For those unfamiliar with the topic, the doctrine of alter ego is a means by which a court may look past the legal separateness of an entity to impose liability against its owner, or vice-versa (the latter is known as “reverse veil piercing”). For example, if Mr. Able uses his Beta Company to commit a fraud against investors, and Mr. Able takes all the money from investors leaving Beta Company unable to pay its liabilities, the alter ego doctrine would operate to impose liability on Mr. Able.
In 1985, the authors Frank Easterbrook and Daniel Fischel in their paper, Limited Liability and The Corporation, for the University of Chicago Law Review, spoke of the alter ego doctrine as being “like lightning, it is rare, severe, and unprincipled.” Today we will discuss one of the unprincipled parts of alter ego that I find to be particularly troublesome.
There are two questions to be asked. The first question may be stated as: When is alter ego to be tested? This is the easier question to resolve. Since the purpose of the alter ego doctrine is to ignore the fiction of the entity and impose the underlying liability against the real wrongdoer, the time to test alter ego will typically be at the time that the liability arose.
Note that in some cases, alter ego might be tested as a later time, such as in those instances where after the liability arose the defendant created a new entity in an attempt to shield assets. In such a case, alter ego liability would then be tested at the time the creditor makes a collection attempt. But in the vast majority of cases, the time to test alter ego liability will be when the liability arises, e.g., that moment in time when the truck driven by an employee of the defendant corporation crashes into the hypothetical busload of plastic surgeons.
This is, however, nothing but my opinion based on what I intuitively feel would be the most logical time to test alter ego. As far as I have been able to discern through my limited research, the courts have been quiet on this issue and have not given anything like meaningful guidance. This is surprising considering the many tens-of-thousands of court opinions that deal with alter ego: It is an issue that the past decisions have simply glossed over.
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Most likely, those courts came to the conclusion (if they thought about it at all) that defining the particular time when alter ego was to be tested was simply not important in the context of those cases. Issues of alter ego seem largely to be resolved much in the way that pornography was described by Justice Potter Stewart in lamenting that it was difficult to define but, “I know it when I see it”. That approach, however, may create difficulties when the second question is asked: Should the court consider only events close in time to the event or events giving rise to liability?
Intuitively, the answer seems (to me at least) to be in the affirmative. If alter ego liability flows from the underlying liability giving rise to the judgment, then the court should essentially take a “snapshot in time” which looks at all the relevant facts and circumstances near in time to when the underlying liability arose. The problem is that there is a second possible answer, which is that the court may look at all the facts and circumstances involving the entity without regard to the time of the events giving rise to the underlying liability.
To illustrate this problem, consider that an LLC was created in 2005 and in the first five years of its existence it was managed terribly ⸺ proper records were not kept, personal and business moneys were commingled, and business assets used for personal purposes. But nothing bad happened at the time because of all this, and by 2010 the entity was completely cleaned up. Then, in 2015 an event giving rise to liability occurred and it was followed by allegations that the entity was simply the alter ego of its owner, and part of the proof was the mismanagement of the entity from 2005 to 2010.
Now, what happened between 2005 and 2010 didn’t have anything at all to do with the liability which arose in 2015, but it would be proof of something the courts refer to as the “unity of ownership and control” between the entity and the true wrongdoer. So here is the question: Should the court take into account the events of 2005 to 2010 in determining whether the alter ego doctrine should allow the liability to bypass the entity and be imputed to the true wrongdoer?
My own answer would be in the negative, since the events of 2005-2010 are not near in time to the liability event of 2015 and had no part in causing the 2015 event. Effectively, when the entity was finally cleaned up in 2010, that had the effect of curing whatever alter ego issues which existed at that time, and so whatever evidence is weighed by the court should at least be post-2010 if not much closer in time to 2015. Whether the courts would agree with this analysis, however, is not so clear.
And that then brings us to the much bigger practical problem of all this for business transactional and entity lawyers: Can an entity that has in the past been mismanaged every really be cleaned up? Or will an entity that has in the past been mismanaged always and for ever more carry some latent risk that will make it more susceptible to an alter ego challenge should one come along? This is not anything like a hypothetical problem, as daily practitioners are faced with situations where entities have been grossly mismanaged and thus have to make decisions as to whether they should clean them up, or whether they should just close that entity down and start a fresh one with no history of past problems, but which will likely cause some additional expense and perhaps have tax implications as well.
I don’t suggest an answer to that question, other than to state the obvious: Until the courts start to better define the temporal limitations on alter ego, there will be little certainty. If an entity has been grossly mismanaged in the past, then it will indeed have to be considered whether it will forever carry an inherent weakness from that time period, and thus the formation of a new entity will at least have to be on the table for analysis. Hopefully, the logic of the “snapshot in time” (or at least near in time) will ultimately be borne out, but there will continue to be consternation if not some frustration in the interim.