In one of the previous posts, we discussed how a shareholder or officer of a corporation can be personally liable for unpaid wages under the Federal Labor Standards Act (FLSA). Alleging FSLA claims is not the only way for plaintiffs to impose personal liability on key corporate figures. In the context of employment litigation, California courts have long recognized an alter ego doctrine which allows a successful plaintiff to pierce the corporate veil (or disregard the corporate identity) and subject shareholders, parent or sister corporation to liability for wages owed. The issue of shareholder’s liability often emerges in cases where a corporate defendant is either insolvent or on the verge of dissolution. This article discusses how a failure to follow corporate formalities and other factors can lead to alter ego liability and the piercing of the corporate veil.
Under California law, a corporation and its shareholders are distinct and separate entities. Therefore, a shareholder is not personally liable for the contractual obligations and injuries caused by the corporation beyond the extent of the shareholder’s investment in the corporation. Wyatt v Union Mortgage Co. (1979) 24 C3d 773. Limited liability is recognized by the courts to serve the important public policy of encouraging investment by limiting risk. Specifically, limited liability allows investors to invest and expand their businesses without fear that they will lose more than their original investments.
However, limited liability is not absolute or automatic and can be taken away by the courts in instances when the corporation is deemed to be a mere alter ego of the shareholders. This equitable remedy is often referred to as piercing the corporate veil. The idea behind the doctrine is that where a corporation is used by an individual or individuals, or by another corporation, to perpetrate fraud, circumvent a statute, or accomplish some other wrongful or inequitable purpose, a court may disregard the corporate entity and treat the corporation’s acts as if they were done by the persons actually controlling the corporation. Pacific Western Bank v. Stull (Ca. App. 2011).
In general, the two requirements for applying the alter ego doctrine are that
(1) there is such a unity of interest and ownership between the corporation and the individual or organization controlling it that their separate personalities no longer exist, and
(2) failure to disregard the corporate entity would sanction a fraud or promote injustice. Automotriz del Golfo de Cal. S.A. de C.V. v Resnick (1957).
Alter Ego Defendant Must Participate to be Liable
In essence, the alter ego doctrine arises when a plaintiff comes into court claiming that an opposing party is using the corporate form unjustly and in derogation of the plaintiff’s interest. Mesler v. Bragg Management Co., 39 Cal. 3d 290 (Cal. 1985). Therefore, an alter ego doctrine applies only when the shareholder participates in the conduct constituting the abuse of the corporate privilege. For example, in Pearl v Shore (1971), the court held that a defendant, who was a 25-percent shareholder, was not liable as corporation’s alter ego because he had nothing to do with day-to-day operation of the corporation and was a legal stranger to the plaintiff.
Key Factors Indicating Existence of Alter Ego Relationship
In Associated Vendors, Inc. v Oakland Meat Co. (1962) 210 CA2d 825, the California Court of Appeals listed a number of factors that courts take into consideration in deciding whether it is justified to pierce the corporate veil. They include, but are not limited to:
- Commingling of funds and other assets, failure to segregate funds of the separate entities, and the unauthorized diversion of corporate funds or assets to other than corporate uses (Asamen v. Thompson, 55 Cal.App.2d 661);
- the treatment by an individual of the assets of the corporation as his own ( Minton v. Cavaney, 56 Cal.2d 576);
- the failure to obtain authority to issue stock or to subscribe to or issue the same (Automotriz etc. De California v. Resnick, supra, 47 Cal.2d 792)
- the holding out by an individual that he is personally liable for the debts of the corporation ( Stark v.Coker, supra, 20 Cal.2d 839);
- Undocumented diversions of corporate funds or assets which confer no benefit on the entity (e.g., payment of an individual’s mortgage or credit card bills);
- the failure to maintain minutes or adequate corporate records, and the confusion of the records of the separate entities( Riddle v. Leuschner, supra, 51 Cal.2d 574);
- the identical equitable ownership in the two entities;
- the identification of the equitable owners thereof with the domination and control of the two entities;
- identification of the directors and officers of the two entities in the responsible supervision and management;
- sole ownership of all of the stock in a corporation by one individual or the members of a family ( Riddle v. Leuschner)
- Inadequate or nonexistent capitalization (Minton v. Cavaney, 56 Cal.2d 576);
- the disregard of legal formalities and the failure to maintain arm’s length relationships among related entities ( Riddle v. Leuschner, 51 Cal.2d 574; but see Cal. Corp. Code Section 300(e));
- Misrepresentation or concealment of corporate ownership or control, or of personal business activities benefiting the controlling person; ( Riddle v. Leuschner, 51 Cal.2d 574);
- Sharing of offices and locations, or running the entity’s business out of the individual’s home;
- Sharing of employees, attorneys, or other professionals (McCombs v. Rudman);
- Entering into contracts with no intention to perform, intending to use the entity as a subterfuge;
- the diversion of assets from a corporation by or to a stockholder or other person or entity, to the detriment of creditors, or the manipulation of assets and liabilities between entities so as to concentrate the assets in one and the liabilities in another (Riddle v. Leuschner, 51 Cal.2d 574);
- Formation of a corporation to be recipient of another person’s existing liability;
- Failure to complete legal formalities required to properly incorporate;
- Failure to convene meetings of shareholders or directors;
- Failure to file tax returns, or pay income taxes or payroll taxes;
- Manipulation of assets and liabilities between corporations so that assets are concentrated in one person or entity and liabilities are concentrated in another;
- Failure to maintain arms’-length relationships between related entities;
- the use of the corporate entity to procure labor, services or merchandise for another person or entity ( Temple v. Bodega Bay Fisheries, Inc.,;
- Continuation in business under a new name after insolvency; and
- Occurrence of insolvency soon after incorporation.
The above-listed factors are just some of the examples that can be used as evidence in proving an alter ego. However, there is no specific formula to determine when the corporate veil should be pierced, and the result will depend on the circumstances of each particular case.
Close Corporation. Under the California Corporations Code section 300 (e), a failure of a close corporation to observe corporate formalities relating to meetings of directors or shareholders in connection with the management of its affairs, shall not be considered a factor tending to establish that the shareholders have personal liability for corporate obligations.
Effect of Finding Alter Ego Liability
Under the alter ego doctrine, courts will treat he alter ego defendant and the instrumentality or principal as synonymous and not as separate entities. People v. Clauson (1964) 231 CA2d 374. Alter ego liability is joint and several and if the corporate veil is pierced, each defendant is jointly and severally liable for the full amount of the corporation’s liability. Minnesota Mining & Manufacturing Co. v Superior Court (1988) 206 CA3d 1025. If a judgment is obtained, the court’s judgment will not be apportioned among the owners in proportion to their ownership interests. Each would be jointly and severally liable for any obligation of the corporation. Minnesota Mining & Mfg. Co. v Superior Court (1988) 206 CA3d 1025.
While incorporating, conducting corporate affairs, or running business, employers must be aware of an alter ego liability and the harsh consequences of piercing the corporate veil. For aggrieved employees, imposition of alter ego liability can be a powerful tool in recovering unpaid wages and other statutory remedies from entities or individuals (e.g. shareholders, officers, parent or sister corporation) that are not in employment relationship with workers.