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Limiting shareholder liability has always been a primary purpose of operating in the corporate form and, not surprisingly, maintaining the “corporate veil” has always found a place on the checklist of counsel advising any multibusiness company. With the rash of products liability and consumer class actions, coupled with large jury verdicts, businesses today must protect the corporate veil with vigor and purpose. Companies need to manage their risks in a more robust manner, to identify potential exposures and to plan for the possible claims that the liabilities of a corporation may be imputed to related corporations. This derivative risk exposure is of particular concern for both foreign-based entities with investments in the United States and diversified U.S. businesses. This article examines six practical measures that multibusiness companies may use to diffuse the likelihood that the separate identity and limited liability of a corporation will be disregarded. Liabilities may be isolated among separate entities An owner of a corporation, whether an individual or another company, is not normally liable for the corporation’s debts. The law permits the establishment of separate entities for the purpose of, among other things, isolating liabilities among separate entities, and courts recognize a public policy of encouraging investments and affording limited liability to shareholders. There are, however, exceptions. When a court determines that a corporation is an “alter ego” or “mere instrumentality” of its shareholders, the court may “pierce” or disregard the corporate veil to prevent injustice or fraud, or even to do justice or equity. Despite myriad legal decisions and treatises devoted to the subject, the determination of whether a corporation is an alter ego or mere instrumentality of its shareholders remains essentially a factual inquiry based on the circumstances. Nevertheless, there are steps that serve to mitigate the risk of corporate veil piercing. Unfortunately, vigorous maintenance of the corporate veil is often in tension with effective management models and tax strategies. Companies should take a measured, practical approach that incorporates, or at least considers, the following measures as ways to demonstrate the distinct identity or “separateness” of a subsidiary. None of these suggestions would prevent or instantly defeat a veil-piercing claim, and some of them may not be practical for certain businesses. A thorough review of practices of, and risks for, subsidiary investments is prudent governance, and these suggestions offer a reasonable starting place. 1. Observation of corporate formalities. Following corporate formalities is widely acknowledged as a factor in determining whether to maintain the corporate veil. These vary from state to state, but include annual shareholders’ and directors’ meetings; regular election of officers and directors; maintenance of corporate record books, including all meeting minutes; and management of the subsidiary in a manner consistent with its charter and bylaws. Observing these formalities is straightforward and comes at almost no expense to other management or tax concerns. Thorough corporate and financial records also form the basis for relying on the “business judgment rule” and demonstrating the existence of other favorable factual situations. 2. Separation of funds and accounts. Whatever formalities are observed, any claim that a parent corporation and a subsidiary are legally separate entities is not likely to prevail when, in reality, they do not separately account for their finances. When corporate veils have been pierced, there has typically been manipulation or abuse of a subsidiary’s accounting and financial functions. This is not to say that a parent and subsidiary may not achieve economies of scale through various cash-management strategies, such as foreign exchange or overnight investment management; in those situations, however, companies must keep separate accounts and books, record monetary transfers and properly document transactions. The subsidiary operations will commonly be reflected on the parent’s financial statements. It is important that each subsidiary’s financial condition be consolidated through the accounting records of its direct parent or parents, rather than “reported up” to a functional business unit or group that may itself be a sister corporation, or may include unincorporated business divisions of the parent. It is preferable to observe formalities even when there is functional management of the overall enterprise. 3. Adequate capitalization. A subsidiary should be capitalized at a level that is consistent with the level of risk associated with its business operations. Courts routinely focus on capital levels when considering the viability of a corporate veil, though adequate capital is a fluid and imprecise concept. A subsidiary should have sufficient capital to operate without frequent, random and unplanned capital infusions. If a parent habitually funds the subsidiary when liabilities arise in the ordinary course, there is a real risk that it will also be required to fund the subsidiary under extraordinary situations. Similarly, the parent should not siphon funds away from the subsidiary in the form of excessive dividends, even though tax considerations may suggest otherwise. The assessment is whether the dividend is in the best interest of the subsidiary and not the parent. The subsidiary should regularly review its capital position, and the board of directors should make an annual review and determination (properly recorded in connection with its annual meeting) of the adequacy of working capital and the subsidiary’s ability to pay dividends. 4. Directors and officers; corporate control. As a general rule, the stewardship of any corporation is vested in its board of directors-not its shareholders. Each subsidiary should have its own board of directors, which in turn would appoint officers of the subsidiary. The board of the subsidiary should be involved in supervising the officers and the performance of the subsidiary. In reality, a substantial level of control is appropriately exercised by the parent or corporate shareholder to protect a significant investment and, in the public- company context, to satisfy the corporate shareholder’s fiduciary obligations to its own shareholders. Complete domination of the subsidiary, though, creates a risk that a court will determine that the parent is liable for the debts of the subsidiary. There is, of course, a legitimate concern that too much authority vested in a subsidiary’s board can be a threat to the investment. These interests can be balanced by, for example, instituting regular reporting from the executive officers of the subsidiary to the board of the subsidiary, for review and approval, and then to the corporate shareholder for informational purposes. There is no legal impediment to having representatives from the corporate parent on the subsidiary board. Indeed, this “perch”- from which the parent can properly observe and act as steward on the subsidiary investment-is lawful and actually preferred to the common practice of periodic inquiries from a representative of the parent that often lead to fodder for plaintiffs’ lawyers and regulators. 5. Intercompany transactions. Intercompany transactions are critical for multibusiness companies to achieve certain synergies, and should be made on terms that allow businesses to take advantage of these benefits. These transactions can create exposure to a veil-piercing claim when they bear the marks of control and influence that do not reflect arms’-length interaction. Thus, they should be fully documented, and, under certain circumstances, should be approved by the boards of directors of both companies engaged in the transaction. These transactions should be on commercially reasonable terms, though not necessarily on terms that would normally be extended to an outsider. 6. Management of public perceptions. How a subsidiary corporation holds itself out to the public can be very important. The term “subsidiary” implies a separate legal entity, and words such as “division,” “department,” “unit,” and “group” imply unincorporated businesses that are part of the same legal entity (and not afforded the protection of limited liability). Also, a subsidiary that makes excessive use of the parent’s name, other marks or goodwill may be creating the impression that the two companies are a single enterprise. Some public companies make statements in public filings that the subsidiaries are separate legal entities, subject to decentralized management, and governed by corporate control structures applicable to the subsidiaries’ jurisdiction of organization. Key issue is whether a claim will go forward In most cases, the important question is not whether a veil-piercing claim will prevail but whether plaintiffs’ lawyers or regulators can state a viable claim that will serve as leverage. The more that a parent and subsidiary behave like a single entity, the more likely a claim to pierce the corporate veil will withstand scrutiny. Multibusiness companies, in consultation with their attorneys and other advisors, should assess such behavior and develop balanced strategies to promote their businesses while mitigating exposure to a corporate veil-piercing claim. Scott J. Fisher and Patrick S. Coffey are partners, corporate counselors and trial lawyers in the Chicago office of Gardner Carton & Douglas. Both are founding members of the firm’s corporate structure/limited liability task force. They can be reached via e-mail at [email protected] and [email protected], respectively. Robert Wilczek, a partner at the firm, and Matthew Andris, a former associate, contributed to this article.

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