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The most common entities that run the risk of losing the limited liability protection are small, closely held corporations and LLCs made up of family members or a small number of shareholders and members.
Entrepreneurs, real estate investors, real estate brokers, real estate agents and other corporate and LLC entities alike form limited liability companies “LLCs) or corporations for the purpose of shielding themselves, and parent companies, from liability when establishing and operating a business. This article will review the concepts of limited liability and piercing the corporate veil in light of a recent decision issued on March 7, 2024, by the Appellate Division, First Department, in Cortlandt St. Recovery Corp. v. Bonderman [see https://bit.ly/44fdDRT] as well as previous caselaw.
The decision highlights some of the key requirements necessary to establish and maintain limited liability protection for individuals, as well as parent companies that own subsidiaries, when establishing an LLC or corporation. Failure to adhere to these requirements may expose shareholders of corporations and members of LLCs to liability, whether they are individuals or other limited liability entities.
Cortlandt St. Recovery Corp. involved a lawsuit where multiple defendant corporations (the TPG defendants or controlling companies) and individual shareholders were being sued for liability in connection with business transactions involving other so-called related companies (the controlled companies) under the theory of alter ego. The plaintiffs alleged that the TPG defendants, as well as the individual shareholders of the controlled companies, were the “alter ego” of the controlled companies and argued that they all should be held liable for the obligations, liabilities and acts of the controlled companies.
The court in Cortlandt St. Recovery Corp., citing a Third Department decision [see Sutton 58 Associates, LLC v. Pilevsky at https://bit.ly/3vRxhX6], pointed out that New York does not generally favor piercing the corporate veil or “disregard[ing] of the corporate form.” For the most part, provided individuals and companies adhere to the corporate formalities and follow the legal principles established under existing caselaw, the limited liability protection afforded to individuals and companies will stand. Plaintiffs will have the burden of establishing that a shareholder or member, or parent company shareholder or member, is the “alter ego” of a particular company in order for liability to extend to those shareholders or members, or any underlying corporate or LLC owners.
In Cortlandt St. Recovery Corp., the court held that in order for a plaintiff to be successful with a claim to pierce the corporate veil, the plaintiff must: “[1] show complete domination of the corporation in respect to the transaction attacked [and] [2] that such domination was used to commit a fraud or wrong against the plaintiff.” The court further explained that it is not sufficient for a plaintiff to make “mere conclusory allegations that the corporate structure is a sham…” when attempting to pierce the corporate veil.
Further, the plaintiff ‘“…must establish that the owners, through their domination, abused the privilege of doing business in the corporate form to perpetrate a wrong or injustice against that party’.” Generally, this is a significant burden for a plaintiff to overcome and attempts to pierce the corporate veil are many times rejected by the courts as is evident in this case.
The court in Cortlandt St. Recovery Corp. stated that the plaintiffs may not simply make reference to “tangential” or “tenuous” relationships between the defendants and the controlled companies without providing substantive proof that the “domination” as required by law exists. Further, the plaintiff must also establish that such “domination” was used to commit a wrongful act or fraud against the plaintiff.
The court cited various examples in other decisions where multiple entities were treated “as a single entity” and where the “lines of corporate control and responsibility” were “blurred.” The court also referenced cases where there was a “…high degree of intermingling among various entities all controlled either directly or indirectly by family members.” In the instant case, the court pointed out that the plaintiffs failed to provide proof to establish either of two aforementioned prongs.
The court in Cortlandt St. Recovery Corp., citing another First Department decision [see Tap Holdings, LLC v. Orix Financial Corp. at https://bit.ly/3UiT03u], explained that when establishing “domination” courts consider, among others, the following factors:
Ultimately the court dismissed the claims because the plaintiffs did not offer proof that the controlling company owned stock or was involved in the offering memorandum or corporate recapitalization, or that the controlling company disregarded corporate formalities, intermingled funds with the controlled company, had common officers, directors or staff; shared office space or telephone numbers; or interfered with the controlled company’s business decision-making process.
The court also dismissed the claims brought against the individual shareholders because the plaintiffs offered “…no evidence that they were ‘actually doing business in their individual capacities, shuttling their personal funds in and out of the corporations without regard to formality and to suit their immediate convenience.’”
In Walkovszky v. Carlton, a 1966 decision issued by the Appellate Division, Second Department [see https://bit.ly/3W02AKa], the court explained that “[t]he law permits the incorporation of a business for the very purpose of enabling its proprietors to escape personal liability but, manifestly, the privilege is not without its limits. Broadly speaking, the courts will disregard the corporate form, or, to use accepted terminology, ‘pierce the corporate veil,’ whenever necessary ‘to prevent fraud or to achieve equity’.”
The court in Walkovszky, citing the renowned Justice Cardozo, goes on to further explain that “[i]n determining whether liability should be extended to reach assets beyond those belonging to the corporation, we are guided…by ‘general rules of agency’. In other words, whenever anyone uses control of the corporation to further his own rather than the corporation's business, he will be liable for the corporation's acts ‘upon the principle of respondeat superior applicable even where the agent is a natural person.’” Basically, if someone uses the corporation as an alternate ego for personal rather than business purposes, then said person will be liable for the acts of the corporation.
In Austin Powder Company v. McCullough [see https://bit.ly/4aRiXwG], that court further held that “[w]hen a corporation has been so dominated by an individual or another corporation and its separate entity so ignored that it primarily transacts the dominator's business instead of its own and can be called the other's alter ego, the corporate form may be disregarded to achieve an equitable result.” Once the corporate veil is pierced, as the court in Walkovszky held, liability will extend to the individual, or to any other member or shareholder of the company and would include the corporation’s or LLC’s commercial dealings as well their negligent acts.
As discussed, corporations and LLCs are distinct from the individual shareholders who (or the separate parent entities that) form them. Among others, the main advantage is that the shareholders or members of a corporation or LLC are not held responsible for the debts, obligations, liabilities or even the negligence of the company.
Unfortunately, many fail to adhere to the legal requirements necessary to protect against losing the invaluable protection afforded to these entities. The most common entities that run the risk of losing the limited liability protection are small, closely held corporations and LLCs made up of family members or a small number of shareholders and members. However, it is also not uncommon for large corporations and LLCs to fail to follow the requisite parameters established under the law.
As highlighted by the court decisions above, individuals and entities risk losing the limited liability protection if the company, or the individual shareholders or members, engage in fraudulent activities, or do not follow the corporate formalities (e.g., establishing and following Bylaws for corporate entities, preparing operating agreements for LLCs, maintaining minutes, holding member or shareholder meetings, preparing resolutions for major corporate or LLC actions, etc.).
Even when there is only one shareholder or member (or a small few), meeting minutes must be maintained, and resolutions prepared. The corporate veil can also be pierced if the assets and funds of the corporation or LLC are commingled, and personal expenses are paid directly from the business accounts or if there is no real separation between the shareholders or members and the business itself. The corporate formalities must be adhered to because the courts will not think twice about piercing the corporate veil.
One important thing professionals and real estate licensees, who are fiduciaries under the law, must be aware of is that the limited liability protection does not extend to that individual where there is a breach of fiduciary duty owed to a client. However, it would cover them for the obligations and liabilities of the corporate or LLC entity.
Therefore, it is important to understand all of the requirements before forming a corporation or LLC and also consult with legal and accounting professionals before setting any limited liability entity. There are many tax and legal nuances that need to be considered before any of these entities are formed.
Legal Column author John Dolgetta, Esq. is the principal of the law firm of Dolgetta Law, PLLC. For information about Dolgetta Law, PLLC and John Dolgetta, Esq., please visit http://www.dolgettalaw.com. The foregoing article is for informational purposes only and does not confer an attorney-client relationship and shall not be considered legal advice. The views and opinions expressed in this article are solely those of the author and do not necessarily reflect the views or positions of HGAR, its affiliates, or any other entity.
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