Disregarding the corporate entity is also known as the “alter ego doctrine” or “piercing the corporate veil.” Generally, shareholders of a corporation are protected from being held personally liable for the corporation. If, however, the court finds that the corporation is a sham for individual shareholders carrying on their business in a personal capacity, a court may disregard the corporate entity and allow creditors of the corporation to recover using the personal assets of the shareholders.
The court can disregard the corporate entity and pierce the corporate veil, thereby holding shareholders personally liable, in one of two ways: The Van Doren Test or the Laya Test.
The Van Doren Test states that a court will hold a shareholder of a corporation personally liable if:
- First, there is such a unity of interest and ownership that the separate personalities of the corporation and individual don’t exist. Some factors the court may look at to determine this include: the failure to maintain proper, adequate corporate records and comply with corporate formalities; commingling of funds or assets; undercapitalization of the firm; and/or one corporation treating the assets of another corporation as its own.
- Second, maintaining the fiction of the separate corporation existence would either sanction fraud or promote injustice. Some factors the court may look at to determine this include: fraud, deception, and compelling public interest. The injustice must go beyond simply not paying back a creditor. Instead, one example includes unjustly enriching the shareholders.
- The court holds sophisticated creditors bringing these claims to a higher standard. If the party bringing a claim for disregarding the corporate entity is a sophisticated entity, then the court will look at whether the sophisticated creditor assumed the risk.
The Laya Test looks more generally at whether there is an inequitable result. This backs away from the idea that you need something more than the inability of the plaintiff creditor to get damages for breach of contract.
[Last updated in February of 2022 by the Wex Definitions Team]
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