A veil piercing claim can be a worst-case scenario for a private fund manager dealing with a struggling portfolio company investment – the company fails, and ensuing legal claims are brought not only against the portfolio company, but also against the fund and its GPs. How can fund managers manage that risk?

Limited liability is a hallmark of the corporate structure. Yet the legal doctrines of veil piercing and alter ego permit courts to “pierce” or bypass the corporate structure in order to hold shareholders and directors personally liable for a corporation’s actions or debts.  These doctrines have important implications in the context of a fund that owns large stakes in portfolio companies.

If a fund is found to be the alter ego of a portfolio company, the fund may be exposed to significant liabilities even in the absence of direct claims against the fund. For example, if a portfolio company falters and implements a large-scale layoff, there is a high likelihood that plaintiffs will file a WARN Act action.  Outside investors or employee shareholders may pursue misrepresentation and fraud claims against the company based on rosy predictions.  When the portfolio company is insolvent, plaintiffs will seek out the “deep pockets” of the fund itself on a veil piercing or alter ego theory.

This post outlines the general standards for veil-piercing under Delaware law and provides concrete steps that can help to limit the exposure of a fund and its managers to derivative liability claims. We chose Delaware law because of the state’s popularity as a state of incorporation.

An important caveat: As we will discuss in a later post, California law differs in several important respects from Delaware law on this topic.

What Law Applies?

Most states, though not all, choose the law of the state of incorporation when considering veil-piercing claims under the “internal affairs doctrine.” That doctrine generally states that the law of the state of incorporation (e.g. Delaware) controls the “internal affairs” of a corporation.  So, for corporations organized in Delaware, even if a claim is brought in New York or Illinois, Delaware law will typically apply to the veil-piercing claims under the internal affairs doctrine. See, e.g., Fletcher v. Atex, Inc. (2d Cir. 1995) (“Under New York’s choice of law rules, the law of the state of incorporation determines when the corporate form will be disregarded”).

Why is this important? The law in Delaware (like New York and Pennsylvania) is regarded as particularly favorable to owners/managers resisting a veil-piercing claim.  California, on the other hand, is typically considered an easier jurisdiction to pierce the veil.  And rather than looking to the state of incorporation, California courts generally apply California law to alter ego claims, as we will discuss in a later post.

Another difference between states is whether veil piercing is treated as an equitable matter for the judge to decide or a factual question for the jury. In Delaware, for example, a judge decides veil-piercing claims.  Texas is an outlier, where such claims are left to the jury.

These differences are important because choice-of-law determinations in veil piercing cases are, unlike in breach-of-contract lawsuits, not governed by a contractual provision; indeed, by definition no contract could exist between the plaintiff seeking to pierce the corporate veil and the parent corporation, otherwise there would be no need to pierce the veil.  Instead, the applicable law will be determined by the choice-of-law provisions of the forum state.  Most often, courts apply either the law of the state of incorporation of the entity subject to piercing or the law of the forum state.

General Standards in Delaware

Delaware law, which governs many veil piercing claims, provides robust piercing protections. A plaintiff seeking to pierce the corporate veil in Delaware needs to show that the corporation, through its alter-ego, has created a sham entity designed to defraud investors and creditors.  In other words, Delaware requires a plaintiff to demonstrate “an element of fraud” or something like it. See, e.g., Winner Acceptance Corp. v. Return on Capital Corp., No. 3088-VCP, 2008 WL 5352063, at *5 (Del. Ch. 2008).  This is a very high standard.

The veil-piercing analysis in Delaware, as in most jurisdictions, is fact-intensive. Delaware courts consider factors such as:

  1. whether the company was adequately capitalized for the undertaking;
  2. whether the company was solvent;
  3. whether corporate formalities were observed;
  4. whether the controlling shareholder siphoned company funds; and
  5. whether, in general, the company simply functioned as a façade for the controlling shareholder.

Due in large part to the fraud requirement, Delaware courts grant dismissal or summary judgment of alter ego claims with greater frequency than do the courts of many other jurisdictions.

What You Can Do

So, what can you do to protect a fund from piercing claims? We have put together a list of dos and don’ts to help minimize exposure to these types of claims.

Dos:

  • Keep separate books and records for both companies.
  • Have separate meetings of the board and keep separate minutes.
  • Make the board composition of the entities different.
  • Keep separate accounts, including bank accounts, for both companies.
  • Require the use of separate email addresses and letterhead for any individuals with positions in both entities.
  • Where possible, maintain an arm’s length relationship in business dealings between related entities.
  • Adequately capitalize any corporation for its line of business.

Don’ts:

  • The two companies should not use the same office or business location.
  • They should not employ the same employees/attorney.
  • Do not divert assets from a corporation to the detriment of creditors, or manipulate assets and liabilities between entities so as to concentrate the assets in one and the liabilities in another. This is a potential sign of the fraud element that Delaware law requires for veil piercing to apply.
  • Do not have identical equitable ownership in the two entities, especially if the equitable owners have control over both entities.
  • Do not have the same directors and officers responsible for supervision/management of both entities.
  • Do not make the parent liable for the debts of the portfolio company.

Some of these suggestions are relatively fundamental and easy to implement. Others may be harder to accomplish, especially when managing a struggling portfolio company.  Given the risks, it is important to try to follow these guidelines.  If questions arise concerning the risk-reduction measures we’ve outlined above, it always makes sense to consult with outside counsel.

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Photo of Joshua M. Newville Joshua M. Newville

Joshua M. Newville is a partner in the Litigation Department and a member of Proskauer’s White Collar Defense & Investigations Group and the Asset Management Litigation team.

Josh handles securities litigation, enforcement and regulatory matters, representing corporations and senior executives in civil and…

Joshua M. Newville is a partner in the Litigation Department and a member of Proskauer’s White Collar Defense & Investigations Group and the Asset Management Litigation team.

Josh handles securities litigation, enforcement and regulatory matters, representing corporations and senior executives in civil and criminal investigations. In addition, Josh advises registered investment advisers and private fund managers on regulatory compliance, SEC exams, MNPI/insider trading and related risks.

Before joining Proskauer, Josh was senior counsel in the U.S. Securities and Exchange Commission’s Division of Enforcement, where he investigated and prosecuted violations of the federal securities laws. Josh served in the Enforcement Division’s Asset Management Unit, a specialized unit focusing on investment advisers and the asset management industry. His prior experience with the SEC provides a unique perspective to help asset managers manage risk and handle regulatory issues.

Photo of Lee Popkin Lee Popkin

Lee Popkin is a trial lawyer in Proskauer’s Commercial Litigation, Product Liability, and Intellectual Property groups. Lee represents clients in a wide range of industries in high-stakes trials in state and federal courts throughout the country. Lee’s experience includes developing case themes, preparing…

Lee Popkin is a trial lawyer in Proskauer’s Commercial Litigation, Product Liability, and Intellectual Property groups. Lee represents clients in a wide range of industries in high-stakes trials in state and federal courts throughout the country. Lee’s experience includes developing case themes, preparing key witnesses for deposition and trial, taking and defending expert depositions, and drafting and arguing case-dispositive motions.

Lee was recently named to the Best Lawyers in America inaugural “Ones to Watch” list.

Lee’s notable representations and victories include:

  • Universal Standard Inc. v. Target. Counsel to Target in successful defense of Lanham Act trademark infringement action related to its Universal Thread clothing line.
  • Echeverria v. Johnson & Johnson. Trial counsel to Johnson & Johnson in a widely publicized product liability trial relating to the company’s talc-based products and their alleged link to ovarian cancer. After trial, the court entered judgment notwithstanding the jury verdict for the J&J defendants, and, in the alternative, granted J&J’s motion for a new trial.
  • Bed Bath & Beyond Inc. v. 1-800-Flowers.com, Inc. Successfully represented Bed, Bath & Beyond in action to enforce agreement by 1‑800-Flowers to purchase PersonalizationMall.com.
  • Global Holdings v. Church & Dwight, Co., Inc. Secured dismissal of state and federal dilution claims in Lanham Act action regarding a consumer product. The court’s decision made new law in the Second Circuit on the issue of whether a valid registration preempts state law claims of dilution.  Daniels v. Johnson & Johnson. Trial counsel to J&J in product liability trial related to the company’s talc-based products in St. Louis. The jury returned a complete defense verdict on all claims and awarded zero damages.
  • Daniels v. Johnson & Johnson. Trial counsel to J&J in product liability trial related to the company’s talc-based products in St. Louis. The jury returned a complete defense verdict on all claims and awarded zero damages.Daniels v. Johnson & Johnson. Trial counsel to J&J in product liability trial related to the company’s talc-based products in St. Louis. The jury returned a complete defense verdict on all claims and awarded zero damages.
  • Allied Lomar, Inc. v. Diageo North America, Inc. Counsel to Diageo in successful defense of Lanham Act trademark infringement action concerning Blade & Bow Whiskies and the Stitzel-Weller Distillery.
  • Diageo North America, Inc. v. Mexcor. Trial counsel to plaintiff Diageo in a Lanham Act trade dress infringement and dilution action against competitor involving Crown Royal whisky. Obtained a jury verdict and permanent injunction in favor of our client following a two‑week trial.

In addition to her active practice, Lee regularly contributes to the Firm’s false advertising blog, Watch This Space: Proskauer on Advertising Law. Lee also devotes significant time to pro bono matters, and was recognized by KIND for her work representing two sisters from El Salvador fleeing gang violence.

Before joining Proskauer, Lee served as law clerk to the Honorable Sarah S. Vance of the United States District Court for the Eastern District of Louisiana. She received her J.D. cum laude from Harvard Law School.