Starting a limited liability company is always advantageous since directors are not directly liable for any debts that may be incurred by the business. When the corporate veil is pierced, this protection seizes and the business directors and, or shareholders are legally responsible for company liabilities.
‘Piercing the Corporate Veil’ is, therefore, the legal removal of what separates the shareholders from the corporation itself. The Corporate Veil can also be referred to as a legal standing through which corporate owners are protected from the debts and liabilities of a company.
Why pierce the corporate veil?
Goods and services may have been supplied to a particular company without payment. When the seller sues for payment, it is realized that the company is ‘defunct’ or was closed down. All may not be lost because the company owners may have assets. The court will, therefore, ignore the Limited Liability Status of the said company and hold the shareholders and directors personally liable for the accrued debts. Closely held companies (those with one director or a few shareholders) are the most susceptible to corporate veil piercing. This is because;
1) Most of them don’t adhere to corporate formalities
To avoid legal complications, small LLCs should comply with the formation and operational rules including;
- Holding annual general meetings of members, shareholders, and directors
- Coming up with bylaws that govern them
- Keeping minutes from all the company meetings and other relevant records
- Ensuring all the bylaws are adhered to the later by both the agents
- Adequately capitalizing the LLC. Sufficient capital is an indication that the company can operate independently.
- Equality in raising issues and making important decisions.
2) Most of them mix assets
Compared to large companies, small corporations are more likely to combine individual assets with those of the company. A good example is when small company owners use company assets e.g. cars for personal errands or depositing a corporation’s check into an individual bank account. It is always advisable for the company to maintain its own bank account.
More reasons why the corporate veil may be pierced include:
3) No legal separation between company and owners
Company owners may fail to formalize their legal separation with the company in terms of assets and finances. The owners may also operate the business as if the company does not exist. A good example is when personal bills are paid from company accounts or when important decisions are made in a meeting without any recorded minutes. In such cases, the court may rule that the owners are not entitled to the ‘limited liability ‘clause
4) Costs to creditors
If the above-explained factors do exist and the company has not paid its creditors, the court may correct the unfairness by ruling that the corporate veil is pierced.
5) Fraudulent actions by the company
Fraudulent actions may be as a result of recklessness or dishonesty from directors. This can be through extravagant borrowing or make deals with knowledge that the business may not be able to settle the invoices. With such actions, the Limited liability protection to owners and shareholders will seize to exist.
To avoid liability being passed to the owners or shareholders, therefore, the following steps should be taken
- The Limited Liability Company should maintain a separate bank account
- The company name must never be used in any reckless or fraudulent acts
- Creditors must never be told that someone from the company will guarantee payment of the accrued debts
- No commingling of individual assets to those of the company
- When starting a company, initial investment capital should be sufficient
- Company assets should never be diverted for personal benefit
- The company status must always be identified as ‘LLC’ or ‘Inc’.
- When signing all business documents i.e. statements, letters, quotes et cetera, your title or representative capacity must be stated. e.g. ‘Eric Daniels, President, Erin LLC’
- Updating company bylaws and holding annual general meeting with minutes taken
- Documenting all business actions including the business stock ledger
- Maintaining personal financials separate from those of the business
Fraudulent activities may range from asset transfer to another company that the company officials own or financial misrepresentation to lenders for funding. As company directors, therefore, it is of utmost importance to ensure that all local requirements and laws pertaining the modus operandi of the LLC adhere to the latter.
If in any case one of the company shareholders or any other official issued, the lawsuit names him and the company as defendants. To argue the case out, the services of an experienced litigation attorney should be sought.
What would happen if the court pierces the corporate veil?
Most courts are very cautious when it comes to holding shareholders liable for the liabilities of the company. As such, beyond-doubt proof must be provided to indicate that the company’s corporate veil has been pierced. With proof, there will be a loss of protection and liable parties will be responsible for any company debts.
Parties not part of fraudulent activities are not punished, only the ones responsible for the undertakings that led to piercing the corporate veil will lose legal separation of their assets to those of the company. The assets will then be taken from them to reimburse creditors.
Why the corporate veil should not be pierced
It may not be a good reason to pierce the corporate veil. Courts do not prefer it either as it portrays the company as a sham. A bad public image of the company may hurt consumer trust and the economy as a whole. Several other alternatives must be sought first and piercing the corporate veil taken as a last resort measure.
Corporations should follow the set legal regulations to provide no reason for piercing the corporate veil. Adopting such practices will not only strengthen the company but the economy as a whole.