Top 10 Legal Issues Facing Entrepreneurs in Pennsylvania

Topic 3: How to Avoid Personal Liability

Introduction
As discussed in the previous topics, a corporation enjoys its own independent entity status thereby absolving the individuals who comprise the corporation from liability for what the corporation does. This principle is almost always the case, except in rare circumstances, for which every business entrepreneur should be aware of. Therefore, this topic seeks to educate you on the circumstances in which the individual can be held personally liable legally, for acts of the corporation.

Piercing the Corporate Veil
Courts are careful to avoid making the entire theory of the corporate entity useless by allowing the individuals in a corporation to be held personally liable.¹ Nonetheless, courts will not permit the fiction of corporate entity status to lead to an unjust result. Therefore, a court might “pierce the corporate veil” and hold shareholders, directors and/or officers personally liable if they have generally abused the privilege of incorporating and fairness requires it. Such circumstances arise when the court must prevent fraud, illegality, injustice, or when the recognition of a corporate entity would defeat public policy or shield someone from public liability for crime, in which case “piercing the corporate veil” is appropriate.²

Therefore, although there is a strong presumption in Pennsylvania against piercing the corporate veil, a court will not hesitate to treat as identical the corporation and the individuals owning all its stocks and assets whenever it is necessary to avoid fraud and unfairness.³ There are three general instances in which piercing the corporate veil is commonly proper.

The first area where the court might pierce the corporation’s corporate veil is when an individual treats the corporation as his “alter ego”. For example, if a chief executive officer of a corporation commingles personal and corporate funds, uses the corporate car as his own, and uses the corporate credit card to pay for personal purchases, a creditor of the corporation who has been unable to collect its claim from the corporation can likely pierce the corporate veil and personally collect from the chief executive officer for his failure to respect the corporate entity and his fraud and/or unfairness toward the harmed creditor. It should also be noted that only the wrongdoer, here the chief executive officer, would be personally liable (the court would only pierce the corporate veil as against him or her).

The second common area where a court might pierce the corporate veil of a corporation is where there is undercapitalization when formed. For example, if you are a shareholder of a corporation which hauls and disposes nuclear waste, does not carry insurance, and has an initial capitalization of only $1,000.00, and an innocent bystander is injured by the effects of the nuclear waste, that innocent bystander would likely be able to pierce the corporate veil and hold the individual shareholder personally liable for failing to invest enough to cover prospective liabilities. In other words, even though there is a strong presumption against piercing the corporate veil, here a court might, because the corporation was undercapitalized when formed and an innocent bystander was personally injured. It should also be noted that courts are generally more willing to pierce the corporate veil for a tort victim (like the example above) than for a contract claimant.

The third area where a court might pierce the corporate veil is where a director or officer has breached their fiduciary duty to the company. Generally, a director or officer owes their corporation both a duty of loyalty and a duty of care. The duty of loyalty requires a director or officer to discharge their duties in good faith and with a reasonable belief that what they do is in the corporation’s best interest. The duty of care requires that the director or officer must act with that degree of care a prudent person would use with regard to their own business. There are several ways in which the director or officer can breach the duty of care and the duty of loyalty, thereby making the officer or director susceptible to personal liability. Some examples are:

• Misfeasance – where the director or officer does something or makes a decision that causes the corporation to lose money. For example, if a director is not prudent and fails to deliberate, inquire, or research a prospective business opportunity which later hurts the corporation.
  
  
• Nonfeasance – where the director does nothing. For example, if a director or officer fails to attend meetings and otherwise keep themselves abreast of the corporation’s interests and business.
  
  
• Competing ventures – where the director or officer competes unfairly with their corporation. For example, where a director or officer starts their own business within the corporation’s line of work.
  
  
• Interested director/officer transaction – any deal between the corporation and one of its directors or officers that is not disclosed to the board and which otherwise impugns upon the integrity of the director or officer. For example, a director or officer of a corporation cannot sell its own goods to that corporation without getting approval by the board and after full disclosure.
  
  
• Usurping a corporate opportunity – a director or officer may not take a corporation opportunity unless it is fully disclosed to the board and the board independently rejects the opportunity. A corporate opportunity is viewed as something necessary to the corporation, within the corporation’s business line, or something that the corporation has an interest or expectancy in.

The above are common examples of ways in which a director or officer may breach their fiduciary duty, namely the duty of care and of loyalty, that they owe to the corporation. The above examples, however, do not represent an exhaustive list as each claim of director/officer wrongdoing will entail its own distinct facts which the court will review on a case-by-case basis. If a director or officer is found to have breached their fiduciary duty to the corporation, a court will pierce the corporate veil and hold that individual personally liable for the harm caused by the breach. There is, however, a safe harbor in this area of the law which every director or officer of a corporation should be aware of, known as the business judgment rule.

The business judgment rule is a defense that a director or officer will assert when faced with allegations that they have breached their fiduciary duty to the corporation. The business judgment rule holds that a court should not second guess a decision of the director or officer if it was made in good faith, was informed, and had a rational basis. The court is essentially saying that it is not their province to second guess the everyday business judgment of a director or officer who has wide discretion on how to run their corporation. Because of this defense, generally a director or officer will only be personally liable for acts that are irrational or grossly negligent in breaching their fiduciary duty. In such a case, the court would not hesitate to pierce the corporate veil and hold the individual, director, or officer personally liable for the harm that they have caused the corporation and its shareholders.

Conclusion
It is very rare that a court pierces the corporate veil and holds individuals in a corporation personally liable in Pennsylvania. Therefore, entrepreneurs enjoying corporate status should generally feel secure and shielded from personal liability absent egregious acts on their part, such as the examples above. As long as the business entrepreneur is aware of the general circumstances in which a court might pierce the corporate veil, they should be able to shield themselves from personal liability and enjoy the protection their corporate status provides.

¹ S.T. Hudson Engineers, Inc. v. Camden Hotel Development Associates, 2000 Pa. Super. 49 (2000).

² U.S. v. Municipal Authority of Union T.P., 929 F.Supp. 800 (M.D. Pa. 1996).

³ Advanced Telephone Systems Inc. v. Com-Net Professional Mobil Radio, LLC, 2004 Pa. Super. 100 (2004).

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