Piercing The Corporate Veil

Piercing the Corporate Veil

Boris J. Steffen, CPA, ASA, ABV, CDBVPrincipal & Director

Overview

» Parameters of the corporate veil

» Theories used by courts to pierce the corporate veil

» Indicia of alter ego and instrumentality

» Relationship between alter ego, fraudulent and preferential transfers

» Summary

» Summary

» Expert profile

Parameters of the corporate veil

By law a corporation is a legal entity separate and distinct from its shareholders

» The legal distinction between a corporation and its shareholders acts as a “veil” to limit the liability of shareholders to the value of their investment

» Notwithstanding, however, courts will pierce the corporate veil to

› prevent fraud

› achieve equity

› or prevent the violation of a statute or public policy

» Generally, there are two conditions common to the courts’ piercing of the

» Generally, there are two conditions common to the courts’ piercing of the corporate veil› The existence of a unity of interest and ownership such that the separate identities of

the corporation and its owners no longer exist

› Recognition of the corporation as a legally separate entity will lead to an unfair result

» Certain cases also require proof of fraud, demonstrated by

› intent,

› bad faith

› or injustice

Theories used by courts to pierce the corporate veil

The principal theories relied on by courts to pierce the corporate veil are alter ego and instrumentality

The theory of Alter Ego rests on a belief that if a corporation’s owners disregard its separateness, its separateness should also be disregarded to protect creditors. Tests under Alter Ego focus on the

The theory for Instrumentality is that a dominant entity should be held accountable for using a subservient entity as a fiction for its own purposes. Accordingly, the corporate veil will be pierced if the following occur:

Tests under Alter Ego focus on the occurrence of two outcomes:

•The corporation was so influencedas to create a unity of ownership and interest such that it ceased to exist separately

•Recognition of a separate corporate existence would perpetuate a fraud or injustice

following occur:

•Domination of the disputed transaction occurred such that the corporation had no separate mind, will or existence of its own;

•Defendant used such domination to perpetrate a fraud or wrong;

•And such domination was the proximate cause of a loss or unjust injury

Courts dissatisfied with alter ego and instrumentality theories have developed tests under theories of equity

» Tests developed by the courts under theories of equity focus on specific case factors including

› Undercapitalization

› Failure to observe corporate formalities

› Nonpayment or overpayment of dividends

› Siphoning of funds or guarantee of liabilities by dominant shareholders› Siphoning of funds or guarantee of liabilities by dominant shareholders

» Courts may also pierce if a corporation has relied on its form to violate a public policy, statute, or commit fraud:

› A corporation creates a new entity controlled by the same persons to discharge unwanted debts while undermining the ability of the previous corporation to pay the debt

› A corporation liquidates in order to avoid liability for violation of an antitrust, environmental, employment, or other regulatory statute

Indicia of alter ego and instrumentality

Indicia of alter ego

Relevant

Market

Financial dependence

Domination and control

Alter EgoMarket

Lack of separateness

Confusion of corporate identity

Factors indicative of alter ego


Identity confusion


Control and domination

Undercapitalization X X X

Unable to operate as standalone

X X X

Related party transactions to benefit owners and

X X Xto benefit owners and subsidiary

Insolvency X X

Common management, business activity

X X

Lack of corporate formalities

X

Preference of creditors X X

De Facto Merger X X

Indicia of instrumentality

» Majority ownership of subsidiary capital stock by the parent corporation

» Common directors and officers within the parent and subsidiary

» Subsidiary financing by parent

» Parent subscribes to all subsidiary capital stock or causes its incorporation

» Inadequacy of subsidiary capital

» Parent payment of subsidiary salaries, expenses, and losses

» Subsidiary has no business or assets except those given by parent

» Subsidiary has no business or assets except those given by parent

» Corporate documents and officers describe the entity as a department or division of the parent, and identify its businesses and financial obligations as the parent’s

» Parent use of subsidiary property as its own

» Subsidiary executives act on the order, and in the interest, of the parent

» Failure of the subsidiary to follow its own legal requirements

Factors indicative of instrumentality


Identity confusion


Control and domination

Parent corporation ownership of majority of subsidiary capital stock

X X

Common parent and subsidiary directors and officers

X X

Financing of subsidiary X XFinancing of subsidiary by parent

X X

Inadequacy of subsidiary capital

X X

Parent payment of subsidiary salaries, expenses, and losses

X X

Subsidiary executives act on the order, and in the interest, of the parent

X X

Relationship between alter ego, fraudulent and preferential transfers

While equity courts do not follow bankruptcy rules, the indicia of alter ego are characteristic of preference and fraudulent transfer claims

» benefited a creditor

» or was created for or on behalf of an antecedent debt

» made with intent to defraud, hinder, or delay a creditor, and or

» the value of consideration received or

Under Section 547 of the Code, a transfer is preferential and avoidable if it:

Under Section 548 of the Code, a transfer may be avoided as fraudulent if

antecedent debt

» when the debtor was insolvent

» on or within 90 days preceding the debtor’s bankruptcy filing date, and up to one year for an insider

» and gave the creditor more than he would have received in a Chapter 7 liquidation

» the value of consideration received or obligation incurred by the debtor was less than equivalent value, and the debtor

› was or became insolvent,

› had unreasonably small capital,

› and incurred debts beyond its ability to pay at maturity

In either case, the issue of solvency is contested using the balance sheet, adequate capital and cash flow tests

Is the value of the firm’s assets greater than the sum of

the value of its liabilities?

Balance sheet test

Adequate capital test

Does the firm have adequate capital to finance daily operations and service its debt under typical economic and financial circumstances?

Adequate capital test

Is cash flow sufficient to retire debts as they fall due given the firm’s past results, economic conditions, and future opportunities?

Cash flow test

Summary

Summary

» While a firm may be considered legally distinct from its owners, courts will pierce the corporate veil to prevent fraud, achieve equity or preclude the violation of a statute or public policy

» In piercing the corporate veil, courts employ tests under theories of alter ego, instrumentality and equity

» Alter ego is based on the belief that if a firm’s owners disregard its separateness, its separateness should also be disregarded to protect creditors,

separateness, its separateness should also be disregarded to protect creditors, while the theory of instrumentality is that a dominant entity should be accountable for using a subservient entity for its own purposes

» Courts not satisfied with the theories of alter ego and instrumentality have pursued tests under theories of equity, focusing on case specific facts

» Factors indicative of alter ego and instrumentality are those that demonstrate financial dependence, identity confusion, lack of separateness, and control and domination

» The indicia of alter ego are characteristic of preferential and fraudulent transfer claims in bankruptcy litigation

Expert profile

Boris J. Steffen, CPA, ASA, ABV, CDBV(202) 538 – [email protected]

» Boris Steffen is an expert in financial and managerial accounting, corporate finance and valuation with significant multi-industry, multi-company and cross-border experience in operations, finance, strategy and litigation. As an advisor in financing, investment and restructuring transactions and claims, matters in which he has consulted or testified include antitrust and competition policy, bankruptcy, restructuring and solvency, contracts, intellectual property, international trade and arbitration, mergers and acquisitions, business valuation, pricing, costs and profitability, securities and taxes.

» As a corporate development executive and consultant, Mr. Steffen has advised in transactions and claims valued in excess of $100 billion. Sectors in which he has consulted include the aerospace,

claims valued in excess of $100 billion. Sectors in which he has consulted include the aerospace, automotive, beef processing, biotechnology, business services, cable network, chemical, consumer product, defense, document management, electronic imaging, financial services & banking, food & beverage, healthcare, independent power, information technology, insurance, internet, newspaper, magazine, pharmaceutical, oil & gas, printing, pumps & controls, retail, satellite radio, semiconductor, software, steel, telecom, tobacco and electric utility industries.

» Mr. Steffen has held positions in finance, public policy, corporate development and consulting with Inland Steel Industries, the FTC, Bureau of Competition, U.S. Generating, and LECG. He holds a Master of Management degree with specializations in accounting and finance from the Kellogg School of Management of Northwestern University, and a Bachelor of Science degree in Finance and Bachelor of Music degree in Applied Music from DePaul University. He is an Accredited Senior Appraiser, Certified Public Accountant, Accredited in Business Valuation, Certified Distressed Business Valuation Analyst, and member of the AICPA, ABA, ABI, Insol International, AIRA, ASA and American Finance Association.

Piercing the Corporate Veil

Boris J. Steffen, CPA, ASA, ABV, CDBVPrincipal & Director

Piercing The Corporate Veil

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