I recently ran across State v. Weinschenk, 868 A. 2d 200 (Me. 2005), in which the Maine Supreme Court held that the corporate veil could be pierced where, inter alia, the corporation was thinly capitalized at all times and insolvent at the time of trial.
As you may know, I favor abolishing veil piercing in its entirety, but that’s a question for another day. In this post, I want to address the question of when you measure undercapitalization for purposes of piercing the corporate veil.
Evaluating the corporation’s capitalization as of the time of trial is clearly inappropriate. It is widely held that “some ‘wrong’ beyond a creditor’s inability to collect” must be shown before the veil will be pierced. Sea-Land Services, Inc. v. Pepper Source, 941 F.2d 519, 524 (7th Cir. 1991). This is so because a requirement that the corporation be adequately capitalized at the time of trial would be tantamount to a rule of unlimited liability, since a creditor typically will pursue a veil piercing theory only where corporate assets are inadequate to meet its claim.
Conversely, the case law is clear that while undercapitalization standing alone is not a sufficient basis for piercing the corporate veil, undercapitalization at the time the corporation was formed is a factor to be considered.
But what about cases in which the corporation was adequately capitalized at formation, but subsequent developments have left it inadequately capitalized?
Even the strongest proponents of using undercapitalization as part of the veil piercing standard acknowledge that:
Where corporate income is not sufficient to cover the cost of insurance premiums above the statutory minimum or where initially adequate finances dwindle under the pressure of competition, bad times or extraordinary and unexpected liability, obviously the shareholder will not be held liable. -- Walkovszky v. Carlton, 223 N.E.2d 6, 13 (N.Y. 1966) (Keating, J., dissenting).
The case law does, however, contemplate at least two situations in which undercapitalization may be relevant even if the funds put into the corporation at the outset were clearly sufficient to satisfy existing contractual and likely tort obligations: (1) all profits are drained out of the firm in the form of dividends or salaries paid to the controlling shareholders, leaving it with insufficient reserves to meet its likely obligations, or (2) the nature of the firm has changed, such that initially adequate capital is no longer adequate.
As to the former, many cases stand for the proposition that diversion of corporate earnings or siphoning of corporate assets so as to leave the corporation judgment proof is a factor to be considered in deciding whether to pierce the corporate veil, especially where the controlling shareholder was “has notice of a potential claim” at the time of the diversion of funds. JSC Foreign Econ. Ass'n Technostroyexport v. Int'l Dev. & Trade Servs., 386 F.Supp.2d 461, 476 (S.D.N.Y.2005); accord Capital Distrib. Servs., Ltd. v. Ducor Express Airlines, No. 04-CV-5303 (NG)(VVP), 2007 WL 1288046, at *3-4 (E.D.N.Y. May 1, 2007) (by diverting substantially all of the corporation's assets upon being served with plaintiff's complaint, owner of corporation “used his domination to perpetuate [sic] a wrong against” plaintiff).
With respect to the second setting, I direct your attention to Consumer's Co-Op v. Olsen, 419 N.W.2d 211 (Wis. 1988), which held that:
While holding in both tort and contract cases that inadequate capitalization is a factor significant to piercing the corporate veil, we reject the respondent's contention that there is a continuing requirement to maintain an adequate level of capitalization. … Hence, while a court's examination of the adequacy of capitalization may inquire beyond the capitalization at the inception of the corporation, such inquiry may be made only in those circumstances where … the corporation distinctly changes the nature or magnitude of its business. Likewise, it has been observed:
It is clear, therefore, that adequacy of capital must be measured at the beginning period of corporate existence. As a condition to the receipt of a shield of limited liability, the law requires that shareholders adequately capitalize the corporation. Once shareholders have done so, there is no requirement that they provide for losses beyond the amount of their original subscription in the corporation. The case law recognizes that a corporation formed with adequate capital will not subsequently be rendered under-capitalized, so as to impose shareholder liability or require subordination of shareholder loans, merely because the business suffers losses.
* * *
Conversely, where a corporation commences business with capital then adequate, and later substantially expands the size or nature of the business with an attendant substantial increase in business hazards, the corporation might be deemed inadequately capitalized unless there is an infusion of additional risk capital by shareholders.
Personally, I’m not persuaded by the Consumer Co-Op case. The idea that capitalization could become inadequate because the business evolves raises all sorts of difficult questions. How “substantial” does the increase have to be in order to trigger an obligation of an additional infusion by the shareholders? Do all shareholders have to contribute or just those who are active in the business (recall that the veil generally is not pierced as against passive investors)? How much of an additional infusion is required? How would the corporation enforce the obligation to provide additional capital if the shareholders balked?
So what about Weinshenk?
Weinshenk deserves overruling insofar as it contemplates piercing the corporate veil when the corporation is insolvent at the time of trial.
If Maine is going to undertake an overruling of Weinshenk, it should also use that opportunity to preclude the Consumer Co-op caveat about subsequent undercapitalization by virtue of business expansion. Such a rule is likely to discourage capital formation because investors would be reluctant to invest in close corporations if the veil piercing rules effectively require them to supply potentially unlimited amounts of additional capital ad infinitum.
What about veil piercing where the ex post undercapitalization is the result of siphoning of assets or diversion of earnings? There is a case to be made, of course, for leaving such cases to fraudulent transfer law. Indeed, I have made such a case in my work on abolishing veil piercing. If veil piercing is to remain on the books, however, the siphoning cases strike me as the context in which it is most appropriate.