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How to Keep Your Corporate Veil Closed
The State of Texas has long prided itself in being a very corporate friendly state. Laws were created that made it extremely difficult to pierce the corporate veil and impose corporate liabilities upon its individual shareholders, officers, directors, parent companies and subsidiaries. However, in recent years, this protection has started to recede through an emerging legal theory called the “single business enterprise.” This doctrine creates a path for litigants to go beyond the company directly liable for its damages and reach other companies formerly protected.
This article focuses briefly upon the history of the corporate veil in Texas, the current status of the law under the “single business enterprise” theory, and finally on some tips to keep your companies separate to avoid joint liability. Before we go into how to keep your corporate veil closed, let’s get the background of the corporate veil.
The Corporate Veil
The corporate veil has long existed in Texas. However, in 1986, in the landmark case of Castleberry v. Branscum, the Texas Supreme Court set out various methods available to pierce the corporate veil and hold individuals liable for the acts of their corporations. Among those mechanisms was the theory of alter ego. “Alter ego applies when there is such unity between corporation and individual that the separateness of the corporation has ceased and holding only the corporation liable would result in injustice.”
Castleberry v. Branscum
The legislature was quick to react to the very unpopular holding in Castleberry. In 1989, they passed several amendments to Texas Business Corporation Act that limited Castleberry to tort claims. It also provided that for contract claims the corporate fiction will not be disregarded unless there is a showing of actual fraud.
In 1996, the legislature extended that coverage to all contractual obligations of the corporation and any matters relating to or arising from the obligation. If a particular claim against a corporation falls within a contractual cause of action, then the veil may not be pierced absent a showing of actual fraud. The commentary following the 1996 amendments suggests that the actual fraud requirement should be applied, by analogy, to tort claims. This is especially true for those those arising from contractual obligations. Under Section 2.21 of the Texas Business Corporation Act, the person attempting to pierce the corporate veil must show the following:
(1) actual fraud (which has six independent elements);
(2) in relation to the specific transaction; and
(3) primarily for the direct personal benefit of the shareholder.
The Comments to this section note that this language “reflects public policy that the corporate fiction should be recognized absent compelling circumstances to the contrary.”
The strength of the protection afforded by § 2.21 was long recognized by Texas Courts. Under the Act, a plaintiff seeking to pierce the corporate veil must prove actual fraud which involves dishonesty of purpose or intent to deceive.
Importance of the Corporate Veil
The corporate veil is extremely important in keeping the debts and liabilities of one company inside that company. It is a shield that protects not only the officers, directors, and shareholders of a company, but also other commonly owned and operated companies. The shield protects parent companies for the acts of its subsidiaries, and vice versa. It is the insurance that most business owners rely upon in continuing to make business decisions and take risk. Without this protection, most individuals and small businesses cannot afford the risk of doing business and its associated potential liabilities.
The Single Business Enterprise
“The ‘single business enterprise’ theory involves corporations that ‘integrate their resources to achieve a common business purpose…’ In determining whether two corporations were not maintained as separate entities, the court will consider the following factors: (1) common employees; (2) common offices; (3) centralized accounting; (4) payment of wages by one corporation to another corporation’s employees; (5) common business name; (6) services rendered by the employees of one corporation on behalf of another corporation; (7) undocumented transfers of fund between corporations; and (8) unclear allocation of profits and losses between corporations.” Superior Derrick Servs. v. Anderson, 831 S.W.2d 868, 874 (Tex. App. – Houston (14th Dist.) 1992, writ denied).
Conspicuously missing from this list of elements is a showing of any kind of fraud.
Single Business Enterprise Theory
First, it is important to note that the Texas Supreme Court has yet to adopt the single business enterprise theory as a mechanism of applying the liability of one company to that of another. However, the intermediate courts of appeals in Texas have not only adopted it, but are actively using it to spread liability between companies. And while the Texas Supreme Court, even as recently as 2007 in PHC-Minden, L.P. v. Kimberly-Clark Corp., noted that it has yet to formally adopt this theory, by not issuing an express holding renouncing or rejecting the theory, it remains alive and kicking at the trial courts and appellate levels of litigation (where most litigation occurs).
Consider the following example: Company X buys and sells goods for consumption inside the United States. Over the years, it develops an international market; however, because of the increased risk in dealing with a variety of international issues, the owners of Company X create a new company, Company X International to handle the international aspect of the business. Both companies are run from the same location, and while most of their employees are separate, they do share the same in house accounting, human resources, and legal departments. Those employees are all paid by Company X. There is no accounting of Company X International reimbursing for those expenses. And while the two companies have separate bank accounts and separate books of account, they can freely transfer money between the two companies to cover a variety of costs.
This example is not unlike how many businesses run their subsidiaries or sister corporations. It happens every day at every level of business. However, Company X and Company X International meet every element of a single business enterprise. If anything were to happen to Company X International, exposing it to losses, the original Company X is just a liable.
Consider a bigger example: a large oil, telecommunications, or computer company. While there may be one large parent (imagine Exxon Mobile, AT&T, or the like), there are hundreds of subsidiaries. But, there are common owners, common names, shared employees, shared expenses, and an unclear allocation of profits between the many companies. They created these subsidiaries to protect the larger parent. This also protects other related companies from devastation should any of the others go under. Under the current status of Texas law, those protections no longer exist.
Avoiding Common Liability
The answer to this seems somewhat obvious: keep everything separate. Probably the most important area for separateness is in the financial arena. Document all transfers between the companies. Don’t be afraid to have inter-company contracts (i.e. lease agreements, notes, and contribution agreements). Allocate expenses (including salaries) between the companies so that each pays its share. Have policies in place and in practice keeping everything about the businesses separate. Consider having separate boards of directors and offices if that is practical. The problem is that this is not always convenient or practical for many commonly owned companies. Therefore, remember, the more you separate, the better off you are.
There are no promises in litigation. There is also nothing anyone can do to ensure that they won’t be sued. However, there are things you can do to help make sure you win you case. The more prepared you are for these kinds of issues, the more protection you have.