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December 1, 2008

The Alter Ego Doctrine: The Importance of Maintaining Separate Identities

New business entities usually understand the importance of incorporating in order to limit shareholders' personal liability for obligations of the entity. However, such businesses, particularly small start-ups, frequently do not understand the importance of keeping accurate corporate records and carefully complying with corporate formalities as set forth in their articles of incorporation and bylaws. Many such entities simply obtain the services of an attorney to form the company, put the corporate books and seal in a filing cabinet, and focus on the job at hand - doing business. Yet by ignoring corporate formalities, businesses run the risk of losing one of the chief advantages of the business form - shareholder insulation from corporate liability. This is because in many jurisdictions, including California, courts can employ the "alter ego" doctrine to "pierce the corporate veil". In other words, courts can - and will -- use the doctrine to reach through the corporation to the underlying shareholders in order to satisfy the corporation's creditors in certain circumstances. In this article, we discuss the alter ego doctrine and the steps that a corporation can take to minimize its exposure under the doctrine.

The alter ego doctrine is an exception to the general rule that shareholders are insulated from the debts of their corporations. Tomaselli v. TransAmerica, 25 Cal. App. 4th 1269, 1285 (1994). Courts developed this doctrine to address situations where allowing the general rule to stand would be unfair. There are two requirements for application of the doctrine: (1) there is a unity of interests as between the corporation and the shareholders such that the separate identities of each no long exists; and (2) that if the acts in question are treated as those of only the corporation, an inequitable result will follow. Automotriz del Golfo de California v. Resnick, 47 C2d 792 (1957); F. Hoffman-La Roche v. Superior Court, 130 Cal. App. 4th 782, 796 (2005). An inequitable result is one that goes beyond an dissatisfied creditor to embrace those situations where there is a taint of injustice or bad faith. Sonora Diamond Corp. v. Superior Court, 83 Cal. App. 4th 523, 539 (2000). While this, of course, includes outright fraud, it is not only fraud that is captured by this doctrine. As one court stated, "it is sufficient that it appear that recognition of the acts as those of a corporation only will produce inequitable results." Associated Vendors, Inc. v. Oakland Meat Co., Inc., 210 Cal. App. 2d 825, 837 (1962) ("Associated Vendors").

The alter ego doctrine is intensely fact-specific, and its application will vary on the specific circumstances in questions. Nevertheless, the following are types of corporate actions - or inactions - that have contributed to a court's decision to impose alter ego liability:

1. Inadequate capitalization;
2. Use of corporate assets for shareholders' personal benefit, including payment of personal bills;
3. Disregard of legal formalities;
4. Commingling of personal and corporate assets;
5. Failure to file corporate tax returns;
6. Failure to maintain corporate records;
7. Failure to hold shareholder and director meetings;
8. Misrepresentation of ownership;
9. Failure to negotiate at arm's length among related entities; and
10. Use of the corporation as a mere shell or conduit for another corporation or individual.

Associated Vendors at 838-39. This list is by no means exhaustive. However, it does provide an indication of the factors that can lead a court to conclude that a corporation and its shareholders are essentially alter egos.

Further, the alter ego doctrine is not limited to shareholders and their corporations: affected individuals can also include incorporators, officers, directors, and inside and outside counsel and financial advisors. The doctrine also applies to situations involving parents and subsidiaries and other inter-corporate affiliations. Moreover, the California Corporations Code expressly applies the doctrine to limited liability companies. See Cal. Corp. Code § 17101. Significantly, however, California courts have rejected a "reverse alter ego" doctrine in which a plaintiff satisfies its claims against an individual shareholder by reaching past the shareholder to the corporate assets. Postal Instant Press, Inc. v. Kaswa Corp., 162 Cal. App. 4th 1510 (2008).

In short, to avoid exposure to the alter ego doctrine, it is extremely important for a corporation to maintain a separate corporate identity, in part by scrupulously abiding by corporate formalities. We thus urge all corporations to keep (and follow!) a checklist of precautionary measures to avoid the imposition of alter ego liability. Chief among these measures are the following:

1. Maintain separate corporate accounts, and do not use corporate funds for personal purposes.
2. Hold meetings. Follow the requirements set forth in the Articles of Incorporation and bylaws for annual and other meetings.
3. Document meetings and key decisions. Keep records of the meetings held and all significant corporate decisions, such as officer and board member elections, entering into significant contracts (including leases) and key employment decisions.
4. Ensure that an officer of the corporation signs all contracts entered into on behalf of the corporation.
5. Do not enter into loans or other agreements between the corporation and shareholders, officers, or directors that are not negotiated at arms-length.
6. Ensure that all transactions among related entities are also negotiated at arm's-length.
7. Budget and review financial planning at regular intervals.

1. It should also be kept in mind that the alter ego doctrine may apply post-judgment. Under California Civil Code Section 187, a plaintiff may file a motion to add an alter ego as a judgment debtor; provided, however, that the plaintiff can prove the alter ego identify and demonstrate that the alter ego effectively controlled the litigation involving the original (corporate) judgment debtor. NEC Electronics v. Hurt, 208 Cal. App. 3d 772 (1989).

By taking these fundamental steps, a corporation (or other business entity) can go a long way towards preserving its separate identity and protecting its shareholders, member, partners, agents, and related entities from unnecessary risk.

For more information on the alter ego doctrine, assistance in maintaining corporate records, or corporation law in general, please contact either Lawrence Inouye or Colleen Sechrest at 310.712.0100 or send an email to: linouye@shiotani-inouye.com or csechrest@shiotani-inouye.com.