August 8, 2017
Generally, shareholders, directors, and officers of a corporation enjoy a “liability shield.” This means that the foregoing actors are not personally responsible for the debts and obligations of the corporation. This liability shield remains intact even if they make bad business decisions so long as they satisfy certain requirements called fiduciary duties. Fiduciary duties generally include the duty of good faith, care, and loyalty.
In a situation involving breach of a duty, a director or shareholder may be subjected to personal liability for corporate debts (other facts must be present too, as discussed below). For example, a director’s personal home and bank accounts may be subjected to the jurisdiction of the court and used to pay for a business debt if the director violates the fiduciary duty of loyalty by usurping a corporate opportunity. Usurpation of opportunity occurs when a director uses corporate assets and/ or her director status to take advantage of an opportunity belonging to the corporation. In a very basic sense, the duty of loyalty typically equates to someone being greedy and using corporate assets that belong to the corporation and its shareholders. Also in a very basic sense, the duty of care refers to directors and officers having the fiduciary duty to make decisions based upon a deliberative process or with sound, reasoned judgment. Thus, loyalty equates with greed and care means refraining from negligence by making reasoned decisions.
Before a plaintiff can “reach” someone’s personal assets in a lawsuit–under the theory of liability that a director or officer breached his or her fiduciary duty–the plaintiff must first use a doctrine called “piercing the corporate veil.” Once the corporate veil has been pierced, a plaintiff may assert her underlying theory of liability or claim and, if she prevails, can “reach” the director’s personal assets to satisfy the judgment.
A plaintiff (usually a creditor of the corporation) may pierce the corporate veil by demonstrating to a court that the corporation and/ or its owners have engaged in one or more of the following activities: (1) the business was undercapitalized when formed; (2) the owners or directors did not follow corporate formalities; and (3) commingling assets/ failure to maintain separate identities. A corporation is regarded as a legal entity separate and distinct from its owners, directors, and officers (perhaps the principal reason why people are not generally liable for corporate debts). In fact, the Supreme Court of the United States recently reaffirmed the holding that a corporation is regarded as a legal person–meaning that they can sue, be sued, be charged with crimes, and can own assets, among other things.
The foregoing list of factors describes three main areas of conduct in which NC courts have pierced the corporate veil; however, this list is not comprehensive and there are roughly 20 factors that courts will look to in making this determination. Courts will use a totality of the circumstances test as no one factor is determinative. Generally, it is very tough for a plaintiff to pierce the veil because courts recognize the consequences of such a holding. One of the significant results of piercing the veil is that investors will be less likely to assume certain risks if they fear personal liability down the road. Therefore, piercing the veil can hurt the economy and courts know this.
Perhaps the biggest factor that courts look to in determining whether to pierce the veil is the occurrence of fraud or willful wrongdoing (although failure to maintain separateness is also very important). For example, if a director left a corporation, and signed a “non-compete” contract after leaving (stating that he will not compete with his former business for a specified time and in a specified geographic area), and subsequently formed a new corporation that was virtually identical to the business he just left, a court would likely pierce the veil.
This is because, even though he is not technically competing with his former business (the new business is competing with the old business), the court would likely find that the new corporation was a sham or loophole used by that person to circumvent his contractual obligations. Again, one of the biggest reasons for forming a corporation is to obtain a liability shield; thus, directors and shareholders must take caution and avoid the potholes discussed above to avoid personal liability.
It is important to keep in mind that piercing the corporate veil is just the first step in attempting to reach one’s personal assets. Once pierced, the plaintiff must typically assert that the director or officer has breached a fiduciary duty owed to the corporation. As discussed above, the duty of care stands for the principle that directors and officers of a corporation in making all decisions in their capacities as corporate fiduciaries, must act in the same manner as a reasonably prudent person in their position would. Courts will generally adjudge lawsuits against director and officer actions to meet the duty of care under the business judgment rule.
The business judgment rule is a judicial presumption that shields directors and officers from personal liability for unprofitable corporate decisions if the decisions were made in good faith, with due care, and within the actor’s authority.
The business judgment rule stands for the principle that courts will not second guess the business judgment of corporate managers and will find the duty of care has been met so long as the fiduciary executed a reasonably informed, good faith, rational judgment without the presence of a conflict of interest. The burden of proof lies with the plaintiff to prove that this standard has not been met. If the plaintiff meets the burden, the defendant fiduciary can still meet the duty of care by showing entire fairness, meaning that both a fair process was used to reach the decision and that the decision produced a substantively fair outcome for the corporation’s shareholders.
This article contains a very brief examination of corporate liability law in North Carolina. Information herein should not be relied upon in making decisions or as legal advice in general. Readers in need of advice should confer with an experienced attorney before making any decisions that could impact one’s liability shield or one’s potential to remove a liability shield. King Law Offices, PLLC, has several experienced attorneys who can guide you through this challenging process. For a free consultation, please call 828-286-3332.