With all the attention lately to the First Amendment rights of corporations, whether under the free speech or freedom of religion parts of that part of the Bill of Rights, we sometimes lose focus on the most basic benefit of incorporation: the provision of limited liability to the owners and operators of a business. This essentially means that the assets of the business alone are available to any creditors of the business, whether as a result of contract or of tort. While this may seem obvious now, it may surprise a reader to learn that this wasn’t always the case, and that general incorporation laws are just over a century old; before that, charters for corporations were granted by legislatures on a one-off basis. And they often came with severe restrictions on how the corporation could operate. At the very beginning of my legal career, as a summer clerk over 35 years ago, I remember writing a summary of the revolutionary provision of the Washington State Corporations Act that eliminated the requirement that there be a minimum of three directors for a corporation. It was barely 20 years ago that the requirement that the same person not hold the offices of president and secretary was abolished.
The imposition of such requirements has generally been done away with, and with the advent of limited liability companies, or LLCs, and the IRS’s “check the box” rules that allow entities to be taxed in many cases just as they wish, formality as a cost of limited liability seems almost an anachronism.
A recent case decided by Judge Jed Rakoff of the U.S. District Court for the Southern District of New York, however, has caused me to think about all these issues. The case involved a mislabeling claim over whether oil was properly marketed as “100% olive oil.” The oil’s distributor filed for bankruptcy, making the lawsuit against it subject to the automatic stay. So the plaintiffs amended their suit to be against the family management company and the three principal owners of the bankrupt distributor. Their claim was they could pierce the corporate veil. The New York corporate law standard for piercing a corporate veil includes the following:
(1) the owners exercised 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 which resulted in plaintiff’s injury.
The plaintiffs reasoned that since they were claiming the mislabeling was a fraud, that they met the standard and could sue the owners directly.
Judge Rakoff was having none of it. He cited the New York case that established the test and determined there was simply no evidence under the second prong:
To satisfy the second prong, 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 [the plaintiffs] such that a court in equity will intervene.”
In other words, it is not sufficient that the owners may have used the corporation to commit fraud. They must have used the corporate form in some way as a means of committing the fraud. Otherwise, any claim of fraud would be grounds for piercing the corporate veil, pretty much meaning there was no corporate veil.
It might seem an obvious point, but Judge Rakoff’s decision is at least something someone can point to in the next case to try to get sanctions for someone making this entirely too broad claim.