by Craig D. Hasenbalg (Summer 2016)
Most anyone who has had a hand in running a for-profit or not-for-profit corporate entity has, at least vaguely, heard of “piercing the corporate veil.” Not always understood is exactly what that phrase means, and why satisfying the corporate formalities required of profit and not-for-profit corporations is essential.
Piercing the corporate veil is essentially a judge-made rule of law that, in the proper circumstances, strips from the corporate entity one of, if not its most, beneficial characteristic: insulating shareholders, directors and officers from personal liability for corporate debts and obligations. Normally, if an aggrieved third party sues the corporation and wins, any judgment must be satisfied, if at all, from the assets owned by the corporation. The personal assets of those owning and operating the corporation are not at risk of loss. In the worst-case scenario, the corporation may have to be liquidated in order to satisfy any judgment, but the personal savings accounts, real estate, investment accounts, automobiles, and all other assets of the shareholders, directors and officers remain intact.
When the right set of circumstances exist, however, Illinois and the law of all 49 other states (as well as federal jurisdictions) allow the veil of the corporation to be “pierced.” As the name implies, this, in turn, allows the personal assets of those owning and controlling the corporation to be seized to satisfy creditors of the corporation.
Different courts have different formulations of when the corporate veil can and should be pierced. Typically, courts state that in order to pierce the corporate veil, two requirements must be met. First, there must be such unity of interest and ownership that the separate personalities of the corporation and the individual owners no longer exist. Second, circumstances must be such that an adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice. (see Gallagher v. Reconco Builders, Inc., 91 Ill.App.3d 999, 1004 (1st Dist. 1980)).
In order to determine if the forbidden “unity of interest” test and “fraud or injustice” test have been satisfied, a court will analyze various factors. These factors include inadequate capitalization, failure to issue stock, failure to observe corporate formalities, nonpayment of dividends, insolvency of the debtor corporation at the time, nonfunctioning of other officers or directors, absence of corporate records and whether in fact the corporation is only a mere façade for the operation of a dominant shareholder.
While every situation is different, no matter what formulation a court employs to determine whether the corporate existence should be ignored, adherence to corporate formalities inevitably is a factor discussed. In other words, regardless of what other factors may exist, adherence to corporate formalities weighs against piercing the corporate veil in any formulation of the rule. Consequently, satisfying the corporate formalities is an easy way to at least begin tilting the playing field in favor of insulating shareholders from corporate obligations. However, adhering to these formalities is often overlooked.
So what are the corporate formalities? A non-exhaustive list includes paying the “annual report” filing fee and filing the annual report each year to keep the corporation in good standing; conducting an annual meeting of shareholders (and keeping minutes of such a meeting), keeping and updating a corporate book (where the minutes of each meeting should be kept); electing directors (and conducting annual meetings of directors), appointing officers to organize the corporation; and generally keeping a record of all the actions the corporation takes.
It is important to note that not every corporation is the same, and consequently the formalities that must be maintained vary from situation to situation. A minor failure to adhere to corporate formalities is, in the absence of more compelling evidence of fraud or unfairness, not generally grounds for piercing the corporate veil (see Jacobson v. Buffalo Rock Shooters Supply, Inc., 278 Ill.App.3d 1084 (3rd Dist. 1997), holding that when a corporation completed all of the formal documents necessary to its formation, issued stocks, and filed appropriate tax returns, merely missing one annual meeting is not sufficient to show the corporate formalities have been ignored).
On the other end of the spectrum, a complete failure to satisfy even one corporate formality will, even in the face of very insignificant evidence of fraud or other unfairness, justify corporate veil piercing (see Ted Harrison Oil Co. v. Dokka, 247 Ill.App.3d 791 (4th Dist. 1993), holding that where no records were kept, the company did not hold formal shareholder or directors’ meetings, cash distributions were not reflected in the books and records of the corporation, and without any evidence of any formal approval from the shareholders or board of directors for any decisions whatsoever, the corporate veil could be pierced).
Documenting the minutes of corporate meetings — and indeed committing to hold meetings of shareholders and directors in the first place — is, or most times should be, fairly easy and straightforward. Elaborate plans need not be undertaken, and a meeting sufficient to satisfy Illinois law can be held at a convenient time and place for the shareholders, directors and officers of any corporation. Documenting the decisions made at such meetings likewise does not take any special training or knowledge.
However, the failure to perform even these basic corporate functions can lead to disastrous results. Anyone involved in the management of a profit or not-for-profit entity who seeks to rest easy at night, knowing his or her personal assets are not at risk, needs to make sure the corporate formalities are completed, and documents exist to prove adherence to these formalities. If such documents exist, in the absence of true fraud or other wrongdoing, piercing the corporate veil is a rare occurrence.