Liability & Veil-Piercing — Business Associations

Harbor Painters is a general partnership owned equally by Rosa, Dev, and Lin. The firm loses a $96,000 judgment to a paint supplier, spends its last dollar, and the writ against the partnership comes back unsatisfied. Rosa is the only partner with real savings. The supplier wants the whole balance from her, without ever suing the other two. Rosa says she can owe one-third at most. How much can they take?

All of it. Because general partners are jointly and severally liable, and a creditor may collect the entire debt from any single partner, then leave that partner to chase the others. Which is the blunt question this whole topic answers. When the business owes money it cannot pay, whose wallet is on the hook?

Here's the route. First the default rule for each of the three forms. Partnership, where there is no shield. Corporation and LLC, where there is. Then the two side doors that stay open whatever form you pick. Then the specific ways a director or member is still on the hook. And finally piercing, where a court takes the shield away.

Start with the mental model, because it organizes everything. Two layers. Layer one, the entity is liable on its own contracts and for torts in its business. Layer two, does that flow through to the owners? For a partnership, yes by default. For a corporation or an LLC, no. Piercing is how a plaintiff turns that no into a yes.

And then two side doors that stay open whatever form you choose. First, you are always liable for your own torts. Commit fraud yourself, or negligently injure someone doing the firm's work, and no shield saves you, because you answer for what you did, not for the firm's debt. Second, you are liable on anything you personally guarantee.

Now the first form. A general partnership forms automatically when two or more people carry on a business as co-owners for profit. No filing, no paperwork. And the price of that informality is no shield at all. Under RUPA (1997) § 306(a), all partners are liable jointly and severally for all obligations of the partnership, in contract, tort, or otherwise.

Jointly and severally means a creditor may collect the entire debt from any single partner, who then chases the others for contribution. This changed from the old 1914 act, under which partners were only jointly liable on contracts. Under RUPA it is joint and several for everything. One partner can be made to pay 100%.

But personal liability is a backstop, not a first stop. Under § 307(d) a creditor generally must hold a judgment against the partnership and the partner, and have a writ against the partnership come back unsatisfied, before touching personal assets. Which is why Rosa was reachable. Three exceptions. Partnership bankruptcy, the partner's agreement to skip exhaustion, or a court's permission.

Then two timing rules that mirror each other. Incoming partners are protected for the past. Under § 306(b) someone admitted to an existing partnership is not personally liable for obligations incurred before they joined, and their exposure is capped at what they invested. Join in June, and the lease the firm breached in March is not your problem beyond your capital.

Departing partners stay on the hook. Under § 703 a partner who dissociates remains liable for obligations incurred before leaving. And a private deal among the remaining partners to assume the debts does not bind a creditor who never released them. They can also be caught for new debts for two years afterward, unless notice was given.

And one trap catches non-partners entirely. Partner by estoppel, § 308. A person who represents themselves as a partner, or knowingly lets someone else say so, is liable to a third party who extends credit in reliance. Even with no partnership at all. Nod along while your friend tells the bank you are partners, and you can owe that loan.

General partners can buy a shield. Register the firm as a limited liability partnership by filing a statement of qualification, and § 306(c) flips the default. Firm obligations become the firm's alone, and no partner is liable merely for being a partner. A full shield, covering contract debts and tort claims alike.

But watch what it does not do. Two partners in an accounting LLP. One personally botches an audit and misses an obvious fraud. The other had nothing to do with it. The innocent partner is protected, because the shield stops vicarious liability for the firm's debts and the other partner's misdeeds. The one who did the work is still liable. The shield never immunizes what you personally did.

Second form. A corporation is a separate legal person that owns its own assets and owes its own debts. Under MBCA (2016) § 6.22(b) a shareholder is not personally liable for the acts or debts of the corporation, except by reason of their own acts. And the shield covers directors and officers too, not just shareholders.

Add ordinary agency law on top. An agent who signs for a disclosed principal is not a party to the contract. So when the CEO signs a supply contract for a named corporation, the corporation is bound and she is not. She negotiated it, she signed it, and she is still not liable on it.

So the starting point for every corporate question is that the individual is not on the hook for the firm's debt. The real question is whether they breached a duty owed to the corporation, or fell through a side door. A director who approves an ordinary purchase order and commits no tort is simply not liable when the company cannot pay.

Which means claims against directors are almost always for breaching a duty to the corporation. The duty of care under § 8.30 asks them to act in good faith and with the care a person in a like position would reasonably believe appropriate. But the business judgment rule gives breathing room. Courts will not second-guess an informed, good-faith, disinterested decision, even if it loses money. It protects the process, not the outcome.

Loyalty is guarded far more strictly, because it targets self-interest rather than honest mistakes. Fiduciary duties get their own topic. The point to carry here is that a self-dealing director, or one who seizes a corporate opportunity, is exposed, and no exculpation clause will save them.

Then one specific statutory trap. Directors who vote for or assent to an unlawful distribution are personally liable to the corporation for the excess. A distribution is unlawful under § 6.40 if it leaves the corporation unable to pay its debts as they come due, or makes liabilities exceed assets. Vote for a dividend knowing it strands the trade creditors, and § 8.33 reaches you.

And a corporation's articles may carry an exculpation clause under § 2.02(b)(4), eliminating a director's liability for money damages. But it can never excuse four things. A financial benefit the director was not entitled to. Intentional harm. An unlawful distribution. Or an intentional crime.

Third form, and the one most small businesses now choose. The LLC combines the partnership's informality with the corporation's shield. Under ULLCA (2013) § 304 a debt of an LLC is solely the company's, and a member or manager is not personally liable merely by being or acting as one. Contract or tort, and hired non-member managers are covered too.

And the LLC has a feature corporations lack. Quick challenge. Three members run an LLC casually. No meetings, no minutes, no resolutions, though they do keep the company's money in a separate account. A creditor argues that ignoring corporate-style formalities strips the shield. Does that work?

No. § 304(b) says the company's failure to observe formalities is not a ground for imposing liability on members or managers. Unlike a corporation, an LLC does not lose its shield because nobody held a meeting. It can still be evidence in a piercing claim, but standing alone it is not enough.

Two more LLC rules. The side door stays open, so a member who negligently sets up equipment during a class he teaches is personally liable for that tort. And under § 301 a member is not automatically an agent of the LLC just by being a member. Authority comes from the operating agreement, or from actual or apparent authority.

Which brings the great exception. Piercing the veil, the alter-ego doctrine, lets a court disregard the entity and hold owners personally liable. It applies when they have abused the form so badly that respecting it would be unfair. There is no piercing statute, courts call it extraordinary, and it happens almost only against closely held firms. Essentially never against a public corporation.

Most courts require both prongs. Prong one, unity of interest. The owner so dominated the entity and disregarded its separateness that it had no independent existence and was a mere instrumentality. Prong two, injustice. Honoring the separate entity would sanction a fraud or produce an inequitable result. Both are required.

Quick challenge on that. A creditor cannot collect from a closely held corporation and sues Ruth, its sole shareholder. His whole case is that Ruth makes every decision single-handedly. Only director, only officer, only shareholder. No commingling, no fraud, no undercapitalization alleged. Enough to pierce?

No. Domination alone is never enough, because running your own company single-handedly is normal and lawful. Without prong two the shield holds. So what proves prong one? Commingling, paying personal bills from the company account. Undercapitalization, far too little money or insurance for the business's foreseeable risks. Ignoring formalities. Siphoning assets. Using the entity as a facade.

Then four nuances the exam likes. First, contract versus tort creditors. You would expect involuntary tort victims to draw more sympathy, but courts historically pierce somewhat more readily for contract creditors. Second, LLCs pierce too, on the same test, but because § 304(b) discounts formalities it leans on commingling, fraud, and undercapitalization.

Third, reverse piercing, where a court reaches company assets for an owner's personal debt. And fourth, enterprise liability, where affiliated sister companies under common ownership are run as one business with intermingled assets, and a court may treat them as a single enterprise.

One last distinction, and it reorganizes the whole topic. Direct liability rests on the individual's own act, a tort they committed or a debt they guaranteed, and no shield ever covered it, so there is nothing to pierce. Piercing imputes the entity's debt to the owner, and you need it only when the claim belongs to the company.

A word on authorities. This episode named no cases, and that was deliberate. Piercing is judge-made, but the source teaches it as a two-prong test rather than through case names, and the rest runs on three uniform acts. RUPA (1997), the MBCA (2016), and ULLCA (2013). This topic is starred, so nothing is printed for you.

If you keep only three things, keep these. The three defaults. Partners jointly and severally liable under § 306(a), corporate owners shielded under § 6.22(b), LLC members shielded under § 304. The two side doors, your own torts and your own guarantees, which no shield ever closes. And the two piercing prongs, domination plus injustice, both required.

Now the traps, straight from the examiners' favorites. One. Do not say partners are only jointly liable. Under RUPA it is joint and several, torts and contracts alike. Two. Do not let a creditor reach a partner's personal assets before the firm's are exhausted. Three. Do not hold a newly admitted partner liable for debts predating their admission, and do not assume leaving ends liability for the rest.

Four. Do not make a director liable for a corporate debt just because they run the company. Absent piercing, they are not. Five. Do not let an exculpation clause wipe out disloyalty, improper benefits, unlawful distributions, or intentional wrongs. Six. Do not treat an LLC's skipped formalities as strong evidence, because § 304(b) discounts them.

Seven. Do not pierce on domination alone. And eight, the big one. Do not confuse piercing with direct liability. If the owner personally committed the tort or signed the guarantee, that is direct liability, no shield ever applied, and there is nothing to pierce. Naming the layer the question is testing is usually the whole battle.

Time for the quick check, and this one comes straight from the BARGO question bank. Milo is the sole owner and president of a roofing corporation. On a job he personally makes fraudulent misrepresentations to a homeowner about the roof he is selling. She relies on them, overpays, and suffers a loss. She wants to recover from Milo personally, and her lawyer is deciding whether she must prove veil-piercing to get there.

What is her most direct route to Milo's personal assets? Option one. She must pierce the corporate veil to reach him for the fraud. Option two. She cannot reach him, because his fraud occurred in the course of corporate business. Option three. She may hold him directly liable for his own fraud, without piercing at all. Pause here if you want a moment.

The answer is option three. Piercing imputes the entity's debt to the owner, and you need it only when the claim is against the company and you want the person behind it. Milo committed the fraud himself, so he is directly liable and no shield ever covered him. Option one makes her prove domination and injustice she does not need. Option two stretches the shield past its job.

Ask first whether you even need to pierce. Most of the time you do not. There are thirty plus more questions on this topic alone, each with every option explained like that.

Five things to take away. One. General partners are jointly and severally liable for everything, but personal assets are a backstop after the firm's are exhausted. Incoming partners are protected for the past. Departing ones are not. Two. Corporate and LLC owners, directors, officers, members and managers are all shielded by status alone.

Three. Two side doors never close. Your own torts, and anything you personally guarantee. Four. Directors face their own exposures. Fiduciary breach, unlawful distributions, and improper benefits, none of which an exculpation clause can excuse. Five. Piercing takes domination plus injustice, both prongs, and almost never touches a public corporation.

Which is why the supplier takes all $96,000 from Rosa, and why, had she incorporated instead, they would have taken nothing. That one choice was worth the whole judgment. And that is the last stop in Business Associations.

Practice this topic with more than 2,900 exam-style questions, free to start, at nextgenbargo.com. This episode is for education and exam preparation only, not legal advice, and we are not affiliated with or endorsed by the NCBE or any bar examining authority.