form, personal liability can often be imposed. In order to better protect themselves against the limited liability of corporate debtors, creditors should obtain personal guarantees from shareholders or other interested parties.
