Piercing the corporate veil refers to the scenario in which courts don’t hold up the liability shield and find a corporation or LLC’s shareholders/directors personally liable for the corporation’s actions or debts.
One of the most important aspects of any business is protecting it from legal liabilities. This can be done in several ways, but one of the most common is to ensure that your company is structured in a way that protects it from ‘piercing the corporate veil’.
Companies often enter new or related industries by creating corporate structures whereby a parent company forms and often largely owns the other entities. While this corporate structure is beneficial to limit cross liability between companies, there are instances where a court may “pierce the veil” of the subsidiary company and expose the parent company, or even other subsidiaries, to liability. Piercing the corporate veil happens most often to privately held companies.
In this blog post, we will discuss how you can protect your parent company from being held liable for the actions of its subsidiaries, and some of the most effective ways to protect your business from piercing the corporate veil.
When do Courts Pierce the Corporate Veil?
Courts can pierce the corporate veil when the parent company dominates the subsidiary. A plaintiff bringing an action against a parent company hoping to hold the parent company liable for its subsidiaries must prove that some injustice or wrong will be done by not piercing the veil.
Arm’s Length Relationships Between Subsidiary Companies
It’s essential to maintain an “arms-length” business relationship between the parent company and its subsidiaries. Implementing this relationship can be tricky depending on the complexity of the corporate structure and how the companies interact with each other on a daily basis. For example, many brands tend to share resources between companies which could lead to issues with the separation of assets under the liability shield.
If there is overlap between the businesses, it could provide grounds for a court to pierce the veil. Here are some guidelines to protect your holding company from having its corporate veil pierced.
10 Ways to Prevent Courts from Piercing the Corporate Veil
1. Keep accounting books and bank accounts separate.
Have separate payroll, balance sheets, and profit and loss statements to show that the companies are separate working entities. If the subsidiary borrows money from the parent company, make sure to properly document the loan to avoid the appearance of impropriety.
2. Have separate employees and payroll.
Each entity should have its own employees that are paid from the appropriate bank accounts. Also, make sure that the parent company does not hire or fire employees for its subsidiaries.
3. Maintain separate insurance policies for each company.
Having separate insurance policies can invalidate a claim that piercing the corporate veil is necessary to ensure just damages.
4. Ensure No Fraud or Misrepresentation.
Courts look at whether some injustice or wrong was committed when determining whether to pierce the corporate veil. This behavior takes the form of fraudulent or misleading actions, including a company merely used by the parent company to limit its own liabilities.
5. Properly capitalize each subsidiary.
The subsidiary should have enough capital to stand on its own. If a company is not properly funded, it could be seen as merely siphoning money to the parent company. It is important to have separate bank accounts to cover operations and expenses and maintain funds in case a subsidiary is exposed to liability.
6. Use a Management Services Agreement and other contracts to maintain separation.
Your attorney can prepare a management service agreement and, in the case of using some similar talent/resources, subcontractor agreements, between the companies to properly document any crossover of services.
7. Keep the board of directors and advisors separate for each entity.
This will be helpful in showing a court that company decisions are not governed by the exact same people for all the companies.
8. Maintain proper debt/equity balance.
Courts could become skeptical of a parent/subsidiary relationship if the subsidiary’s debt/equity ratio seems disproportionate and not standard for its industry. Also important is that payments cannot flow from one company to another with no apparent legitimate business purpose.
9. Market each company individually.
Make sure each company has its own brand identity including separate websites, social media accounts, email addresses, corporate stationery, logos, and signature blocks.
10. Keep detailed corporate records and follow contracts rules in Bylaws and Operating Agreement.
Stay up to date on corporate responsibilities by following the perimeters in each operating agreement or bylaws. For example, a corporation should hold annual shareholding meetings, keep accurate and timely minutes signed by the directors and officers, and issue ownership with stock purchase agreements.
What Happens When the Corporate Veil is Pierced
If the corporate veil is pierced by a court, the owners, shareholders, or members will likely be held personally responsible for the company’s debts and for damages and found guilty in litigation. Creditors and plaintiffs may go after the shareholder’s real estate, bank accounts, investments, and other assets to pay off the corporate debt or lawsuit damages.
Eliminating the potential of having the corporate veil pierced varies from case to case, and state to state. This risk can be greatly reduced by properly setting up your companies and having solid legal foundations. Make sure to follow corporate formalities and have all the right corporate documents and contracts in place. Your lawyer will help you apply the “arm’s-length” test as a guide.
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Disclaimer: The information in this article is for general information purposes only. Nothing in this article should be taken as legal advice for any individual case or situation. This information is not intended to create and viewing it does not constitute an attorney-client relationship.