The recent case of a federal judge ordering Martin Shkreli to forfeit $7.36 million serves as an example of one of the unique situations when a “corporate veil” is “pierced”.
What is a corporate veil?
In most international jurisdictions, including Canada, corporations are considered an independent legal entity, separate from those who own shares in it. Put simply, when a corporation has debt or loses a lawsuit, the individual owners of the corporation are only liable to the extent of their investment in the company, which is to say, their liability for the loss is limited [Salomon v Salomon & Co (1892) AC 22]. In effect, if a company goes bankrupt and is forced to pay back debt, the shareholders will only lose the value of their shares and will not have to recover the debt through their other personal assets. In this way, a corporation can be thought of as having a veil that shields its shareholders.
Example of limited liability: Jon has a net worth of $500 in personal assets. Of those assets, he owns 100% of shares in ABC Co., worth $100. ABC goes bankrupt; creditors are owed $300. Due to limited liability, Jon will only lose $100 (equal to his share total of ABC Co.) and the creditors will not have access to his remaining $400 of net worth.
What is piercing the corporate veil?
“Piercing the corporate veil” refers to a court setting aside limited liability and holding shareholders of a corporation personally liable for the corporation’s actions or debts. While uncommon, extreme actions by shareholders, directors, or officers warrant this drastic step. Situations where a corporate veil may be pierced can include where a corporation is a mere sham used to limit personal liability, or where a corporation is used as a tool to commit fraud [Personal Liability of Directors, BLG, Spring 2007]. In the case of Martin Shkreli, co-founder and former CEO of Turing Pharmaceuticals, he was held personally liable for his breach of fiduciary duty owed to the corporation. A breach of fiduciary duty is a personal offence charged not to the corporation, but to the individual who held the fiduciary duty to the corporation, namely a director or an officer (Ontario Business Corporations Act, s. 134]. Although the corporation held the financial losses, and his gross misconduct was committed during his time as CEO of the corporation, the $7.36 million that a court required him to forfeit was out of his personal assets.
What actions warrant piercing the corporate veil?
In a broad sense, a court is likely to hold shareholders personally liable when there is a degree of inseparability between the individual and the corporation. This can include intermingling of personal and corporate assets, or gross misconduct through fraud or deception. Cases like Clarkson Co v. Zhelka state that the corporate veil can be pierced when those in control expressly direct a wrongful thing to be done or when a corporate entity is completely dominated and controlled and being used as a shield for fraudulent or improper conduct [Clarkson Co v. Zhelka (1967) 2 OR 565]
How can I protect my assets if the corporate veil is pierced?
The defense around each subsequent corporation and its assets is that they are truly their own operating businesses, with their own shareholders, boards, and business plans. This lowers the risk to them, and increases the legal protection value to stacking up new corporations to hold real estate.
Let’s use an example:
Say you have a holding company, XYZ. You buy assets A, B, and C, setting up A Inc., B Inc., and C Inc. You set XYZ as the only shareholder for A Inc., B Inc., and C Inc. But if A Inc. were sued, it could potentially affect XYZ, and thereby B Inc. or C Inc. as well, since a litigator can go after every asset. However, if each of A Inc., B Inc., and C Inc. has their own investors, board, etc., then it’s harder for a court to say that it all falls on a sole shareholder, and the assets are afforded more protection.
Assets are also sometimes held in a trust with many potential beneficiaries. In this example, in the event that an individual is sued personally, the assets that are held by the trust have, in theory, many potential beneficiaries, and are not only the assets that benefit that specific individual. In plain language, the individual would claim “those assets are not mine”; rather they are owned by the trust.
That argument may prove to be a successful defense from creditors, so long as it is truthful - assets transferred into a trust in a hurry before a claim may not be protected. For those that are looking to protect assets long into the future (to start or preserve a family dynasty) can start to think about these concerns, and should certainly seek legal counsel and accounting counsel to confirm the options available based on their specific context.
- A corporate veil limits the shareholders’ liability for the company’s losses or debts.
- “Piercing the corporate veil” means removing this cap and holding the shareholders personally liable.
- Setting up subsequent corporations as their own operating businesses, or converting assets to be held by a (family) trust are potential ways to preserve assets - if these options are adopted, seek appropriate counsel and consider whether the purpose of the business or trust is aligned with the concept of an operating business, or a trust that exists for the benefit of it’s beneficiaries.