Alter Ego Liability or Piercing the Corporate Veil in Colorado
In general, the purpose of creating a business entity is to insulate the owners and shareholders of that business from personal liability. Business entity formation is a legal creation that, because the owners and shareholders are insulated from liability, incentivizes people to take risks and start new businesses since they will not have to worry about their personal assets being taken if the business fails. However, this insulation of liability can be removed where certain conditions are met. This article addresses what’s required to remove that liability.
More specifically, while shareholders of a corporation are generally not personally liable for the acts or debts of the corporation, they may become liable where the corporation acts as an “alter ego” for an individual or other related corporate entities See C.R.S. § 7-106-203(2). The act of collapsing one entity into another such that any insulation from liability is removed is called “piercing the corporate veil” and stems from principles of equity. See Krendl & Krendl, Colorado Methods of Practice, § 1:58 (2009).
Because corporations are a legal construct that insulates their shareholders from liability, in rare circumstances, where fairness dictates, the corporate form is disregarded such that the owners or, in some cases, the managers of the company may be found personally liable for the debts and liabilities of the corporation. However, because the purpose of creating a corporation is to protect shareholders from liability, courts strongly disfavor piercing the corporate veil and only do so under exceptional circumstances. See Skidmore, Owings & Merrill v. Canada Life Assur. Co., 907 F.2d 1026, 1027 (10th Cir. 1990); Leonard v. McMorries, 63 P.3d 323, 330 (Colo. 2003).
Procedurally, the party seeking to pierce the corporate veil has the burden of proof and must prove that the veil should be pierced by a preponderance of the evidence, the traditional burden of proof in civil cases. See U.S. v. Friedland, 173 F. Supp.2d 1077, 1092 (D. Colo. 2001); McCallum Family L.L.C. v. Winger, 221 P.3d 69 (Colo. App. 2009). Further, the legal claims at issue can play into whether the corporate veil should be pierced for a company. Specifically, courts are more likely to pierce the corporate veil in a tort case as opposed to a contract case. See Yoder v. Honeywell Inc., 104 F.3d 1215, 1222 (10th Cir. 1997). Additionally, because piercing the corporate veil is an equitable result, there is no right to a jury trial and the decision to pierce the corporate veil must be made by the court.
Overall, at its simplest, alter ego liability occurs where another individual or entity is made liable for the debts of a corporation because they are equitably considered the same legal entity. The piercing of the corporate veil can happen in multiple directions. For example:
– A subsidiary corporation can be held liable for the debts of its parent corporation and vice versa;
– An individual owner or manager of a company can be personally held liable for the debt of the company; and
– Reverse piercing can occur where a company is held liable for the personal debts of an individual owner or manager.
These situations are all addressed in further detail below.
Alter Ego Liability for Parent Companies and Subsidiaries
Importantly, it is neither uncommon nor illegal for a corporation to form a subsidiary corporation to protect it assets from liabilities arising from the subsidiary’s independent actions. In such circumstances the corporate fiction and insulation from liability will be maintained where the subsidiary and parent are truly indeed maintained as separate entities.
However, where the subsidiary is not treated as a separate legal entity and is used for an improper purpose, courts may determine that piercing of the corporate veil is appropriate such that they the two entities are legally considered the same and, thus, both liable for each entity’s debts.
In determining whether or not to pierce the corporate veil between a parent company and its subsidiary, Colorado courts look at the following factors:
– Whether the parent corporation owns all or a majority of the capital stock of the subsidiary;
– Whether the parent and subsidiary have common leadership such as directors or officers;
– Whether the parent finances the subsidiary;
– Whether the parent subscribes to all the capital stock of the subsidiary or otherwise causes its incorporation;
– If the subsidiary has grossly inadequate capital;
– Whether the parent corporation pays the salaries or expenses or losses of the subsidiary;
– Whether the subsidiary has substantially no business except the parent corporation or no assets except those conveyed to it by the parent corporation;
– Whether the parent refers to the subsidiary as a separate corporation or as a department or subdivision of the parent;
– Whether the directors or executives of the subsidiary take independent action or only take action as directed by the parent; and
– Whether the formal legal requirements of a corporation are observed by the subsidiary, for example keeping corporate meeting minutes and maintaining required corporate filings.
See Fish v. East, 114 F.2d 177, 191 (C.C.A. 10th Cir. 1940). Notably, no single one of these factors is determinative of whether the corporate veil should be pierced. Instead, courts look to the totality of the circumstances and whether the subsidiary is acting as the alter ego of the parent in light of these factors. Where fairness dictates that the parent and its subsidiary should be considered the same legal entity the corporate veil will likely be pierced.
Alter Ego Liability for Individual Shareholders or Corporate Insiders
In addition to piercing the corporate veil for subsidiary or parent liability, the corporate veil may also be pierced to find individual shareholders or corporate insiders – e.g,. managers of directors – liable for the debts of the corporation.
While, traditionally, corporations are pierced with respect to individual owners, Colorado courts have found that the veil can also be pierced with respect to non-owners that are exercising sufficient control over the company that they can equitably be considered to be shareholders. See McCallum Family L.L.C. v. Winger, 221 P.3d 69 (Colo. App. 2009).
Specifically, in Lafond v. Basham, 683 P.2d 367, (Colo. App. 1984), the Colorado Court of Appeals determined that:
A corporate entity may be disregarded and corporate directors may be held personally liable if equity so required . . . if adherence to the corporate fiction would promote injustice, protect fraud, defeat a legitimate claim, or defend crime, the invocation of equitable principles for the imposition of personal liability may occur.
In LaFond, the corporation at issue was a closely owned entity where the corporate director’s wife and son owned all of the shared of the corporation; however, the director was found to control and direct both of them with respect to business decisions. The director also testified that “he owned the corporation” at trial. Accordingly, because the director exercised domination and control over the company, the Colorado Court of Appeals determined that piercing of the corporate veil was appropriate even though the director was not technically an owner of the company. See id.
In a more recent decision, the Colorado Supreme Court specifically enumerated a three-part test in determining whether the corporate veil should be pierced. See In re Phillips, 139 P.3d 639 (Colo. 2006). The three-part test consists of:
(1) Determining if there is a unity of interest and lack of respect given to the separate identity of the corporation by its shareholders such that the personalities and assets of the corporation and the individual are indistinct.
Factors for determining whether the first part is met are similar to the factors regarding piercing the corporate veil between a parent and its subsidiary. These factors include:
– Whether the corporation is operated as a separate entity;
– Whether there has been commingling of funds and other assets;
– If adequate corporate records and minutes are maintained;
– Whether legal formalities for a corporation are maintained;
– Whether arms-length relationships among related entities are maintained;
– The nature of the ownership and control of the corporation;
– Whether the corporation has assets or is undercapitalized;
– Use of a corporation as a shell, instrumentality of conduit of an individual or another corporation; and
– Diversion of corporate funds or assets to noncorporate uses.
(2) Determining whether adherence to the legal fiction of the corporation would result in fraud, promote injustice, or lead to an evasion of legal obligations.
Importantly, in order to meet this element, the showing of inequity must flow from the misuse of the corporate form. That is, only when the shareholders disregard the separateness of the corporate identity and when that act of disregard causes the injustice should the corporate veil be pierced. If the corporate form was not used to shield the shareholder’s improper action, the corporate veil may not be pierced.
(3) Lastly, an equitable result must be achieved by disregarding the corporate entity since the piercing a corporate veil is an equitable remedy.
See In re Phillips, 139 P.3d 639 (Colo. 2006); Cherry Creek Card & Party Shop, Inc. v. Hallmark Marketing Corp., 176 F. Supp. 2d 1091, 1097 (D. Colo. 2001). Accordingly, where these requirements are met courts will find that the corporate veil should be pierced and the corporate fiction abandoned.
Reverse Piercing of the Corporate Veil
While piercing the corporate veil seeks to hold individuals or other corporations liable for a related corporation’s debts, reverse piercing seeks to hold a corporation liable for the debts of an individual. The Colorado Supreme Court has found that reverse piercing is permissible under Colorado law.
The law in this area is not yet well developed; however, the same three-part test enumerated above for determining whether piercing is applicable towards an individual is also applied for reverse piercing from an individual towards a corporation. See In re Phillips, 139 P.3d 639, 644 (Colo. 2006).
Application of Alter Ego Liability to Other Entities besides Corporations
Originally, alter ego liability was premised on piercing the legal fiction of separate entities specifically with respect to corporations. However, with the development of new business entities such as Limited Liability Companies (“LLC”), Limited Partnership (“LP”), Limited Liability Limited Partnerships (“LLLP”), the doctrine has since been expanded to business forms other than corporations.
In particular, Colorado courts have specifically found that, at a minimum, alter ego liability can also be applied to LLCs. Importantly, as with corporations, LLCs under Colorado law limit liability such that the LLCs members and owners are not personally liable for the debts of the company.
However, several Colorado cases have found that piercing of the corporate is permissible with respect to LLCs on the same basis that corporations may have their corporate veil pierced. See Piercing the Corporate Veil of an LLC or a Corporation, 39 Colo.Law. 71 (2010).
Accordingly, under current Colorado law, it seems that alter ego liability is potentially applicable to all business entities provided that the three –part test for piercing the corporate veil enumerated above is met.
Procedural Aspects of Alter Ego Liability
While piercing the corporate veil can extend liability through or to another company, importantly alter ego liability is not an independent cause of action in itself. In other words, piercing the corporate veil only acts to extend liability from one entity to another, there still needs to be an underlying claim that gives rise to that liability. See The Alter Ego Doctrine in Colorado, 28 Colo.Law. 53 (1999).
Procedurally, when pleading alter ego liability allegations in a lawsuit, certain requirements need to be met. In particular, the party asserting alter ego has the burden of demonstrating a prima facie case in in its pleadings in order for the presiding court to exercise jurisdiction over the alter ego entities. See First Horizon Merchant Services, Inc. v. Wellspring Capital Management, LLC, 166 P.3d 166 (Colo. App. 2007).
More specifically, a party must allege facts in its pleadings that – outside of other contradictory evidence – would be sufficient enough for the court to find that alter ego liability exists. See id. at 178. Along these lines, the allegations must be more than just conclusory statements and, instead, must contain sufficient facts to meet the prima facie showing requirement. Id. If insufficient facts are not plead or only conclusory statements are made, then the alter ego entities may be dismissed from the lawsuit based on lack of personal jurisdiction. Id.
In contrast, if sufficient facts are plead to meet the alter ego requirement, then the presiding court may exercise jurisdiction over all the alter ego defendants. The ability of the court to do this stems from the underlying nature of alter ego liability which, in essence, alleges that the entities function as the same legal entity. See Warad W., LLC v. Sorin CRM U.S., Inc., 119 F.Supp.3d 1294 (D. Colo. 2015).
Accordingly, where a court has proper jurisdiction over a defendant, if sufficient facts are plead to make a prima facie case of alter ego liability with respect to other defendants, the court may exercise jurisdiction over those other entities even where the other entities have no contacts with the forum state or are located in another country. See id.
Ultimately, however, while sufficient facts may be plead to make a prima facie showing for pleading requirements, that does not automatically mean that alter ego liability will be established. Instead, it merely means that sufficient facts have been plead to bring other entities into the lawsuit where personal jurisdiction may not otherwise be established. Alter ego liability still needs to be established and proven at trial.
© 2016 J.D. Porter, LLC; Jordan Porter. Denver, Colorado.