Clients usually form corporations for one simple reason: to insulate themselves from liability. In some instances, however, the corporate status is abused. In those situations, the doctrine of alter ego allows a litigant to "pierce the corporate veil" and go after individual corporate officials, holding them responsible for sins committed in the corporate name. It is therefore highly consequential for those alleging it, as well as for those defending against it.
In the world of civil litigation, the alter ego doctrine is often invoked, but it's difficult to establish. The trick is knowing when the doctrine applies, and what evidence is required to prove it.
No, the alter ego doctrine is not a device for taking stock of bipolar litigants, or those with multiple personalities. Alter ego is a legal theory that applies to a variety of defendants, and it can greatly expand the scope of liability to include entities and individuals otherwise protected by the corporate veil. Large, sophisticated companies with multiple affiliated corporate entities can be brought into suits and face significant exposure on the ground that an affiliate is not really separate--and is thus an alter ego. Even entrepreneurs operating through a limited liability company can--at least in California--find their liability shield challenged on the basis of alter ego. And the timing of an alter ego claim can also have repercussions. Given the doctrine's importance, it is worthwhile to explore it and take a look at recent developments in this area of law.
Two Elements, Many Factors
To establish alter ego, a plaintiff must show that two conditions are met: First, there must be such a unity of interest and ownership between the corporation and its equitable owner that the separate personalities of the corporation and the shareholder (or other corporate entity) do not in reality exist. Second, there must be an inequitable result if the acts in question are treated as those of the corporation alone. (See F. Hoffman-La Roche v. Superior Court, 130 Cal. App. 4th 782, 796 (2005).)
In discussing alter ego, courts have often emphasized that it is a "limited doctrine" that will be invoked "only where recognition of the corporate form would work an injustice to a third person." (Tomaselli v. Transamerica Ins. Co., 25 Cal. App. 4th 1269, 1285 (1994).) In other words, alter ego is the exception, not the rule. Indeed, the very purpose of establishing a corporate form is to isolate and limit liability to the corporation, as well as protect its shareholders.
Sufficient Unity of Interest
The first issue--whether there is such a unity of interest that the separate personality of the corporation no longer exists--can be both enigmatic and fact-intensive.
What is a unity of interest? The usual assumption is that all affiliated corporations have a sufficiently unified interest. But what about a small, privately held corporation in which the principal shareholder, president, and CEO are the same person? Such a situation certainly seems to present a unity of interest. However, as is often the case in litigation, the answer is that old lawyerly saw: It depends.
Courts have identified a number of factors that are relevant, though not dispositive, in determining whether the requisite unity of interest exists. Some or all of those factors may be present in any given case: Are funds commingled? Are corporate formalities followed? Is the corporation adequately capitalized? Are transactions conducted at arm's length? Is there a failure to maintain minutes or adequate corporate records? Are records of the separate entities confused?
Common equitable ownership and shared directors and officers between the corporation and its alleged alter ego are not alone sufficient to warrant a formal alter ego finding, but those factors can be significant when coupled with other facts suggesting a lack of separateness. Evidence that the corporation is used as a mere shell, instrumentality, or conduit for a single venture, or for the business of an individual or another corporation, will weigh heavily in the determination of alter ego.
Parent-subsidiary and corporate-affiliate relationships can also be subject to alter ego claims, but they still require a showing of a sufficient unity of interest. As courts have explained, "[a] parent corporation is not liable on the contract or for the tortious acts of its subsidiary simply because it is a wholly owned subsidiary. Some other basis of liability must be established. 'Stock ownership alone is not enough.' " (Northern Natural Gas Co. of Omaha v. Superior Court, 64 Cal. App. 3d 983, 991 (1976).) Consequently, courts will impose liability "only where the parent controls the subsidiary to such a degree as to render the latter the mere instrumentality of the former." (Institute of Veterinary Pathology, Inc. v. California Health Labs., Inc., 116 Cal. App. 3d 111, 119 (1981).)
In the end, not every factor need be shown. Alter ego is a highly fact-sensitive doctrine. The analysis often comes down to whether the corporation at issue is treated as a separate entity generally and at all times, and not simply for the purpose of shielding its shareholders or corporate affiliates from liability.
Litigators on either side of an alter ego claim need to consider what relevant factors are present and how to marshal the evidence to aid their position. One of the most important preparatory steps is to identify the witnesses who can testify regarding the underlying alter ego factors. You will need someone to explain under oath how a person (or persons) manipulated the corporation and misused it as their personal piggy bank. In addition, you must identify the documents that are relevant and probative to either establish or diminish the alter ego claim.
Evidence regarding the unity of interest can be the subject of lay or expert testimony. In complex cases, forensic accounting expertise may provide a true picture of a corporation's finances, and capitalization, and may demonstrate--or refute--that corporate financial records are maintained properly. In other cases, fact witnesses (often from the alleged alter ego entity itself) will have knowledge of the company's operations and structure and will be in a position to supply evidence regarding the extent to which the corporation is truly separate from its shareholders or corporate affiliates.
The second element is similarly fact-intensive. Assuming a lack of separateness, is it necessary to pierce the corporate veil in order to avoid an inequitable result? In this context, an important issue concerns the meaning of the word inequitable. Some courts have explained that the "alter ego doctrine does not guard every unsatisfied creditor of a corporation but instead affords protection where some conduct amounting to bad faith makes it inequitable for the corporate owner to hide behind the corporate form." (Sonora Diamond Corp. v. Superior Court, 83 Cal. App. 4th 523, 539 (2000).) Thus, "[d]ifficulty in enforcing a judgment or collecting a debt does not satisfy this standard." (83 Cal. App. 4th at 539.) Indeed, if it did, the limited liability protections of the corporate form would be of little value: A creditor would always pursue the assets of the shareholders and affiliated corporations if a corporate debtor could not or would not pay, rendering the shareholders guarantors of all corporate debt.
Courts frequently state that the corporate form will not be recognized if to do so would "sanction a fraud or promote injustice." (See Webber v. Inland Empire Investments, Inc., 74 Cal. App. 4th 884, 900 (1999).) The court made clear in Webber that the focus is on whether the corporation's very purpose is to defraud an innocent party. Other cases seem to focus less on actual bad faith on the part of the alleged alter ego, and more on whether the result would be unjust if the corporate veil is not pierced. The injustice must flow from the illusion of separateness created by the alter ego relationship. Under either approach, if wrongdoing or bad faith is shown, it is much more likely that the claimant will satisfy the "inequitable result" requirement.
Procedural Alternatives for Raising Alter Ego
In California there are two procedural means for bringing an alter ego claim. First, although it is not a cause of action as such, the factual bases for an alter ego claim can be alleged in a complaint, along with other causes of action against the defendant and its claimed alter ego. Thus, the potentially liable parties are all brought into the suit at the outset, and the issue of alter ego is litigated as part of the underlying case.
For alter ego defendants, liability will hinge first on the alter ego finding and then on the merit of the underlying claim. Alternatively, alter ego can be raised after judgment has been rendered against a corporate defendant. Under provisions in the Code of Civil Procedure, upon proper motion a judgment can be amended to add additional judgment debtors if it is shown that the proposed judgment debtors are alter egos of the original corporate judgment debtor--and that they controlled the underlying litigation. (See Cal. Code Civ. Proc. § 187.) With control of the litigation established, the alter egos are deemed to have been "virtually represented" in the lawsuit (NEC Electronics, Inc. v. Hurt, 208 Cal. App. 3d 772, 778 (1989)). The purpose of the virtual-representation doctrine is to ensure the protection of the alter ego's due process rights. To prevail under section 187, the judgment creditor plaintiff must both prove the two elements of alter ego and establish that the new defendant effectively controlled the litigation of the original judgment debtor.
What does control of the litigation mean for purposes of satisfying due process? Courts have explained that "[c]ontrol of the litigation sufficient to overcome due process objections may consist of a combination of factors, usually including the financing of the litigation, the hiring of attorneys, and control over the course of the litigation." (NEC Electronics, 208 Cal. App. 3d at 781.) Generally, some "active defense of the underlying claim" is required (208 Cal. App. 3d at 778.) If so, one wonders whether a default judgment that by definition was not actively defended could ever be amended to add an alter ego. On the other hand, if the decision to take the default judgment emanated from the alleged alter ego, perhaps the standard could be met.
A prior judgment against a corporation "can be made individually binding on a person associated with the corporation only if the individual to be charged ... had control of the litigation and occasion to conduct it with a diligence corresponding to the risk of personal liability that was involved." (208 Cal. App. 3d at 778-79.)
Either procedure can be an effective means of invoking the alter ego doctrine. Bringing a motion under section 187 adds the additional hurdle of having to prove control of the litigation. On the other hand, the facts suggesting alter ego may not be evident at the outset of the lawsuit, and may not become apparent until the plaintiff seeks to collect on its judgment. If the facts indicating alter ego are discovered before trial and while there is still time to amend the complaint to add the new defendants to the action, a plaintiff must make a tactical decision whether amending the complaint is preferable to bringing a motion later to amend the anticipated judgment.
Consequences for Arbitration
The right of an alleged alter ego to compel arbitration is coextensive with the rights of the entity with which it is alleged to have a unity of interest. That is the essential finding of a recent California decision concerning arbitration and alter ego claims.
Generally, only signatories to arbitration agreements can enforce them by compelling arbitration of claims subject to the agreement. Until recently, no reported California case discussed the rule when a nonsignatory individual, sued as an alter ego of a signatory corporation, moves to compel arbitration. In Rowe v. Exline (153 Cal. App. 4th 1276 (2007)), the court allowed a nonsignatory (an alleged alter ego) to enforce an arbitration provision. Given the stated public policy in favor of arbitration in federal and state court, this decision further enhances the ability of an alleged alter ego to defend itself in arbitration if the claims are within the scope of the arbitration clause. The limits on discovery and on exemplary damages in arbitration, as compared with state court, can make that option worth considering for individuals facing alter ego claims.
Reverse Alter Ego
Outside California some courts have permitted, as an extension (or reversal) of alter ego doctrine, "third party" or "outside reverse piercing of the corporate veil." Under this theory, rather than piercing the veil to reach shareholder or affiliated corporate assets, the doctrine works in reverse: A creditor reaches corporate assets to satisfy claims against an individual shareholder. However, a recent California appellate decision rejected this view, finding the reasoning behind reverse piercing to be "flawed," and stating that "a third party creditor may not pierce the corporate veil to reach corporate assets to satisfy a shareholder's personal liability." (Postal Instant Press, Inc. v. Kaswa Corp., 162 Cal. App. 4th 1510, 151213 (2008).) The Kaswa decision is welcome news to entrepreneurs who do not want their company to become a target for its shareholders' judgment creditors.
Despite alter ego being a bedrock principle of the common law for many years, the legal issues and policies affected by it are dynamic. As new corporate schemes emerge, alter ego principles will likely morph with the times. Effectively representing corporate defendants or plaintiffs in business litigation of any stripe requires an understanding of the many permutations and potential applications of alter ego. In addition, companies large and small need to understand how to best manage their operations and activities to minimize their exposure to alter ego claims.
Though the alter ego doctrine may at times appear to be the seed of extensive litigation, the lesson to be learned is quite simple. Clients who respect the corporate form--and corporate formalities--should face no problem. Those who don't--majority shareholders who control corporate activities and use the corporation as a personal bank account--will indeed have to pay the piper in litigation if their misuse of a corporation's separate identity causes injustice to third parties.
Daniel T. McCloskey is of counsel to Greenberg Traurig's Silicon Valley office in East Palo Alto, where he litigates complex business and intellectual property disputes.