Legal Definitions - disregarding the corporate entity

Disregarding the corporate entity, also commonly known as "piercing the corporate veil" or the "alter ego doctrine," is a legal principle that allows a court to set aside the usual protection that a corporation offers its owners.

Normally, one of the main benefits of forming a corporation is that its owners (shareholders) are not personally responsible for the company's debts or liabilities. This is called "limited liability." However, if a court finds that the corporation is not truly operating as a separate business but is instead being used as a personal front or a sham by its owners, it may "disregard the corporate entity." This means the court will look past the corporation's legal separation and hold the individual owners personally liable for the company's obligations, allowing creditors to access their personal assets.

Courts typically consider two main conditions when deciding whether to disregard the corporate entity:

• Lack of Separation: There is such a close connection between the owners and the corporation that they essentially operate as one and the same. Indicators of this might include:
  • Failing to keep proper corporate records or follow legal formalities (like holding board meetings).
  • Mixing personal funds and assets with corporate funds (commingling).
  • Not providing the company with enough financial resources to operate properly (undercapitalization).
  • Treating the corporation's assets as if they were personal property.
• Unfair Outcome: Allowing the corporation to remain separate would lead to fraud, deception, or a significant injustice. This injustice must be more than simply a company failing to pay its debts. It often involves situations where the owners would unfairly benefit or escape responsibility for their actions at the expense of others.

It's important to note that courts generally apply this principle cautiously, as it goes against the fundamental concept of limited liability. Also, if the party seeking to disregard the corporate entity is a sophisticated business or individual, the court might consider whether they understood and accepted the risks involved when dealing with the corporation.

Here are some examples illustrating when a court might disregard the corporate entity:

• Example 1: Commingling Funds and Lack of Formalities

  Imagine a small landscaping business, "Green Thumb Inc.," owned by Mr. Smith. Mr. Smith frequently uses the company's bank account to pay for his personal mortgage, family vacations, and children's tuition. He rarely holds formal board meetings, doesn't keep detailed corporate minutes, and often signs contracts without clearly indicating whether he's acting on behalf of the corporation or himself. When Green Thumb Inc. defaults on a large loan from a supplier, the supplier discovers the extent of Mr. Smith's personal use of company funds. A court might disregard Green Thumb Inc.'s corporate entity, finding that Mr. Smith treated the company as his personal piggy bank, blurring the lines between his personal and business finances. This would allow the supplier to pursue Mr. Smith's personal assets to recover the debt.

• Example 2: Undercapitalization and Deception

  Ms. Chen starts "Safe Home Security Systems Inc." with only $100 in capital, despite planning to install complex and potentially hazardous security systems in homes. She then secures several large contracts, knowing that the company has virtually no financial reserves to cover potential damages or liabilities if a system malfunctions. When a faulty installation by Safe Home Security Systems Inc. causes significant property damage to a client's home, the client sues. The company has no assets to pay for the damages. A court might find that Ms. Chen intentionally undercapitalized the company, setting it up to fail or to avoid responsibility for foreseeable risks. Disregarding the corporate entity would allow the client to seek compensation directly from Ms. Chen's personal assets, preventing her from using the corporation as a shield for her irresponsible business practices.

• Example 3: Asset Stripping and Injustice

  Mr. Davis owns "Old Mill Manufacturing," a company facing financial difficulties and significant outstanding debts to its employees for unpaid wages and to a pension fund. Just before Old Mill Manufacturing declares bankruptcy, Mr. Davis forms a new company, "New Age Products LLC," and sells all of Old Mill Manufacturing's valuable machinery, patents, and customer lists to New Age Products LLC for a fraction of their true market value. Old Mill Manufacturing is left as an empty shell with no assets to pay its creditors. A court could disregard the corporate entity of Old Mill Manufacturing (and potentially New Age Products LLC), concluding that Mr. Davis used the corporate structure to unfairly transfer assets and avoid his obligations, thereby promoting a clear injustice against the employees and the pension fund. This would allow creditors to pursue Mr. Davis's personal assets or the assets transferred to New Age Products LLC.