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Ohio Supreme Court makes it Easier for Corporations to Avoid Liability

by Professor Stefan Padfield on October 9, 2008

in Business,Stefan Padfield

The Ohio Supreme Court made national news last week when it issued its opinion in the case of Dombroski v. Wellpoint, Inc. In that case, the Court ruled that plaintiffs could only "pierce the corporate veil" to pursue shareholders directly if the shareholders had committed "fraud, an illegal act, or a similarly unlawful act."  Understanding why this ruling made national news, and why it provides additional cover for corporate defendants, requires a bit of background information.

The limited liability corporation has been described by no less an authority than the then-President of Columbia University as "the greatest single discovery of modern times…. Even steam and electricity are far less important."  This admiration stems from the fact that before states created the legal fiction of the corporation, investors in a business were often deemed to be partners and thus personally liable for the debts of the business.  As you can imagine, that made trying to raise capital for risky ventures extremely difficult.  But by separating ownership from control in the corporate form (i.e., the investors were the owners but the business was controlled by the board of directors), investors were able to be shielded from liability beyond the value of their investment.  This innovation, together with the immortality of the corporate entity and the free transferability of shares, created a wealth accumulation vehicle that some now think threatens to rule the world.

Of course, this freedom from personal liability raised the specter of abuse of the corporate form so as to take advantage of others and avoid personal liability in the course of doing so.  In order to combat this problem, courts developed the doctrine of "piercing the corporate veil."  One way of thinking about this doctrine is to consider it a judicial response to the failure of investors to maintain the separation of ownership and control that originally justified their limited liability.

While the doctrine is far from clear, the tests courts use to determine when they will pierce the corporate veil can be broadly broken into two inquiries.  The first is whether the shareholder has exercised a level of control over the corporate entity so as to reduce that entity to no more than an "alter ego" or "mere instrumentality" of the shareholder.  This inquiry often relies on reviewing a number of factors such as undercapitalization, failure to observe corporate formalities, and non-functioning of officers and directors besides the defendant shareholder.  The second inquiry is whether some injustice will result from refusing to pierce the corporate veil.  In Ohio, these general inquiries are encapsulated in a version of the following test, which asks whether:

(1) domination and control over the corporation by those to be held liable is so complete that the corporation has no separate mind, will, or existence of its own; (2) that domination and control was used to commit fraud or wrong or other dishonest or unjust act, and (3) injury or unjust loss resulted to the plaintiff from such control and wrong.

The language I just quoted is from the decision of the U.S. Court of Appeals of Sixth Circuit in the case of Bucyrus-Erie Co. v. Gen Prods. Corp. This is the case that the Ohio Supreme Court in Dombroski says forms the basis for Ohio's veil piercing law.  However, the Ohio Supreme Court has basically limited the inquiry under the second prong to whether the shareholders' conduct constitutes an illegal act.

And this is why the case made national news.  This is an extremely narrow application of the veil piercing doctrine.  In fact, Justice Pfeifer, writing in dissent, asserts that the decision "places Ohio within the most restrictive jurisdictions for proving a case of piercing of the corporate veil."  I checked eight different corporate law treatises, and not one of them described the test this narrowly.  While I do not believe that Ohio will be the only state to have limited its veil piercing doctrine in this way, I believe it is fair to say that it is very much the minority position.  The reason that this is a boon to corporate defendants is that corporations are often the main defendants in these cases (as was the case in Dombroski itself) because they are the sole shareholder of a wholly-owned subsidiary.

In rendering its decision, the Ohio Supreme Court expressed concern that allowing veil piercing on the basis of merely unjust or inequitable conduct (apparently, that type of conduct is an acceptable part of doing business in the corporate form these days) will open floodgates of liability for close corporations and controlling shareholders of public companies.  I believe the empirical evidence is to the contrary.  Courts have been quite adept at limiting the exercise of their equitable discretion and have applied the doctrine sparingly even without limiting their review solely to cases of illegal conduct.  Does the Ohio Supreme Court not trust the Ohio bench to exercise its discretion judiciously?

There is no way I can do justice to the numerous issues raised by the veil piercing doctrine in a short blog post, and there are clearly good policy arguments on both sides, but hopefully there's enough here to generate some discussion.  A video of the oral argument in Dombroski is here.