The Three Justifications for Piercing the Corporate Veil

Posted by Jonathan R. Macey, Yale Law School, on Thursday March 27, 2014 at 9:20 am
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Editor’s Note: Jonathan R. Macey is the Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law at Yale University. The following post is based on an article co-authored by Professor Macey and Joshua Mitts of Sullivan & Cromwell LLP. The views in this post are those of Mr. Mitts and not his employer.

The doctrine of piercing the corporate veil is shrouded in misperception and confusion. On the one hand, courts understand the fact that the corporate form is supposed to be a juridical entity with the characteristic of legal “personhood.” As such courts acknowledge that their equitable authority to pierce the corporate veil is to be exercised “reluctantly” and “cautiously.” [1] Similarly, courts also recognize that it is perfectly legitimate to create a corporation or other form of limited liability company business organization such as an LLC “for the very purpose of escaping personal liability” for the debts incurred by the enterprise. [2]

Apparently inconsistent with the “limited liability” nature of the corporate enterprise, the list of justifications for piercing the corporate veil is long, imprecise to the point of vagueness and less than reassuring to investors and other participants in the corporate enterprise interested in knowing with certainty what the limitations are on the scope of shareholders’ personal liability for corporate acts. For example, veil piercing may be done where the corporation is the mere “alter-ego” of its shareholders, where the corporation is undercapitalized, where there is a failure to observe corporate formalities, where the corporate form is used to promote fraud, injustice or illegalities. [3]

In this Article we argue that there is a rational structure to the doctrine of corporate veil piercing not only in theory, but in practice as well. Our idea is that, despite the fact that courts are inarticulate to the point of incoherent in their reasoning in particular “piercing” cases; a rational taxonomy can be derived from this morass.

The entire universe of piercing cases can be explained as judicial efforts to remedy one of the following three problems. While some of these problems previously have been identified, this is the first Article is the first to identify all of the economic and policy problems that piercing attempts to ameliorate. And it is the first to present a taxonomy that can explain all of the decisions in this area, and that can be used methodologically to evaluate the quality of piercing decisions.

First, piercing the corporate veil is used as a tool of statutory interpretation in the sense that piercing the corporate veil is done in order to bring corporate actors’ behavior into conformity with a particular statutory scheme, such as social security or state unemployment compensations schemes. For example, as explained in detail in the Article, sometimes the corporate form will be ignored in order to accomplish the specific legislative goal of a government benefit program that distinguishes between owners and employees. And of course, sometimes the corporate form will be respected where doing so is necessary to reach a result that is consistent with a particular state or federal statutory scheme.

Second, piercing also is done by courts in order to remedy what appears to be fraudulent conduct that does not the strict elements of common law fraud. Specifically, it is used as a remedy for “constructive fraud” in the contractual context. Simply put, if a court becomes convinced that a shareholder or other equity investor has, by words or actions, led a counter-party to a contract to believe that an obligation is a personal liability rather than (or in addition to) a corporate debt, then courts sometimes will use a piercing theory to impose liability on the individual shareholder rather than a fraud theory.

The third ground on which courts pierce the corporate veil that we identify is the promotion of what we term accepted “bankruptcy values.” In particular, bankruptcy law strives to achieve an orderly disposition of the debtors’ assets, either through corporate reorganization or liquidation. One way that bankruptcy law achieves these goals is by preventing shareholders from transferring corporate assets to themselves or to particular favored creditors ahead of creditors in times of acute economic stress. This result is accomplished in the context of a formal bankruptcy proceeding by invoking the doctrine of equitable subordination as well as by the bankruptcy trustee’s power to avoid and set aside preferential transfers and fraudulent conveyances. Outside of bankruptcy (and sometimes in the context of bankruptcy proceedings as well), the goal of eliminating opportunism by companies in financial distress is accomplished by disregarding the corporate form.

All of the piercing cases can be explained as an effort to accomplish one of these three goals. Thus it is our view that all of the standard litany for justifications for disregarding the corporate form, which include failure to observe corporate formalities, undercapitalization, alter ego, mere instrumentality, ownership of all or most of the stock in the company, payment of dividends, failure to pay dividends, etc. are mere proxies for one of the three core reasons for piercing described above.

We demonstrate that our theory consistently explains the results in the leading cases on piercing the veil. Significantly, we find no piercing cases in which a court pierces the corporate veil solely because a corporation is undercapitalized. This finding is consistent with the fact that legislatures permit thinly capitalized firms to engage in business and generally do not require that companies be well-capitalized in order to be formed. Moreover, we find that, although courts do invoke the mantra of undercapitalization to justify a determination to pierce the corporate veil, we find that, in each case, there are other justifications for veil piercing that are consistent with our taxonomy.

We test our theory systematically by applying machine learning and automated text analysis methods to classify 9,380 federal and state cases mentioning veil-piercing or disregarding the corporate form. We show that the three goals we have identified are a superior predictor of actual veil-piercing decisions than the largely incoherent doctrines espoused by the courts. We also show that undercapitalization is actually a particularly poor predictor of veil-piercing outcomes. Most significantly in our view, we find that the application of topic modeling demonstrates that the distribution of ideas in the text of these opinions tracks our theories more or less precisely.

The full article is available for download here.

Endnotes:

[1] Dewitt Truck Brokers v. W. Ray Flemming Fruit Co., 540 F.2d 681 (4th Cir. 1976).
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[2] Bartle v. Home Owners Co-op, 127 N.E. 2d 832 (N.Y. 1995).
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[3] Baatz v. Arrow Bar, 452 N.W.2d 138 (S.D. 1990).
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  1. [...] In conducting the research for their paper, which is titled “ The Three Justifications for Piercing the Corporate Veil,” Macey and Mitts performed a sophisticated data analysis on more than 9,000 opinions in search of instances where plaintiffs succeeding in uncovering the owners behind a corporate form. Their work was highlighted in a post on the Harvard Law Forum on Corporate Governance and Financial Regulation website. [...]

    Pingback by Authors Home in On Three Reasons to Pierce Corporate Veil | Law.com — March 31, 2014 @ 5:40 am

 

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