Alter-Ego Allegations Require Expert Accounting Assistance

March 2006

Alter-ego is one of the most commonly alleged equity-based principals.  Where the facts warrant, courts will disregard the separate legal existence of corporations (including LLCs) and its shareholders (or members).  The purpose of "piercing the corporate veil" is to prevent the abuse of corporations, and thereby protect creditors who might otherwise not be paid.

Piercing the corporate veil is a common law doctrine that is recognized in all 50 states.  To successfully prosecute such a claim, the plaintiff must prove that (i) there is a unity of interest between the corporation and the potential debtor, such that they have no practical separate existence, and (ii) an inequitable result will occur if the corporation alone is held responsible.   

In California, courts often consider a list of factors to determine whether alter-ego liability is appropriate.  No one factor must be present or is controlling.  These factors are generally laid out in re: Associated Vendors, Inc. v. Oakland Meat Packing Co. (20 Cal.App.2nd 825 and 26 Cal.Rptr. 806 (1962)). 

In summarizing prior cases, the Associated Vendors' Court identified a number of possible factors, the most notable of which are:  

1. Commingling of funds and other assets, failure to segregate funds of the separate entities, and the unauthorized diversion of corporate funds or assets to other than corporate uses  
2. Treatment by an individual of the assets of the corporation as his own; Diversion of assets from a corporation by or to a stockholder or other person or entity 
3. Disregard of legal formalities, including the failure to maintain minutes or adequate corporate/accounting records 
4. Domination and control of the corporation by its equitable owners  
5. Use of the same office or business location, the employment of the same employees and/or attorney  
6. Failure to adequately capitalize a corporation 
7. Use of a corporation as a mere shell, instrumentality or conduit for another person or entity; Use of the corporate entity to procure labor, services or merchandise for another person or entity  
8. Failure to maintain arm's length relationships among related entities 

The factors listed above involve factual allegations which are subject to enormous potential dispute.  Because of this, corporate veil cases are often expensive to litigate.  However, accounting expert witnesses can lessen this burden because of their ability to summarize and interpret detailed records.  Consequently, accounting experts can be a cost-effective way for both plaintiffs and defendants to present their positions. 

Here are some examples of where accounting and valuation assistance can be invaluable: 

1. Determining whether assets were commingled requires an inspection of accounting and other business records that memorialize the transactions in question.  Legal counsel will need to know how the transactions were characterized to ascertain whether monies and other assets were properly segregated.   
2. Common business practices and shared services between related companies might (or might not) be undue domination by a parent or controlling shareholder.  Accountants experienced with larger enterprises can provide insights as to whether the practices used in your situation are common, appropriate, and benefit the potentially-dominated corporation.  This often involves measurement of the costs involved, and determination of the economic alternatives available to the potentially-dominated corporation.   
3. Adequacy of capital is a judgmental determination that necessarily considers the risks of the business, and how these business activities were financed.  In making these determinations, a financial analyst must consider the business model of the company being studied, and make comparisons to what other well-managed enterprises have been, and are doing.  
4. The existence of common vendors, employees, and processes can be determined through an inspection of the accounting records of the parent, subsidiary, and other related firms.  
5. Transactions between related parties may be appropriate (or not), depending upon the price and terms used for the transactions.  This issue can be determined by an appraisal of the fair market value of the exchange. 
6. Whether the potentially-dominated corporation is too dependent on its shareholder(s), or vice versa, can be determined by analyzing the operations of each.  These transactions and operations are recorded in business records which an accountant will be able to understand and interpret.     
7. Are the shareholder's personal transactions being paid by the potentially-dominated corporation?  Sometimes this is readily apparent, but this might also require an inspection of the underlying business records.   
8. The nature and timing of shareholder withdrawals and/or loans must be determined.  Creditors appropriately want to know where the money went, and when.  Accountants can determine this through an inspection of the accounting records, checks, and deposits of the sending and receiving entities.   
9. For all of the above inquiries, the accounting records may be incomplete, or not trustworthy.  A forensic accountant can assess the completeness and accuracy of the records obtained in discovery.   

Fulcrum Inquiry is a licensed CPA firm that assists attorneys with forensic accounting , fraud examinations, and appraisals in disputed situations.  Our professionals have significant experience on behalf of both plaintiffs and defendants in disputes involving piercing the corporate veil.