Best Practices for Maintaining Corporate Separateness (Corporate Counsel)
By Stephen C. Lewis
June 9, 2014
Reprinted with permission from the June 9 edition of Corporate Counsel ©2014 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact (877) 257-3382 - [email protected] or visit www.almeprints.com.
Best Practices for Maintaining Corporate Separateness
By Stephen C. Lewis and Nicole Martin, Barg Coffin Lewis & Trapp
You’ve just gotten off the phone with the CEO of one of your company’s subsidiary corporations—Sub A. Several thousand neighbors of Sub A’s main production facility have filed a lawsuit for personal injuries and property damage they attribute to groundwater and air contamination caused by the facility.
Worse, your company, Parent Inc., has also been named as a defendant. Although it never owned or operated Sub A’s facility, Parent has substantial in-house environmental expertise. When the contamination was first discovered several years ago, Parent’s in-house environmental engineers stepped in to lead the investigation and cleanup. These activities included hiring and supervising remediation experts, and editing reports they submitted to the state regulators overseeing the site.
Looking down the road, you know that Sub A probably has sufficient financial strength and independence to survive this litigation, but the plaintiffs seek to “pierce the corporate veil” and also hold Parent liable, including for punitive damages. Can Parent extricate itself from this lawsuit at an early stage, based on the argument that it is not liable for the acts of Sub A?
Given its involvement in Sub A’s activities, Parent is likely to have a difficult time achieving an early exit. Whether it succeeds will turn on the outcome of a careful examination of the degree to which Parent and Sub A have operated as separate corporations, particularly with respect to Sub A’s environmental contamination problem.
Putting aside issues relating to successor or “continuation of business” liability, and recognizing that substantial marketing and other benefits can accrue to an entity that is part of a corporate “family,” this article focuses on the importance of preserving the separate statuses of parent corporations and their subsidiaries, and recommends some best practices for maintaining such corporate distinctions.
Maintaining Corporate Separateness Is Critical to Shielding a Parent
When the activities that distinguish a parent from its subsidiary become blurred, the subsidiary’s liabilities may be imputed to the parent. Indeed, a primary goal of a plaintiff’s lawyer suing a corporate subsidiary is often to “pierce the corporate veil” and attempt to bring the larger, better known and “deep pocket” parent into the litigation as a defendant.
Courts are generally reticent to pierce the corporate veil, but the more a subsidiary can be characterized as merely a “conduit” for the parent’s activities, the more vulnerable the parent becomes to an “alter ego” attack. Although the applicable tests and burdens vary across jurisdictions, evaluating whether one company is the “alter ego” of its parent is a highly fact-intensive inquiry, and no single factor controls.
For example, in order to pierce the corporate veil in California, there must be such a “unity of interest and ownership” between the subsidiary and the parent corporation that the “separate personalities” of these entities cease to exist, and there must be an “inequitable result if the acts in question are treated as those of the [subsidiary] alone.” Sonora Diamond Corp. v. Superior Court, 83 Cal.App.4th 523, 538 (2000). In evaluating these criteria, California considers such factors as: the commingling of funds and other assets between parent and subsidiary, one entity holding itself out as being liable for the other’s debts, identical equitable ownership of the two entities, the “use of one as a mere shell or conduit for the affairs of the other,” inadequate capitalization, disregard of corporate formalities, lack of segregation of corporate records, the same offices and employees, and identical directors and officers.
Best Practices for Maintaining Corporate Separateness
In-house counsel for both parent and subsidiary corporations are uniquely positioned to promote and protect the vital distinctions among their related corporate entities. Day to day, the importance of maintaining these distinctions may not seem as critical as other near-term goals and deadlines. But if these distinctions are not carefully maintained and litigation rears its head, a successful effort to pierce the corporate veil can place the parent at substantial risk. While no bulletproof or uniform protocol exists, the following practices can assist in-house counsel in minimizing that risk:
1. Adhere to the Corporate Formalities Upon Formation/Acquisition
- Ensure adequate capitalization of the subsidiary upon formation/acquisition.
- Maintain separate articles of incorporation, bylaws, board of directors’ meetings and meeting minutes for the subsidiary.
- Avoid having identical officers and directors serve the parent and its subsidiary.
2. Maintain Corporate Distinctions During Operations
- To the extent officers and directors of the parent and subsidiary overlap, emphasize the importance of their “changing hats” as appropriate to correctly reflect the corporate entity on whose behalf they are acting.
- Avoid “commingling of funds” and maintain separate bank accounts. If the subsidiary borrows from the parent, ensure an “arm’s length” transaction and document the specific business purpose(s) for the loan.
- Maximize the subsidiary’s independence from the parent in its day-to-day activities. While the parent will of course monitor the subsidiary’s financial and operational performance, and implement general corporate-wide policies and procedures, it should not manage the subsidiary’s daily operations or internal affairs.
- In day-to-day operations—staff meetings, internal memoranda, emails—be as precise as possible in accurately identifying which corporate entity is responsible for, or engaging in, a given activity.
- Expressly and directly convey to management, employees, consultants and others hired by your, or a related, corporate entity the importance of their understanding at all times on whose specific behalf they are speaking or acting—e.g., which corporate entity is the contracting party. And encourage them to contact you if they have questions. Consider preparing internal memoranda describing these relationships and conducting periodic internal audits of communications and reports to ensure corporate relationships are being correctly characterized. If you learn of any misrepresentations, immediately correct them.
3. Maintain Corporate Distinctions in Interactions with Regulatory Agencies and During Litigation
- When outside counsel, employees or consultants communicate with regulatory agencies, make a point of ensuring that such communications correctly reflect the corporate entity on whose behalf the communication is made, and each entity’s relationship to the events, contracts and properties at issue. Errors in such communications provide ammunition to a plaintiff’s attorney intent on piercing the corporate veil. For example, in reviewing a draft report to be submitted by an environmental consultant to a regulatory agency, ensure that the history of ownership and operation of the facility at issue is accurately described.
- Make sure as early in litigation as possible that your outside counsel, company employees, consultants and experts understand and respect the distinctions among the related entities, and the relationship of each to the particular events, contracts and properties at issue. If they have learned to appreciate the importance of these distinctions prior to becoming involved in the litigation, all the better.
- Throughout the litigation, keep corporate entity distinctions clear, and immediately try to correct any inaccuracies as they arise in, for example, expert reports, responses to written discovery and deposition testimony by company employees.
The Bottom Line
Maintaining corporate separateness among related business entities is a challenging task that requires constant vigilance by in-house counsel. Following the guidelines listed above can help preserve the separateness of related entities and improve the likelihood that a parent can extricate itself from litigation arising from its subsidiary’s activities.
Stephen C. Lewis is a founding partner of, and Nicole M. Martin is an attorney with, the San Francisco-based environmental law firm Barg Coffin Lewis & Trapp. They can be reached at [email protected] and [email protected], respectively.