The corporate veil is one of the most important legal tools in protecting the personal assets of shareholders or the assets of a large parent company. Courts are generally loath to revoke the protections offered by a corporation, and will typically do so only in the event of gross misconduct. Using corporations and subsidiaries as tools to limit the liability of parent companies and shareholders is a legitimate business practice that can be an invaluable part of a risk management and a successful legal strategy.
Subsidiaries are part of a smart legal strategy
The use of subsidiaries, when properly implemented, confer significant advantages to a business. Subsidiaries are essential secondary businesses controlled by means of ownership shares held by the parent company; in the eyes of the law, they are separate and distinct entities. Therefore, any action taken against a subsidiary is entitled only to the assets and capital held by that entity. By creating a subsidiary, organizations can distribute assets and add layers of protection to the parent company.
However, the corporate veil isn’t invulnerable; it does not protect against illegal acts or reckless business practices, nor does it afford protection when the company is non-compliant with the rules regarding corporate maintenance. There are a number ways that plaintiffs asserting claims can seek to pierce the corporate veil. Knowing these vulnerabilities (and how to protect against them) is the key to protecting other tiers of subsidiaries, the parent company’s assets and, ultimately, the shareholders’ personal assets.
The larger a corporate group (i.e., the more subsidiaries it contains), the more complicated it becomes to guarantee that the entire organization is in compliance with the rules of corporate formation and maintenance. Failure to properly maintain a corporation can create liabilities that have a ripple effect on the entire organization. However, a parent company can minimize the risk that a court will elect to pierce the corporate veil of a subsidiary (or, worse, the parent company itself) by:
- Following the rules. Set the tone when filing for incorporation; comply with corporate statutes by properly issuing stock certificates, adequately funding and insuring the business entity, and filing required documents on time.
- Creating separate and distinct accounts. One of the primary arguments used for piercing the corporate veil is a lack of distinction between two different legal entities. To eliminate confusion, ensure that each tier of your organization maintains separate and independent bank accounts.
- Clearly defining all transactions that occur between related entities. Ensure that each level of the corporate group keeps separate records, books and bank accounts, and document transfers of assets between the different entities. This includes loans and other arrangements.
- Ensuring that each entity has appropriate debt to equity ratios. Carrying all of an organization’s debt in one subsidiary and all of its assets in another isn’t good business- it’s illegal. The law considers each corporation to be a separate entity. As such, each entity has to be capable of standing alone.
- Maintaining operational distance. A subsidiary should hire and fire its own employees, maintain a separate board of directors and generally operate without direct control from the parent company. Each subsidiary should have separate offices and phone numbers and file separate tax returns.
These five points boil down to two main ideas; statutory compliance ensures that the corporate structure remains intact, and establishing separate and distinct identities for each business entity is of paramount importance. At the end of the day, however, it’s important to remember that subsidiaries are a kind of insurance intended to protect the parent company, not a guarantee against financial loss of any kind. Essentially, a well-structured corporate group should use subsidiaries to protect against catastrophic financial damage, a sort of “acceptable loss” entity that ensures the survival of a larger group.
Proper preparation prevents poor performance
It’s all too easy to allow the operational aspects of a business to overshadow maintenance and compliance protocols, cutting off your best defense at the knees. However, if your corporation isn’t properly administered, everyone from shareholders to employees can suffer the consequences. Growing a corporate group has a unique set of challenges, but growing pains aren’t a necessary part of business expansion.
At Gertsburg Law, our business attorneys help your company grow intelligently. Many of our lawyers have worked as in-house counsel, so we know corporate governance from the inside; additionally, our team has advised and litigated corporate governance matters as outside counsel. Our Cleveland corporate governance attorneys advise the members of the board of directors, in-house counsel, the corporate officers, and key executives about what rules are required, which ones are advisable, the risks for each type of decision, and the best way to implement these rules so they become part of the corporate culture. To learn more about how we can help, call 440-571-7777 or contact us to schedule an appointment at our offices in Cleveland and Chagrin Falls.
