Holes in the corporate veil: confronting the myth of reduced liability for small businesses and entrepreneurs under corporate forms.

Author:Lahm, Robert J., Jr.
 
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ABSTRACT

Entrepreneurship textbooks are devoid of some of the more complex legal analysis that would lead would-be business founders to a more informed understanding of the limitations of corporate forms in affording protection from personal liability. Indeed, these texts may have contributed to what amounts to a myth in causing entrepreneurs to believe that they are personally separate and invulnerable, so long as they have taken the step to incorporate, as compared to operating as an individual under a sole proprietorship. The authors of this paper have quoted the term "myth," because practicing corporate attorneys and the plaintiffs they represent, the courts, and legal scholars are keenly aware of ongoing efforts to devise strategies and methods to pierce the corporate veil; of course, defendants also do become aware of their vulnerabilities (but perhaps too late).

Despite such a legal landscape, our review of contemporary entrepreneurship textbooks and the scholarly literature of entrepreneurship undergirding these texts demonstrated a failure to convey that increasingly, there are holes in the corporate veil. This paper provides an overview of issues that merit consideration on the topic of the corporate veil and veil piercing, and concludes with a discussion of implications for entrepreneurship teaching, research, and practice.

INTRODUCTION

"An important consideration in starting a business is whether to form it as a corporation. Organizing a business as a corporation offers many advantages. For example, the ability to sell stock can be a significant help when raising capital" (Peckinpaugh, 2000). "When presented with any kind of potentially devastating liability, an attorney's instinctive response is to create a separate corporation to 'shield' the rest of the corporate family, and the individual assets of those who direct it" (Jackson, 2001). The basis for this present paper is dispelling the "myth" (Graham, 2002) of the corporate veil, the affects of which are the mistaken opinion that entity formation makes individuals bullet proof for all but acts of fraud (Lowenstein, 1989; Prieston, 1999; Russell, 2004; Shub, 2006; Wagoner, 1996) and intentional acts of gross negligence (Bendremer, 2005; Hughes, 2004; Rolle, 2003).

The authors of this paper believe that this myth is due to a paucity of coverage in entrepreneurship textbooks, and because a lack of attention has been given to veil piercing in the scholarly literature of entrepreneurship, which at least insofar as this topic is concerned seems to exist in a relative vacuum, separate from legal scholarship. This statement should not be interpreted as a criticism. Rather, we recognize that entrepreneurship is a relatively new and emergent scholarly discipline. Further, we think it is quite reasonable to posit that perhaps other factors are in play, such as the widely disseminated explanations regarding the benefits of forming a corporation that appear in generalized business books, on web sites, and in articles disseminated through the popular press and trade publications (sans any adequate explanation to the effect that "there is always a catch"--one must abide by certain rules and conditions in order to pass the legal test of veil piercing).

"Most savvy business people are aware that corporations offer some protection to officers, directors and shareholders from personal liability. What many people may not know is that the corporate shield from personal liability is not infallible" (Hughes, 2004). As suggested by practicing attorney Stanford A. Graham, Esquire, "the majority of veil piercing activity never makes it to the courtroom. Rather, when business owners are threatened with litigation, and become aware of their vulnerability to veil piercing, they pay expensive settlements to avoid litigation" (Graham, 2002). Indeed, "situations are often compromised because they are so expensive to litigate" (Hays, 1998). Settlements under a threat of suits that may involve veil piercing are also possible, and in these instances, reporting may be obscured (Guglielmo, 1996).

Generally, piercing is a remedy to hold individuals accountable for abuses of the corporate form, including hiding behind a corporate entity in order to defraud creditors, investors or other claimants (Bainbridge, 2001; Caudill, 2003; Mirchandani, 1998; Russell, 2004; Wagoner, 1996).

"The [veil piercing] doctrine most often arises in connection with plaintiffs' attempts to hold corporate shareholders liable for the debts of the corporation" (Bendremer, 2005). As case law indicates, being undercapitalized (and knowing so) is not reason to hide behind the corporate veil when one defaults on a contract or other obligation (Peckinpaugh, 2000). In instances such as these, the remedy (on the part of a plaintiff) of veil piercing is apparent because the business was undercapitalized to carry out the terms of the agreement from the start.

However, veil piercing can become even more tumultuous, and "the risk is much greater than most people realize" (Graham, 2002). The corporate veil will not protect a business when acts or omissions will result in unfairness to the injured party: "The determination of whether the doctrine applies centers on whether there is an element of injustice..., fundamental unfairness, or inequity" ("State ex rel. Christensen v. Nugget Coal Co.," (1944). Unfairness!!! To this we exclaim "holy cow," as the inclusion of this descriptive term in the court's finding is very far reaching, as most any plaintiff can assert unfairness.

For the reasons suggested above, we were compelled to offer this first paper as a contribution to the scholarly literature of small business and entrepreneurship (hereinafter our references to the scholarly literature of small business and entrepreneurship will be expressed simply as, "entrepreneurship" for purposes of brevity and expediency).

REVIEW OF EXISTING LITERATURE ON "PIERCING THE CORPORATE VEIL" WITHIN THE SCHOLARLY LITERATURE OF ENTREPRENEURSHIP

Vanderbilt University Professor of Law Robert Thompson (Robert B. Thompson, 1995) is regarded to have provided an "exceptional study" of veil piercing (Morrissey, 2007; Rapp, 2006). "Veil piercing issues can also arise with regard to limited partnerships ('LPs') and limited liability partnerships ('LLPs'). Like LLCs, LPs and LLPs are unincorporated business entities" (Bendremer, 2005). However, the need for this present paper became evident after a series of searches in the scholarly entrepreneurship literature revealed a dearth of research on the subject of the corporate veil and veil piercing. Search attempts conducted on databases used by ProQuest demonstrated that veil piercing was only covered within the literature from within scholarly and professional legal and accountancy contexts, typically associated with legal, finance or accounting oriented journals.

With parameters for our searches set to identify only articles with full-text availability and results in the citation and abstract, we identified 155 articles in ProQuest databases originating from sources that were not associated with the scholarly entrepreneurship literature. Upon attempting to combine the term "corporate veil" with others such as "corporate veil" AND "entrepreneurship" we found only one result (from an Australian journal published in 1992).

The popular business press produced some results in our ProQuest searches (but upon examination, some of these were erroneous and associated with other topics). Finally, we also examined several leading entrepreneurship textbooks and found that forms themselves were typically well covered, but emphasis on possible pitfalls and vulnerabilities was not as well developed as probably should be (Hisrich, Peters, & Shepherd, 2008...

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