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4 • 2020

The Benefits of a Loan-out Company: Is Limited Personal Liability Really a Major Benefit?

When courts and commentators discuss loan-out companies, they invariably mention at least two benefits for actors and other creatives who choose to offer their services through such companies: (1) limited personal liability, and (2) financial benefits such as advantageous tax treatment for the company’s artist-owner.[1] We’ll discuss the first of those purported benefits in this article.

The general rule of limited personal liability

It is a fundamental premise of corporate law that “a corporation exists independently of its owners, who are not personally liable for its obligations, and that individuals may incorporate for the express purpose of limiting their liability.”[2] A California appellate court expounded on this premise in the best known of all cases involving a loan-out company:

Corporations are separate legal entities, distinct from their shareholders and officers. They are formed for numerous business reasons, including as a shield from liability and for tax purposes. The statutory scheme which provides for the formation of corporations affords such entities privileges of separability. The liability of a corporation does not automatically attach to its shareholders, the owners of the corporation. This is so even if the stock of the corporation is wholly owned by a single person. Rather, a corporation sues in its own name, is sued in its own name, transacts business separate from its shareholders and enters into contracts on its own accord. By their very nature, corporations have a separate identity from their owners and corporate obligations are not obligations of the shareholders.[3]

These principles apply to personal service corporations, which “are entitled to the same separability of identity as are other corporations. … As a general rule, the sole shareholder of a personal service corporation is not liable for the obligations of the corporation.”[4] Lest there be any doubt that this rule also applies specifically to loan-out companies, the court stated that “[p]erformers’ ‘loan-out’ companies are not sham entities.”[5]

The fundamental premise of “separability of identity” between a business entity and its owner(s) played a central role in the result in that case, in which the court of appeal reversed an $8.135 million judgment against the actor Kim Basinger and her loan-out company, Mighty Wind Productions, Inc. (“Mighty Wind”), in favor of Main Line Pictures, Inc. (“Main Line”). Mighty Wind had an employment agreement with Basinger and agreed to “loan out” her acting services to Main Line for the film “Boxing Helena.” When Basinger backed out of making the film, Main Line sued Mighty Wind and Basinger for breach of contract. Importantly, Main Line expressly rejected any reliance on an alter ego theory (which we will discuss below) to hold Basinger liable for Mighty Wind’s obligations under the lending agreement.[6] Because Basinger was not Mighty Wind’s alter ego, Mighty Wind was a “separate corporate entity, distinct from Basinger,” the two were “not synonymous,” and Basinger could not be held “liable for the corporate obligations” of Mighty Wind, in accordance with the general rule.[7] Thus, if Main Line’s contract for Basinger’s acting services was “only with Mighty Wind, then only Mighty Wind can be liable for a breach of the contract.”[8] In short, the court affirmed the principle that the artist-owner of a loan-out company cannot ordinarily be held liable for the company’s obligations, including obligations related to the artist’s own performance of services for a third party.

Piercing the corporate veil/alter ego liability

Although Main Line rejected any reliance on an alter ego theory to hold Basinger liable for Mighty Wind’s contractual obligations to Main Line for Basinger’s acting services, even in that case the California appellate court recognized that owners can be held liable for the company’s debts in situations where the owner is the “alter ego” of the corporation, which permits the “corporate form [to] be disregarded and the corporate veil … pierced.”[9] Under California law, there are two requirements to invoke the alter ego doctrine and pierce a company’s veil to hold its owner liable for the company’s obligations: (1) there must be such a unity of interest and ownership between the company and its owner that the separate personalities of the corporation and the individual do not really exist; and (2) an inequitable result will follow if the acts in question are treated as those of the corporation alone.[10] Deciding whether those two requirements are met to permit the corporate veil to be pierced is a highly fact-specific inquiry that “necessarily var[ies] according to the circumstances in each case.”[11] In the famous Associated Vendors case cited by the Basinger court, the court listed a wide variety of factors that are pertinent to a trial court’s determination whether to pierce the corporate veil under the “particular circumstances” of a case, including, “the treatment by an individual of the assets of the corporation as his own,” “the failure to maintain minutes or adequate corporate records,” “sole ownership of all of the stock in a corporation by one individual or the members of a family,” “the failure to adequately capitalize a corporation; the total absence of corporate assets, and undercapitalization; [and] the use of a corporation as a mere shell, instrumentality or conduit for a single venture or the business of an individual[.]”[12]

As we have noted before, that is a lot to think about, and veil-piercing remains a murky phenomenon about which business owners may have little control. But the bottom line is that owners of loan-out companies, like the owners of any other kind of business entity, may be able to reduce their risk of being held personally liable for the company’s debts and obligations by taking care of the things they can easily control, including following corporate formalities such as issuing shares, electing officers, holding required meetings, and keeping minutes of those meetings.[13]

We do, however, need to note a significant concern specifically in the context of loan-out companies. When determining whether to pierce the corporate veil in a particular case, courts are instructed that “no one factor governs the analysis” and that they “should look at all the circumstances to determine whether the alter ego doctrine applies.”[14] Even so, empirical studies have identified a strong connection between piercing the corporate veil and undercapitalization of a new corporation. For example, one study we examined found that in cases where courts noted that the corporation was undercapitalized, in that there was not enough money to fund the business properly from the get-go, the courts pierced the corporate veil in about three out of every four of those cases, whereas the courts pierced in only about one out of every ten cases where that factor was not present.[15]  The idea is that courts will not hold business owners liable for corporate obligations, but only where the owners see to it that sufficient capital was made available, at least initially,[16] to pay the corporation’s anticipated debts.[17]  Simply put, you can’t start a corporation with no capital and reasonably expect that your personal assets will be protected from the corporation’s creditors.[18]

The problem is that undercapitalization is essentially one of the hallmarks of a loan-out company, the sole asset of which is usually its artist-owner’s services or rights.[19] That is precisely why the third party that “borrows” the artist-owner’s services, or licenses the artist’s rights, usually insists on contracting not just with the artist’s single-asset loan-out company but also directly with the artist to obtain, in a so-called “inducement” agreement or letter, a guarantee of the loan-out company’s obligations under the lending or licensing agreement. As one federal court explained in a case involving a loan-out company formed by the singer Vince Neil for the sole purpose of holding his trademark and merchandising rights and then licensing those rights to a third party for an upcoming concert tour,

the function of an inducement letter is to ensure that the performing artist subscribes to the underlying obligations of the loan out company’s contract. Since the purchaser of the service enters into a contract with an often under-capitalized company, whose only asset is the underlying right which is to be purchased, the purchaser needs some assurance that the performer is willing to honor the contract of his [loan-out] company, lest its only recourse be against a shell corporation.[20]

We have not found a case directly on point, but we suspect that in a case where the third party seeks to pierce the loan-out company’s veil to hold its artist-owner personally liable for the company’s obligations under a lending or licensing agreement, as the plaintiff did in the Neil case but not in the Basinger case, the loan-out company’s single-asset, undercapitalized status will provide a strong argument in favor of imposing alter ego liability on the artist-owner.[21] Thus, when the issue is properly raised,[22] it is questionable whether limiting personal liability really will be that much of a benefit to forming a loan-out company after all.

[1]See, e.g., Great Entm’t Merch., Inc. v. VN Merch., Inc., No. 95 CIV. 9333 (LBS), 1996 WL 355377, at *1 n.1 (S.D.N.Y. June 27, 1996) (loan-out companies “are common in the entertainment industry where performing artists offer their services or rights through separate corporations in order to reap tax and retirement benefits, and shield themselves from personal liability”); Aaron J. Moss & Kenneth Basin, Copyright Termination and Loan-Out Corporations: Reconciling Practice and Policy, 3 Harv. J. Sports & Ent. L. 55, 72 (2012) (“Loan-out corporations offer two primary benefits to the artists who use them: limited personal liability and beneficial tax treatment.”).

[2]Superior Transcribing Serv., LLC v. Paul, 72 A.D.3d 675, 676, 898 N.Y.S.2d 234, 235 (2010).

[3]Main Line Pictures, Inc. v. Basinger, No. B077509, 1994 WL 814244, at *5 (Cal. Ct. App. Sept. 22, 1994) (citations omitted).

[4]Id. at *6 (citing Laughton v. Comm’r, 40 B.T.A. 101 (1939), remanded, 113 F.2d 103 (9th Cir. 1940), a case involving the actor Charles Laughton’s loan-out company).

[5]Id.; see also id. (distinguishing the professional service corporations of other professionals such as physicians and attorneys, who may be personally responsible for professional malpractice under special statutory rules; by contrast, “[n]o such special rules apply to the contractual obligation of an actress’s ‘loan-out’ corporation”).

[6]Id. at *4, 6.

[7]Id. at *6.

[8]Id. at *7. That did not decide the issue in Basinger, solely because there remained a factual question, which was not properly resolved by the jury, as to whether Basinger herself had orally agreed directly with Main Line to appear in “Boxing Helena.” Id.

[9]Id. at *6 (citing, among other cases, Associated Vendors, Inc. v. Oakland Meat Co., 210 Cal. App. 2d 825, 26 Cal. Rptr. 806 (1962)); see also Alexander v. Cmty. Hosp. of Long Beach, 46 Cal. App. 5th 238, 255, 259 Cal. Rptr. 3d 340, 357-58 (2020), review denied (July 15, 2020) (“Under the alter ego doctrine, a corporate identity may be disregarded—the ‘corporate veil’ pierced—where an abuse of the corporate privilege justifies holding the owner of a corporation liable for the actions of the corporation.” (internal quotation marks omitted)).

[10]See, e.g., Alexander, 46 Cal. App. 5th at 255, 259 Cal. Rptr. 3d at 358; Associated Vendors, 210 Cal. App. 2d at 837, 26 Cal. Rptr. at 813.

[11]Associated Vendors, 210 Cal. App. 2d at 837, 26 Cal. Rptr. at 813.

[12]Id. at 838-40, 26 Cal. Rptr. at 813-15 (copious citations omitted); see also Successor Agency to Former Emeryville Redevelopment Agency v. Swagelok Co., 364 F. Supp. 3d 1061, 1078 (N.D. Cal. 2019) (giving a shortened list of the Associated Vendors factors); Basinger, 1994 WL 814244, at *6 (noting that Main Line had “presented no evidence on many key alter ego factors, such as the number or identity of the shareholders, directors or officers of the corporation, the extent of its capitalization[,] or its compliance with corporate form and formalities”).

[13]See eMinutes Blog, Can You “Moneyball” Alter Ego Liability? (Aug. 23, 2017); eMinutes Blog, Reducing Risk of Alter Ego With Some Simple Things (Apr. 10, 2016).

[14]Swagelok Co., 364 F. Supp. 3d at 1078 (internal quotation marks omitted).

[15]See John H. Matheson, Why Courts Pierce: An Empirical Study of Piercing the Corporate Veil, 7 Berkeley Bus. L.J. 1, 31 (2010).

[16]See Burkhead v. Stewart Title Guar. Co., 649 F. App’x 567, 569 (9th Cir. 2016) (“[U]ndercapitalization is determined at the time of incorporation and cannot be proved merely by showing that the corporation is now insolvent.” (internal quotation marks omitted)).

[17]See, e.g., Automotriz Del Golfo De California S. A. De C. V. v. Resnick, 47 Cal. 2d 792, 797, 306 P.2d 1, 4 (1957) (in bank) (“If a corporation is organized and carries on business without substantial capital in such a way that the corporation is likely to have no sufficient assets available to meet its debts, it is inequitable that shareholders should set up such a flimsy organization to escape personal liability. The attempt to do corporate business without providing any sufficient basis of financial responsibility to creditors is an abuse of the separate entity and will be ineffectual to exempt the shareholders from corporate debts. It is coming to be recognized as the policy of the law that shareholders should in good faith put at the risk of the business unincumbered capital reasonably adequate for its prospective liabilities. If the capital is illusory or trifling compared with the business to be done and the risks of loss, this is a ground for denying the separate entity privilege.” (internal quotation marks omitted)).

[18]See Aliya Medcare Fin., LLC v. Nickell, No. CV 14-07806 MMM (EX), 2015 WL 11072180, at *21 (C.D. Cal. Sept. 25, 2015) (“The ‘total absence of corporate assets’ is a factor which can require alter ego liability to be imposed.” (quoting Zoran Corp. v. Chen, 185 Cal. App. 4th 799, 811, 110 Cal. Rptr. 3d 597, 607 (2010))).

[19]See, e.g., Home Box Office, Inc. v. Directors Guild of Am., Inc., 531 F. Supp. 578, 597 (S.D.N.Y. 1982) (loan-out companies formed by film directors “have as their sole asset the services of the individual director,” and they have “no other employees, no offices, and no equipment, and they engage in no business activities other than renting out the services of the director-owner”), aff’d, 708 F.2d 95 (2d Cir. 1983).

[20]Great Entm’t Merch., 1996 WL 355377, at *1 (emphasis added; footnote omitted); see also id. at *3 (finding quite believable the third-party licensee’s assertion that “it would never have entered into a contract with a single asset company, incorporated the day before the contract was signed, without the protection of a financially responsible guarantor”).

[21]Because the third party did not move for summary judgment on its alter ego claim against Neil, the court left “the highly relevant issue of piercing the corporate veil for a later day.” Id. at *3. The parties may have settled the case before that day arrived, however, as there was no follow-up decision on the veil-piercing issue.

[22]One commentator has suggested that production companies and other third parties contracting with loan-out companies will rarely have the occasion to make an alter ego claim, since “the situations in which a loan-out corporation is utilized, such as facilitating tax benefits for the artist, do not raise issues what would be affected by piercing the corporate veil.” 1 Thomas D. Selz, et al., Entertainment Law 3d: Legal Concepts and Business Practices § 8:32 (Westlaw updated through Dec. 2019) (footnote omitted). At the same time, however, the commentator acknowledges that “situations involving breach of contract,” as in the Neil and Basinger cases, “or serious bodily injury may involve efforts to pierce the corporate veil.” Id. But it is precisely in those situations that doing business in the corporate form is supposed to provide protection from personal liability to business owners. Consequently, it remains questionable whether limiting the artist-owner’s liability for his or her loan-out company’s debts and obligations really is a significant benefit of doing business as a loan-out company.