Businesses choose to form affiliate or subsidiary entities for a broad range of reasons. Frequently, the decision is motivated by a desire to protect a parent company's assets from the risks associated with venturing into new markets or developing a novel technology or product line. While this is a sound corporate strategy, a parent company must be certain to respect the separateness of its subsidiary or affiliate entities, or the parent risks finding itself liable for the subsidiary's torts, debts and other misconduct.
A parent corporation and its subsidiaries and affiliates are presumptively regarded as separate and distinct legal entities, even when the entities have common management and overlapping stock ownership. The benefits of limited liability provided by the corporate form, however, are not without limit and may be forfeited by an unwary business owner. It should come as no surprise that astute plaintiffs' lawyers are always on the lookout for opportunities to reach the assets of a parent company in the event of misconduct by one of its subsidiary or affiliate entities.
This theory of ascending liability, often referred to as "piercing the corporate veil," is among the most frequently litigated issues in corporate law. When determining whether piercing the corporate veil is warranted, courts rely, in one form or another, on either the instrumentality or identity test. In short, these tests focus on whether a subsidiary or affiliate operates as a truly independent organization, free from the control and influence of its parent.
Whether piercing is justified is an extremely fact-specific inquiry. While little can be done to prevent a lawsuit from being filed, a parent company that vigilantly ensures the separateness of its subsidiaries and affiliates greatly increases its chances of protecting its assets should litigation arise. The discussion below identifies some of the factors courts review when evaluating a piercing claim and actions that businesses should take to limit liability.
Compliance with Corporate Formalities
Meetings and Organizational Documents
Companies that strictly observe corporate formalities are more likely to be viewed as operating independently than those that do not. The most fundamental formality is strict compliance with all organizational documents (Articles of Incorporation, By-Laws, etc.). While organizational documents must be properly executed, it is also important that the directors and officers have a thorough understanding of the documents and abide by the restrictions contained within them. This necessarily dictates that a company hold all meetings as the organizational documents require. Good record keeping is also an essential element of observing corporate formalities, as all actions taken at a meeting must be recorded in the company's minutes and placed in the corporate record book.
Always Conduct Business in the Corporate Name
When multiple entities operate under the same corporate umbrella, it is critical that each entity consistenly conduct business in its proper corporate name. A failure to do so may create ambiguity about which corporate entity is acting. Such ambiguity frequently leads to the inference that an entity is not operating as a truly independent organization but rather is acting at the behest of its parent. There are several common-sense steps that can be taken to ensure that customers are clear about which entity they are doing business with. These steps include instructing company representatives to sign all documents using the complete and official company name, using letterhead that precisesly identifies the entity responsible for a mailing and making certain that each corporate entity maintains a distinct online indetity (email addresses, webpage, etc.).
Maintain Separate Finances
To avoid the appearance of being engaged in a common enterprise, entities that are part of the same corporate family must be certain to avoid comingling funds. This is most easily accomplished if each entity maintains separate financial records and bank accounts. This does not mean that a parent company is prohibited from loaning funds to a subsidiary or affiliate. If a loan is made, however, it is crucial that it is properly documented and made only after the appropriate corporate actions have been taken.
It should be noted that some courts view undercapitalization as a sufficient reason to pierce the corporate veil. Therefore, a parent company forming a subsidiary or affiliate must ensure that the new entity is properly capitalized from the outset. Otherwise, the parent risks appearing as though the new entity was formed to do its bidding while avoiding the risk of a large financial loss.
Respect Corporate Barriers
In developing businesses, it is not unusual for a founding member or majority shareholder to serve as a board member for a parent company as well as its subsidiary or affiliate. Such scenarios, as a result of their outward appearance, are ripe for piercing claims. Thus, directors serving on the board of multiple companies under the same corporate umbrella must be acutely aware of their fiduciary duties.
A director's fiduciary duty of loyalty to a company is not diminished by appointment to multiple boards. A director serving on multiple boards must be certain to act in the best interests of the company of the board on which they are sitting. A director who fails to do so risks creating the appearance that an affiliate or subsidiary company is not truly independent but is being used an as instrumentality of the parent.
A director serving on the board of a parent and its subsidiary will inevitably encounter situations where there is a potential conflict of interest. For example, a board member may be asked to vote on a proposal that would not be in the best interest of the subsidiary but would greatly benefit the parent company. A director in such a situation must disclose the potential conflict to the other board members and then, if it is determined that there is a conflict, ask to be recused from the vote and any deliberations leading up to the vote. Typically, approval of a resolution by the disinterested directors is sufficient to avoid any claims of impropriety. Many companies that frequently encounter these situations provide annual fiduciary training to directors as a preventative measure.
While limited liability protection enables companies to explore new lines of business without risking established corporate assets, an inattentive parent company can find itself on the hook for more than it bargained. To maintain the limited liability protections afforded by the corporate form, it is essential that both the parent company and its subsidiaries or affiliates strictly observe corporate formalities and respect corporate boundaries. Though most of the aforementioned suggestions are little more than good business practices, they may serve as an invaluable insurance policy if a lawsuit arises.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.