Disregarding Corporate Personhood Imposes Personal Liability

11/15/2011 12:46 pm ET | Updated Jan 15, 2012
  • Brad Reid Senior Scholar, Dean Institute for Corporate Governance and Integrity, Lipscomb University

Recent commentary has considered the legal and social implications of a corporation being considered a "person." An interesting aspect of contemporary capitalism is the ability to create legal entities that have a separate existence from owners and managers. The British East India Company, chartered in 1600, is an early example. However, there are four well-known legal rules -- alter ego, responsible corporate officer, direct participation, and respondeat superior -- that disregard corporate personhood to impose personal liability on shareholders and officers for corporate debts and torts. Each of these will be briefly discussed.

A recent Wall Street Journal article entitled, "Debts of Defunct Law Firms Haunt Partners in Next Job" noted that the "unfinished business doctrine" allows the possibility of obtaining the profits for business started at an old law firm in bankruptcy and taken to a new firm. The basic argument is that that this work is an asset of the partnership as an entity and not the individual attorney. While "personhood" is traditionally reserved for corporations, a variety of other business forms have significant aspects of the personhood/separate entity concept as this contemporary example illustrates.

A recent decision by the federal Court of Appeals for the Second Circuit, Teitelbaum v. Lay Siok Lin, reinforces the conventional wisdom that is possible to disregard the existence of a limited liability company (LLC) under the "alter ego doctrine" in the same way that a traditional corporation may be disregarded. Disregarding the LLC entity imposes personal liability for debts upon an individual member.

The Second Circuit upheld personal liability despite the Utah state limited liability company statute that states that "failure of a company to maintain records, to hold meetings, or to observe any not a ground for imposing personal liability on any member, manager, or employee for any debt, obligation, or liability of the company." The Court wrote that other factors indicated that the defendant had "conducted his private and corporate business on an interchangeable or joint basis as if they were one." A 2002 Texas court decision, Pinebrooke Properties, Ltd. v. Brookhaven Lake Property Owners' Association, stated that failure to observe corporate formalities is not evidence of "alter ego."

The "alter ego doctrine" allows the disregarding of a corporate entity and imposing personal liability on shareholders for corporate obligations when the individual and corporate personalities are essentially one and observing the corporate form would promote injustice or inequity. Factors that are considered in an alter ego analysis include the failure to observe corporate formalities, the undercapitalization of a one-man corporation, nonpayment of dividends, siphoning of corporate funds by a dominate shareholder, non-functioning of officers and directors, lack of corporate records, use of the corporation as a facade for operations by the dominate shareholder, and the use of the corporate entity to promote injustice or fraud.

While it is impossible to create a precise checklist that a court will follow in applying the alter ego doctrine, generally some form of fraud and a commingling of personal and corporate assets are significant factors to consider. The bottom line is that the corporation or LLC must be respected as an independent legal entity (person) from that of the dominate shareholder. A very recent federal district court decision, In re ClassicStar Mare Lease Litigation, observed that the corporation in question was used "as a mere instrumentality" to defraud investors. The "responsible corporate officer" doctrine imposes liability on supervisory corporate officers when the corporation engages in illegal activity even if they did not directly participate in the wrongdoing. This rule dates from a 1943 U.S. Supreme Court decision, U.S. v. Dotterweich, in which a corporation's president was found criminally liable for the corporation's shipping misbranded and adulterated drugs. The Supreme Court wrote:

"The prosecution to which Dotterweich was subjected is based on a now familiar type of legislation whereby penalties serve as effective means of regulation. Such legislation dispenses with the conventional requirement for criminal conduct -- awareness of some wrongdoing. In the interest of the larger good it puts the burden of acting at hazard upon a person otherwise innocent but standing in responsible relation to a public danger."

The federal Food, Drug and Cosmetic Act and the Clean Water Act specifically provide criminal penalties under the responsible corporate officer doctrine. The responsible corporate officer doctrine is another example of disregarding corporate personhood to impose personal liability.

Of course a corporate shareholder or officer who directly engages in or authorizes wrongdoing, even on behalf of a corporation, is personally liable for that action. For example, operating a business as a corporation does not prevent the owner of the corporation from being personally liable for a traffic accident while the owner is driving the corporation's truck. A 1968 Texas decision, Western Rock Co. v. Davis, applied this rule when the owners of a corporation damaged neighboring properties while blasting.

A fourth basis for personal liability, "respondeat superior," let the superior respond, imposes vicarious liability upon an innocent employer when injuries are caused by an employee acting within the scope of employment. In a 2003 California case, Yamaguchi v. Harnsmut, a jury was entitled to decide a restaurant's owner's respondeat superior liability for the actions of a kitchen assistant who threw hot oil on a police officer. The police officer had sued the restaurant owners for negligent retention and supervision and vicarious liability. The Court noted that:

"This liability is based not on the employer's fault, but on public policies concerning who should bear the risk of harm created by the employer's enterprise. It is considered unjust, for example, for an employer to disclaim responsibility for injuries occurring in the course of its characteristic activities."

The Court stated approvingly:

"An employer may therefore be vicariously liable for the employee's tort -- even if it was malicious, willful, or criminal -- if the employee's act was an outgrowth of his employment, inherent in the working environment, typical of or broadly incidental to the employer's business, or, in a general way, foreseeable from his duties."

In this period of allegations of corporate overreaching and arrogance, it is noteworthy that a variety of existing contemporary legal doctrines exist to impose personal liability upon shareholders and officers. These include alter ego, the responsible corporate officer doctrine, direct participation in the wrongdoing, and respondeat superior. Legislation could amend these rules. The expansion or contraction of personal liability within the corporate context is a debatable public policy question that will likely be analyzed in depth.