Asset Protection: Veil Piercing

Our July 23, 2018 blog entry, Asset Protection: The Filing Entity, explains how a filing entity such as a corporation or LLC is designed to protect personal assets from the risks of owning and operating a business.  But, what about “piercing the corporate veil?”

Piercing the Corporate VeilPiercing the corporate veil–veil piercing–occurs when a court looks beyond the assets of the entity to the personal assets of its owners to satisfy the debts, liabilities, or other obligations of the entity.  Historically, Texas permitted veil piercing when an entity (1) was the alter ego of its owners, (2) was used for an illegal purpose, or (3) was used as a sham to perpetrate a fraud.  Numerous legal theories, tests, and/or factors developed under these three broad categories of veil piercing.

Presumably, in light of the proliferation of veil piercing litigation and liability exposure that, for practical purposes, was undercutting the public policy in favor of providing personal asset protection through the use of filing entities, the Texas legislature stepped in.  In 2006, the legislature enacted Texas Business Organizations Code (“TBOC”) §101.114 titled “Liability for Obligations.”  TBOC §101.114 states that “[e]xcept as and to the extent the company agreement specifically provides otherwise, a member or manager is not liable for a debt, obligation, or liability of a limited liability company, including a debt, obligation, or liability under a judgment, decree, or order of a court.” 

 

TBOC §21.223, titled “Limitation of Liability for Obligations,” also limits historical veil piercing theories with the following language:

 

(a)  A holder of shares, an owner of any beneficial interest in shares, or a subscriber for shares whose subscription has been accepted, or any affiliate of such a holder, owner, or subscriber or of the corporation, may not be held liable to the corporation or its obligees with respect to:

         (1)  the shares, other than the obligation to pay to the corporation the full amount of consideration, fixed in compliance with Sections 21.157-21.162, for which the shares were or are to be issued;

         (2)  any contractual obligation of the corporation or any matter relating to or arising from the obligation on the basis that the holder, beneficial owner, subscriber, or affiliate is or was the alter ego of the corporation or on the basis of actual or constructive fraud, a sham to perpetrate a fraud, or other similar theory; or

         (3)  any obligation of the corporation on the basis of the failure of the corporation to observe any corporate formality, including the failure to:

                 (A)  comply with this code or the certificate of formation or bylaws of the corporation; or

                 (B)  observe any requirement prescribed by this code or the certificate of formation or bylaws of the corporation for acts to be taken by the corporation or its directors or shareholders.

However, TBOC §21.223(b) left open a single avenue for veil piercing when the obligation arose from or related to a contractual relationship and the entity was used to perpetrate an actual fraud primarily for the direct personal benefit of the owner.

(b)  Subsection (a)(2) does not prevent or limit the liability of a holder, beneficial owner, subscriber, or affiliate if the obligee demonstrates that the holder, beneficial owner, subscriber, or affiliate caused the corporation to be used for the purpose of perpetrating and did perpetrate an actual fraud on the obligee primarily for the direct personal benefit of the holder, beneficial owner, subscriber, or affiliate.

Corporate formalities

Although TBOC §21.223(a)(3) expressly eliminates the “failure to follow corporate formalities” commonly pointed to in historical veil piercing law, it is still best practice to follow corporate formalities to avoid failure to do so being pointed to as part of an alleged actual fraud.  Further, if multiple entities are oned, it is best practice to avoid undocumented transfers between the entities, sharing employees and the same accounting system, one entity paying the wages of the other entity, and unclear allocation of profit and loss between the entities.

Veil piercing based on the Texas Tax Code 

Texas Tax Code § 171.255 establishes that directors, officers, and managers of a filing entity have personal liability for the debts of the entity when the filing entity privileges are forfeited for failing to timely file a report or pay a tax or penalty.  The time period of personal liability exposure extends from the date the report, tax, or penalty becomes due until the entity privileges are revived.

 

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