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general / Civil Practice

Discomfort dealing with limited liability

1017 ldj judge robert harri

Mental Health Courthouse

Robert Steven Harrison

Judge, Los Angeles County Superior Court

Mental Health

Loyola Law School, 1984

One of an attorney's clients fills a huge order only to find that its customer goes out of business and cannot pay. Another is injured at a store with lapsed insurance. A gnawing doubt sends the attorney back to search his files only to find out that the defendant is a corporation, meaning there may be little or no recovery. Hearing the attorney explain the concept of limited liability, the client replies, "You mean I've been hurt and nobody is going to pay? Can't you sue the owners? What kind of attorney are you?"

The object of this article and self-study test is to provide an overview of limited liability issues, including the rationale and origin of limited liability, the alter ego doctrine, and other alternatives to the doctrine.

Basics

Most attorneys are uneasy about the concept of limited liability. Lawyers are taught in law school about the purpose of corporations - to promote enterprise by limiting investors' risk to the capital invested - and many have told their friends to incorporate for protection of their personal assets from their business creditors. Lawyers are trained to be vigorous in representing the interests of their clients, and bristle at the idea that a client's chances of recovery can be thwarted merely by the defendant's choice of business form.

This ambivalence is also reflected in the law, although the clear legislative trend is to expand the use of limited liability. For instance, the British joint stock company (precursor to the modem corporation) was invented in the early 1600s but did not acquire limited liability until 1855. In California, shareholders were similarly not protected from personal liability for corporate debts until the Great Depression in 1929. Today, nearly any enterprise can become a limited liability company upon filing a statement of organization and adopting a written operating agreement. Corp. Code Section 200.

Trial lawyers routinely seek to hold owners of small limited liability entities personally liable for company debts by either naming them in the complaint or seeking to add them as defendants on the judgment after trial, based upon formalistic allegations that the legal entity is really a sham and nothing more than an alter ego of the owners who should be personally liable for its debts. Some judges require little proof to support these allegations and, if a default is obtained, require no further proof.

Alter Ego

The case law on the alter ego doctrine does not support the predilection toward stripping a company's statutory limited liability. Though first recognized in California as early as 1921, this equitable doctrine is only designed to prevent an owner's abuse of the corporate form, not to provide alternative sources to pay company debts. It is supposed to be an "extreme remedy, sparingly used" to prevent the misuse of statutory limited liability by the device of sham entities formed to commit fraud or other misdeeds. Sonora Diamond Corp. v. Superior Court, 83 Cal. App. 4th 523 (2000).

Further, an owner must be given the opportunity to defend the creditor's claim before being held personally liable for the company's debts. NEC Electronics Inc. v. Hurt, 208 Cal. App. 3d 772 (1989); see Wulfien v. Dolton, 24 Cal. 2d 878 (1944) (creditors cannot levy on assets held by insiders by executing on judgment against corporation, but must bring separate action). To insure robust appellate review, a statement of decision is also required if requested in any proceeding to add the owner as a judgment debtor. Gruendl v. Gewen Partnership Inc., 55 Cal. App. 4th 654 (1977).

Succinctly stated, the alter ego doctrine requires: "(1) that there be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist and (2) that, if the acts are treated as those of the corporation alone, an inequitable result will follow." Messler v. Bragg Management Co., 39 Ca1. 3d 290 (1985) (internal citation omitted); Isaacson v. Union Trust Co. of San Diego, 210 Cal. 473 (1930) (giving creditors recourse to debtor's assets held in bare corporate shell).

A Closer Look

The description of the alter ego doctrine above is elegant but misleadingly simple for several reasons. First, both requirements must be met to apply the alter ego doctrine, and the burden of proof is on the party seeking to avoid the statutory limited liability. Second, the doctrine should prevent fraud or injustice; "bad faith in one form or another is an underlying consideration." Third, the court must examine each claim on a case-by-case basis, looking for significant factors such as commingling of funds and other assets, the unauthorized diversion of corporate assets for non-business purposes, the owner's treatment of the entity's assets as his own, limited beneficial ownership in a family or individual, failing to observe legal formalities, and undercapitalization. Associated Vendors Inc. v. Oakland Meat Co., 210 Cal. App. 2d 825 (1963) (comprehensively surveying cases identifying factors held to support alter ego liability).

These factors must, however, be considered in context; otherwise, the alter ego doctrine threatens to "swallow the rule" and undermine the purposes of limited liability. Most small businesses, for instance, resemble sole proprietorships, being thinly capitalized and closely held by one or a few family members. "It is common knowledge that many [undercapitalized] corporations have been highly successful, that others have prospered but without legendary success, and that still others have failed in part, at least, because of inadequate capital. Such is the story of our American enterprise system." Harris v. Curtis, 8 Cal. App. 3d 837 (1970) (affirming denial of alter ego liability for a family owned motel business initially capitalized with only $1,000); see Carlesimo v. Schwebel, 87 Cal. App. 2d 482 (1948) ($1,221.82 held sufficient to capitalize grocery).

Similarly, many family businesses lack perfect adherence to accounting rules and other formalities. Owners may take salary right out of a cash register or use the company account to pay a personal debt. They may fail to issue stock or hold shareholder meetings. See, e.g., Mid-Century Ins. Co. v. Gardner, 9 Cal. App. 4th 1205 (1992) (president was not alter ego of his wholly owned company just because he took a salary from the company and it provided him a car for his personal use); Auer v. Frank, 227 Cal. App. 2d 396 (1964) (no alter ego liability merely for failure to issue stock).

Other Alternatives

Before resorting to the equitable remedy of the alter ego doctrine, lawyers and courts should first consider whether adequate remedies exist under substantive law. Postal Instant Press Inc. v. Kaswa Corp., 162 Cal. App. 4th 1510 (2008). Notably, there are five well-established (but often overlooked) grounds upon which an owner and any agent of the limited liability entity may be held personally liable for the company's debts:

(1) Where the owner or agent affirmatively cosigns for the debt. Civ. Code Section 2343(1); compare Carlesimo (officer who signed contract bearing corporate letterhead not personally liable).

(2) Where the owner or agent guaranties the debt. Such a guarantee need not be in writing when under the circumstances a creditor shows it relied upon the promise of the individual to pay the debt. Civ. Code Sections 1624(a)(2) and 2794(2); see Michael Distributing Co. v. Tobin, 225 Cal. App. 2d 655 (1964).

(3) Where the owner or agent neglects to disclose the full name of the limited liability entity. G.W. Anderson Constr. Co. v. Mars Sales, 164 Cal. App. 3d 326 (1985) (incomplete corporate name); W.W. Leasing Unlimited v. Commercial Standard Title Ins. Co., 149 Cal.App.3d 792 (1983) (fictitious business name). Such disclosure may, though, be made by third parties to shield the agent. Bush v. Vernon, 135 Cal. App. 2d 33 (1955).

(4) Where the owner or agent has committed a wrongful act. Civ. Code Section 3343(3). It does not matter whether the act was committed in the agency, or under contract. See Shafer v. Kahn, Shafton, Moss, Figler, Simon & Gladstone, 107 Cal. App. 4th 54 (2003) (attorney liable for misrepresentations made to opposing party). The rule applies to negligence (Pacific Tel. & Tel. Co. v. Standard American Dredging Co., 38 Cal. App. 293 (1918)), but not mere inaction (Mears v. Crocker First Nat. Bank of San Francisco, 97 Cal. App. 2d 482 (1950)).

(5) Where the owner or agent removes assets from the limited liability entity either intending to hinder, delay or defraud creditors, or exchanging less than fair value when the entity is insolvent or will become unable to meet its expected obligations. Civ. Code Sections 3439.04(a)-(b) and 3439.05. See Fisher v. Gibson, 90 Cal. App. 4th 275 (2001). "Whether a conveyance was made with fraudulent intent is a question of fact, and proof often consists of inferences from the circumstances surrounding the transfer." Filip v. Bucurenciu, 129 Cal. App. 4th 825 (2005).

Nearly all California cases where alter ego liability was found could have been predicated instead upon one of the foregoing theories. The notable exceptions are where a corporation is intentionally underfunded for its operations or formed to evade existing contractual obligations. See, e.g., Engineering Service Corp. v. Longridge Inv. Co., 153 Cal. App. 2d 404 (1957) (underfunded development corporation designed to escape liability for subdivision expenses); Kohn v. Kohn, 95 Cal. App. 2d 708 (1950) (transfer of partnership assets to corporation designed to reduce partner's marital settlement payments to former spouse).

Conclusion

New businesses contribute significantly to economic innovation and vitality, but over half fail in the first five years according to the SBA. Although individual creditors may suffer, statutory limited liability serves the legislative objective of promoting commercial risk. The alter ego doctrine provides a necessary restraint on abuse, but an entity's statutory limited liability should be respected absent evidence of a scheme by the owners to treat the entity as a sham to defraud creditors.

#186

Ben Armistead


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