THE ALTER EGO DOCTRINE: PIERCING THE VEIL IN CALIFORNIA

The most fundamental benefit of limited liability entities is that their owners are rarely held liable for the entity’s actions. In other words, owners of limited liability entities are not personally liable for their company’s debts and obligations. The most common types of entities that provide limited liability are corporations, limited liability companies, and limited partnerships. Although limited liability entities provide a strong barrier between the entity and its owners, that protection from personal liability is not absolute. This article will discuss how courts determine the circumstances in which owners can be held accountable for their company’s debts in California.

To enforce personal liability on an entity’s owners, a plaintiff must accomplish what is called “piercing the veil.” Piercing the veil in California involves a two-prong test under what is called the Alter Ego Doctrine. The Alter Ego Doctrine was established to keep individuals or other entities from abusing limited liability laws, and particularly to prevent the use of sham entities solely formed for the purpose of committing offenses such as fraud. The application of the Alter Ego Doctrine is done on a case-by-case basis based on the facts of that particular case, and both of its prongs must be satisfied, but a court is not required to use the Alter Ego Doctrine, even if both prongs are in fact satisfied.

The two prongs of the Alter Ego Doctrine are as follows.

1. Prong 1. Unity of Interest: Where there is such a unity of interest between the owner and the entity, that the separate personalities between them either does not, or no longer exists.
2. Prong 2. Evidence of Inequitable Results/Injustice: Where the facts of the case evidence that an inequitable result would occur upon the failure to disregard the entity. In other words, continuing to recognize a distinction between the owner and the entity would promote injustice or allow fraud.

Although there are only two prongs, it is very difficult to satisfy the Alter Ego Doctrine. Generally, it takes a convincing argument to successfully pierce an entity’s veil, otherwise, forming a limited liability entity would serve little purpose.

Let us examine each prong in more detail.

1. PRONG ONE – Unity of Interest:

The party attempting to pierce the veil has the burden to prove that the distinction between an owner and their entity does not exist. But what does that look like? There are several factors and examples a court might consider when deciding as to whether a unity of interest exists. The following are some factors that California courts will consider.

1. Failure to maintain minutes or adequate records.
2. Treatment by an individual of the legal entity’s assets as their own.
3. Absence of any assets belonging to the legal entity.
4. Legal entity is not adequately capitalized.
5. Commingling of assets and funds.
6. Failure to segregate funds.
7. Unauthorized diversion of funds or assets to other than the legal entity’s uses.
8. Use of the same office or business location.
9. Use of legal entity as a shell company.
10. Concealment of management and/or financial interests.
11. Misrepresentation of personal business activities.
12. Disregard of legal formalities.
13. Failure to maintain arm’s length business relationships.
14. Diversion of assets from a legal entity to an owner to the detriment of creditors.
15. Contracting with another with the intent to avoid performance by use of the legal entity.
16. Use of the legal entity as device for illegal transactions.
17. Confusion of the records of separate entities.
18. Sole ownership of all the legal entity’s interest by one individual or the members of a family.

The foregoing factors are only a small sample of factors a court may consider. However, the existence of any one of these factors does not necessarily satisfy the unity of interest prong. It is within a court’s discretion to consider the presence of these factors, along with other circumstances that may be unique to the case to determine whether a unity of interest exists.

2. PRONG TWO – Evidence of Inequitable Results/Injustice:

The primary goal of the Alter Ego Doctrine is to avoid injustice. To be successful, the party attempting to pierce the veil has the burden to prove that continuing to recognize the entity as distinct from its owners will ultimately lead to an inequitable result, and that the only remedy to prevent fraud or injustice, is for the court to allow the piercing of the entity’s veil.

The party attempting to pierce the veil does not have to prove all the elements of fraud, or an actual showing of fraud. Rather, the showing of bad faith can be enough to satisfy this prong. The reason actual fraud is not required is because injustice may occur without the presence of actual fraud. However, a mere showing that a party is a disgruntled creditor from a failed a business venture is usually not enough to satisfy this prong.

• Key Takeaways:

The key takeaways regarding the Alter Ego Doctrine are the following.

1. The Alter Ego Doctrine was designed to be an equitable remedy and to prevent injustice.
2. The Alter Ego Doctrine examines specific facts and is implemented on a case-by-case basis.
3. The Alter Ego Doctrine is a two-prong test, and both prongs must be met to successfully pierce an entity’s veil.
4. The court has the discretion to use the Alter Ego Doctrine and is not required to use it even if both prongs are satisfied.
5. It is very difficult to satisfy the Alter Ego Doctrine.
6. Party attempting to pierce the veil does not have to prove fraud, showing of bad faith can be enough.

If you are an owner of a legal liability entity, the best way to avoid losing your limited liability is to keep up on the following.

1. Maintain your entity’s records.
2. Open a separate bank account in the entity’s name.
3. Never commingle your personal money with the entity’s.
4. Adopt bylaws or a similar governing document.
5. Keep your books up to date.
6. Keep meeting minutes.
7. File the Statement of Information on time.
8. Pay the entity’s taxes.

In conclusion, the Alter Ego Doctrine is designed to prevent injustice, and therefore a legal entity’s protection from personal liability is not absolute in California. However, the policy behind limited liability laws is important, and therefore it is imperative to remember that a court will generally not allow piercing of the veil unless there is no other path to justice.