Nicholas R. Frazier

It is a violation of every assumption we make about incorporation. It has been called the most litigated issue in corporate law. Yet many business owners fail to acknowledge it. I am referring to the doctrine of “piercing the corporate veil.” It is an unfortunate, awkward metaphor–a better moniker might be “piercing the corporate shell,” because that is essentially what it refers to.

A business’s owners (e.g. shareholders, members, managers) ¹ are generally thought to be protected from the liabilities of the business. If the business gets sued, or goes bankrupt, the owner may assume that, in the main, he or she will not be personally held responsible. This is precisely why many small businesses are formed. Limited liability is, in fact, thought to be a foundational cause for the unbridled success of the American economy in the last 200 years.

Although limited liability is seen as an overall positive benefit to society, there are occasions when the legal fiction has been abused. For that reason, courts have created the concept of piercing the corporate veil.

The Law of Piercing in North Carolina

In North Carolina, a corporation is generally treated as distinct from its shareholders.  While this is a safe assumption in the vast majority of cases, it is not absolute. Courts can and will make an exception, when applying this corporate fiction would accomplish some fraudulent purpose, operate as a constructive fraud, or defeat some strong equitable claim.  If and when these exceptions apply, the court is said to have “pierced the corporate veil” to make individuals responsible for a corporation’s liabilities. In effect, the court ignores the very legal existence of the corporation.

Piercing is not an easy concept, and there are few clear rules governing its application. As Judge Frank Easterbrook has said, “There is a consensus that the whole area of limited liability, and conversely of piercing the corporate veil, is among the most confusing in corporate law.” Justice Cardozo, the poet of jurisprudence, observed that the doctrine is “enveloped in the mists of metaphor.”

Regardless, courts have of necessity developed guidelines concerning piercing. North Carolina courts follow the so-called “instrumentality rule.” Under the rule, if a corporation is operated as a “mere instrumentality or alter ego” of the shareholder, using it as a shield to skirt the law, the corporation will be ignored, and the shareholder will be held personally liable. ²

In order to prevail under the instrumentality rule, a plaintiff must prove three elements: (1) that the shareholder’s control of the corporation amounted to “complete domination” with respect to the transaction at issue; (2) that the shareholder used this control to commit a wrong, or to violate the other plaintiff’s rights; and (3) that this wrong or breach of duty was the proximate cause of the injury to the other party. ³

Equity is an overarching consideration in the application of these rules. That is, courts will look at the fairness to the parties, plaintiff and defendant, of either disregarding the corporate form or allowing it to limit the liability of its shareholders. If it would be patently unfair to the suing party for the court to let a shareholder shield itself from responsibility (by hiding behind a corporation), then in all likelihood the court would not do so. ⁴

Bankruptcy court is another forum where a corporation should be wary of the possibility of piercing. However, a bankruptcy court will generally follow the piercing rules of the state where it is situated. The recommendations that follow, therefore, remain sound in both matters of North Carolina’s state court and matters of our bankruptcy courts.

General Recommendations for the Corporation or LLC

Because courts handle piercing on a case-by-case basis, it is difficult to draw bright lines when considering how a business can protect itself. Although there are few absolutes, the following best practices should assist in achieving and keeping a legitimate “corporateness.” These recommendations are tailored to small corporations and LLCs in North Carolina, but any small business may benefit from following these simple rules.

The first and most important recommendation is to build your corporate philosophy on a foundation of good faith and fair dealing. Treat your business’s stakeholders as you would yourself want to be treated. It should go without saying that a business based on fraud and deceit will probably not fare well when the specter of piercing appears. And as a practical matter, friends don’t like to sue each other. Make friends with those who have an interest in your business, and cultivate the friendships regularly.

There are a few more specific recommendations that any LLC member or corporate shareholder should keep in mind:

1. Separate your money. Keep a separate bank account for your business. Don’t put personal funds in your corporate account, and vice versa.
2. Likewise, be careful when moving funds from corporate accounts to personal accounts, and vice versa. If you loan money to your business, or pay yourself a dividend, document it.
3. Keep separate bookkeeping records for yourself and your business.
4. Capitalize your business adequately.
5. Make sure that your business has sufficient insurance to cover the most common liabilities.
6. Pay attention to corporate formalities, both required and nonrequired. If your business makes an important decision (e.g. entering into a lease agreement for office space, changing the bylaws), document it with a resolution. File annual reports with the Secretary of State on time.
7. Consider entering into an employment agreement with your business. This will make clear your relationship with your business, and the process itself will force you to carefully consider you and your business’s respective rights and duties.

Piercing is like the measles of small business. Measles is relatively rare in this country, but it is nevertheless a dangerous, highly contagious disease. Fortunately, a vaccine is available to greatly reduce the risks of contracting the virus. Similarly, you can vaccinate your corporation against the rare, but dangerous, possibility of piercing. By respecting the separate corporate identity, and by practicing good corporate ethics, you can help keep your business healthy and long-lived.

As always, check with your own attorney before making any decisions concerning your business. This is meant to be a brief overview of the general concepts, not legal advice; only your attorney can review your own particular facts and circumstances and advise you accordingly.