March 9, 2011
Content originally posted on MGLAW.net
The safeguarding of shareholders' personal assets from creditors-or, the "corporate veil"-is one of the most important features of the modern day corporation. Sometimes, though, courts "pierce" the corporate veil to hold shareholders, directors and officers personally responsible for the corporation's debts.
I. The Corporate Veil
Under Tennessee law, a corporation is presumptively treated as a distinct entity, separate from its shareholders, officers, and directors. Schlater v. Haynie, 833 S.W.2d 919, 925 (Tenn.Ct.App.1991). This separate status "protects [ ] shareholders from direct responsibility for the corporation's debts and other liabilities". Cambio Health Solutions, LLC v. Reardon , 213 S.W.3d 785, 790. However, courts may still disregard the corporate entity (or "pierce the corporate veil") in order to impose liability on a parent corporation or controlling shareholder, where the two entities are in fact identical or indistinguishable and where necessary to accomplish justice. Pamperin v. Streamline Mfg., Inc., 276 S.W.3d 428, 436 -438 (Tenn. Ct. App. 2008) (citing Manufacturers Consol. Serv., Inc. v. Rodell, 42 S.W.3d 846, 866 (Tenn. Ct. App. 2000)).
Courts unanimously agree that the corporate veil should be pierced "with great caution and not precipitately." Oceanics Schools, Inc. v. Barbour, 112 S.W.3d 135, 135 (Tenn. Ct. App. 2003) (quoting Schlater, 833 S.W.2d at 925). Courts also agree that the burden of proof is on the party wishing to pierce the veil. Id. However, there is not a consensus among Tennessee courts on the exact circumstances justifying piercing of the corporate veil.
II. The Main Factors Courts Look To in Piercing the Corporate Veil
The conditions under which the corporate veil will be pierced vary widely according to the circumstances of each case. However, courts have discussed several situations where the remedy may be appropriate. For example, the corporate veil has been held to be properly pierced "upon a showing that [the corporation] is a sham or a dummy or where necessary to accomplish justice." Schlater, 833 S.W.2d at 925. It is also sometimes equitable to pierce the corporate veil when the corporate entity is the alter ego of a shareholder or of some other entity, Oceanics Schools, Inc., 112 S.W.3d at 139; Manufacturers Consolidation Service, 42 S.W.3d at 866; Stigall v. Wickes Machinery, 801 S.W.2d 507, 510-11 (Tenn.1990), or when the corporation is liable for a debt but is without funds due to some misconduct on the part of the officers and directors, Muroll Gesellschaft M.B.H. v. Tennessee Tape, Inc., 908 S.W.2d 211, 213 (Tenn. Ct. App. 1995); Anderson v. Durbin, 740 S.W.2d 417, 418 (Tenn. Ct. App. 1987).
The most common factors used by Tennessee courts today to determine whether to pierce the corporate veil, originate from Federal Deposit Ins. Corp. v. Allen, 584 F.Supp. 386, 397 (E.D.Tenn.1984):
(1) whether the entity has been used to work a fraud or injustice in contravention of public policy, (2) whether there was a failure to collect paid in capital; (3) whether the corporation was grossly undercapitalized; (4) the nonissuance of stock certificates; (5) the sole ownership of stock by one individual; (6) the use of the same office or business location; (7) the employment of the same employees or attorneys; (8) the use of the corporation as an instrumentality or business conduit for an individual or another corporation; (9) the diversion of corporate assets by or to a stockholder or other entity to the detriment of creditors, or the manipulation of assets and liabilities in another; (10) the use of the corporation as a subterfuge in illegal transactions; (11) the formation and use of the corporation to transfer to it the existing liability of another person or entity; and (12) the failure to maintain arms length relationships among related entities.
Id. (citing cases from various jurisdictions). These are known as the Allen factors. Other factors that courts consider include:
the nonpayment of dividends; the treatment by an individual of corporate assets as his own; the failure to maintain minutes or adequate corporate records and the confusion of the records of the separate entities; the identity of equitable ownership in the two entities; the absence of corporate assets; the use of a corporation as a mere shell, instrumentality or a conduit for a single venture or the business of an individual or another corporation; the concealment or misrepresentation of the identity of the responsible ownership, management and financial interest or concealment of personal business activities; and the use of the corporate entity to procure labor, services, or merchandise for another person or entity.
In re B & L Laboratories, Inc., 62 B.R. 494, 504 (Bkrtcy.M.D.Tenn.1986) (citations omitted). No one factor is conclusive; rather, courts will rely upon a combination of factors in deciding the issue. Oceanics Schools, 112 S.W.3d at 140; see also, e.g., VP Buildings, Inc. v. Polygon Group, 2002 WL 15634, 3 -6 (Tenn. Ct. App. Jan. 8, 2002).
In VP Buildings, Inc., the sole shareholder of a defunct corporation was held liable for the corporation's debt because she had abused the corporate form. The shareholder appealed and the appellate court affirmed. In affirming the decision, the appellate court recounted the history of the corporation and the shareholder's disregard for the corporate form. The corporation was initially capitalized with only $500, a gross undercapitalization under the circumstances. The sole shareholder was the sole director and president of the corporation. All of the corporation's minutes for the seven years preceding the year in which the dispute arose were documented by a computer-generated repetition of the minutes of the year before. In addition, the corporation was not licensed to do business in Tennessee. Eventually, the company was administratively dissolved in Kentucky for failure to file annual reports for several years. Finally, even though the corporation was losing money year after year, the sole shareholder continued to pay herself large salaries.
Considering all of these facts together, the court of appeals found that there was sufficient evidence that the corporate entity was a mere instrumentality for the shareholder, that the shareholder had abused the corporate form to the extent that the corporation was a sham, and that disregarding the corporate entity was necessary to accomplish justice. Thus, the trial court had correctly disregarded the corporate entity and imposed liability on the shareholder.
In addition to the foregoing factors, courts also sometimes require the plaintiff in a veil piercing case to satisfy certain additional elements. This occurs primarily where the plaintiff is seeking reach the assets of a parent company for liabilities of its subsidiary.
III. Additional Elements in the Parent/Subsidiary Context
In order to pierce the corporate veil of a subsidiary company and reach its parent's assets, the Tennessee Supreme Court has held that three elements must be present:
(1) The parent corporation, at the time of the transaction complained of, must exercise complete dominion over its subsidiary, not only of finances, but of policy and business practice in respect to the transaction under attack, so that the corporate entity, as to that transaction, had no separate mind, will or existence of its own.
(2) Such control must have been used to commit fraud or wrong, to perpetuate the violation of a statutory or other positive legal duty, or a dishonest and unjust act in contravention of third parties' rights.
(3) The aforesaid control and breach of duty must proximately cause the injury or unjust loss complained of.
Continental Bankers Life Ins. Co.of the South v. Bank of Alamo, 578 S.W.2d 625, 632 (Tenn.1979). The absence of any one of these elements prevents piercing the corporate veil. Loew v. Gulf Coast Development, Inc., 1991 WL 220576, 4 (Tenn. Ct. App. Nov. 1, 1991) (citations omitted); see also, e.g., Alcoa Inc., v. Tennessee State Bd. Of Equalization, 2011 WL 598435, 10 (Tenn. Ct. App. Feb. 18, 2011).
In Loew v. Gulf Coast Development, Inc., the appeals court reversed the trial court's decision to disregard the separate identities of three corporate defendants, because the decision was based only on the first element-control. The trial court made no findings with regard to the second and third elements. In reversing the ruling, the court of appeals held that "corporate separateness will not be disregarded unless the corporate structure is an artifice created for the purpose of committing fraud or injury upon the complaining victim. Since the plaintiff had not put forth proof of any such purpose, the trial court had erred in disregarding the separateness of the corporate defendants. When the plaintiff does present evidence of fraudulent purpose, the outcome is usually much different.
Remember, though, that piercing the corporate veil is not just a way to reach the assets of parent company-it can also be a way to reach the assets of a company's individual shareholders. In that situation, courts disagree on whether the three Continental Bankers elements apply.
IV. Additional Elements Outside the Parent/Subsidiary Context
When it comes to reaching individual shareholders' assets, some courts have required the three Continental Bankers elements to be met. See, e.g., Island Brook Homeowners Ass'n, Inc. v. Aughenbaugh, 2007 WL 2917781, 6 (Tenn. Ct. App. Oct. 5, 2007); Tennessee Racquetball Investors, Ltd. v. Bell, 709 S.W.2d 617, 622 (Tenn. Ct. App. 1986). In Island Brook Homeowners Ass'n, Inc., a homeowner sued a development company after having a gym constructed in her home which she was unable to use for her personal fitness business due to restrictive covenants. The homeowner attempted to pierce the corporate veil of the company to reach the assets of its individual owners. The court acknowledged that the Continental Bankers decision dealt with the parent/subsidiary context, but explained that the elements have also been required in actions to hold individual owners of a corporation liable under the alter ego theory. Id. at *6 (citing Tennessee Racquetball Investors, Ltd., 709 S.W.2d at 622).
Other courts, however, have expressly held that the Continental Bankers elements are not required in the individual shareholder context. For example, in Schlater v. Haynie, 833 S.W.2d 919, 925 (Tenn.Ct.App.1991) (appl. perm. appeal denied May 11, 1992), the Tennessee Court of Appeals stated that Continental Bankers was inapplicable to the case before it involving a corporation/stockholder relationship, because Continental Bankers addressed only parent/subsidiary relationships. Several recent cases analyzing the corporate veil question in the individual shareholder context have failed to mention the Continental Bankers elements at all. See, e.g., Genuine Auto Parts Co. v. Convenient Car Care, Inc., 2005 WL 1522021 (Tenn. Ct. App. Jun. 28, 2005; Spivey v. Page, 2004 WL 350651 (Tenn. Ct. App. Feb. 24, 2004); Oceanics Schools, Inc., 112 S.W.3d 135, supra. Most of these cases rely exclusively on the Allen factors and the factors described in In re B & L Laboratories, Inc., 62 B.R. 494, supra. A few, however, do not engage either of the Continental Bankers elements or the Allen factors, instead applying a "skullduggery" test. See, e.g., Durham v. Dormer Enterprises, Inc., 1992 WL 97075, *7 (Tenn. Ct. App. May 12, 1992) (holding that sole shareholder's disposing of corporation's assets in anticipation of litigation was precisely the kind of skullduggery or downright fraud which permits piercing the corporate veil).
Even without the Continental Bankers elements, control and fraudulent intent still play an important role in the analysis in individual shareholder cases. The first Allen factor considers whether the entity has been used to work a fraud or injustice in contravention of public policy. Many of the remaining factors gauge the amount of control the shareholder exercised over the company (by considering, for example, whether one individual had sole ownership of stock and whether the individual and the entity shared the same office or business location). Thus, the Allen factors may subsume the Continental Bankers elements. The only difference is that the Allen factors are meant to be considered as a whole, without any one factor controlling, whereas courts using all three Continental Bankers elements seem to treat these three elements as controlling. The difference in the court's treatment, for example, could be that the existence of a fraud or injustice would be a consideration under Allen, but a requirement under Continental Bankers.
Whether in the parent/subsidiary context or the individual shareholder context, the determining factors in corporate veil piercing cases continue to be the factors articulated in Allen. In some cases, the three elements set forth in Continental Bankers will also be required. Regardless, fraudulent intent and control over the company remain the most determinative factors in all cases. To avoid being held liable for the debts of the company, business owners should take care to follow corporate formalities as best as possible, maintain arms length relationships with the company at all times, and refrain from using the corporation as a subterfuge for fraudulent activity.