October, 1997
Piercing the Corporate Veil for Contractual Debts
When an insolvent subsidiary corporation is no longer able to pay its debts, its creditors often look to the parent corporation for payment. As a general matter, since the parent and subsidiary are separate corporations, which limits the liability of each company's shareholders, creditors are unlikely to be able to impose a debt of the subsidiary upon the subsidiary's shareholder (the parent), unless the parent has guaranteed the debt. However, creditors often attempt to get behind this veil of limited shareholder liability - that is, to "pierce the corporate veil" of the subsidiary.
Courts have looked at a number of factors to assist them in determining whether the corporate veil should be pierced. The veil is more likely to be pierced in a case where both the parent and the subsidiary are closely held corporations, are under common control, and are engaged in similar businesses, especially where one or both corporations failed to observe the formalities of corporate conduct (such as keeping separate and adequate corporate books and records, holding regular meetings of the board of directors and annual shareholder meetings to elect directors, approval by the board of key agreements, etc.) required under state law. Courts are also likely to allow the veil to be pierced where a corporation had inadequate capitalization to conduct its business, corporate funds were siphoned off, the corporation had no functioning officers besides the dominant shareholders, and fraud was involved. As a general matter, where the debts are based upon contractual provisions agreed upon by the subsidiary, rather than upon a tort that the subsidiary committed, courts are far less likely to pierce the veil and hold the parent responsible. Absent a showing that there was an improper intermingling of the parent and subsidiary corporations' activities and/or a substantial disregard of the separate nature of the corporate entities, the creditors are likely to fail in their attempts to hold the parent corporation liable.
In a recent Massachusetts case, Birbara v. Locke, 99 F.3d 1233 (1st Cir. 1996), the federal Court of Appeals refused to hold a parent corporation liable for its subsidiary's debts. The parent, which was a public corporation, had purchased the subsidiary after the subsidiary had become insolvent and defaulted on a number of its contractual obligations. The parent loaned the subsidiary substantial sums of money in an attempt to make it profitable again, but that amount was not enough, and the subsidiary failed to make contractually agreed upon payments to its debtors. Although the parent offered a settlement package which included cash, notes, and stock of the publicly traded parent corporation, the creditor plaintiffs rejected the settlement offer and sought to have the parent held liable for the full amount owed to them by the subsidiary.
The Court of Appeals, applying Massachusetts law, refused to find the parent liable. Although two members of the subsidiary's board of directors were also members of the board of directors of the parent, the court concluded that the two companies had distinct boards of directors, held separate board meetings and kept separate financial records which accurately reflected that the funds transferred by the parent to the subsidiary were in the form of loans to the subsidiary. The court also found that the plaintiffs were not misled as to the status of the parent and subsidiary corporations and the relationship between the parent and the subsidiary. As the plaintiffs were unable to show that the parent exercised some form of "pervasive control" over the subsidiary or that there was any "fraudulent or injurious consequence of the intercorporate relationship," the court refused to pierce the corporate veil and hold the parent corporation liable for the debts of the subsidiary.
As Birbara indicates, a court is unlikely, except in extremely egregious circumstances, to hold a parent corporation liable for its subsidiary's debts where a parent corporation is careful to keep separate books and records from its subsidiary, to run the parent and any subsidiary corporations as separate entities, and to make it clear to creditors and the public that there are two distinct entities. Accordingly, in order to preserve the limited liability accorded the parent corporation as the shareholder of the subsidiary, the parent corporation's officers should take steps to ensure that each of the corporate family members is treated as a distinct entity, that each entity makes its own decisions, and that the parent corporation does not use the subsidiary as a front for the actions of the parent.
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