The Limitations of Limited Liability: Lessons for Entrepreneurs (and Their Attorneys)

Abstract:     
An entrepreneur does not start a new business expecting it to fail. Yet, according to various statistics, most independent start-up businesses fail within the first year, while as many as 90% are no longer in business after three years. This is why the issue of personal liability for the owners of the business is critical.

Historically, the entrepreneur could protect personal assets by forming and operating the business as a corporation, recognized by state law as a legal entity separate from the owner of the business for purposes of imposing liability. Although operating a business as a corporation presumptively shields the personal assets of the owners from the claims of the business's creditors, a creditor may ask a court to ignore this liability shield when the corporation is unable to pay its debts and goes bankrupt. Disregarding or, "piercing," the statutory limited-liability shield permits the business debts to be satisfied out of the owner's personal assets. Absent a judicial decision to, "pierce the corporate veil," in this manner, the limited liability created by the applicable corporate statute stays intact and the creditor must shoulder the loss.

It is crucial that entrepreneurs and the attorneys advising them do everything possible to avoid potential, "piercing." However, there are no clear guidelines for this task. Writing in a piercing case in 1926, one of the great judges of the common law, Benjamin Cardozo, wrote that, "[t]he whole problem of the relation between [owners and their] corporations is one that is still enveloped in the mists of metaphor. Metaphors in law are to be narrowly watched, for starting as devices to liberate thought, they end often by enslaving it." Metaphors provide little guidance to entrepreneurs and their attorneys about what will result in a loss of limited liability.

Sixty years later Robert Clark, renowned corporate scholar and Harvard Law School Dean, commented, "Do you notice anything intellectually disturbing about this [standard piercing-the-veil] formulation? That's right; IT'S vague. It hardly gives you any concrete idea about which conduct does or does not trigger the doctrine--not enough of an idea, at least, to give you the ability to counsel clients in a meaningful way."

Now that presumptive limited liability for business owners has become the norm through the proliferation of new forms of limited liability entities (LLEs) such as the limited liability partnership and the limited liability company, the stakes are more significant than ever. New forms of business organizations as well as corporations must address the issue of when limited liability might be lost.

The start-up business owner and the attorney counselor must prepare for the possibility that the business may fail. Creditors of the business may ask the court to ignore the separate legal existence of the LLEs and impose personal liability on the owner. It appears that the courts will follow the same general procedure for piercing the veil of the more modern LLEs based on the standards that have been historically applied to pierce the corporate veil of the corporation. The purpose of this article is to describe these standards and to distill some basic, practical lessons that entrepreneurs and their attorneys can follow to lessen the disastrous potentiality of piercing.

Number of Pages in PDF File: 10

Keywords: Piercing, limited liability, alter ego, instrumentality

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