United States Corporate Law: Part 3

Shareholder liability for debts.

One of the basic principles of modern corporate law is that people who invest in a corporation have limited liability. For example, as a general rule shareholders can only lose the money they invested in their shares. Practically, limited liability operates only as a default rule for creditors that can adjust their risk. Banks which lend money to corporations frequently contract with a corporation's directors or shareholders to get personal guarantees, or to take security interests in their personal assets, or over a corporation's assets, to ensure their debts are paid in full. This means much of the time, shareholders are in fact liable beyond their initial investments. Similarly trade creditors, such as suppliers of raw materials, can use title retention clauses or other devices with the equivalent effect to security interests, to be paid before other creditors in bankruptcy. However, if creditors are unsecured, or for some reason guarantees and security are not enough, creditors cannot (unless there are exceptions) sue shareholders for outstanding debts. Metaphorically speaking, their liability is limited behind the "corporate veil". The same analysis, however, has been rejected by the US Supreme Court in Davis v Alexander, where a railroad subsidiary company caused injury to cattle that were being transported. As Brandeis J put it, when one "company actually controls another and operates both as a single system, the dominant company will be liable for injuries due to the negligence of the subsidiary company."

There are a number of exceptions, which differ according to the law of each state, to the principle of limited liability. First, at the very least, as is recognized in public international law, courts will "pierce the corporate veil" if a corporation is being used to evade obligations in a dishonest manner. Defective organization, such as a failure to duly file the articles of incorporation with a state official, is another universally acknowledged ground. However, there is considerable diversity in state law, and controversy over how much further the law ought to go. In Kinney Shoe Corporation v Polan the Fourth Circuit Federal Court of Appeals held that it would also pierce the veil if (1) the corporation had been inadequately capitalized to meet its future obligations (2) if no corporate formalities (for example meetings and minutes) had been observed, or (3) the corporation was deliberately used to benefit an associated corporation. However, a subsequent opinion of the same court emphasized that piercing could not take place merely to prevent an abstract notion of "unfairness" or "injustice". A further, though technically different, equitable remedy is that according to the US Supreme Court in Taylor v Standard Gas Company corporate insiders (for example directors or major shareholders) who are also creditors of a company are subordinated to other creditors when the company goes bankrupt if the company is inadequately capitalized for the operations it was undertaking.

Tort victims differ from commercial creditors because they have no ability to contract around limited liability, and are therefore regarded differently under most state laws. The theory developed in the mid-20th century that beyond the corporation itself, it was more appropriate for the law to recognize the economic "enterprise", which usually comprises groups of corporations, where the parent takes the benefit of a subsidiary's activities and is capable of exercising decisive influence. A concept of "enterprise liability" was developed in fields such as tax law, accounting practices, and antitrust law that were gradually received into the courts' jurisprudence.

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