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Simple English definitions for legal terms
disregarding the corporate entity
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A quick definition of disregarding the corporate entity:
Disregarding the corporate entity means that sometimes, if a company is just a front for the people who own it, the court can hold those people responsible for the company's debts. Usually, the people who own a company are not responsible for its debts, but if they are using the company to do bad things or cheat people, the court can make them pay instead. There are two tests the court can use to decide if the people who own the company should be responsible for its debts: the Van Doren Test and the Laya Test. The court will also look at whether the people who are owed money knew what they were getting into when they did business with the company.
A more thorough explanation:
Disregarding the corporate entity is also known as the “alter ego doctrine” or “piercing the corporate veil.” It means that the court can hold shareholders of a corporation personally liable for the corporation's debts and obligations if the corporation is a sham for individual shareholders carrying on their business in a personal capacity.
For example, if a corporation fails to maintain proper, adequate corporate records and comply with corporate formalities, commingles funds or assets, or undercapitalizes the firm, the court may disregard the corporate entity and allow creditors of the corporation to recover using the personal assets of the shareholders.
The court can disregard the corporate entity and pierce the corporate veil, thereby holding shareholders personally liable, in one of two ways: The Van Doren Test or the Laya Test.
The Van Doren Test states that a court will hold a shareholder of a corporation personally liable if:
- There is such a unity of interest and ownership that the separate personalities of the corporation and individual don’t exist.
- Maintaining the fiction of the separate corporation existence would either sanction fraud or promote injustice.
For example, if a corporation fraudulently transfers assets to a shareholder to avoid paying a creditor, the court may disregard the corporate entity and hold the shareholder personally liable for the corporation's debt.
The court holds sophisticated creditors bringing these claims to a higher standard. If the party bringing a claim for disregarding the corporate entity is a sophisticated entity, then the court will look at whether the sophisticated creditor assumed the risk.
The Laya Test looks more generally at whether there is an inequitable result. This means that the court will disregard the corporate entity if it would be unfair to allow the shareholders to avoid personal liability for the corporation's debts and obligations.
For example, if a corporation fails to pay its debts and obligations, and the shareholders have used the corporation to unjustly enrich themselves, the court may disregard the corporate entity and hold the shareholders personally liable for the corporation's debt.