Piercing the Corporate Illusion

Piercing the Corporate Illusion

(Friday, February 22, 2008 ) - Jordan S. Halpern

Generally people will incorporate their business so as to limit their personal liability. As corporations are considered separate legal entities from the shareholders, incorporation ensures in most cases that potential losses (which may be attributable to individuals) become limited to what has been previously invested. These parties are protected by what is known as the “corporate veil”. The million dollar question therefore is… “How well are they actually protected?”

Unfortunately, individuals are not completely protected. Recent case law seems to suggest that there are situations where the corporate veil is insufficient to protect the individual shareholders and in certain circumstances the directors and officers as well. The personal assets of these individuals can become fair game in the wake of a dispute.

This is not to say that it is a simple matter for a court to pierce the corporate veil – the threshold continues to be a high one. However, it is important for those individuals relying on corporations to protect them from increased personal liability to be aware of some of the dangers and risks of their position. These individuals should also be mindful that this protection is anything but failsafe. Here are some scenarios where courts have ruled that individuals would not enjoy the protection usually provided by the corporation’s separate legal status:

* When shareholders do not treat corporations as separate entities from themselves and merely use it as an “alter-ego”, “puppet”, “conduit” or an agent of themselves (whether in an effort to deceive another party as to who they are actually dealing with, or for other improper purposes). In this scenario, the courts tend to view the corporation as a sham or a “cloak” for the shareholder, and recognize that the debts and liabilities of the corporation are actually those of the shareholder. In such cases, corporate formalities such as annual filings, meetings, and separate accounting records are often disregarded.

* When the shareholders have used the corporation in such a way so as to commit any fraudulent activities, the courts will not allow the shareholders to hide behind the corporation’s separate legal status. A corporation engaging in conduct “akin to fraud” will warrant a piercing of the corporate veil. This will occur when a corporation is being controlled and used by its shareholders (or directors and officers) as a shield for fraudulent or improper conduct, whether or not the corporation was originally legitimate. The conduct need not actually be fraudulent, it would be sufficient for the conduct to be merely “akin” to fraud.

* Where piercing the corporate veil will serve to link affiliated companies with a parent, subsidiary or otherwise affiliated corporation. This will occur in circumstances where one company is acting as nothing more than a “puppet” or agent of another (not unlike the situation noted above, however, in this circumstance, the “puppet master” is another corporation rather than an individual). Such an inquiry would turn on issues such as where the profits were going, which company was in control, who was truly making the decisions, etc. The corporation’s separate legal status will not be lifted to expose the individuals to personal liability in every (or even many) situations of a parent and subsidiary corporation, rather, depending on the circumstances, the separate legal entity of an affiliated corporation will not bar the corporate veil from being lifted when a court deems it to be necessary.

* Where it is in the interest of justice to pierce the corporate veil due to policy reasons. The various policy reasons a court may use as justification are potentially limitless and may relate to such areas as matrimonial disputes, tax or tortious acts committed by an employee of the corporation, just to name a few. One relevant example in Ontario was a matrimonial case (Arsenault v. Arsenault ((1998) OJ no. 1423)) where a husband was the sole shareholder of a corporation. The court was suspicious of how the gentleman was controlling the corporation after the separation from his wife and before the resolution of their financial issues. It was believed that he was attempting to protect certain assets from being applied to support payments that he would be forced to pay to his wife. To avoid financial injustice for the wife, the court found it to be appropriate to look beyond the incorporated status of the company and recognize that the assets in question truly belonged to the husband. The court concluded that “…in the end, although a business person is entitled to create corporate structures and relationships for valid business, tax and other reasons, the law must be vigilant to ensure that permissible corporate arrangements do not work (towards) an injustice…In appropriate cases, piercing the corporate veil…may be an essential mechanism…”

Beyond actually piercing the corporate veil, there are additional circumstances where directors and shareholders can be held personally liable for various corporate acts (or omissions) such as unpaid wages to employees and issuing shares without receiving payment. A thorough discussion of the additional considerations falls beyond the scope of this article, but suffice it to say that there are too many potential pitfalls in the business world to proceed without seeking the appropriate guidance and advice.

Whether or not a corporate veil would be pierced for a specific purpose or policy reason will depend heavily on the facts and circumstances of the particular case. As a prudent shareholder/owner, one must ensure that the dealings of the corporation are legitimate and that the proper steps are being taken to maintain the corporation’s good standing. If there is any doubt or concern, it is vital to consult with a lawyer when evaluating whether you are at risk of suffering any personal liability, as well as how to carry on with your business. The illusion that too many people are misled to believe is that you are entirely protected as an individual when you incorporate your business. Do not be fooled - protect yourself as best as you can.

Jordan S. Halpern is an associate lawyer with BrazeauSeller.LLP. He practices in the areas of corporate/commercial transactions as well as commercial and residential real estate.