Identity crisis - How experts identify alter ego companies
From the May/June 2018 issue of BCC Advisers Litigation & Valuation Report
on’t give up on defendants that appear to have limited financial resources. In some cases, plaintiffs may be able to successfully assert that the defendant is nothing more than an “alter ego” for a more solvent company. How do you know when an alter ego exists? Here are a few questions to investigate.
Is the defendant inseparable from a parent or subsidiary?
Alter ego litigation generally is sought to “pierce the veil” of a corporation or limited liability company (LLC) or take away the owners’ limited liability protection. Doing so provides access to the financial resources of a defendant’s subsidiaries — or even individual shareholders. But to be successful, plaintiffs need to show that a company and its shareholders lack separate identities. (The alter ego doctrine may apply to corporations, LLCs and other entities. For simplicity, we use the terms “corporate” and “corporation” in this article.)
Courts are more likely to disregard a corporate form if the shareholders themselves disregarded the corporation’s separate existence. For example, if the shareholders neglected corporate formalities — such as electing officers and directors and keeping meeting minutes — the corporation might be an alter ego. In addition, commingling of funds and assets can blur the distinctions between a corporation and its shareholders.
Lack of separateness also can be an issue when a parent corporation has one or more subsidiaries. Plaintiffs who dealt with a subsidiary may have believed they were dealing with the parent. The businesses may have been so similar that it was difficult to tell them apart. Or the parent’s actions or representations may have led the plaintiff to believe that the parent would stand behind the subsidiary’s obligations.
Similarities between a parent and subsidiary can create confusion and support application of the alter ego doctrine. Entities may not be separate, for example, when they share the same (or similar) product line, name, branding or management team.
The existence of transactions between a corporation and its shareholders or parent that aren’t conducted at arm’s length also merits attention. A financial expert can provide insight into whether such situations are ordinary and appropriate or whether they indicate abuse.
Is the defendant dependent on related parties?
One common sign that a company is an alter ego is financial dependence on its shareholders or parent. This relationship often is demonstrated when the corporation is undercapitalized, the shareholders or parent owns most of the assets used in the business and leases them or sells them to the corporation at bargain rates, or the shareholders or parent makes undocumented or below-market loans to the corporation or relieves the corporation of its payment obligations.
Typically, experts analyze a corporation’s capital structure and compare key financial ratios and indicators to those of similar companies to determine whether the defendant is undercapitalized. They also may review the company’s operating history and analyze intercompany transactions and relationships to determine whether the corporation became undercapitalized due to operating losses or irregularities in its financing. Experts further analyze transactions to determine whether they were conducted on an arm’s-length basis.
Does another entity control the defendant?
Although operational similarities and financial dependence provide experts with solid leads, nothing says “alter ego” like a parent that exercises undue influence or dominates a corporation. In this case, the shareholders or parent may cause the corporation to favor it over third parties, by, for example, giving it preferred status over other creditors.
In such cases, a financial expert can review the corporation’s operations and transactions, examine accounting records and apply valuation techniques. These tools help the expert determine whether the corporation’s dealings with related parties are legitimate and unbiased — or involve undue control or domination by its owners.
Consult with a financial pro
Alter ego companies aren’t always easy to identify, because dishonest companies know how to structure related-party entities to hide financial assets and evade responsibility. A financial expert can be a valuable tool for unraveling covert relationships and proving that a defendant has abused the corporate structure.