What is Alter Ego? When Is Alter Ego Invoked?

Under normal circumstances, the liability of shareholders is limited to their investment in the corporation. This protection from personal liability may be lost, however, if the courts find a basis for invoking the alter ego doctrine. Under this doctrine, if it would be inequitable not to do so, the courts may disregard the legal fiction of a corporation’s separate existence distinct from that of its shareholders and “pierce the corporate veil,” thus exposing the shareholders to personal liability for corporate debts and obligations.

Reasons for Invoking Alter Ego Doctrine

A common reason for invoking the alter ego doctrine is that failure to do so would work an injustice on the corporation’s creditors or other third parties. In other words, the shareholders are attempting to use the corporation as a shield against liabilities that would otherwise inure to them personally. See, e.g., Minton v Caveney (1961) 56 C2d 576 (tort claims); Minifie v Rowley (1921) 187 C 481 (contractual obligations); People v Clauson (1964) 231 CA2d 374 (tax liabilities).

“Piercing the corporate veil” is a legal phrase used to describe the removal of corporate entity protection to hold shareholders or directors personally liable for corporate debts and liabilities.

Limited corporate liability in California, whether through a limited liability company, limited liability partnership, or corporation, is the foundation of the corporate form. Small, closely held corporations are the most susceptible to veil piercing. Nevertheless, corporate protections are difficult to overcome absent illegality,  serious corporate misconduct as defined under case law with regard to tax and non tax creditors, and by statute for tax creditors of the corporation.

The Presumption of Limited Liability

Anytime damages are sought directly from a corporate subsidiary, parent company, shareholder, or director, California presumes corporate protection. The plaintiff must overcome this presumption based on the facts of each case. This can be done in two ways:

(1) at common law, where wrongful conduct is typically required, or

(2) under the “alter ego” doctrine of liability.

California Alter Ego Liability

Shell companies, holding companies, and subsidiary corporations are commonly used to limit the liability of a parent company. Such constructions are not illegal per se, but they can be misused. The primary avenue of piercing the corporate veil in California is the alter ego doctrine, which allows veil piercing when the liable business entity is merely an “alter ego” of the party you seek to hold liable. California courts may pierce the corporate veil under this doctrine if:

  • The entities have a unity of interest, i.e., they share funds, are run by the same directors, and have the same shareholders, and
    It would be unjust to treat the corporate acts as separate from the acts of the shareholder or the alternative corporation.
  • Wrongful conduct is not required to pierce the corporate veil under the alter ego theory of liability in California. Instead, the primary consideration is whether it would be unreasonable or unjust to refuse to pierce the veil. This requires a case-by-case factual analysis.

Factors to Consider for Veil Piercing in California

California courts may pierce the corporate veil when one or more of the following factors are present and the same are indicative of injustice:

  • The individual defendant controls the corporation;
  • The individual defendant owns all or almost all of the corporate stock;
  • There is a co-mingling of private and corporate assets such as shared bank accounts, funds, and records;
  • The business shares residential or corporate address;
  • Corporate funds are used to pay the personal debts and expenses of the individual defendant or alternative corporation;
  • The corporation fails to adhere to certain corporate formalities such as the election of directors;
  • There are insufficient corporate records;
  • The business has insufficient assets and capital;
  • The individual defendant is the primary “employee” or contractor of the entity; and
  • It appears the corporation is a shell corporation.

Taken together, these factors are indicative of misuse of the corporate form for private gain.

Alter Ego Doctrine

Normally, the corporation is an insulator from personal liability for shareholders and officers of a corporation from the claims of creditors. Limited liability for the persons involved in the corporation is a protection afforded by the corporate form and the privileges associated with the fictional entity created by statute and recognized by the state, and as such, the individual shareholders and officers are protected by the corporation from individual/personal liability and subject only to limited liability. However, there are occasions when the shield from liability afforded by the corporation will be denied, and instead the courts will look beyond the corporate form and deal with the substance of the transaction as if the corporation does not exist and render the shareholders and officers personally liable for acts and liabilities of the corporation. This is the alter ego doctrine.

The alter ego doctrine arises when a plaintiff comes into court claiming that the opposing party is using the corporate form unjustly and in a way that is harmful to the plaintiff’s interests. In certain circumstances, the court will disregard the corporation and hold the individual shareholders and officers liable for the actions of the corporation. Since the separate personality of the corporation is a statutory privilege, when it is abused, it will be disregarded and the corporation looked at as a collection or association of individuals, liable for the acts done in the name of the corporation. This is called “piercing the corporate veil” an equitable doctrine based on fairness, justice and public policy to impose liability on the individuals who disregard and abuse the corporate form. When a court disregards the corporate entity, the court does not dissolve the corporation, rather, the court disregards the fiction of the corporate entity or will pierce the corporate veil, thus disregarding the corporate privileges, and fastening liability on the individual shareholders.

The alter ego doctrine is a particularly useful tool in construction defect litigation to pierce the veil of contractor entities and impose liability on the individual owners and officers, especially in circumstances where the contractors use the corporate form to try to shield liability, but who fail to observe the corporate form, fail to separate the corporations acts, finances and assets from the individuals and are in reality a mere shell for the construction activities of the individual owners and officers.

There is no litmus test to determine when the corporate veil will be pierced, rather the application of the doctrine and the result will depend on the circumstances of each case. There are, nevertheless, two general requirements: (1) that there be a unity of interest and ownership that the separate personalities of the corporation and the individual(s) no longer exists, and (2) that, if the acts are treated as those of the corporation alone, an inequitable result will follow.
The 14 Factors to Test for Alter Ego Liability

The alter ego test encompasses a host of factors: Listed as follows:

Commingling of funds and other assets, failure to segregate funds of the separate entities and the unauthorized diversion of corporate funds or assets to other than corporate uses
The treatment by an individual of the assets of the corporation as his own
The failure to obtain authority to issue stock or to subscribe to or issue the same
The holding out by an individual that he is personally liable for the debts of the corporation, the failure to maintain minutes or adequate corporate records, and the confusion of the records of the separate entities
The identical equitable ownership in the two entities, the identification of the equitable owners with the domination and control of the two entities, identical directors and officers in separate entities responsible for supervision and management, sole ownership of all stock in a corporation by one individual or the same members of a family
The use of the same office or business location, the employment of the same employees and/or attorney
The failure to adequately capitalize the corporation, the total absence of corporate assets and undercapitalization
The use of the corporation as a mere shell, instrumentality or conduit for a single venture
The concealment and misrepresentation of the identity of the responsible ownership, management and financial interest, or concealment of personal business activities
Disregard of the legal formalities and the failure to maintain arm’s length relationships among related entities
The use of the corporate entity to procure labor, services or merchandise for another person or entity
The diversion of assets and liabilities from a corporation by or to a shareholder or other person or entity, to the detriment of creditors, or the manipulation of assets and liabilities between entities so as to concentrate the assets in one and the liabilities in another
The contracting with another with the intent to avoid performance by use of a corporate entity as a shield to personal liability
The formation and use of a corporation to transfer the existing liability of another person or entity

Note: This list is not exhaustive and courts may consider other factors according to the circumstances of each case. No single factor is determinative and the courts will examine all of the circumstances to determine whether to apply the doctrine. In other words, these factors are critically important, and the issue of alter ego liability will depend on the facts and circumstances of each case.