Several years ago I wrote an article entitled Abolishing Veil Piercing, whose titular thesis called on courts to scrap the doctrine known as piercing the corporate veil. The standard justification for veil piercing argues it serves as a safety valve allowing courts to address cases in which the externalities associated with limited liability seem excessive. As such, veil piercing is called upon to achieve such lofty goals as leading shareholders to optimally internalize risk, while not deterring capital formation and economic growth, but while promoting populist notions of economic democracy. The task is untenable. Veil piercing is rare, unprincipled, and arbitrary. Such a doctrine is highly unlikely to consistently effect socially beneficial policy outcomes. Instead, veil piercing achieves neither fairness nor efficiency, but rather only uncertainty and lack of predictability, increasing transaction costs for small businesses.
I therefore argued for abolishing veil piercing so as to refocus judicial analysis on the appropriate question, which I posited to be: Did the defendant-shareholder do anything for which he or she should be held directly liable? Did the shareholder commit fraud, which led a creditor to forego contractual protections? Did the shareholder use fraudulent transfers or insider preferences to siphon funds out of the corporation?
In this article, I extend the argument to LLCs.
At the outset, a distinction must be drawn between veil piercing and enterprise liability. Allocating liability within a business enterprise comprised of multiple corporations and/or LLCs involves far different policy considerations than does holding liable the natural persons who own a limited liability company. These tasks should be unbundled.
Intra-corporate group liability issues should be treated as a species of enterprise liability, with veil piercing being limited to determining the of the ultimate owners of the enterprise.
In the leading Kaycee decision, the Wyoming supreme court concluded: “We can discern no reason, in either law or policy, to treat LLCs differently than we treat corporations.” Admittedly, there is a certain intuitive logic to treating LLCs the same way we do corporations. Yet, why privilege the assumption that corporations and LLCs are to be treated the same?
Granted, there is little direct evidence that legislatures intended to treat LLCs and corporations differently. Yet, if legislatures had intended to incorporate the corporate law doctrines, they easily could have done so explicitly. Indeed, some states did exactly that. Given the ready availability of such models, one could infer that subsequently adopted statutes were not intended to incorporate corporate law rules in the absence of an explicit command so to do.
It is surprisingly difficult to find coherent explanations of the policy justifications for piercing the LLC veil, as opposed to mere assertions by fiat that such reasons exist. Two tend to crop up most frequently. One depends on a notion of corporate personhood and thus can be dismissed out of hand. The other views limited liability as creating a negative externalities-based market failure, which is true, but proves too much.
First, the externalities argument makes a better justification for repealing the general rule of limited liability than it does for carving out a veil piercing-based exception to the general rule. Hansmann and Kraakman, of course, invoked the externalities argument to justify their proposal the limited liability should be eliminated with respect to tort claims.
In lieu of rehashing those arguments, suffice it to note that their proposal has not been embraced by either legislatures or courts. To the contrary, “states have been busily expanding the scope of limited liability through the creation of such new enterprise forms as limited liability companies and limited liability partnerships.”
Second, there is no reason to believe that veil piercing causes equity claimants to internalize the risks associated with their business’ operations. Both in rhetoric and application, the doctrine focuses on such irrelevancies as observation of organizational formalities, not on whether the equity claimants used their control to externalize risk.
It seems unlikely that veil piercing even inadvertently addresses concerns over negative externalities. As we all know, the law of veil piercing is remarkably vague. Indeed, the doctrine is nothing more than analysis by epithet. As a result, application of the doctrine is rare, unprincipled, and arbitrary. The members of a LLC have a far greater chance of being struck by lightning than being held personally liable for their firm’s debts and other obligations.
Equity claimants of a limited liability entity, moreover, can very effectively insulate themselves from veil piercing-based personal liability by complying with minimal organizational formalities and providing modest levels of capital and/or insurance. How can such a dysfunctional doctrine possibly create appropriate incentives for the equity claimants of either a corporation or LLC to optimally internalize the social costs of their business activities?
Would abolishing veil piercing give businesses a license to externalize risk willy-nilly? I think not. First, market forces significantly constrain their ability so to do.
Second, the important category of cases in which a LLC’s members externalize business risks through personal misconduct remains subject to sanction under a number of legal regimes. In many nominally piercing cases, the plaintiff in fact could have brought a direct action against the shareholder under such theories as fraudulent conveyance or what have you.
Finally, in evaluating the externalities-based justification for veil piercing, context is critical. Modern industrial enterprises can do harm on a vast scale. In evaluating my competing proposal to abolish veil piercing with respect to LLCs, however, it is necessary to banish this specter from your mind. The appropriate mental image is not Union Carbide’s Bhopal disaster, to which so many critics of limited liability point, but rather Walkovszky’s injury at the hands of Carlton’s driver.
So framing the issue facilitates cost-benefit analysis. As we have seen, veil piercing has real costs. Ex ante, investors are denied certainty and predictability. Some investors will over-invest in expensive precautions, while others will under-invest in insurance and risk reduction. Ex post, the vague veil piercing standards lead to expensive litigation and, not infrequently, erroneous results.
Abolishing veil piercing would have significant affirmative benefits. George Priest has noted "that the expansion of enterprise liability since the 1970s in tort law has imposed differentially burdensome costs on small business."
Truly limited liability free of the risk of veil piercing could be viewed as one of the alternative government subsidies that offsets the differential burden of the tort system on small business. Interestingly, Larry Ribstein suggests that the spread of unincorporated limited liability entities, such as the LLC, was a backdoor mechanism for achieving tort reform. One thus may plausibly infer that the legislative expansion of the availability of limited liability reflects a shift in legislative intent “from merely encouraging and protecting passive investors to actively promoting business.”
The benefit of such a subsidy goes beyond the standard rationale of promoting capital formation. The 19th century legislators who first adopted limited liability as a central feature of corporate law did so, Stephen Presser contends, to encourage small and impecunious entrepreneurs to start and grow new businesses.
Entrepreneurs and other small business owners who tie up the bulk of their financial and human capital in their business have limited ability to protect that investment through diversification. Without the shield of limited liability, accordingly, only very wealthy persons would incorporate new businesses. Only persons of pre-existing wealth could afford to start a new business while maintaining a diversified portfolio of investments. This situation was precisely what limited liability was intended to remedy.
The shield of limited liability was created so as to encourage "the small-scale entrepreneur" and keep "entry into business markets competitive and democratic." Presser demonstrated that "the policy of limited liability, and its policy of encouraging incorporation by persons of modest means facilitated the growth of a viable urban democracy by allowing a wide participation in businesses that could most advantageously be organized as corporations.” In other words, limited liability “helped equalize the opportunities to get rich."
In turn, as Michael Novak has observed, the pursuit of wealth by entrepreneurs has been a major factor in destroying arbitrary class distinctions, by enhancing personal and social mobility.
With the LLC having displaced the close corporation as the vehicle of choice for smaller firms, Presser’s argument from democratic theory now applies to LLCs even more forcefully than it does to corporations.
Pro-piercing commentators typically argue that it would be “unfair to allow LLC is to possess the positive aspects of limited liability ... without also carrying the negative possibility of piercing.” This argument assumes a fact not in evidence, of course; namely, that veil piercing is sound public policy. In this article, I have demonstrated that the emerging doctrines for piercing the LLC veil are hopelessly dysfunctional. They encourage inefficient investment in irrelevant precautions, while encouraging expensive and complex litigation. They may discourage capital formation in small businesses by exposing those businesses to a disproportionate share of the burden from the tort liability system, which in turn undermines the valuable democratic contribution—at the risk of being too corny, the American dream—of small business ownership and entrepreneurship.
