Behind the Veil and the Blurred Distinctions of Entity Liability

Charleston Bankruptcy Member Robert Kerr, Litigation Member Chris Ogiba and Corporate Associate Trey Robinson were published in the Association of Corporate Counsel South Carolina Chapter’s Summer 2014 newsletter. Their article, “Behind the Veil and the Blurred Distinctions of Entity Liability,” discusses lesser-known theories in South Carolina jurisprudence that could negate standard liability protections if certain measures are not taken when forming or acting through corporate entities. The article can be seen in its entirety below.

as published in the ACC South Carolina Chapter's 2014 Summer Newsletter

As corporate counsel, you are well aware that the practice of creating, expanding, or reorganizing corporate entities and their subsidiaries is fraught with legal peril, both for your client and its officers and directors. However, this practice is necessary for a multitude of business reasons, including expanding your organization, creating special purpose entities for financing, mergers and acquisitions, or restructuring for taxation purposes. These new entities may take the form of limited liability companies or corporations. One of the main benefits you will appreciate when creating such an entity is the liability shield afforded to your client and its officers and directors. In most modern corporate structures, the parent company operates, in whole or in part, through its subsidiaries or holds assets in separate entities. You may consider the parent company and its directors safe from liability for actions and activities engaged in by these subsidiaries and separate entities. While most attorneys are aware that an entity’s veil may be pierced, there are lesser-known theories that have developed in South Carolina jurisprudence that may also negate standard liability protections if certain measures are not taken when forming or acting through corporate entities. Ignoring these potential pitfalls can lead to devastating results for not only the individual directors or members of an entity but also for other entities within a business’s corporate structure.

As mentioned above, one of the primary benefits of setting up a corporation or LLC is the protection that it provides investors and/or the owners of the entity from personal liability for the debts and liabilities of the entity. However, a South Carolina court may “pierce the corporate veil,” thus removing the liability shield and subjecting the shareholders of a corporation or the members of a LLC[ii], as the case may be, to personal liability for the entity’s obligations.

The seminal South Carolina veil piercing case is Sturkie v. Sifly.[iii] The court set forth a two-prong test to determine whether it is appropriate to pierce the corporate veil. The first prong of the test is “an eight factor analysis, [which] looks to observance of the corporate formalities by the dominant shareholders.”[iv] No single factor is sufficient to satisfy the test and a plaintiff does not need to prove all of the factors, but case law seems to give more importance to the undercapitalization of the entity and the commingling of funds.[v] The second prong of the Sturkie test is whether the evidence shows that the party seeking the pierce the veil will “suffer injustice or fundamental unfairness” if the corporate identity is allowed to stand.[vi]South Carolina courts will not pierce the corporate veil without “substantial reflection.”[vii] However, post-Sturkie case law provides additional criterion that may lead to veil piercing.

The alter-ego theory is a procedural weapon that, if applicable, will result in the piercing of the corporate veil.[viii] The alter-ego theory, also called the instrumentality theory, is implicated where one entity acts through another without maintaining proper separation. Under this theory, a parent entity can be held accountable for the acts or liabilities of its subsidiary entity. In Colleton County Taxpayers Association v. School District[ix], the court held that the “alter-ego theory requires a showing of total domination and control of one entity by another and inequitable consequences caused thereby.”[x] The South Carolina Supreme Court went on to state that “control may be shown where the subservient entity manifests no separate interest of its own and functions solely to achieve the goals of the dominant entity.”[xi] The court does narrow the analysis by adding that there must be inequity or misuse of control which results in injustice, fraud or a contravention of public policy for the alter-ego theory to apply.[xii] In its dismissal of the plaintiffs’ claim, the court pointed out that the corporation, alleged to be an instrument of the school district, appointed its own directors, approved its own by-laws and oversaw its own operations. As is clear from the analysis in Colleton County, South Carolina courts will consider the factors from Sturkie in determining whether a parent entity is exercising total domination and control over a subservient entity.[xiii]

The inequity prong of the veil piercing test is more difficult to satisfy than the eight-factor test prong. When a corporation is insolvent, certain acts by a corporation’s director(s) may satisfy the latter prong, even though those same acts would not satisfy the Sturkie test if the corporation were solvent.[xiv] Generally, the directors of a corporation have a duty to act in the best interests of the corporation and the shareholders of the corporation.[xv] This responsibility is commonly referred to in terms of a director’s duty of care and duty of loyalty.[xvi] However, “when the corporation becomes insolvent, the fiduciary duty of the director shifts from the stockholders to the creditors.”[xvii] In Federal Deposit Insurance Corporation v. Sea Pines Company, the Fourth Circuit Court of Appeals “set aside the corporate cloak” of a subsidiary and held the parent entity liable because the directors of the insolvent subsidiary acted in the best interest of its parent and to the detriment of subsidiary’s creditors.[xviii] As a result of the subsidiary’s “unjust and fundamentally unfair” actions and “interlocking directorships and undercapitalization,” the court treated the subsidiary as an extension of the parent corporation rather than as a separate legal entity.[xix]

The case law cited above provides insight as to measures corporate counsel can take in setting up new corporate entities to prevent veil piercing. First and foremost, any new entity should be properly capitalized with sufficient funds to engage in whatever business purpose it will serve; the mere filing of paperwork with the South Carolina Secretary of State is not enough to properly form and maintain a corporate entity. For a corporation, director(s) should be elected and officer(s) appointed. If possible, an entity should have more than one officer and director, and the officers and directors should be actively involved in the operation of the entity. Separateness should also be maintained among parent and subsidiary entities, such as special purpose vehicles, to avoid an alter-ego claim. This can be accomplished by avoiding overlapping directors or officers, maintaining separate bank accounts, and ensuring that each entity has its own governing documents. While a subsidiary will always be controlled to some degree by the principals of the parent company, it is important that the control not reach the point where there is no semblance of the existence of a separate entity.

Corporate entities must...