Piercing all the veils: applying an established doctrine to a new business order.

• Author: Morrissey, Daniel J.

Who wins and who loses as a result of ... limited liability? "The controversy over this issue among legal historians is one of the hottest topics in historiography and intriguingly enough, the debate over the justice of shareholder limited liability has recently become an important contemporary topic as well." (1)

Stephen B. Presser and James S. Zainaldin

1. INTRODUCTION II. LIMITED LIABILITY A. Origins B. The Law of Limited Liability C. The Conceptual Justifications for Limited Liability D. The Economic Arguments 1. The General Theory 2. Limited Liability and Creditors of a Public Firm 3. Limited Liability as Enhancing Share Value in Public Firms 4. Claims in Close Corporations 5. Differentiating between Closed and Public Firms III. THE LIMITS OF LIMITED LIABILITY A. The Piercing Doctrine B. A Jumbled Jurisprudence? C. The Current Standards 1. Some General Points 2. A Multiplicity of Approaches 3. Contract Claims 4. Tort Claims and Undercapitalization IV. THE RISE OF LLCS AND LLPS A. Earlier Business Forms B. The Creation of Limited Liability Companies C. The Structure of LLCs D. The LLP Alternative E. Selecting Between LLCs and LLPs V. THE LIMITED LIABILITY OF LLCS AND LLPS A. Extending the Shield B. Statutory Provisions for Limited Liability 1. LLC Statutes 2. LLP Statutes C. The Grounds for Disregarding the Liability Shield of LLCs and LLPs 1. The Appropriateness of Piercing 2. The Effect of Statutory Language and Non-Corporate Status 3. Defining the Standards for LLC and LLP Veil Piercing 4. The Benefits of a Flexible Approach VI. CONCLUSION I. INTRODUCTION

   "Piercing the corporate veil" (piercing) has a long, if controversial, history in the law of business. (2) It allows creditors of such an entity to disregard the limited liability normally given its shareholders and hold them personally answerable for the debts of the enterprise. (3) The remedy arose as a counterbalance to the asset shield normally afforded corporate investors, and it is closely tied to important issues involving the accountability and social responsibility of business. (4)

   In the last decade, this special protection--at first only given to corporate shareholders (5)--has been extended to investors in two new business entities, the limited liability company (LLC) and the limited liability partnership (LLP). Consequently, concerns have been expressed about whether the piercing doctrine should be applied to those companies and, if so, how it should affect their liability shields. (6)

   The principle of limited liability has long safeguarded the personal assets of corporate stockholders. It developed from the concept that corporations have a separate legal existence from their shareholder owners. (7) Limited liability was hailed as a crucial innovation that both fostered entrepreneurship and encouraged widespread equity investment in commercial ventures. (8) In more recent times, economic theorists have shown how the principle also promotes the efficient allocation of investment capital. (9)

   In the early part of the last century, no other business organization afforded owner/operators such protection for their personal property. The general partnership had existed at common law and was given statutory authorization about that time. While it entailed no organizational formalities (10) and empowered all the co-owners of a business with managerial control, (11) each partner remained personally liable for the debts of the enterprise. (12)

   Also around the turn of the last century, limited partnerships became authorized by statute. Unlike general partners but like shareholders, investors there were afforded a shield against personal liability. Limited partners, however, risked losing it if they became involved in the operation of their businesses. (13) Corporate shareholders, by contrast, could become active in that way without forfeiting their protected status, so long as they did so in the separate roles of either directors or officers. (14)

   In the latter part of the last century, as tax considerations became a more important factor in business planning, the "flow through" treatment for profits and losses that partnerships offered investors proved more attractive than the corporate model. (15) Tax law usually mandated double taxation of a corporation's profits and allowed shareholders no direct attribution of its losses which could be used to shelter other income from taxation. (16) However, both general and limited partnerships were imperfect instruments for investors because, as has been said, the former raised the specter of personal liability for its owners, (17) and the latter could likewise result in such unpleasant consequences for any limited partners who became active in management. (18)

   Legal innovators went through several intermediate steps to remedy that unsatisfactory choice (19) and finally hit upon a new entity, the LLC. (20) It could provide its members with partnership-like flexibility in its operation, while at the same time giving them full limited liability protection regardless of how active they became in the business. When the IRS ruled that the LLC was entitled to flow-through tax treatment, it seemed that the ideal structure for a non-publicly-held business had now been created.

   The LLC thus became quite popular during the last decade and now appears to be the preferred legal entity for closely held firms. (21) However, it still entails some organizational and operational formalities that have the potential for being costly, cumbersome, and/or inconvenient for its members. (22) Better still, particularly for businesses with just a few owners, would be the general partnership, if all its owners could be afforded the protection of limited liability. Just such a legal entity, the limited liability partnership, was authorized in the early 1990s with professional associations--like legal and accounting firms--in mind. (23) The LLP may be organized and operated just like an uncomplicated general partnership, requiring only a simple public filing to guarantee its owners the protected status once reserved for shareholders and limited partners. (24) It now appears to be the best legal organization for small businesses with just a few owners who work closely together.

   But what about the legal shield that purports to safeguard LLC members and LLP partners from personal liability? Should its protection be absolute? It is promised to them by statute, but in the corporate context courts for some time have disregarded that shield when its application would cause injustice. That jurisprudence, although longstanding, is somewhat disjointed, (25) and has therefore led one commentator to argue that it should have no applicability to LLCs and LLPs--particularly when the statutes that authorize those new legal entities make no mention of such relief. (26) The existing corporate remedy has been undisciplined, he says, and has led to costly and unpredictable results. (27) Why carry it over to new entities whose laudable purpose is to encourage the capital formation and commercial risk-taking that are so beneficial to our economy?

   This Article, however, will argue the opposite. While limiting entrepreneurial liability serves a valid goal, it ought not to be upheld in situations where fraud or injustice would occur. In those cases, contract or tort creditors should be able to secure relief from those who own the business. And since LLCs and LLPs offer their members and partners more direct management power than usually afforded shareholders, there may be even greater justification to hold them personally accountable for the obligations of their businesses than the stockholder/owners of a corporation.

   Before it presents that theory in full, however, this Article will first give a brief description of limited liability itself--how it arose in the corporate context and was then applied to other entities. It will examine the initial reasons for the liability shield and the justification for carrying it over to other forms of business organizations. It will then discuss some recent support and criticism of it and evaluate the merits and shortcomings of those comments.

   The Article will next focus more fully on the theories that allow for piercing the corporate veil. As has been mentioned, some commentators have noted that this area of law is something less than a seamless web. (28) That inconsistency appears most glaring in cases that indicate a judicial proclivity to pierce more often when the person seeking redress is a contract creditor rather than a tort plaintiff. (29)

   What the piercing doctrine may lack in conceptual clarity, however, may be remedied through close scrutiny of the typical situations where it appears. They usually involve one or a very few shareholders who have a dominant and controlling interest in a corporation and use it to defraud or otherwise deal unfairly with those affected by the business.

   The Article will then examine several theories that have been advanced to justify piercing either LLCs or LLPs. Since by business law standards both those entities are still quite new, there are limited cases to review here. But the LLC is one of the most important developments in business law in some time and it may take several decades for judicial opinions to flesh out all its doctrinal implications.

   The Article will conclude with some guidelines on applying veil piercing to those new entities. Courts of course should respect the basic legislative judgment that owners of LLCs and LLPs are entitled to shield their personal assets from the obligations of their firms.

   Yet the equitable remedy of piercing the corporate veil has grown up to deal with egregious situations where business owners have conducted their operations in a fraudulent, unjust, or socially irresponsible manner. This Article will argue that it should be extended to cover similar states of affairs involving LLCs or LLPs--particularly since the owners of...