Sec. 1.5. The Doctrine of Limited Liability - In Concept and As Applied
A. The Doctrine of Limited Liability in Concept
At the dawn of the Mercantile Age of England in the sixteenth century, the concept of the corporation developed to provide a legal context to implement the increasingly sophisticated investments and conduct of trade and commerce. The doctrine of limited liability defined the corporation and distinguished it from the only other form of business entity which was the general partnership and the various iterations of the general partnership.
As it has been since time immemorial and still is today, a general partnership is formed by two or more individuals who conclude a contract under which they agree to pursue a business for profit. Each partner is personally liable for any debt or obligations which the partnership or any partner incurs in furtherance of the business of the corporation. If partnership assets are not sufficient, a creditor can satisfy its judgment out of the personal assets of each other partner. The doctrine of limited liability corporation was fundamentally alters this principle. In a corporation, the shareholders are not liable for the debts and obligations which the corporation incurs. This means that a creditor of the corporation nor a creditor of any other shareholder can reach the personal assets of any shareholder to satisfy a judgment against the corporation.
Until the early 20th century only shareholders of a corporation were afforded limited liability. In first years of the 20th century, a general partnership could form as a limited partnership (LP) in which the limited partners were afforded limited liability as long as there was at least one general partner who was liable to the extent of its personal assets. In recent years, a general partnership can choose to be a limited liability partnership (LLP) in which all partners are afforded limited liability. Similarly, a limited partnership can choose to be a limited liability limited partnership (LLLP) in which even the general partner is afforded limited liability. Limited liability is afforded to the members of a limited liability company (LLC), the members of a nonprofit association (UNP) and, under the USTEA and some other jurisdictions, for trustees and beneficiaries of a statutory business trust. A defendant in a case in which the doctrine of limited liability is at issue asserts limited liability as an affirmative defense.
B. The Doctrine of Limited Liability as Applied in Principle
The doctrine of limited liability is afforded to shareholders and interest holders of a business entity by statute. The terms and conditions which determine whether or not and how the doctrine applies are set forth in case law. Therefore, the judicial inquiry is essentially in equity and governed by precedent. This means that, even though the concept of the doctrine is the same, the application of the doctrine in particular instances may differ from state to state.
There are two circumstances under which the doctrine never applies to protect the assets of a shareholder or interest holder:
- Limited liability is not afforded to a shareholder or interest holder who commits tortious acts or omissions while that shareholder or interest holder is acting as an individual or as an agent of the business entity.
- Limited liability is not afforded to a shareholder or interest holder who has individually guaranteed a contractual obligation of the business entity.
C. The Doctrine of Limited Liability as Applied to Shareholders of a Corporation
Because limited liability was originally afforded only to shareholders, cases involving corporations have set up the fundamental elements as to whether and how the doctrine is applied. These cases are referred to as “piercing the corporation veil”. The doctrine protects the personal assets of a shareholder only as long as the status of a shareholder is as a shareholder. The shareholder cannot use limited liability to protect its personal assets from the debts and obligations which are purportedly liabilities of the corporation but are actually, as a matter of fact, the liabilities of the shareholder as an individual.
Because a corporation is a legal person, the corporation must be operated in a manner which demonstrates that, as a matter of fact, it is separate and distinct from its shareholders, even if it has only one shareholder. The courts have developed certain common sense facts which, if established, demonstrate that the corporation has a legal existence separate and distinct from the shareholders.
- Compliance with statutory corporate formalities such electing directors, appointing officers, authorizing/issuing shares, shareholder agreements and bylaws, and votes,
- Creation and maintenance of corporate minutes or written resolutions within which to record votes and actions by the board of directors and the business operations of the corporation,
- Maintaining corporate accounts and funds separate from the accounts and funds of the shareholders,
- Preventing the shareholders from using corporate assets for personal uses, and
- Maintaining corporate offices, telephones, emails, and websites which are separate from those of the shareholders.
In addition to separateness, the courts perform inquire as to whether the courts should or can infer from the facts it is “unjust” to afford limited liability to the shareholders. For this inquiry, the courts usually consider the following facts:
- Whether the corporation is undercapitalized given its business purpose and, if so, whether a creditor did or could have reasonably ascertained that fact,
- Whether the corporation incurred debts and obligations at an unreasonable rate and magnitude given its revenues,
- Whether the corporation incurred obligations that the shareholder knew or should have known could not be satisfied in due course or were not reasonably calculated to achieve the business purpose of the corporation.
D. The Doctrine of Limited Liability as Applied to Interest Holders of Unincorporated Entities
The enabling statutes of unincorporated entities such as LPs, LLPs, LLCs and UNPAs afford limited liability to the interest holders of these business entities limited liability. The elements of separateness and equity each apply to cases which involve affording limited liability to interest holders of unincorporated business entities. These cases are referred to as “disregarding limited liability” and not “piercing the corporate veil”. However, because of the differences in substance between corporations and unincorporated entities, the statutory formulation of limited liability differs.
The statutory formulation is that no interest holder is personally liable for the debts or obligations of the unincorporated entity, whether in tort or contract, solely by reason of being an interest holder of the entity. This statutory formulation recognizes the principle that an interest holder is liable for its own tortious acts or omissions or contract obligations. If the creditor has a legally cognizable claim against an interest holder other than merely the fact that the interest holder is an interest holder of the unincorporated entity, then the creditor can proceed against the personal assets of the interest holder. There are far fewer cases which involve disregarding the limited liability of an unincorporated entity than cases which involve piercing the corporate veil. The facts which demonstrate separateness derive from the corprofacts with some differences.
- Unincorporated entities are not required to perform, create or maintain corporate formalities.
- Create an organizational agreement such as an operating agreement or partnership agreement,
- Appoint entity principals to operate the business of the unincorporated entity and act through written resolutions,
- Create agreements with principals which specify responsibilities,
- Issue certificates of interests to the interest holders,
- Other than an LP, LLP or LLLP, whether the unincorporated entity has one interest holder or two or more interest holders, and
- Maintain accounts, funds and assets in the name of the unincorporated entity only.
With respect to the equity inquiry, the facts to be considered are the same as the facts for
a corporation.
E. The Doctrine of Limited Liability and Statutory Business Trusts
The issue of whether and how the doctrine of limited liability applies to any trust which engages in commercial activities is supremely significant to the constituents. Limited liability is fundamental to the conduct of commercial activities. Uncertainty as to this issue restricts the ability of trusts to choose in which commercial activities it will engage. The statutory business trust statutes eliminate this uncertainty. The constituents are afforded limited liability by statutory mandate and not based on decades of decisions in case law.
The statutory business trust statutes which adopt the USTEA or are based on the USTEA afford limited liability to the trustees and the beneficiaries. There are even fewer cases which involve the application of the doctrine of limited liability to trustees and beneficiaries of statutory business trusts than there are for other unincorporated entities. The elements of separateness and equity will apply. A court will base a judgment on facts which are adapted from the facts that apply to unincorporated entities. These facts are:
- Whether the trustee and the beneficiary are the same individual or entity,
- Whether the governing instrument allocates authority to the beneficiary such that the beneficiary can veto fundamental decisions made by the trustee,
- The circumstances under which the beneficiary can remove a trustee, and
- Whether assets have been transferred or assigned exclusively to the dominion and control of the statutory business trust.
With respect to the equity inquiry, the facts to be considered are generally the same as the
facts for a corporation.
F. The Doctrine of Limited Liability and Commercial Trusts
For commercial trusts as well as donative and charitable trusts the issue whether and how the doctrine of limited liability applies is governed by the case of each state. Although some common general principles can be gleaned, the issue is usually limited to the facts of each case. The cases have limited precedential value. The Uniform Trust Code places the many of general principles in a systematic and organized scheme. However, it does not set forth a statutory mandate like the one set forth in the statutory business trust statutes.