I. Consider the Following Scenario…
Pretend that you are an investor in a new restaurant with a chef who desires to leave her current position. She thinks she will run an amazing restaurant.In addition, she even learned some delicious secret recipes from her current employer!
You decide to invest with her and she needs your help because she has no experience running a business.
You decide to take no role in the day-to-day management of the chef’s restaurant. Investing in a restaurant is risky, so you arrange to have her incorporate her business without you personally being named as an officer, agent, shareholder or employee. Nonetheless, you want to help give the chef’s business a strong start by providing some funding, arranging a few sales contracts, and helping to negotiate the lease for the storefront of the chef’s new restaurant. When the chef’s restaurant opens, the chef never names other officers or directors nor does she keep a book of corporate records. Remember, for the chef, corporations “just aren’t her thing”—she wants to focus on making food. Therefore, she also decides to transact all funds for the restaurant through personal checking and savings account in her name.
Later, the chef’s restaurant becomes insolvent after having missed most of its payments to creditors. Even worse, the chef’s corporation receives a judgment from her old employer under the Illinois Trade Secrets Act1 for selling products based on their secret recipe. The chef’s former employer never named you to the lawsuit leading to this judgment. Luckily, since you are just a non-shareholding investor, you are personally protected from this judgment against the chef’s corporation, right?
Not exactly. Illinois and other states have found an investor personally liable for a judgment entered against a corporation, even where that investor was not an officer, shareholder, director or employee of the corporation, nor a party to the lawsuit underlying the judgment.2 Courts term such an action as “piercing the corporate veil.”3 In fact, in 2014, the Illinois Appellate Court ruled in Buckley v. Abuzir that the corporate veil could be pierced to hold a defendant who was a non-shareholding investor in his sister’s bakery personally liable under the Illinois Trade Secrets Act.4 The facts in Buckley are similar to the scenario discussed in the first three paragraphs of this blog post. The defendant in Buckley claimed he“merely supported” his sister’s corporation by “providing funds to start the business, negotiating [the business’s] lease, and arranging accounts and sales agreements…” 5 He also had denied any wrongdoing that was the basis for the underlying judgment against his sister’s corporation.6
II. How A Creditor Holding A Judgment Can Reach Non-Shareholding Investors by Piercing the Corporate Veil
Generally, performing work on behalf of a corporation protects shareholders, officers, employees and owners from personal liability.7 In most jurisdictions, a plaintiff who obtains a judgment against a corporation can file an action “to pierce the corporate veil” to collect money on a judgment from a corporation’s owners.8 Courts often “claim to be reluctant to pierce the corporate veil.”9 However, one study found Illinois Courts granted an action to pierce the corporate veil in 52.50% of cases where requested by plaintiff.10
In order to “pierce the corporate veil,” a party needs to “make a substantial showing that one corporation is a dummy or sham for another [person or corporation].”11 Piercing the corporate veil requires showing “(1) there is such a unity of interest and ownership that the separate personalities of the corporation and the parties who compose it no longer exist, and (2) circumstances are such that adherence to the fiction of a separate corporation would promote injustice or inequitable circumstances.”12
Showing “unity of interest” between a corporation and another person to pierce the corporate veil requires the court to consider various factors, including “(1) inadequate capitalization; (2) failure to issue stock; (3) failure to observe corporate formalities; (4) nonpayment of dividends; (5) insolvency of the debtor corporation; (6) non-functioning of the other officers or directors; (7) absence of corporate records; (8) commingling of funds; (9) diversion of assets from the corporation by or to a stockholder or other person or entity to the detriment of creditors; (10) failure to maintain arm’s-length relationships among related entities; and (11) whether, in fact, the corporation is a mere façade for the operation of the dominant stockholders.”13
In Illinois, a court may find that an individual was an “equitable owner” of a corporation in instances where that individual was not officially affiliated with a corporation as a shareholder, officer, director or employee.14 A court will consider an individual an “equitable owner” if facts support the finding that he or she had actually exercised control over the corporation.15 In other words, merely holding stock or an official position in a corporation is not a requirement to pierce the corporate veil because “[t]here are many ways to organize a sham corporation. In some instances, the wrongdoer neither holds stock nor serves in an official capacity.”16
III. How Can Investors Protect Themselves From Personal Liability?
A careful investor should ensure that a corporation is diligent in observing corporate formalities and not commingling funds between personal accounts or that of other corporations. Examples of corporate formalities include maintaining corporate records and appointing a board of directors with regularly documented meetings. Furthermore, a corporation should refrain from financial decision-making that may be construed as diverting assets to the detriment of creditors. However, each case is different, and a lawyer should be consulted in setting up and maintaining a corporation, as well as for legal representation in an action to pierce the corporate veil.
It is important to keep in mind that piercing the corporate veil requires the court to find that not doing so would “promote injustice,” meaning “there is some unfairness, such as fraud or deception, or the existence of a compelling public interest that justifies piercing [the corporate veil].”17 Therefore, a court will not pierce the corporate veil merely because a corporate entity is insolvent and owes money on a judgment from a creditor. Rather, the judgment must be for fraud, misappropriation of trade secrets or other cases where “some unfairness” exists in protecting an individual from personal liability for a judgment against a corporation.18 Therefore, an excellent first step for an investor to protect himself or herself from personal liability in a potential action to pierce the corporate veil is to act diligently in vetting potential corporate investments to ensure that a corporation is conducting lawful operations that do not amount to wrong-doing, conversion of funds,fraud, misappropriation of trade secrets, violation of consumer protection laws, as well as violations of other laws meant to protect people and businesses from unfair business practices.
Again, a lawyer should be consulted in decision-making to legally protect oneself as an investor or when setting up a corporation, as well as in any legal representation involving a corporation, such as an action to pierce the corporate veil. Please contact McKenna Storer for further assistance.
For information about this topic and other related blogs, contact James Cook at McKenna Storer.
1 765 ILCS 1065/1
2 Buckley v. Abuzir, 2014 IL App (1st) 130469, ¶¶ 9, 29.
3Id. at ¶ 9. It is further important to note that piercing the corporate veil can and more often will apply to individuals who are also officers, shareholders, directors or employees of a corporation. See Id.
4 Id. at ¶ 5.
5 Id.
6Id.
7Id. at ¶ 12.
8 Id. at ¶¶ 9, 11.
9 Id. at ¶ 11.
10 Id. (citing Peter B. Oh, Veil-Piercing, 89 TEX. L. REV. 81, 107, 115 (2010)).
11Buckley, 2014 IL App (1st) 130469, ¶ 12.
12 Id. at 13 (quoting Tower Investors, LLC v. 111 E. Chestnut Consultants, Inc., 371 Ill. App. 3d 1019, 1033-34 (1st Dist. 2007)).
13 Gass v. Anna Hospital Corp., 392 Ill. App. 3d 179, 186 (2009).
14 Buckley, 2014 IL App (1st) 130469, ¶ 29.
15Fontana v. TLD Builders, Inc., 362 Ill. App. 3d 491, 501-02 (2d Dist. 2005).
16Buckley, 2014 IL App (1st) 130469, ¶ 31.
17 Id. at ¶ 34.
18Id.