Piercing the Corporate Veil, Financial Responsibility, and the Limits of Limited Liability

Creditors of insolvent corporations often ask courts to “pierce the corporate veil” and hold shareholders personally liable for a corporate obligation. Veil piercing is the most heavily litigated issue in corporate law, yet legal doctrine in this area is notoriously incoherent. Courts typically base their decisions on conclusory references to criteria of doubtful relevance. Results are unpredictable. Similar outcomes are now occurring in cases brought against the owners of various kinds of newly sanctioned limited liability entities, and so a bad situation is only going to get worse. In this Article, I argue that this state of affairs results from a lack of understanding of the policy basis for limited liability. Once a better understanding is achieved, veil piercing can then serve the useful function of distinguishing legitimate from illegitimate reliance on statutory limited liability. After surveying efficiency rationales for limited liability and finding them unpersuasive, I propose that the best way to understand the purpose of limited liability is as a subsidy designed to encourage business investment. The subsidy comes at the expense of corporate creditors. It is easy to see how this is so as to victims of corporate torts; limited liability requires that they bear their losses to the extent they exceed corporate assets. It is less obvious that shareholders actually gain value from contract creditors, who can insist on compensation ex ante for the increased risk of default that limited liability entails, but even in this context I argue that recent research in behavioral economics suggests that shareholders do benefit at creditors’ expense from the statutory limited liability default rule. However beneficial the limited liability subsidy may be to corporate shareholders and to society more generally, it should not be so broad as to protect illegitimate behavior. In particular, limited liability should not provide the occasion for shareholders to behave opportunistically toward third parties. As to contract creditors, that means imposition of risk that creditors have not agreed to bear, as, for example, when controlling shareholders cause a corporation to incur a debt while having no reasonable basis for believing that it will be repaid. Similarly, when corporations engage in activities likely to injure others, shareholders act opportunistically if they have failed to provide a reasonable amount of compensation, either through liability insurance or cash reserves. As to both contract and tort creditors, the key concern is use of limited liability as a device deliberately or recklessly to extract value from third parties without their consent and without compensation; absent the limited liability 1308 EMORY LAW JOURNAL [Vol. 56 shield, such practices could not be effective because business owners would bear full responsibility for creditor claims. Fairness and efficiency considerations necessitate denial of limited liability in cases of opportunism because the subsidy to investors comes at too great a cost to corporate creditors. In particular, if limited liability is to protect opportunism, the cost of credit is higher for all corporate borrowers because lenders are unable ex ante to discriminate between those who are trustworthy and those who are not. Likewise, tort victims bear too heavy a cost if limited liability shields shareholders who have failed to insure against third party injuries. Limited liability should instead be limited to situations in which shareholders have managed the business with due regard for bargained-for expectations and potential accident victims. If corporate insolvency has occurred despite the shareholders’ reasonable efforts, the limited liability shield should protect them. In other words, the availability of limited liability should depend on whether the controlling shareholders have managed the business in a financially responsible manner. Courts confronted with veil piercing claims thus should tailor the scope of limited liability to those circumstances in which it is warranted according to sound public policy. Deployed in this way, limited liability would protect shareholders from the kinds of losses that should be their primary concern, namely business insolvency due to causes that could not reasonably have been anticipated or prevented: contractual obligations that are unpayable because of developments that were unforeseen when they were undertaken and tort claims that exceed an insurance policy’s reasonably chosen coverage limit. Limited to situations like this, limited liability would still provide investors with a significant benefit. It would therefore continue to facilitate corporate law’s business subsidization policy, but the cost of that subsidy would be reduced to an amount that respects legitimate creditor and societal interests. 2007] PIERCING THE CORPORATE VEIL 1309