CORPORATIONS

Examples and Explanations

Fifth Edition

Alan R. Palmiter
Professor of Law
Wake Forest University

ASPEN
PUBLISHERS

76 Ninth Avenue, New York, NY 10011

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 32
Piercin£f the
Corporate Veil

Limited liability tempts insiders to exploit the corporation's creditors. Insiders

can use their control to create a deceptive appearance of corporate solvency,
engage in self-dealing transactions, distribute corporate funds to themselves,
or undertake high-risk/high-retum corporate projects. In each case, any gains
accrue to the insiders and — because of limited liability — any losses fall on
outside creditors.
As a protection against insider abuse, courts sometimes disregard the rule
of limited liability and "pierce the corporate veil" to hold shareholders, direc-
tors, and officers personally liable for corporate obligations. Piercing is difFer-
ent from other protections afforded corporate creditors. In a piercing case —

• The business has been properly incorporated (see Chapter 29 —

promoter liability on preincorporation transactions).
• T h e Corporation is obligated to the creditor (see Chapter 3 0 —
authority o f corporate agents to bind the Corporation).
• Distributions to shareholders have been statutorily proper (see
Chapter 31 —limitations on distributions to shareholders).

When is piercing appropriate? This is one of the most perplexing and most
litigated questions in corporate law. The cases are rich in metaphors — alter
ego, dummy, instrumentality, sham —but often short on principled analysis.
This chapter considers the factors courts have articulated to decide piercing
cases (§32.1) and oudines a principled basis for weighing these factors (§32.2).

§32.1 Traditional Piercing Factors

The piercing doctrine, an exception to limited liability, seeks to protect out-
siders who deal with the Corporation. When a court pierces the corporate veil,

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§32.1 Protection o f Corporate Creditors

it places creditor expectations ahead of insiders' interests in limited liability.

Courts do not take this step lightly. Disregarding limited liability chills capital
formation and desirable risk-taking. Furthermore, those who have voluntary
dealings with the company can protect themselves by contract, and involun-
tary creditors (such as tort victims) often are protected by insurance or
government regulation.
Courts have articulated different tests for piercing the corporate veil, such
as the "instrumentality" doctrine or the "alter ego" test. These tests focus on
the use of control or ownership to "commit fraud or perpetúate a dishonest
act" or to "defeat justice and equity." But these tests provide little guidance,
and results in particular cases do not seem to tura on which test a court
employs.
Rather, particular piercing factors seem more relevant even though no
one factor emerges as determinative. It is generally believed that courts are
more likely to pierce in the following situations —

• the business is a closely held Corporation

• the plaintiff is an involuntary (tort) creditor
• the defendant is a corporate shareholder (as opposed to an individual)
• insiders failed to follow corporate formalities
• insiders commingled business assets/affairs with individual assets/
affairs
• insiders did not adequately capitalize the business
• the defendant actively participated in the business
• insiders deceived creditors

Although a few jurisdictions have attempted to codify the weight to be

given some of these factors, piercing remains largely a judicial function. See
Tex. BCA art. 2.21 (1997) (no piercing for failure "to observe any corporate
formality" and in contract cases unless Corporation used to perpetrate "actual
fraud"); ULLCA §303(b) (no piercing for limited liability company's failure
to observe usual formalities).

§32.1.1 Closely Held Corpovations

Courts pierce the corporate veil only in closely held corporations or corporate
groups. No reported case of piercing has ever involved the shareholders of a
publicly traded Corporation. See Robert B. Thompson, Piercing the Corporate
Veil: An Empirical Study, 76 Cornell L. Rev. 1036 (1991) (looking at all
piercing cases on Westlaw through 1985). Shareholders in closely held cor-
porations usually manage the business, choosing the risks the business takes
and the asset coverage for those risks. Moreover, investment diversification
and stock trading markets — two of the reasons for limited liability — are far
less important to investors in a closely held business.

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 Picrcing the Corporate Veil §32.1

Just because a business is closely held, however, does not mean its share-
holders or managers are subject to unlimited liability. Although courts in
piercing cases often refer to shareholder "domination" or "absolute control"
as factors, this is the usual state of affairs in most closely held corporations.
Other factors must support piercing, because encouraging capital formation
and rational risk-taking remain valid reasons for limited liability in a closely
held business.

§32.1.2 Involuntary Creditors

Courts often are less willing to pierce the corporate veil for creditors whose
dealings with the Corporation were voluntary—such as suppliers, employ-
ees, customers, and lenders. So long as they are not deceived, voluntary
creditors usually can anticípate the corporation's "no-recourse" structure
and contract for personal guarantees, higher prices, or assurances on how
the business will be conducted. For example, in Brunswick Corp. v. Waxman,
599 F.2d 34 (2d Cir. 1979), the court rejected a supplier's claim against
shareholders who had set up a no-asset "straw" Corporation solely to make
payments under the supply contract. The court refiised to pierce since the
supplier, which knew the Corporation had minimal capitalization and was
incorporated to assure limited liability for its shareholders, was not misled
and assumed the risk. Even when shareholders make vague assurances that
they will "stand behind" the corporate obligations, courts have refused to
pierce on behalf of sophisticated contract creditors who failed to insist on
formal personal guarantees. See Theberge v. Darbo, Inc., 684 A.2d 1298 (Me.
1996) (no piercing even though shareholder's actions described as
"shrewd" and "sharp business tactics").
Involuntary creditors — such as tort victims and retail custom-
ers — cannot easily protect themselves contractually, ñor do they knowingly
assume the risk of dealing with a "no-recourse" business. But courts do not
pierce simply because an involuntary creditor suffers a loss that exceeds cor-
porate assets. The rule of limited liability shifts the risks of the business to
outside creditors, whether voluntary or involuntary. To encourage corpora-
tions to buy liability insurance and to manage business risks better, some
commentators have urged a rule of pro rata liability (liability assessed per
share) in cases brought by tort creditors.
But in practice courts continué to pierce only when other factors are
present. In fact, Thompson's study of reported piercing cases found that
piercing happens less frequently in tort cases (31 percent) compared to
contract cases (42 percent). Although this may simply reflect that tort
victims are more likely to sue indiscriminately all available deep pockets,
while contract creditors are more likely to sue only when they feel deceived
or abused, the results demónstrate the respect that courts give limited
liability.

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§32.1 Protection of Corporate Creditors

§32.1.3 Enterprise Liability Doctrine

Courts sometimes use the enterprise liability doctrine to disregard múltiple

incorporations of the same business under common ownership. The doctrine
pools together business assets to satisfy the liabilities of any part of the enterprise;
the assets of individual owners or managers are not exposed. For example, the
doctrine covers the situation where risky underinsured operations are placed in a
manufacturing "subsidiary" while business profits flow to a marketing "parent"
Corporation. (A parent Corporation is one that holds sufficient stock to exercise
control over a subsidiary Corporation.) Or the doctrine can be used when a
business is split into a number of separate "brother-sister" corporations, each
owned by the same investors, so that the assets of each "affiliate" Corporation are
isolated from the risks of the others. Enterprise liability is more likely when the
managers who run the "asset" Corporation also run the "risk" Corporation.
Consider the famous case of Walkovsky v. Carlton, 223 N.E.2d 6 (N.Y.
1966). Carlton had set up ten wholly owned cab corporations in which he was
the controlling and dominant shareholder. Following a common practice in
New York City's taxi business, each Corporation owned two cabs and
employed its own taxi drivers. A taxi driver of one of the corporations ran
over Walkovsky, who sued all of Carlton's corporations (the owner of the
offending cab, the nine other cab corporations, and the owner of the central
garage) and Carlton himself. As required by statute, each cab Corporation
carried insurance in the amount of $10,000, but no more. The cabs were
heavily mortgaged, and the only other assets of valué (the licenses authorizing
taxi operation in New York City) were judgment-proof by law.
Walkovsky sued on two theories: (1) Carlton's whole taxi enterprise was
Hable, making all the affiliated assets available on an enterprise liability theory;
and (2) Carlton was Hable in his personal capacity. The court accepted the
enterprise liability theory since Carlton's corporations, held out to the public
as a single enterprise, were artificially separated into different corporations. But
the court rejected the argument that Carlton's use of múltiple corporations or
his minimal insurance coverage justified personal liability. The court remanded
to allow the plaintifF to allege that Carlton had conducted the business in his
"individual capacity" and suggested Carlton would be Hable if he had
"siphoned o f f " assets by taking wrongful dividends and distributions.

Parent-Subsidiary Piercing. When a subsidiary incurs liabilities, creditors

will often look to the parent Corporation's assets. But simply isolating business
assets and risks in different corporations does not justify piercing. Instead, courts
have required a showing that the parent dominated the subsidiary so that they
acted as a "single economic entity" and recognizing corporate separateness
would be unfair or unjust. See Radasznvski v. Telecom Corp., 981 F.2d 305
(8th Cir. 1992) (refusing to pierce parent's corporate veil where subsidiary
trucking company had purchased minimum insurance, even though insurance
company was financially unsound and ultimately unable to pay claim). For

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 Picrcing the Corporate Veil §32.1

example, a pharmaceutical company that had acquired a subsidiary that manu-

facturad breast implants was held liable for the subsidiary's allegedly defectíve
producís since the parent controlled the subsidiary's board, annual budgets,
financial arrangements, employment policies, regulatory compliance,
manufacturing quality control, and public relations. In addition, the parent
had failed to provide insurance to cover the subsidiary's potential exposure
and had permitted the use of its ñame in the subsidiary's ads and packaging.
In re Silicone Gel Breast Implants Products Liability Litigation, 887 F. Supp.
1447 (N.D. Ala. 1995).
Thompson's study indicates courts pierce to reach corporate defendants
(37 percent) lessfrequently than individual defendants (43 percent). Although
this result might seem surprising, it reflects the judicial valué placed on limited
liability as a tool in business planning. So long as creditor expectations are not
abused or business risk-taking is not excessive, the reasons for limited liability
apply whether the investor is a Corporation or an individual and whether the
assets to be protected are held by an individual or a business.

§32.1.4 Failure to Observe Corporate Formalities

One of the most common, and most criticized, factors that courts mention in
piercing the corporate veil is whether the corporate participants have observed
corporate formalities, such as holding shareholders' and directors' meetings,
issuance of stock, election of directors and officers, passing resolutions autho-
rizing payments, and keeping corporate minutes. In deciding to pierce, courts
sometimes refer to the failure to observe formalities on the theory shareholders
have used the Corporation as their "alter ego" or "conduit" for their own
personal affairs.
The relevance of corporate formalities is hard to explain. Rarely do the
unobserved formalities relate to the creditor's claim; their introduction at trial
often seems little more than an afterthought. Nonetheless, the attention that
courts give to corporate formalities can be explained at a few levels. First, it has
been argued —perhaps simplistically — that anyone who disregards the cor-
porate form should not be allowed to claim the privilege of limited liability.
Second, it can be argued — more meaningfully — that the failure to observe
formalities may indícate that creditors have been confused or misled about
whom they were dealing with. Third, it can be argued—perhaps most
meaningfully —that a lack of formalities suggests shareholders systematically
disregard corporate obligations. That is, lack of formalities provides indirect
evidence of shareholder commingling and siphoning of assets.

§32.1.5 Commingling Assets and Affairs

Courts also justiíy piercing when shareholders fail to keep corporate and per-
sonal assets separate. Using a corporate bank account to pay for personal

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§32.1 Protection o f Corporate Creditors

expenses, for example, is a sure way to risk piercing. As with the emphasis on
corporate formalities, the theory is that corporate creditors have a valid
expectation that business assets will be available to meet their claims. The
commingling of assets, often accomplished by corporate participants who
"completely dominated" corporate affairs, allows an inference that the
participants disregarded creditor interests.
In cases of enterprise liability, courts often cite confusion of a subsidiary's
affairs with those of the parent Corporation, or among subsidiaries, as a reason
for disregarding separate incorporation. Creditors may be confiised about
which entity they are dealing with, whose credit is on the line, and which
corporation is responsible for accidents. Mixing assets, failing to observe for-
malities, having officers who do not identify in which capacity they are acting,
and using the same trade ñame or stationery are common indiscretions used to
justify enterprise liability.

§32.1.6 Undercapitalization and Purposeful Insolvency

Courts state a willingness to pierce the corporate veil when a corporation is

formed or operated without capital adequate to meet expected business obli-
gations. Courts sometimes justify piercing if there is nominal capitalization or
a purposeful failure to insure.
But simply organizing or running a business that has little or no cap-
ital, standing alone, is generally not sufficient to pierce the corporate veil.
To require that corporations be formed and operated always with adequate
capital to meet all contingencies would add a significant burden to en-
trepreneurial activity. An exception proves the rule. In a largely discredited
decisión by the California Supreme Court, Minton v. Cavaney, 364 P.2d
473 (Cal. 1961), the piercing doctrine reached its zenith. The court sug-
gested the undercapitalization of a corporation organized to run a swim-
ming pool was sufficient to hold a director personally Hable when a young
girl drowned soon after the pool opened. Justice Traynor reasoned that
piercing is proper when a corporation's capital is "trifling" compared to its
business risks and the defendant actively participated in the conduct of
corporate affairs. Courts in other jurisdictions, as well as more recent Cal-
ifornia courts, have rejected this broad undercapitalization rule. In fact,
courts often decide not to pierce even after making explicit findings of
undercapitalization. See Baatz v. Arrow Bar, 452 N.W.2d 138 (S.D.
1990) (refusing to pierce veil of bar that served alcoholic beverages to
uninsured drunk driver, even though bar carried no insurance and was
capitalized with borrowed money).
Sometimes undercapitalization is purposeful, as when the corporation is
run to always be insolvent. In general, creditors expect businesses with which
they deal will be run to be profitable with reserves set aside to meet corporate
obligations as they become due and payable. Purposeful insolvency resulting

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from a shareholder's undisclosed siphoning of whatever corporate assets

become available can justify piercing. For example, in DeWitt Truck Brokers,
Inc. v. W. Ray Flemmint0 Fruit Co., 540 F.2d 681 (4th Cir. 1976), one Ray
Flemming had set up a one-man Corporation to run a fruit brokerage, selling
growers' produce and arranging for its transportation to buyers. Flemming
collected the sales price from buyers, taking out his selling commission plus an
amount to cover transportation charges, and remitting the balance to the
growers. Often, however, he paid himself a salary that included amounts he
withheld as transportation charges. When one of the transporters sued for
unpaid charges, Flemming claimed the company was insolvent and that his
liability was limited. The court pierced the corporate veil and held Flemming
personally liable. By pocketing transportation charges, he abused the
transporters' extensión of credit.

§32.1.7 Active Corporate Participation

Piercing the corporate veil does not imply a disregard of the corporate exis-
tence for all purposes. Often piercing—and henee personal liability — is
appropriate for some corporate participants, but not others. See Freeman v.
ComplexComputingCo., 119 F.3d 104 (2d Cir. 1997) (holding "consultant"
liable for corporation's obligations where consultant received bulk of corpo-
rate revenues and, when Corporation sold its assets, 60 percent of purchase
price went to consultant). Shareholders who are not active in the business and
have not acted to disadvantage creditors are less likely to be personally liable
than those whose actions resulted in a depletion of assets. See MBCA §6.22
(shareholder "may become personally liable by reason of his own acts or
conduct"). Piercing, according to the Thompson study, is more likely in
one-person corporations (49 percent) compared to corporations with three
or more shareholders (35 percent).
One implication of this is procedural. A shareholder sued on a piercing
theory has a due process right to litígate the underlying issue of corporate
liability. Even if the Corporation has been held liable, there is no res judicata
or collateral estoppel effect if the shareholder was not a party to the suit against
the Corporation.

§32.1.8 Deception

Perhaps the most critical factor in piercing cases is the presence of a misrep-
resentation. In Thompson's exhaustive study of piercing cases, courts almost
always pierced (92 percent) when there was a finding of misrepresentation, but
rarely (2 percent) when the court explicitly stated there was no misrepresen-
tation. That is, if a creditor is deceived into believing that the Corporation is
solvent or that the creditor is otherwise protected, piercing is a near certainty.

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This makes sense. Corporate limited liability creates a default

"no-recourse" rule that those who deal with the Corporation will look only
to business assets. Unless they obtain personal guarantees or take other pro-
tective steps, the personal assets of corporate participants are not available to
satisfy corporate obligations. But when corporate participants falsely create the
appearance of sufficient business assets or otherwise mislead creditors, courts
understandably refuse to enforce the usual "no-recourse" understanding.

§32.1.9 Distinguishing Divect Personal Liability

Many cases that hold shareholders liable are not piercing cases at all. If a
shareholder has personally obligated herself for debts of the Corporation, lia-
bility arises not from disregarding the corporate entity but from the share-
holder's personal guarantee. Some courts have extended this idea and have
held that the statute of frauds is not an impediment to a creditor who extends
credit to the Corporation on the basis of a shareholder's oral guarantee. The
creditor, induced to deal with the Corporation by a false promise, can sue the
shareholder personally. Weisserv. Mursam Shoe Corp., 127 F.2d 344 (2d Cir.
1942). Other courts simply use the piercing doctrine as a safety valve to avoid
the problems of enforcing an oral personal guarantee.
Likewise, if a shareholder or corporate manager commits a tort in the
course of corporate business, she is liable under traditional tort and agency
rules. For example, if a director approves business activities knowing that they
will injure others, liability arises from the director's tortious act. See Western
Rock Co. v. Davis, 432 S.W.2d 555 (Tex. App. 1968) (holding director liable
for approving rock-blasting even after company, which was deteriorating
financially, had been sued for previous blasting). Piercing the corporate veil
is unnecessary to reach the tortfeasor's personal assets.

EXAMPLES
1. Five years ago Don incorporated a clock repair business, Timend, Inc. The
corporation rented a downtown storefront from Metro Realty under a
ten-year lease. During the first few years, the business did modestly well.
Don drew a salary that approximated net earnings (revenues less
expenses). Although he kept meticulous records of receipts and payments,
he did not observe any corporate formalities. He held no shareholders' or
directors' meetings; he adopted no corporate resolutions when he paid
himself a salary; he authorized no dividends. Last year the business began
to struggle, and Don's salary shrinks.
a. Don closes the shop. He tells Metro Realty that Timend can no longer
make lease payments. Is Don personally liable under the lease?
b. Can Metro Realty pierce the corporate veil to recover from Don per-
sonally?

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c. When Don signed the lease, he had told Metro Realty that he would
stand behind it. Metro did not get Don's guarantee in wridng. Does
the statute of frauds prevent Metro from suing on the guarantee?
d. Last year Howard, a Timend employee, drove the company van over
Petunia's prize flowers. Howard was acdng within the scope of his
employment, and Timend is liable to Petunia. Can Petunia recover
from Don?
e. Last year Patrick brought his grandfather clock to Don's shop for repairs.
Howard ruined it, and Timend's insurance does not cover the damage.
Don admits he incorporated the business to shield himself from liability
in these circumstances. Can Patrick recover from Don personally?
f. Suppose Don had set up a separate corporation, Heirloom Timepieces,
to repair clocks valued at more than $5,000. Don used separate invoice
forms for Heirloom, which subcontracted its work to Timend. If
Patrick's repairs were on an Heirloom invoice, can he look to Timend's
assets for recovery?
2. Rupert incorporates Exquisite Timepieces Ltd., a mail-order business that
sells "designer" watches through TV infomercials. He capitalizes the
business enough to buy TV time and an initial stock of watches. ETL
gets off to a good start. Rupert receives a generous salary equal to 80
percent of gross receipts. He keeps meticulous records and observes cor-
porate formalities to a tee. As new orders come in, he filis prior orders.
After a while, customer orders go unfilled. Soon there is a staggering
backlog of unfilled orders.
a. Rupert writes expectant customers, " E T L has experienced a cash flow
crisis and cannot fill your order." Can the customers pierce the corpo-
rate veil?
b. Paula, an ETL customer, says her watch has a corrosive backing that turned
her skin purple. Assuming ETL would be liable in tort, is Rupert liable?
c. Laura is Rupert's sister and an ETL shareholder. She did not take a
salary or participate in running the business. If the corporate veil is
pierced because of Rupert's acüvities, is Laura liable to the company's
creditors?
d. ETL was one of many mail-order businesses set up by Rupert—all
separate subsidiaries of a holding company, Mail-Order Possibilides,
Inc. Each subsidiary — one for watches, another for records, another
for gold jewelry, another for vegemadcs — flowed through its profits to
MOP. Are the assets of the MOP group available to cover ETL's debts?

EXPLAN ATIONS
la. No, Don is not liable under the lease. Even though he signed it and
stopped making payments, he acted on behalf of the corporadon. The
corporate form provides limited liability to managers who act for, and
shareholders who invest in, the corporation. Unless Don obligated

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 §32.1 Protection of Corporate Creditors

himself through a personal guarantee or a court uses the piercing doctrine

to disregard corporate limited liability, Metro Realty can look only to
corporate assets for repayment. This is the essence of limited liability.
Ib. Probably not. The piercing factors are split:

For piercing Against piercing

• Timend is closely held and • Metro Realty is a voluntary

Don dominated the business
(factor 1).
• Don did not observe
corporate formalities
(factor 4).
• The business was operated
on a no-profit basis and did
not have sufficient capital to
meet its ten-year lease
commitment (factor 6).
• Don was an active participant
(factor 7).
creditor that could have sought
a personal guarantee (factor 2).
• Don is an individual manager/
shareholder and imposing
personal liability on him may
discourage socially useful
but risky businesses (factor 3).
• Don kept corporate and personal
assets separate and paid himself a
salary only after covering
expenses (factor 5).
• Don did not deceive Metro
Realty or give any personal
guarantees (factor 8).

The score is 4-4. As you might have suspected, the piercing factors alone
do not provide a definitive answer for planning or in litigation.
Nonetheless, Don's case is not a good piercing candidate. It seems
little more than a case ofa garden-variety failed business. If piercing applies
here, it would apply in virtually every failed business, and limited liability
would become an empty promise. Don never deceived or systematically
avoided creditors. His failure to observe corporate formalities does not
provide indirect evidence that he purposefully avoided creditor expecta-
tions. He paid himself after paying current expenses. By failing to get
personal guarantees or security interests in particular business assets,
Metro Realty assumed the risk of Timend's business failure. See Consum-
eras Co-op v. Olsen, 419 N.W.2d 211 (Wis. 1988) (refusing to pierce cor-
porate veil of failed fuel wholesaler where there was no commingling of
personal and corporate assets and no improper withdrawals of capital),
le. No. The statute of frauds is not a bar. Although Metro may not be able to
hold Don contractually Hable, Metro can hold Don personally Hable on a
piercing theory. Some courts have avoided the statute of frauds by piercing
the corporate veil to protect creditor expectations. From the creditor's
perspective, the transaction arguably was not on a nonrecourse basis.
One important issue in this contract case will be whether Metro relied
on Don's promise. Some courts have not permitted piercing when a so-
phisticated creditor could have insisted on personal guarantees or other
protections. The case might turn on whether Metro was aware that an oral
promise might not be enforceable.

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Id. Maybe. Don's liability in Petunia's tort case will depend on the same
piercing factors discussed above in Metro Realty's contract case. The
only significant differences are that Petunia, unlike Metro, is an involuntary
creditor and the Corporation did not carry sufficient insurance to cover her
loss — both adding weight to a piercing argument. Nonetheless, courts
remain reluctant to pierce in tort cases unless other factors support pierc-
ing. In fact, Thompson's study indicates that piercing occurs less frequendy
in tort cases compared to contract cases. The study, however, may reflect
only that disappointed contract creditors, compared to injured tort victims,
are more selective about the cases in which they assert piercing liability.
Don'tforget that Don may also be liable on other theories besides
piercing. If he had hired Howard knowing that Howard had a miserable
driving record or if he had told Howard to speed as he made deliveries,
Don might be liable to Petunia in tort — regardless of piercing.
le. Probably not. Although the Corporation is liable on a respondeat superior
theory, piercing will depend on much the same factors discussed above
with respect to Metro Realty. A significant question is whether Patrick
should be treated as a voluntary or an involuntary creditor. In theory
Patrick could have sought personal guarantees or demanded higher in-
surance coverage before he left his clock at the shop. But expecting retail
customers to make such demands is unrealistic. Piercing may be a more
efficient way of assuring responsibility to creditors. But piercing seems
inappropriate if Don did not make any personal guarantees, mislead
Patrick about insurance, or viólate any minimum insurance requirements.
That Don incorporated solely to avoid personal liability is not relevant.
The promise of limited liability is meant to promote business in the
corporate form.
If. Perhaps not. Piercing would not extend liability to an individual share-
holder or manager, but instead would redraw the boundaries of the enter-
prise's assets. Courts have accepted a theory of enterprise liability when a
business artificially separates assets from risks to avoid claims by involun-
tary creditors. This is particularly so when, from the creditor's perspective,
the business appeared to be more than a shell.
In our case, enterprise liability may depend on whether Patrick was
aware of the fragmentation. If Patrick did not know he was dealing
with an asset-less shell, a court might well aggregate the assets of the
two corporations as though they were a single enüty. The actual
enterprise — as evidenced by its location, its subcontracted work, and
the nature of its business — was essentially one. But if Patrick was aware
of this separation, perhaps because of the separate invoice forms, he might
be seen as a voluntary creditor who assumed the risk of dealing with a
corporate shell.
2a. Probably. Rupert is less deserving of limited liability. But, as in Don's
failed business, the piercing factors are less than clear. Some indicate

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 §32.1 Protection o f Corporate Creditors

piercing is appropriate:
For piercing Against piercing

• ETL is a closely held Corporation • Rupert is an individual manag-

(factor 1).
• The mail-order customers were in-
voluntary victims, hardly able to
demand personal guarantees or
contract protections (factor 2).
• The business was operated so that
eventually orders could not be filled
(factor 6).
• Rupert was an active participant
(factor 7).
er/ shareholder (factor 3).
• He observed corporate formal-
ities (factor 4).
• He kept corporate and personal
assets separate (factor 5).
• He never personally guaranteed
that the orders would be filled
(factor 8).

Again the score is 4-4. But unlike Don's business, Rupert's business con-
stituted an abuse of creditor expectations. By taking a salary based on
receipts, not after-expense earnings, Rupert put his interests ahead of
the company's customers. Mail-order customers assumed their payments
would be used to buy and ship their merchandise. Instead, they were used
to construct a pyramid scheme. Piercing seems likely. Although he never
expressly misrepresented the nature of the business, Rupert's case has a
"sleaze factor" and smells of fraud. See K.C. Roofing Center v. On Top
Roofing, Inc., 807 S.W.2d 45 (Mo. Ct. App. 1991) (piercing corporate
veil of roofing supply business where insiders took salaries and rent based
on receipts and changed corporate ñames frequently).
2b. Probably, on a few theories. Paula is an involuntary creditor, and the
factors favoring piercing discussed in the previous answer also favor pierc-
ing in her case. The self-induced insolvency that resulted from the way
Rupert ran the business, besides violating the expectations of contract
creditors, also undermines tort deterrence and compensation goals. The
business was run so that its risks were never internalized and so assets were
unavailable to satisfy legitímate claims.
In addition, through his televisión ads, Rupert implicitly represented to
customers that ETL would use customer payments to fill their orders, not
line his pockets. From a customer perspective, the ads were misleading.
Not only is this a powerful factor favoring piercing, it may also support an
independent claim of deceit against Rupert. Even though customers pur-
chased watches from the Corporation, Rupert may be individually liable for
intentionally misleading customers as to material facts on which they
relied to their detriment —the tort of deceit. Privity is not necessary.
Finally, Rupert may be liable as a tortfeasor if his negligence caused
Paula's injuries. If he had failed to exercise the care of a reasonable person
in purchasing the business's merchandise — as suggested by the assump-
tion ETL would be liable — he also is personally liable under negligence
principies.
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2c. Probably not. The corporation does not cease to exist because some of its
shareholders are subject to personal liability. Piercing the corporate
veil — disregarding the rule of limited liability — happens shareholder
by shareholder. Only those shareholders whose actions are related to
the piercing factors, particularly those who "dominated" the business
and abused creditor expectations, may be held personally liable for the
corporation's obligations.
2d. The question of disregarding corporate structures—whether the divi-
sión is "horizontal" (parent-subsidiary corporations), "vertical" (broth-
er-sister corporations) or, as here, both —is a recurring piercing problem.
Much will depend on the traditional piercing factors, including whether
the plaintiff acceded to the no-recourse structure and whether there was
confusion as to the separateness of the many corporations.
Beyond this, the principal reason for limited liability—promoting
capital formation—provides a usefiil springboard for analysis. If the
tiered corporate structure had encouraged desirable investment or busi-
ness risk-taking, piercing (whether vertical or horizontal) may be inappro-
priate. Amassing all of the assets for the creditors of any one corporation
would put businesses whose capital is provided by a holding company at a
competitive disadvantage compared to those businesses whose capital is
provided by individuáis or widely dispersed investors. The holding com-
pany would be exposed to liability to which other limited liability investors
are not; the affiliates would be exposed to liability to which independent
companies are not.
If MOP's mail-order subsidiaries operate separately, so that it can be
said they represent separate investment decisions, the rule of limited
liability teaches that a "no-recourse" structure deserves presumptive
respect. The mail-order creditors would have to show more than the
existence of related businesses.

§32.2 Distilling a Principie — Solving the

Piercing Conundrum
Is it possible on some principled basis to distinguish between Don's failed busi-
ness and Rupert's mail-order fast shuffle? Counting and weighing factors is an
unpredictable game with potentially high costs to efficient capital formation.
General principies of creditor protection — of which the piercing cases repre-
sent a subset —provide some usefiil insights into the piercing conundrum.

§32.2.1 Uniform Fraudulent TransferAct

Limiting the discretion of debtors and protecting the expectations of creditors

beyond the terms of their contract has a long history in the law. The notion
that debtors cannot use sham transactions to hide their assets from

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creditors—whether or not the matter is addressed explicitly in the con-

tract — is as oíd as Román law and in England was codified in the Statute
of Elizabeth (1571). Today it is embodied in the Uniform Fraudulent Transfer
Act (UFTA). The UFTA helps explain many of the piercing factors, as well as
when they are (or are not) relevant.
The UFTA, like its predecessor the Uniform Fraudulent Conveyance
Act, is relatively straightforward. It defines certain debtor transactions as
"fraudulent" and allows creditors with matured or maturing claims to void
such transactions or to seize the property fraudulently conveyed. UFTA §7.
The UFTA defines three categories of "fraudulent" transfers —

• any transfer that the debtor made with the actual intent to hinder,
delay, or defraud present or future creditors—particularly when the
transfer is to an insider or relative of the debtor [UFTA §4(a)(l)]
• any transfer for which the debtor does not receive reasonably equiva-
lent valué and that leaves the debtor with unreasonably small assets in
relation to her actual or anticipated needs [UFTA §4(a)(2)(i)]
• any transfer for which the debtor does not receive reasonably equiva-
lent valué and that the debtor knew or should have known would
render him insolvent [UFTA §4(a)(2)(ii)]

In short, even when it cannot be shown the debtor is purposeiully trying

to avoid her creditors, transfers by the debtor are "constructively" fraudulent
if they are for questionable valué or threaten the debtor's ability to pay her
other debts as they become due. For example, suppose Sam sold Patty a fancy
sports car for $15,000 on her promise to pay over two years, but Sam foolishly
failed to perfect a security interest in the car. If Patty stops making installment
payments and sells the car to her brother Billy for $500, the UFTA permits
Sam to have the transaction set aside as fraudulent and to attach the car.

§32.2.2 Applying UFTA to Piercing Conundrum

The UFTA, and its philosophy of protecting creditor expectations, is a useful

starting point for considering the piercing conundrum. It helps explain the
results in our two earlier piercing examples (see Examples and Explanations
above)—

• Don's case — n o fraudulent transfers. Although Don continued to

draw a salary, it was one that seemed related to the valué of his services.
The corporation's inability to meet its obligations under the lease was
not because Don had siphoned away assets from the business for
himself in transactions of questionable valué. He had not misled
creditors and had not acted to avoid the lease. Disregarding limited
liability in the case of a failed business would dampen the incentive to
invest and take rational business risks.

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EXAMPLES
1. Fenimore is the solé shareholder and president of Pent-Ultimate Inc., a
high-rise construction company. The company, which Fenimore set up
with only $1,000 in capital, leases all its equipment (scafFolding, machin-
ery, cranes) at a high annual rent from Fenimore. Because of these heavy
rentáis, the Corporation has rarely run a profit. Although Fenimore gen-
erally does not follow corporate procedures, the rental arrangement be-
tween him and Pent-Ultimate was specifically approved by the company's
three-person board.
a. Edifice Trust lent Pent-Ultimate money for the construction of a high-
rise hotel. When construction costs run higher than expected, Pent-
Ultimate defaults on the loan. Can Edifice Trust recover from Feni-
more under the UFTA?
b. Patricia, a passerby at one of Pent-Ultimate's job sites, was badly hurt
when a beam fell on her. The Corporation has the minimum insurance
required by law, but not enough to satisfy the judgment Patricia
obtains against Pent-Ultimate. Can Patricia recover from Fenimore
under the UFTA?
2. Should there be piercing liability:
a. In Edifice Trust's case?
b. In Patricia's case?

EXPLANATIONS
la. Perhaps. If Edifice Trust can show the rental payments to Fenimore were
"fraudulent transfers," it could recover the excess of the rental payments
over market valué from Fenimore as first transferee. UFTA §8(b)(l)
(creditor may recover "valué of the asset transferred, . . . subject to ad-
justment as the equities may require"). The rental payments would be
fraudulent under the UFTA if Fenimore intentionally set them up to avoid
creditors. Above-market transfers to insiders, especially when concealed,
are badges of fraud. Comment, UFTA §4(b). In addition, the rental pay-
ments would be constructively fraudulent if: (1) they were not for "rea-
sonably equivalent valué"—that is, if they were significantly above
market rates; (2) they left Pent-Ultimate with assets that were "unreason-
ably small" in relation to its business; or (3) Fenimore should have known
Pent-Ultimate would incur debts (like the construction loan) beyond its
"ability to pay as they became due." UFTA §4(b).
A fraudulent transfer theory has some difficulties. It may be difficult to
show that Fenimore intended to avoid creditors; he may have hoped the
business would generate revenues to cover expenses. Presumably, the
sophisticated Edifice Trust extended credit knowing of the rental arrange-
ment and believing Pent-Ultimate had a sufficient margin for its business.
And even though the rental payments were high, they may not have been

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unreasonable or clearly above market. Even if the rental payments were

above market, they may not have been the reason for Pent-Ultimate's
inability to pay the construction loan. The unexpected cost overruns
may undermine the assertion that Pent-Ultimate was operating without
sufficient assets.
Ib. Perhaps. Patricia, like any other creditor, would have to show the rental
payments to Fenimore were "fraudulent transfers." UFTA §8(b)(l)
(judgment against first transferee). The same analysis above would
apply. If the rental arrangement was not above market, it may be hard
to show Fenimore intended to avoid the company's creditors or that the
company had not received "reasonably equivalent valué." But operating a
ultra-hazardous high-rise construction business with minimal reserves
may suggest the company was run with "unreasonably small" capital.
In this way, the particular risks of the business factor into the UFTA
analysis.
If the rental arrangement was above market or left the business with
insufficient assets to cover likely personal injury claims, Patricia might be
able to recover from Fenimore to the extent the payments were unrea-
sonable. Although Patricia became a creditor of Pent-Ultimate only when
her claim against the company matured, the rental payments are fraudu-
lent under the UFTA whether the creditor's claim arises before or after the
transfer was made. UFTA §4(a).
2a. Perhaps. The piercing analysis is similar to that ofthe UFTA. Applying the
piercing factors, it will be relevant that Edifice Trust is a voluntary creditor
that could have inquired, and presumably did, into Fenimore's rental
arrangement. If Fenimore disclosed it, Edifice Trust could have protected
itself against the corporation's insolvency by seeking personal guarantees
or by demanding that Fenimore charge market-rate rentáis. A principal
reason for corporate limited liability — to encourage socially desirable
risk-taking — argües against piercing liability. The UFTA also recognizes
this by not imposing liability if the above-market transfers did not under-
mine the business.
2b. Perhaps. Piercing is more likely, though again the piercing analysis is
similar to that under the UFTA. As the piercing factors suggest, Patricia
(an involuntary creditor) was unable as a practical matter to protect herself
against Fenimore's above-market rental arrangement. Fenimore's practice
of effectively depleting the Corporation of capital reserves was something
that Patricia could not have prevented. The UFTA's prohibition against
above-market transactions that leave the Corporation with "unreasonably
small" assets provides a framework for considering whether Fenimore
owed a duty to Patricia (and other potential tort victims) not to siphon
away assets.
On the one hand, the arrangement had been going on for quite a while
without apparently hurting other creditors. Perhaps reserves were

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sufficient. The argument would be buttressed ifthe excess rental payments

could have been properly paid to Fenimore as dividends or other distribu-
tions (see Chapter 31). Moreover, if Fenimore had complied with man-
datory insurance requirements applicable to construction companies,
state law would seem to favor corporations engaged in construction rather
than the creation of reserves to satisfy potential tort claims.
On the other hand, Fenimore's rental arrangement created a "no-
recourse" structure in which business assets were separated from business
risks. If the company's ultra-hazardous activities could be expected to
injure outsiders, its undercapitalization would likely factor into the court's
analysis. If, as it appears, the rental arrangement was designed to leave an
empty corporate shell, piercing is more likely. Passersby would expect that
a big construction company has adequate financial reserves to back its
responsibility to public safety.

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