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6 • 2023

The Importance of Reflecting Initial Capital Contributions in Entity Formation Documents

In this article, we recommend that business owners make adequate initial capital contributions when forming a new business entity and include information reflecting those capital contributions in their entity formation documents.

One of our most revisited topics over the years has been piercing the corporate veil (which is sometimes also referred to as alter ego liability).[1] That should come as no surprise as courts and commentators have repeatedly indicated that the single most litigated issue in all of corporate law is whether to pierce the corporate veil in a particular case.[2] Why is this so important to us (and should be to you)? One of the primary reasons that businesspeople spend the time and money to form their business as a corporation or limited liability company is to protect their personal assets from being used to pay business obligations.[3] But that all goes down the drain if a court decides to pierce the entity’s corporate veil[4] and thereby hold the entity’s owners personally liable for the obligations of the business.[5]

The topic is important enough that it has spawned a cottage industry among academics conducting and reporting empirical studies to determine what factors make it more or less likely that a court will pierce the corporate veil in a particular instance.[6] We waded through the literature to see if we could clear away some of the “haze surrounding” this “poorly understood” area of the law.[7] Because the commentators do not agree on precisely what causes courts to pierce the corporate veil,[8] we ultimately recommended what we referred to as “moneyballing” alter ego liability. By that, we meant that while entity owners may have little control over some factors that commentators have found go into piercing the corporate veil (such as whether the plaintiff was an entity or an individual), they should take care of the things they can control, which includes some very simple steps like “following corporate formalities such as issuing shares, electing officers, holding required meetings, and keeping minutes of those meetings.”[9] To that list we can add the subject of this article—ensuring that the entity’s formation documents reflect that the entity was adequately capitalized through the owners’ initial capital contributions—as well as opening up a separate bank account for the entity and not commingling personal and business funds.[10]

Most of the empirical studies have consistently reported that undercapitalization, when found by a court, is a significant factor in piercing the corporate veil.[11] For example, in one comprehensive study examining cases from 1990 to 2008, the author concluded that “[o]f the cases where the court found insufficient funds to start a business, it pierced in 77.3% of cases and refused to pierce in 22.7% of cases”; conversely, “[w]here the court found that there were not insufficient funds to start the business, it refused to pierce in 92.5% of those cases and pierced in 7.5% of those cases.”[12]

It is a measure of just how murky this area of the law is that one study took issue with even those seemingly convincing numbers. In that paper, Professors Macey and Mitts theorized that undercapitalization “in fact rarely, if ever, provides an independent basis for piercing the corporate veil.”[13] At the same time, however, they recognized that “courts do invoke the mantra of undercapitalization to justify a determination to pierce the corporate veil.”[14] In fact, Macey and Mitts mustered support for their position by trying to show that Minton v. Cavaney,[15] which they described as a “leading case often mistakenly cited for the proposition that undercapitalization alone is sufficient to pierce the [corporate] veil,” does not really support that proposition.[16]

But we think all of that just emphasizes our point about moneyballing alter ego liability: if you’d have to go to that much trouble in litigation to explain away cases like Minton emphasizing undercapitalization as a factor (or in that case, the factor) in favor of piercing the corporate veil, why not just make sure the entity is adequately capitalized from the get-go? And better yet, you can include proof that the entity was adequately capitalized in your entity formation documents by having them reflect the founders’ capital contributions. That way, there is one less thing for a disgruntled creditor to cite if an alter ego claim does unfortunately arise later. For example, if your formation documents only reflect capital contributions of some minimal amount (such as $1 or $100), then even if you later capitalized the entity adequately, those would be documents that the creditor could obtain in discovery and use to try and prove that the entity was undercapitalized, such that your personal assets could be made available to satisfy the business’s obligations to the creditor. By contrast, if the formation documents reflect capital contributions that most would find adequate, then the creditor would have to find some other compelling reason for the court to pierce the corporate veil. And recall what an uphill battle that would likely prove to be for the creditor, in light of Professor Matheson’s finding that courts refused to pierce in 92.5% of those cases in which it was found “that there were not insufficient funds to start the business.”[17] Talk about tilting the odds in your favor.

Note also that Professor Matheson said insufficient funds to “start the business.” In our view, that accurately reflects that to avoid an undercapitalization argument, the funds should be injected into the entity from the outset as true contributions of initial capital, and not just as advances on revenue that the owners anticipate that the new entity will take in once the business is up and running. Again, this is simply an exercise in turning the odds in your favor if you’re ever faced with a veil-piercing scenario. While Professors Macey and Mitts accurately pointed out that states such as Delaware and New York “permit[] corporations to be formed without equity contributions from their founders,”[18] the fact remains that courts in Delaware and New York nonetheless still consistently cite inadequate capitalization as a relevant factor in deciding whether to pierce the corporate veil.[19] In that case, why not do everything you can to remove that factor from the equation by adequately capitalizing the entity from the outset and reflecting the founders’ initial capital contributions in the formation documents?

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

[2] See, e.g., Buckley v. Abuzir, 2014 IL App (1st) 130469, ¶ 11, 8 N.E.3d 1166, 1170; Richmond McPherson & Nader Raja, Corporate Justice: An Empirical Study of Piercing Rates and Factors Courts Consider When Piercing the Corporate Veil, 45 Wake Forest L. Rev. 931, 931 & n.1 (2010); Lee C. Hodge & Andrew B. Sachs, Piercing the Mist: Bringing the Thompson Study into the 1990s, 43 Wake Forest L. Rev. 341, 341 & n.1 (2008); Robert B. Thompson, Piercing the Corporate Veil: An Empirical Study, 76 Cornell L. Rev. 1036, 1036 & n.1 (1991).

[3] See Hodge & Sachs, supra note 2, at 341 (“One of the central aspects of the corporate form is that the corporation represents a legal entity that exists separately from its shareholders and owners. Under this principle, the obligations of the corporation are not imputed to the owners, directors, or shareholders of the corporation, and shareholders’ losses are capped at the amount of their investments.” (footnote omitted)).

[4] Although the doctrine is generally referred to as “piercing the corporate veil,” it can also be applied to reach the personal assets of members of limited liability companies. See, e.g., In re DePetris v. Traina, 2022 NY Slip Op 07232, at *2, 211 A.D.3d 939, 940-41, 181 N.Y.S.3d 298 (2nd Dep’t) (“Generally, a member of a limited liability company cannot personally be held liable for any debts, obligations or liabilities of the limited liability company, whether arising in tort, contract or otherwise. The concept of piercing the corporate veil is an exception to this general rule, permitting, in certain circumstances, the imposition of personal liability on members for the obligations of the limited liability company.” (cleaned up)).

[5] See Hodge & Sachs, supra note 2, at 341.

[6] In addition to the articles cited in note 2, see also Jonathan Macey & Joshua Mitts, Finding Order in the Morass: The Three Real Justifications for Piercing the Corporate Veil, 100 Cornell L. Rev. 99 (2014); Peter B. Oh, Veil-Piercing, 89 Tex. L. Rev. 81 (2010); John H. Matheson, Why Courts Pierce: An Empirical Study of Piercing the Corporate Veil, 7 Berkeley Bus. L.J. 1 (2010).

[7] Buckley, 2014 IL App (1st) 130469, ¶¶ 11-12, 8 N.E.3d at 1170.

[8] Which courts do in a disturbingly high number of cases. See id. ¶ 11, 8 N.E.3d at 1170 (citing some of the empirical studies, which “show that Illinois courts pierce the corporate veil in approximately 42% to 52% of cases, near the average for American courts”).

[9] eMinutes, supra note 1, Reducing Risk of Alter Ego with Some Simple Things.

[10] See Matheson, supra note 6, at 33, 54 (commingling of funds has a consistently significant effect on a court’s decision to pierce the corporate veil; courts pierced in about 81% of the cases in which commingling was found to be present).

[11] See, e.g., Matheson, supra note 6, at 33-34, 55; McPherson & Raja, supra note 2, at 957 (undercapitalization resulted in a pierce rate of about 73% before 1986, about 89% from 1986 through 1995, and about 95% from 1996 through 2005).

[12] See Matheson, supra note 6, at 33.

[13] See Macey & Mitts, supra note 6, at 99.

[14] Id. at 103; see also id. at 107 (the factors that courts “claim” to consider when piercing the corporate veil include “significant undercapitalization of the business entity (capitalization requirements vary based on industry, location, and specific company circumstances)”).

[15] 56 Cal. 2d 576, 15 Cal. Rptr. 641, 364 P.2d 473 (1961).

[16] Macey & Mitts, supra note 6, at 127-28. In that case, the California Supreme Court emphasized the corporation’s inadequate capitalization: “The equitable owners of a corporation … are personally liable … when they provide inadequate capitalization and actively participate in the conduct of corporate affairs. In the instant case the evidence is undisputed that there was no attempt to provide adequate capitalization[, which] … was trifling compared with the business to be done and the risks of loss.” Minton, 56 Cal. 2d at 579-80, 15 Cal. Rptr. at 643, 364 P.2d at 475 (cleaned up).

[17] Matheson, supra note 6, at 33.

[18] Macey & Mitts, supra note 6, at 110 & n.39 (citing Del. Code Ann. tit. 8, § 151 (permitting the issuances of stock without par value) and N.Y. Bus. Corp. Law § 501 (same)).

[19] See, e.g., Manichaean Capital, LLC v. Exela Techs., Inc., 251 A.3d 694, 706 (Del. Ch. 2021); DePetris, 2022 NY Slip Op 07232, at *2, 211 A.D.3d at 941.