Vail Daily column: The alter ego doctrine
Ryan Summerlin March 19, 2013
In common parlance, when you think of alter ego, you might think of Superman bursting from an urban phone booth, the shell of mild-mannered reporter, Clark Kent, left discarded on the crenulated phone booth floor. Derived from the Latin, the term alter ego means, literally, other (alter) self (ego). Clark Kent is Sup’s others self, or second self or even the other side of one self.
In the law, the term alter ego has another, but similar meaning. Although it still means “second self, the way it is generally employed is to connote a legal identity different from the person or persons assuming such identity. Take, for example, a small businessman who for tax, protected liability, and other reasons has chosen to conduct his business as a “subchapter S corporation” rather than as a sole proprietorship. He may even be the sole shareholder, officer and director of the business. But since all legal entities (such as a “subchapter S corporation”) are considered to be legal “persons” under the law, the businessman’s small business has a legal identity wholly separate from his own.
In the preceding example, say the guy’s name is Cosimo and his small corporation’s name is Cosimo’s, Inc. It could be fairly said that Cosimo Inc. is the alter ego (or other self) or our friend Cosimo. It is he in another guise but legally distinct from him.
Under what is known in law as the “alter ego doctrine,” a court may, in some specific circumstances, disregard a corporation or other entity’s (such as a limited liability company or limited liability limited partnership) separate legal identity and hold the individuals comprising it directly responsible for the acts of the entity itself. To understand the import and implications of such disregarding of the corporate, LLC, LLLP or other entity’s separate existence, you must first appreciate why such entities are formed in the first place.
To distill down a lot of law to its essence, business enterprises are formed as corporations, LLCs, LLPs, LLLPs and other legally recognized forms, mainly to provide the principals involved with the protection of limited liability from what is known as “vicarious liability.” What this means is that while an individual cannot be protected from his or her own acts of negligence or wrongdoing, he can, by properly employing the vehicle of a recognized business entity, shield himself from the wrongful or negligent acts of others with whom he deals in the course and conduct of his business. Simply, if your fellow shareholder (or the entity itself through its agents or employees) does something wrongful or negligent, responsibility for such wrongdoing will not vicariously flow to the innocent party who just happens to be in business with the wrong-doer or who holds shares in the company committing the wrong.
Say British Petroleum fouls a waterway in violation of the Clean Water Act. You, as a shareholder, will not be held responsible for the costs of cleaning up the mess. The entirety of your liability is up to the level of your investment in the corporation; the value of the stock may fall and you may lose the value of your investment, but you will not have to “come out of pocket” to bail BP out of the box it has polluted itself into. Such a set up promotes commerce, limits liability to those actually committing the wrong, and makes limitless sense in a market-driven economy such as ours.
To apply the alter ego doctrine and, thereby to extend the reach of liability and quash the protections normally afforded by doing business as a recognized limited liability entity (such as a corporation or limited liability company), the court must find that the individuals comprising the entity disregarded the entity and used the entity as a shell and conduit for the transaction of their own private affairs. The court must find that, by their own conduct, the principals have not conducted the business as a separate entity; accordingly, the entity, as a separate legal being has ceased to exist and, in no longer existing, it can no longer be afforded limited liability protection.
The doctrine of alter ego does not create assets for or in the corporation, but simply fastens liability on the individual or individuals who use the corporation as an instrumentality in conducting their own personal business, and that liability springs from a fraud perpetuated upon third persons dealing with the putative entity, wrongfully believing it to have a separate and distinct existence.
Most good lawyers will counsel their clients that, if an entity is to maintain its separate existence, it must “act like a corporation” (or LLC, LLP, or LLLP as the case may be). This means, among other things, maintaining separate and distinct books and records, maintaining separate and distinct bank and operating accounts, notifying all the world of the separate legal identity and existence of the business by such acts as employing letterhead and business cards with the entity’s name and mode of existence (such as Cosimo, Incorporated, rather than just “Cosimo’s”), and by acting with proper “formality” in the conduct of the entity’s business. What this means, generally, is that the acts taken by the corporation, LLC or other entity, must be in accordance with its by-laws or operating agreement and other organizational instruments.
While corporations, LLCs, LLP, LLPs and the other business entities afford significant advantages, primary among them the limited liability which flows from such existence, one must play by the rules and subscribe to the entity as a separate being. If not, the alter ego doctrine might well be employed against those playing fast and loose with the system and, like Superman in the phone booth, the principals may be caught with their trousers tripped down around their ankles.
Rohn K. Robbins is an attorney licensed before the bars of Colorado and California who practices in the Vail Valley with the law firm of Stevens, Littman, Biddision, Tharp and Weinberg LLC. His practice areas include business and commercial transactions, real estate and development, family law, custody, divorce and civil litigation. He may be heard on Wednesdays at 7 p.m. on KZYR radio (97.7 FM) and seen on ECOTV 18 as host of “Community Focus.” Robbins may be reached at 970-926-4461 or at either of his e-mail addresses, email@example.com or firstname.lastname@example.org.