Counterterrorism: Conventional Tools for Unconventional Warfare · 2009. 5. 6. · MARCH 2005 U NI...

MARCH 2005 UNITED STATES ATTORNEYS ' BULLETIN 1

Counterterrorism: Conventional Toolsfor Unconventional WarfareDarrell D. Dorrell, CPA/ABV, MBA, ASA,CVA, CMA, DABFA, CMCPresidentfinancialforensics®

Gregory A. Gadawski, CPA, CVA, CFEPrincipalfinancialforensics®

I. Introduction

Terrorists seek our annihilation. Theyconspire by any and all means to obliterate us.Their methods are insidious. They exploit ourlaws and freedoms which, when compared to theirhome countries, offer nearly unfettered movementthroughout our society to plot and execute theirattacks. Consequently, they see our laws andfreedoms as avenues by which to achieve theirmeans.

The purpose of this issue of the United StatesAttorneys' Bulletin is to demonstrate how civillaws can be employed via forensic accountingtactics as new weapons in the counterterrorismarsenal. Paraphrasing the FBI's dictum, theUnited States should use any and all means to"[d]elay, disrupt or dismantle terrorist activities."

A. Stop the money—stop the terrorists

Terrorists cannot function without money.Consequently, disrupting the flow of moneydisrupts terrorists' activities, and is a veryeffective law enforcement strategy. However,interrupting the money flow is more complex thanit would seem.

There are several federal criminal statutes,such as the USA PATRIOT Act, Pub. L. No. 107-56, Stat. 272 (2001), that are designed to disruptthe flow of terrorist money. The USA PATRIOTAct made major changes to the currency reportinglaws and the money laundering laws. In addition,the Bank Secrecy Act, 31 U.S.C. §§ 5311-5330,requires many organizations to file SuspiciousActivity Reports (SARS) in the event evidence ofsuspicious transactions is uncovered. The Bank

Secrecy Act also requires the filing of CurrencyTransaction Reports (CTRs) to create a paper trailfor large currency transactions.

In an effort to evade detection, terrorists can,and often do, operate on a "shoestring." A primeexample is the October 2000 bombing of theU.S.S. Cole. The bombing killed seventeen andwounded thirty-nine U.S. Navy personnel, andnearly sank a $924 million warship. By oneestimate, the total cost to terrorists was less than$20,000. The Cole was procured in FY1991 at acost of about $789 million. This is equivalent toabout $924 million in FY2001 dollars.Congressional Research Service, The Library ofCongress, Terrorist Attack on USS Cole:Background and Issues for Congress, Order CodeRS20721, Updated January 30, 2001.

Complicating matters, legitimate,quasi-legitimate, and fraudulent businesses andbusiness fronts can obscure funds flow so thatdetection becomes extremely difficult. Forexample, international waste paper-brokersroutinely wire substantial sums worldwide in theirindustry. Conversely, retail store fronts, such asrestaurants, deal in small individual sums that arelarge in their aggregate. However, proving that theentities were operated as the instrumentalities of atarget operator (terrorist suspect), or determiningthat the transactions were not executed atreasonably equivalent value, could demonstratealter ego and/or fraudulent transfers. This wouldresult in a disruption of money flow and/or assetaccess.

Disrupting money flow must comply withfederal, state, and local laws, otherwise theterrorists win. However, not only criminal statutescan be employed. Civil laws and related forensicaccounting tools can be employed, which adds toour prosecutorial arsenal.

B. Civil tools used by federal lawenforcement

Federal law enforcement has employed civiltools since the early 1900s. In the 1930s the U.S.Treasury Department (Treasury) used a

2 UNITED STATES ATTORNEYS ' BULLETIN MARCH 2005

cutting-edge forensic accounting tool to defeatAmerica's quasi-terrorist threat—organized crime.

The specific forensic accounting tool used byfederal law enforcement was, and still is, knownas the net worth method. It was used to helpconvict Alphonse (Al) Capone in Capone v.United States, 51 F.2d 609 (7th Cir. 1931). Usingthis technique, authorities compared his reportedincome with his evident income and proved thathe had failed to accurately report his financialcondition to the Internal Revenue Service (IRS).

Recent nationwide developments indicate thatvarious federal agencies are pursuing civil toolssuch as alter ego. For example, the three-memberOccupational Safety and Health ReviewCommission, which hears appeals fromadministrative law judges' decisions, will soondecide whether Occupational Safety and HealthAdministration (OSHA) regulators should beallowed to pierce the corporate veil and pursue theindividuals running companies to hold them, orsuccessor alter ego companies, responsible forfines and other enforcement actions. CindySkrzycki, Panel Weighs Letting OSHA Pierce theCorporate Veil, WASHINGTON POST Mar. 23,2004, at E.1. Also, the IRS has routinelydisregarded corporate entities in its pursuit of taxevaders in estate and gift matters. See Strangi v.Commissioner, 115 T.C. 478, 487 (2000); Hacklv. Commissioner, 118 T.C. 1 (2002). A U.S.District Court in Baum Hydraulics Corp. v.United States, 280 F. Supp 2d 910 (D. Neb.2003), upheld an IRS lien against a corporate alterego, citing 26 U.S.C. § 6321. Additionally,United States v. Reading Co., 253 U.S. 26 (1920),is an early example of how federal authoritiespursued misuse of the corporate form (alter ego)in a restraint of interstate commerce case. Asrecently as July 2003 the use of alter ego has beendiscussed in connection with combating terroristfinancing. See Jeff Breinholt, Terrorist Financing,51 United States Attorneys' Bulletin 4 (July 2003).

Finally, certain statutes make corporateparticipants personally liable for actions they takeor fail to take on behalf of the corporation. SeeComprehensive Environmental ResponseCompensation and Liability Act of 1980(CERCLA), 42 U.S.C. §§ 9601-9675 (1988). ThisAct imposes liabilities on certain owners oroperators of polluting facilities, thus piercing thecorporate veil.

II. The civil statutes ascounterterrorism weapons

The modern-day civil statutory weapons usedin forensic accounting consist of the legal doctrineof alter ego, fraudulent transfer, and solvencyanalysis. These three techniques are discussed indetail below.

A. Alter ego

The doctrine of alter ego is applied throughvarious descriptors including.

• Corporate disregard.

• Disregarding the corporate entity.

• Disregarding its separate corporate existence.

• Ignoring the (corporate) fiction.

• Piercing the corporate veil.

Alter ego in Latin means "second self."BLACK 'S LAW DICTIONARY, 77 (6th ed. 1990). Inapplying the legal doctrine of alter ego, onestrives to persuade the court to remove an entity'scorporate veil, or intended protection, to exposethe owners to judgment. Such action providesaccess to owners who would otherwise beprotected by the entity structure.

Alter ego is commonly employed incombination with a wide range of civil matters,(antitrust, breach of fiduciary duty, fraudulentconveyance/transfer, lost profits,misrepresentation, patent infringement, andothers) that seek damages from parties otherwiseprotected by, or even disassociated with, anentity(ies). A critical component necessary for thecourt to invoke alter ego consists of control overan entity.

Alter ego is also commonly employed incriminal matters. Robert B. Thompson's 1991 alterego study found that nearly 67% of criminal casessuccessfully pierced the corporate veil, which wasintended to shield the acts of the shareholders.Thompson maintains that "piercing the corporateveil is the most litigated issue in corporate law."Robert B. Thompson Piercing the Corporate Veil:An Empirical Study, 76 CORNELL L.J. 1036, 1036(July 1991).


B. Fraudulent transfer or conveyance

The civil tool known as fraudulent transfer orfraudulent conveyance derives from common lawand the Bankruptcy Code, 11 U.S.C. § 548. It istypically employed in connection withdebtor/creditor relationships where an asset and/orliability has been transferred for less thanreasonably equivalent value within one year of thefiling of the bankruptcy petition, with the intent ofdefeating a creditor's rights.

The common law provisions typicallyoriginated from the Uniform FraudulentConveyances Act (UFCA) or Uniform FraudulentTransfer Act (UFTA) and include measurementsof badges of fraud that can be employed directlyor indirectly. Thus, assets can be recovered andtransfers voided when they constitute actual orconstructive fraud.

Fraudulent transfer/conveyance is pursued inthe same way among federal and statejurisdictions and can be used in combination witha wide array of other matters, including alter ego,solvency, merger, and acquisition.

C. Solvency

The concept of solvency (and insolvency) isgenerally familiar to most Americans. However,the definition of solvency is problematic inadjudication. Typically, courts require an opinionregarding the solvency (or the lack thereof) of anentity or transaction at a particular point(s) intime. In such cases, solvency is nearly universallydefined as "a company's ability to meet theinterest costs and repayment schedules associatedwith its long-term debt obligations." ROBERT N.ANTHONY, MANAGEMENT ACCOUNTING: TEXTAND CASES 301 (Richard D. Irwin ed., McGraw-Hill 1964).

Solvency analysis utilizes three tests. Theseare the balance sheet test, the cash flow test, andthe adequate (reasonable) capital test. Each ofthem is set forth in detail in section IX of thisarticle

D. Forensic accounting techniques

The selected forensic accounting techniquesdescribed above reflect only a fraction of the toolsavailable to forensic accountants. Nevertheless,they illustrate the breadth and depth of tacticsavailable to federal law enforcement. Selected

forensic accounting techniques are defined below,and a few highly pertinent techniques arehighlighted.

Benford's law is the statistical technique forthe objective analysis of numerical data sets. Theresult of a Benford's law analysis can indicatewhen a significant portion of a numeric data setcontains artificial or contrived numbers, whichpinpoints potentially fraudulent transactions. Theartificial or contrived numbers are evidenced bythe vast numbers of nonrandom, duplicative, androunded entries. Benford's law states that digitsand digit sequences in a legitimately prepared dataset follow a predictable pattern, i.e. a geometricsequence. Therefore, each digit and digitcombination can be used as a statisticalbenchmark for the prepared data. The techniqueapplies a data-analysis method that identifiespossible errors, potential fraud, or otherirregularities. Benford's law is such a potentforensic/investigatory tool that it is separatelyaddressed.

Expectations-based statement analysisconsists of analyzing the language patterns usedby a subject during interviews to assess histruthfulness. The FBI teaches its special agentsthat specificity can indicate veracity. That is, thestatement, "I heard a shot and saw him standingover the body," is less specific than, "I saw himpoint the gun at the victim, I heard the shot, sawthe recoil, saw the victim clutch his chest andfall." All other things being equal, the secondstatement is more likely the truth.

A genogram is a diagram of the informationgathered during background research, interviews,interrogation, and surveillance. It is often preparedin conjunction with other output such as eventsanalysis. A genogram represents relationshipsamong target subjects and reflects personalconnections among other subjects. The genogrammaps out relationships and traits that mayotherwise be missed.

Proxemics, according to its founder, EdwardT. Hall, is the study of humankind's "perceptionand use of space." It has parallels to kinetic andparalinguistic communications. Proxemics can beconsidered the forerunner of body language.EDWARD T. HALL, THE SILENT LANGUAGE 83(Anchor Books 1990).

A time-line analysis is a powerful tool fordemonstrating causal elements of activity-basedevidence, and also assists in validating parties'


claims.

E. Synergy of the civil statutory weapons

The civil statutory weapons of alter ego,fraudulent transfer, and solvency exhibit uniquecharacteristics that permit them to be usedindividually and/or in combination in a widevariety of matters. The forensic accountingtechniques discussed above support themindividually or in combination. Consequently,these weapons offer a synergistic approach thatcan be modified to the respective target scenarioat hand.

The respective techniques can apply beyondthe areas of law for which they were originallyenacted. For example, solvency tests can be usedin nonsolvency cases such as financial analysis inshareholder dissension suits. Fraudulent transfercan be used to analyze mergers and acquisitions.

III. Why use civil laws in addition tocriminal laws?

A. Civil laws supplement criminal law

Employment of civil statutory weaponsagainst terrorists supplements, but does notsupplant, federal criminal statutes. Forensicaccounting techniques are force-multiplier tools.Specifically, low-level terrorist threats can bethwarted with civil tools. This allows scarce lawenforcement resources to concentrate on thehigher-level, higher-payback terrorist targets. Inaddition, the civil evidence gathering process canbe less labor and resource-intensive than criminalprocesses and readily-available public informationcan be accessed and applied in civil processes.Further, the stringent chain of custody of evidencerequirements do not apply in civil matters.

Criminal prosecution can require years toachieve. Civil matters often progress more rapidlybased upon evidentiary considerations and relatedattributes. Further, civil objectives can sometimesbe achieved through summary judgments andinjunctions, thus accelerating the outcomesignificantly.

B. Levels of proof for criminal and civillaws

Another advantage to using civil laws is thatthe standard of proof for civil matters is lessrigorous than the criminal standard, i.e. beyond areasonable doubt. Nevertheless, both criminal andcivil levels of proof comprise a continuum ofprogressively more stringent requirements.

For criminal matters, such continuum isordinarily presented as no significant proof,reasonable basis, probable cause, preponderanceof evidence, prima facie case, proof beyond areasonable doubt, and absolute proof of guilt.HAZEL B. KERPER, INTRODUCTION TO THECRIMINAL JUSTICE SYSTEM 207 (2d. ed. 1972).Their respective measures are presented below.

• No significant proof implies complete doubtor suspicion or a lack of factual support.

• Reasonable basis is belief that there is asignificant possibility that the individual hascommitted or is about to commit a crime.

• Probable cause is belief that there is asubstantial likelihood that the individualcommitted a crime.

• Preponderance of evidence is belief, based onall the evidence presented, that it is morelikely than not that the individual committed acrime.

• Prima facie is belief, based on prosecutionevidence only, that the individual is so clearlyguilty as to eliminate any reasonable doubt.

• Beyond a reasonable doubt in evidence meansfully satisfied, entirely convinced, or satisfiedto a moral certainty. The phrase is theequivalent of the words clear, precise, andindubitable.

• Absolute proof of guilt is belief so certain thata defendant is guilty as to eliminate evenreasonable doubts.

For civil matters, the continuum ispreponderance of the evidence and clear andconvincing evidence.

Preponderance of the evidence is evidencewhich is of greater weight or more convincingthan the evidence which is offered inopposition to it; that is, evidence which as awhole shows that the fact sought to be provedis more probable than not. . . . That amount ofevidence necessary for the plaintiff to win in a


civil case. It is that degree of proof which ismore probable than not.

BLACK 'S LAW DICTIONARY 1182 (6th ed. 1990).

Preponderance is determined by moreconvincing evidence and its probable truth oraccuracy, rather than the amount of evidence.Thus, a clearly knowledgeable witness couldprovide the preponderance of evidence over manyother witnesses delivering weak testimony.Likewise, a signed agreement could carry moreweight than testimony regarding the parties'intentions.

Clear and convincing proof results inreasonable certainty of the truth of the ultimatefact in controversy. It is proof which requiresmore than a preponderance of the evidence butless than proof beyond a reasonable doubt. Clearand convincing proof will be shown where thetruth of the facts asserted is highly probable.HAZEL B. KERPER, INTRODUCTION TO THECRIMINAL JUSTICE SYSTEM 251 (2d. ed. 1972).

Civil standards such as preponderance of theevidence and clear and convincing proof are lessonerous than the criminal standard of beyond areasonable doubt. With less rigorous evidence andproof standards, third parties can be even moreeffectively employed as consultants, contractors,and witnesses in civil matters.

IV. Discussion of alter ego

Alter ego, fraudulent transfer, and solvencyare discussed in this article by profiling therespective technical and legal guidance. Eachtopic is supported by actual exhibits successfullyemployed in civil cases. Although the exhibits andrelated materials are matters of public record, theywere altered so that the parties are unrecognizable.

The alter ego doctrine is addressed mostextensively because.

• The doctrine holds the highest promise ofdirectly linking and interrupting terrorsuspects.

• Alter ego is highly conceptual in nature andhas the greatest overall potential for wideapplication in concert with other elements,both civil and criminal.

• The current technical literature covering alterego is less comprehensive than eitherfraudulent transfer or solvency.

• Several comprehensive fraudulent transferinternet sources already exist, including: www.assetprotectiontheory.com,www.fraudulenttransfers.com, andhttp://www.irs.gov/irm/part5/ch16s18.html.

• Several solvency resources already exist,including: www.insolvency.com,http://www.prenhall.com/divisions/bp/app/cfldemo/RA/LiquidityRatios.html, and http://www.toolkit.cch.com/text/P06_7300.asp.

These materials add to the AUSAs'counterterrorism arsenal.

Alter ego statutes and precedents vary widelyby jurisdiction. However, alter ego claims areordinarily determined by evaluating the indicators,or indicia, of alter ego. That is, where thepreponderance of evidence supports the indicia,then alter ego can be granted by the court.Conversely, absence of sufficient indicia canpersuade the court to leave the corporate structureintact. Note that selected portions of this alter egodiscussion have been adapted, with permission,from Darrell D. Dorrell & Christine A. Kosydar,Alter Ego Diagnosis to Find Potentially HiddenAssets in Divorce Cases, 18 AM. J. FAM. L. 7(2004).

A. Determination of alter ego

In the traditional sense, alter ego isdetermined by evaluating a parent and subsidiarycompany's relationship to determine whether theparent (i.e., through the controlling party) met thefollowing three crucial conditions with respect toa complainant.

• The parent exercised control and authority tothe extent that the subsidiary was a mereinstrumentality of the parent.

• The parent committed a fraud or wrong withrespect to the complainant.

• The complainant suffered an injury as a resultof the fraud or wrong (causation).

Note that all three conditions must be met for thecourt to invoke alter ego.

A parent company is defined as a "companyowning more than 50% of the voting shares, orotherwise a controlling interest, of anothercompany, called the subsidiary." BLACK 'S LAWDICTIONARY 1114 (6th ed. 1990). Subsidiary isdefined as "[u]nder another's control. Term isoften short for 'subsidiary corporation; i.e. one


that is run and owned by another company whichis called the parent.'" Id. at 1428. A holdingcompany is defined as "[a] company that usuallyconfines its activities to owning stock in, andsupervising management of, other companies." Id.at 731.

The classic alter ego matter is based on thetraditional parent-child corporate structure wherea parent or holding company owns a controllinginterest in a subsidiary entity. However, otherrelationships may exhibit alter ego characteristics,including sister corporations and brother-sistercorporate structures. Finally, multipleparent-subsidiary-brother-sister corporatestructures, and tiered parent-subsidiary-brother-sister corporate structures may exhibit alter egocharacteristics. Sister corporation is defined as"[t]wo corporations having common orsubstantially common ownership by sameshareholders. [Battelstein Inv. Co. v. UnitedStates, 302 F. Supp. 320, 322 (S.D. Tex. 1969)]."Id. at 1387. Brother-sister corporation is definedas "[m]ore than one corporation owned by thesame shareholders." Id. at 194.

B. Improper purpose

Use of the corporate entity for an improperpurpose is at the heart of corporate veil cases. Thetypes of situations in which such improperactivities arise are classified under five headings,but the most pertinent activity is the violation ofpublic policy, including evasion of statutes.

The origin of the corporate veil doctrine aroseas a result of violations or evasions of somestatute or other strong public policy through theinstrumentality of a subservient corporation. SeeH. BALLANTINE, CORPORATIONS § 122 (rev. ed.1946); HARRY G. HENN, LAW OF CORPORATIONS§ 252 (2d ed. 1970); FREDERICK J. POWELL,PARENT AND SUBSIDIARY CORPORATIONS § 1(1931). United States v. Reading Co., 253 U.S. 26(1920), is an early example of the misuse of thecorporate form and demonstrates that the doctrinehas long been wielded as a weapon by federalauthorities.

The general rule cited by these authorities isusually cast in the words of Judge Sanborn inUnited States v. Milwaukee Refrigerator Transit,142 F. 247, 255 (E.D. Wis. 1905).

If any general rule can be laid down in thepresent state of authority, it is that acorporation will be looked upon as a legal

entity as a general rule, and until sufficientreason to the contrary appears; but, when thenotion of legal entity is used to defeat publicconvenience, justify wrong, protect fraud, ordefend crime, the law will regard thecorporation as an association of persons.

C. Beneficial interest

Stock ownership, however, is not an absoluterequirement for piercing the veil. A more preciserequirement is that the dominant party must havesome beneficial interest in the subservientcorporation. In Soderberg Advertising v.Kent-Moore Corp., 524 P.2d 1355 (Wash. Ct.App. 1974), the defendant had an option toacquire the subservient corporation, but no actualstock ownership. Pursuant to contractualagreements, however, the optionee had effectivecontrol over the subservient corporation and abeneficial interest because of his right to purchasethe company. In connection with other factors, itwas found that the dominant party was, in fact,liable for certain actions taken through theinstrumentality of the subservient corporation.

The doctrine can apply if the interest held iseither control or minority interest in a subsidiaryentity. Alter ego characteristics are alsoencountered between nonrelated entities lackingany indication of formal corporate relationships.For example, a shareholder held separatecontrolling interests in corporation A andunrelated corporation B. Corporation A held a fewsubsidiaries, and unrelated corporation B heldseveral multiple-tiered subsidiaries, some ofwhich were inactive.

On paper, the two parent corporations appearseparate and distinct and the only obviousrelationship is the common controllingshareholder. Nonetheless, the group of companiesexhibited many alter ego characteristics.Significant asset conveyances were conductedbetween and among the corporation's subsidiarieswithout fair market value consideration, andproduct marketing and labeling contained aconfusing and inconsistent use of corporatenames. The product names were portrayed tocustomers without identification of corporateownership. Further, legal and financialjustification was obtained after the fact for certainevent-specific transactions. Finally, receipts anddisbursements were transacted through thesubsidiary providing the most benefit to theparent.


Exhibit 1 was constructed in a civil matterwhere the plaintiff sought to pierce several of thedefendant's corporate veils in order to recoverpayment pursuant to a triggered contingent leaseliability. The Target Subject Group was a large,closely-held multistate group of companies with along history of acquiring smaller companies toenlarge its business. Target gained control ofAcquired Subject & Sons, Inc. in its usualmanner, noting that there was a contingent leaseliability attached to the entity. The acquisitionagreement attempted to indemnify the target fromthe contingent liability, but it did not providesufficient protection.

The Target Subject Group acquired thesmaller company for $21 million (cash, stock, anddebt) in the year 2000 and duly recorded thetransaction in various records, (corporate purchaseagreement, general ledger, audited financialstatements, and income tax returns). In late 2001,however, the acquired company's $24 millioncontingent lease liability was triggered(post-acquisition). Consequently, the TargetSubject Group attempted to rerecord thetransaction at a near-zero value, advising thecreditor that they could have the stock now worth$700,000, instead of the original acquisition price.

The rerecording of the initial acquisitiontransaction was quite complex and involvedcompetent attorneys and accountants whoprovided technical advice. The advisorsrecommended a framework that required thetransfer of operating assets (without contingentliabilities) and the revaluation of a new class ofstock. See Exhibit 1 (Target Subject Group).

The plaintiff was faced with two significantchallenges. First, if he began his challenge at thelowest level in the organization chart, AcquiredSubject & Sons, Inc. (at the lower right-handcorner of Exhibit 1), he might be compelled topierce the veils of several companies atsuccessively higher levels. The second, andgreater challenge, was almost insurmountable.The ownership was common among oneshareholder, but separate and distinct between thetwo groups of companies as indicated by thedotted-line borders on the left-hand and right-hand side of Exhibit 1. Therefore, the plaintiffsought to pierce the veil directly, via a one-shot-one-kill technique whereby the Acquired Subject& Sons, Inc. entity could be directly linked to thecontrolling shareholder. This is illustrated by thebold, double-arrowed line connecting "Owner"

(shaded, in the upper left-hand corner of Exhibit1) to Acquired Subject & Sons, Inc. (shaded, inthe lower right-hand corner of Exhibit 1).

Exhibit 1 is the corporate organization chartillustrating the entire group of entities comprisingthe defendant's companies. The chart indicatesthat twenty-one companies were contained withinthe overall target group, but some entities werenot delineated for the sake of clarity (lower left-hand corner under the heading, "EntitiesUnaccounted For"). The composition of Exhibit 1is best reviewed from the left-right, top-downperspective as described below.

Beginning in the upper left-hand corner, thefirst item of information, containing the columnheadings of "Shares" and "%," identifies for eachshareholder their respective ownership amountsand percentages for the left-hand dotted line groupof companies. Specifically, the "Owner" (namewithheld) holds 1,178,628 shares representing65.5% of the group of companies contained withinthe left-hand dotted line group of companies.Also, the same party holds 58,668 unitsrepresenting 3.3% of the outstanding units of thegroup of companies contained within the right-hand dotted line group of companies.

The left-hand dotted-line group of companiesis comprised of the "Target Subject Company"(bold font) and its wholly-owned affiliates, "ShellAcquisitions, Inc." and "Transport Shell, Inc."Note that there are no ownership connections ofany sort to the right-hand dotted-line group ofcompanies.

The right-hand dotted-line group ofcompanies is comprised of the "Target Subject ofWashington, LLC" (bold font) and it's wholly-owned, partially-owned, and affiliate-ownedaffiliates. Note that "Target Subject ofWashington, LLC" owns 100% of the "TargetSubject of CITY #2, LLC." That entity in turnowns 100% of "Target Subject of CITY #3, LLC"and also owns 100% of "Target Subject of City#4, LLC." The names of the respective cities arewithheld for confidentiality since the matter dealswith territorial franchises.

Note also within the right-hand dotted-linegroup of companies that "Target Subject ofWashington, LLC" (bold font) owns 78.99% of"Target Subject of CITY #1, LLC," (bold font).Target Subject of CITY #1, LLC is in turnpartially owned (19.748%) by "Acquired Subject#1, LLC" and 1.262% of "Acquired Subject &


Sons, Inc." respectively. Note that there are noownership connections of any sort to the left-handdotted line group of companies.

The litigation was triggered by post-acquisition transactions involving "AcquiredSubject & Sons, Inc." The "Legend" at themiddle-left portion of Exhibit 1 shows a dottedline box for "Acquired Subject & Sons, Inc."indicating that it was an "Inactive Company."

The challenge of persuading the court toinvoke alter ego lay in the utter disconnectednessof the two groups of companies. That is, thegroups of companies reflected by the left-handand right-hand dotted line rectangles had no legalconnection. By design of the plaintiff, and uponadvice of counsel, they were structured to appearseparate and distinct.

The bold, double-arrowed line connecting theupper left-hand shaded "Owner" cell with thelower right-hand shaded "Acquired Subject &Sons, Inc." cell demonstrates how alter ego wasused to connect the seemingly disparate groups ofcompanies. It was determined that if alter egoattributes could be shown, then the attemptedseparation of all the entities would be disregardedby the court, and the plaintiff would receive hisdesired award. The tactic was effective since thedefendant realized that connecting his actions tothe right-hand group of companies through alterego would expose his entire corporate empire toliability.

V. Alter ego literature

A. Frederick J. Powell

FREDERICK J. POWELL, PARENT ANDSUBSIDIARY CORPORATIONS (1931), is a landmarktext that established guidelines for assessing theinstrumentality rule and the eleven circumstancesthat may be indicative of alter ego. Mr. Powell's1931 work must be read in its entirety to reap thefull appreciation of his guidance. In particular, heis credited with establishing the InstrumentalityRule. Salient elements crystallize his viewpoint asindicated below.

Section 5. The Instrumentality Rule.

The Instrumentality Rule, in its shortest form,may now be stated:

So far as the question of control alone isconcerned, the parent corporation will be

responsible for the obligations of itssubsidiary when its control has been exercisedto such a degree that the subsidiary hasbecome its mere instrumentality.

Id. at 8-9.

The Instrumentality Rule is recognized in alljurisdictions in this country and our problemtherefore is to determine the circumstances whichrender the subsidiary an "instrumentality" withinthe meaning of the decisions. This is primarily aquestion of fact and of degree.

Section 6. The circumstances rendering thesubsidiary an instrumentality.

It is manifestly impossible to catalogue theinfinite variations of fact that can arise butthere are certain common circumstanceswhich are important and which, if present inthe proper combination, are controlling. Theseare as follows:

1. The parent corporation owns all or most ofthe capital stock of the subsidiary.

2. The parent and subsidiary corporationshave common directors or officers.

3. The parent corporation finances thesubsidiary.

4. The parent corporation subscribes to all thecapital stock of the subsidiary or otherwisecauses its incorporation.

5. The subsidiary has grossly inadequatecapital.

6. The parent corporation pays the salariesand other expenses or losses of the subsidiary.

7. The subsidiary has substantially nobusiness except with the parent corporation orno assets except those conveyed to it by theparent corporation.

8. In the papers of the parent corporation or inthe statements of its officers, the subsidiary isdescribed as a department or division of theparent corporation, or its business or financialresponsibility is referred to as the parentcorporation's own.

9.The parent corporation uses the property ofthe subsidiary as its own.

10. The directors or executives of thesubsidiary do not act independently in theinterest of the subsidiary but take their orders


from the parent corporation in the latter'sinterest.

11. The formal legal requirements of thesubsidiary are not observed.

Id.

Powell explained his rationale for each of thepreceding circumstances as indicated below.

(a) The parent corporation owns all or most ofthe capital stock of the subsidiary.

It is familiar law in all jurisdictions in thiscountry that ownership of stock alone will notrender the parent corporation liable. This isbut a statement of the fundamental rule thatstockholders are not liable for the corporateobligations. The result is the same whether theparent company owns all the stock, or allexcept directors' qualifying shares or a smallamount in outside hands. The immunity, ofcourse, extends to the normal exercise of astockholder's rights, such as the election ofdirectors, changes in the capital stockstructure and the approval of the usualactivities of the Board of Directors on behalfof the Corporation. This element of stockownership is present in practically all theparent and subsidiary cases, and in theabsence of unique circumstances (as wheredominance is achieved through writtencontract or express agency), control by stockownership is essential to the application of theInstrumentality Rule.

(b) The parent and subsidiary corporationshave common directors or officers.

It is also clear that the parent corporationdoes not lose its immunity as a stockholdersimply by furnishing from its own personnelthe directors and principal officers of thesubsidiary. In the case of principalsubsidiaries this is the usual practice. Theofficers of the two corporations are often thesame in large part and at least a majority ofthe subsidiary's directors are usually directorsof the parent corporation. This commonpersonnel, however, is an important factor inthe application of the Instrumentality Ruleand in nearly all the cases in which the parentcorporation has been held liable, we find thiselement or else dummy or subservientdirectors or executives of the subsidiary.

(c) The parent corporation finances thesubsidiary.

The parent corporation is the natural source ofthe subsidiary's credit, and generally it is themost efficient source, for normally it hassuperior resources and can capitalize theincrement in value due to the combination andco-ordination of several subsidiaries under acommon supervisory management.Accordingly, the fact alone that the parentcorporation finances the subsidiary will notsubject the parent corporation to liability,although stock ownership and commonpersonnel are also present. But this element offinancing is important.

Thus far we find the law squaring withconventional business practice but weapproach the danger line when we introduceadditional elements showing a further exerciseof control by the parent corporation. One ormore of these additional elements is present innearly all the cases in which judgment hasbeen rendered against the parent corporation.As already indicated, a hard and fast rulecannot be laid down but, as a rough guide, itmay be stated, generally, that proof of thefollowing additional elements (sometimes oneand often two) will be sufficient to hold theparent corporation. Some, of course, are moreimportant than others.

(d) The parent corporation subscribes to allthe capital stock of the subsidiary or otherwisecauses its incorporation.

If the ownership of all the capital stock of asubsidiary and the normal exercise of therights incident to that ownership do notdestroy the immunity of the parentcorporation, the acquisition of an existingcorporation by purchase of its capital stock isof course equally harmless. And there is noreason why the parent corporation should notaccomplish the same purpose–and with thesame results–by itself causing theincorporation of the subsidiary in the firstinstance. Except in the case of railroads andpublic utilities, this is probably thecommonest method by which a system ofparent and subsidiary corporations is built up.

If, therefore, the degree of control exercisedby the parent corporation is not sufficient toconstitute the subsidiary a mereinstrumentality, the further fact that the parentcorporation caused the subsidiary to beorganized will not force the case over the line.But in weighing all the circumstances in a


given case, it is an evidential fact of value,particularly when it can be shown that thecorporation was organized for a specialpurpose such as the creation of a new orenlarged department.

Sometimes (particularly in the so-calledone-man corporation cases), the courts pointout that the purpose of organizing ormaintaining the subsidiary was to secure theprofits if it succeeded and to avoid the lossesif it failed. This though must be applied withcaution for of course this is a principal objectof most incorporations and, by itself, is alawful purpose. When a claim is based on theorganization of the subsidiary as a step in analleged scheme to defraud creditors [see§ 13(a)], a finding of this special purpose isoften vital.

(e) The subsidiary has grossly inadequatecapital.

Manifestly, the fact that the subsidiary'scapital is wholly disproportionate to theamount of the business that it actuallyconducts, is strong proof that it is a meredummy or arm of the parent corporation. Inthe well known Luckenbach Steamship case,two corporations were controlled by acommon stockholder. One of them turnedover steamers worth hundreds of thousands ofdollars to the other which had a capital of onlyten thousand dollars and which operated themunder leases at a rental based on far belowtheir real value. "Putting aside an inquiry intothe motive for this arrangement" the Courtfound it would be "unconscionable to allowthe owner" to escape liability by turning themover" to a $10,000 corporation, which issimply itself in another form."

This does not impugn the principle that theparent corporation may finance the subsidiarywithout subjecting itself to liability. That theparent corporation should be the principal orsole source of the subsidiary's credit fromtime to time, is one thing. But that it shouldlaunch the subsidiary in business withoutfurnishing the appropriate funds or obligatingitself to do so, is quite another. If thesubsidiary is financially helpless and, throughthe fault of the parent corporation can call onthe parent corporation for capital funds onlywhen and if the parent corporation pleases togrant them, it is cogent evidence that the

subsidiary is a mere tool in the hands of theparent.

It does not follow that a parent corporationmay not organize a subsidiary, permit it tobuild up a business and then may not refuse inwhole or in part to act as the subsidiary'sbanker. If there are no other circumstances onwhich to ground an application of theInstrumentality Rule, the mere fact that theparent has not furnished the subsidiary withadequate capital will not bring the Rule intoplay. In other words, this element ofinadequate capital is merely persuasive butnot controlling. The question of estoppel inthese cases is discussed in § 13(e).

(f) The parent corporation pays the salariesand other expenses or losses of the subsidiary.

This reference is not to the case in which theparent corporation ultimately finances theexpenses or losses of the subsidiary. Thegeneral right to finance is, as we have seen,clear. But where the subsidiary has no fundsor means to meet its payroll or other currentexpenses, or its trade losses as they occur, andthe parent corporation from its own treasurydirectly and regularly pays these bills as if theemployees and business were its own, astrong case against the parent corporation ismade out.

(g) The subsidiary has substantially nobusiness except with the parent corporation,or no assets except those conveyed to it by theparent corporation.

These facts tend to show a position ofsubordination on the part of the subsidiaryand lend color to the claim that it is notconducted as a separate corporation but just asif it were a mere department of the parentcorporation. Here again a distinction must bemade. A corporation which manufacturesautomobiles may have a wholly ownedsubsidiary that does nothing but supply it withbatteries. If all the separate legal requirementsof the subsidiary as a distinct corporation areobserved, the parent corporation does notbecome subject to the obligations of thesubsidiary, even though the latter, as apractical matter, is a department or division ofthe parent corporation. This "department" or"division" formula, enunciated in some of thecases as the test of the parent corporation'sliability, should therefore not be regarded as


an absolute equivalent of the InstrumentalityRule but rather as a concrete description orpartial summary of certain circumstancesproperly entering into the application of theRule.

(h) In the papers of the parent corporation orin the statements of its officers, the subsidiaryis described as a department or division of theparent corporation, or its business or financialresponsibility is referred to as the parentcorporation's own.

Proof to this effect has a double function. Itmay create a so-called estoppel, and under the"department" or division" formula it is alsoprobative of the fact of subordination. Theformer question is discussed later in § 13 (e);the latter, in the preceding subdivision.

(i) The parent corporation uses the property ofthe subsidiary as its own.

This reference is to cases in which the parentcorporation helps itself to the cash and otherproperty of the subsidiary as if it owned themdirectly. Direct appropriation by the parentcorporation of the subsidiary's profits withoutany declaration of dividends by the latter'sdirectorate, is an illustration. This is almostalways fatal proof against the parentcorporation.

(j) The directors or executives of thesubsidiary do not act independently in theinterest of the subsidiary, but take their ordersfrom the parent corporation in the latter'sinterest.

The Instrumentality Rule cannot becircumvented by equipping the subsidiarywith directors or officers who are ostensibly,but not actually, independent of the parentcorporation. If, in fact, they took their ordersfrom the parent corporation or someone whocontrolled it, and acted in the interest of theparent corporation rather than the subsidiary,the record names and formal set-up will notavail. The result is the same where the samepersons are directors of both corporations, butact in the interest of the parent corporation.

Direct proof of this affirmative subserviencyof the subsidiary's officers is conclusive of thecase against the parent corporation, insofar asthe Instrumentality Rule is concerned. Butsuch direct proof is not forthcoming. Usuallythis subserviency is an ultimate fact to be

deduced from all the facts of the case and theother elements previously discussed indicatethe circumstances which often are availablefor this purpose.

(k) The formal legal requirements of thesubsidiary are not observed.

The observance of the technical formalitieslegally incident to the operation of thesubsidiary as a separate corporation is veryhelpful in avoiding the Instrumentality Rule.Thus, proof that meetings of the subsidiary'sstockholders and directors were held, thatminutes were properly kept, that thesubsidiary made its separate statutory reports,maintained its own books of account, had itsown bank account and paid its own bills, isstrong evidence against the parentcorporation's liability. But the observance ofthese formalities is all of no avail when theproof as a whole shows that in the actualconduct of the business the parent corporationcompletely dominated the subsidiary and usedit as a mere creature. Payment of rent by thesubsidiary to the parent corporation, the use ofseparate letter or bill-heads, the existence offormal contracts between them, etc., are allfutile when they are essentially nothing butsham or paper transactions.

Id. at 10-19.

Finally, nearly all references to Powelloverlook the following clarification found later inhis book when he pulls together his commentaryin application to an alter ego case:

Section 26. Complainant's case.

Except in cases of express agency of thesubsidiary, or the actual commission of a tortby the parent corporation, either alone orjointly with the subsidiary, there are threeessential elements in the complainant's causeof action against the parent corporation. Hemust prove first, that the parent corporationhas exercised its control over the subsidiary,not in the manner normal and usual withstockholders, but to such a degree that it hasreduced the subsidiary to a mereinstrumentality; second, that this control hasbeen exercised in such a way as to constitutefraud, wrong or injustice with respect to thecomplainant; and third, that (except in casesof so-called estoppel) a refusal to disregardthe separate corporate entity of the subsidiary


would result in unjust loss or injury to thecomplainant.

Taking up these three elements in order:

First Element: Defendant's control.

The following constitute the exercise ofnormal and usual control over the subsidiary:

(a) Causing the subsidiary to be organized;

(b) Acquiring and holding all its capital stock;

(c) Exercising the usual voting rights ofstockholders, including the election ofdirectors, ratification of the acts of directorsand officers, changes in capital stockstructure, etc.;

(d) Furnishing the subsidiary with the samedirectors and officers that the parentcorporation has;

(e) Financing the subsidiary.

The following constitute the exercise ofabnormal control and reduce the subsidiary toa mere instrumentality:

(a) Disregarding the formal legal requirementsof the subsidiary as a separate corporation.Illustrations are: failing to hold meetings of itsboard of directors and stockholders or to keepseparate bank accounts, books and otherbusiness papers, or to distribute dividends byway of declaration, etc. But observance ofthese formal requirements will not avail if thesubsidiary is run as a mere puppet or creatureof the parent corporation.

(b) Operating the subsidiary in the interests ofthe parent corporation and not in the interestsof the subsidiary; in other words, using thesubsidiary as a mere branch or divisionwithout regard to its separate interests andrights. The usual evidence of this is the factthat the subsidiary is managed on the directorders of the parent corporation's officers intheir capacity of the representatives of theparent corporation, or that the parentcorporation directly handles the property ofthe subsidiary as if it were its own.

Persuasive evidence that the subsidiary is amere instrumentality are the facts that it hasno business except with the parent corporationor no assets except those conveyed to it by theparent corporation; that its capital is grosslydisproportionate to the volume of its business;that the parent corporation pays its salaries or

other expenses, or its losses; and that in thepapers or statements of the parent company orits officers, the subsidiary is referred to as amere department or division of the parentcorporation, or its business of financialresponsibility as the parent's own.

Id. at 103-04.

Section 28. Working chart of proper parentand subsidiary corporation management.

To keep the parent corporation immune fromliability for the obligations of its subsidiary,two pitfalls must be avoided: first, a violationof the formal corporate requirements of thesubsidiary, and second, a disregard of itsseparate business interests.

The subsidiary, if a new corporation, must, ofcourse, be incorporated and organized inaccordance with statute. The representativesof the parent corporation may be itsincorporators and subscribe to all its capitalstock. After organization, periodic meetingsof stockholders and directors should be heldas required by statute and the by-laws.Minutes of these meetings should bepermanently recorded in proper form.

A separate bank account, separate books ofaccount and separate letter and bill headsshould be kept, and all other paper workindividual to the subsidiary's business, shouldbe maintained separately.

The subsidiary should be furnished with areasonable amount of capital. This may bedone by the parent corporation and it is notessential that all the capital be supplied at thesame time. Nor is it necessary that the parentcorporation legally obligate itself to furnishany specific amount. But, on the other hand,the subsidiary should from time to time befurnished with an amount proportionate to itsgrowing business and it should have areasonable amount with which to beginbusiness.

The subsidiary's receivables should, in theabsence of good business reasons to thecontrary, be collected and banked by it, notthe parent corporation. Its expenses should bepaid out of its own bank account unless theyinvolve an apportionment of overheadexpenses paid by the parent corporation in thefirst instance, but in that case the method ofapportionment should be accurately and


clearly agreed upon as a matter of recordbetween the two corporations, and theirrespective books of account should preciselyshow the corresponding debits and credits. Ifcare is constantly exercised, expenseschargeable only to the subsidiary and notinvolving any apportionment between it andthe parent corporation or other subsidiariescan be paid in the first instance by the parentcorporation and then charged to thesubsidiary. In this practice, however, it is easyfor things to drift into the position in whichthe parent corporation in the first instance isspending large sums for the account of thesubsidiary and later seeing that the propercorporate action is taken by the subsidiary toreimburse or credit it. This is dangerousmeddling with the immunity of the parentcorporation as stockholder of the subsidiary,and carelessness or neglect may often result injust such a condition creeping into a largeorganization, although everyone concerned isacting in entire good faith. Whencircumstances will permit, it is preferable tohave the parent corporation advance thenecessary moneys to the subsidiary (on openaccount or otherwise) and then have thesubsidiary expend them from its own treasury,and in accordance with antecedent corporateauthority on its part. Such advances should bebased on proper corporate authorization, andaccompanied by proper corporate records, onbehalf of both corporations. The authorizationmay be general or confined to specificinstances from time to time.

The profits of the subsidiary should bedistributed to the parent corporation by way ofdividends with the usual declaration on boardresolution, and not informally appropriated bythe parent corporation. And in all ways theparent corporation should never directlyutilize assets of the subsidiary as if they wereits own. The direct physical operation of thesubsidiary must be through the subsidiary'sown officers and through its own channels asa separate corporation, and not as a meredepartment of the parent corporation operateddirectly by the corporate organization of theparent corporation.

The second requirement that the business ofthe subsidiary must be run in its interest andnot that of the parent corporation is notusually difficult to observe. It is safer to equipthe subsidiary with the same personnel as that

of the parent corporation than to use clerks orsubordinates. Theoretically the latter's actionsmight be entirely for the benefit of thesubsidiary and as judicious as those of anindependent directorate - but a board of minoremployees can hardly be independent, andthis set-up breeds suspicion and is a badge ofundue subserviency that will prove verydamaging to the parent corporation in any suitagainst it by the subsidiary's creditors.

The subsidiary's directors, whoever they are,must, of course, run the business in its owninterest. They must not be improvident withits resources even though their action may, forextraneous reasons, benefit the parentcorporation. But the relationship between thetwo corporations, their normal identity inbusiness interest and the fact that the parentcorporation is in a position to benefit thesubsidiary in so many ways, gives thesubsidiary's directors ample discretion toadjust its affairs to those of the parentcorporation for all legitimate purposes andwithin all reasonable limits. In the ordinaryrun of business the interests of the parent andsubsidiary are the same and no questionshould arise. If the time comes when thelarger interests of the parent corporationconflict with the smaller interests of thesubsidiary, the parent corporation shoulddissolve or merge the subsidiary and absorbits business or else dispose of the subsidiaryand thus place it at arm's length.

The parent's executives should be mostcareful with respect to their written or oralrepresentations regarding the relationshipbetween the parent and the subsidiary. To saythat the subsidiary is a subsidiary of the parentcorporation or that the parent corporationowns all its capital stock or has financed it inthe past, is unobjectionable. But to say thatthe parent corporation will finance thesubsidiary in the future and that it will standback of the subsidiary's obligations or that thesituation is the same as if the customer orcreditor were dealing with the parentcorporation, is almost always fatal. And thecommon business practice of describing thesubsidiary as a "division" or "department" ofthe parent corporation on letterheads, isdangerous, and in some jurisdictions would besufficient to turn the scales against the parentcorporation. Consolidated financialstatements, if properly entitled, are in order.


The preceding requirements square with alllegitimate business requirements. They are butan observance of good corporate practice andby insisting on those requirements, the lawimposes no undue burden on business, butmerely demands that there shall be no abuseof the privilege to do business in corporateform. If these limitations are not in accordwith the exigencies of the case, the business isnot adaptable to management through themedium of parent and subsidiarycorporations.

Id. at 108-11. See also Beckeley v. Third AvenueRailway, 155 N.E. 58 (N.Y. 1926); H. Ballantine,Parent and Subsidiary Corporations, 14 CAL. L.REV. 34, 34 (1925); MAURICE I. WORMSER, THEDISREGARD OF THE CORPORATE FICTION ANDALLIED CORPORATE PROBLEMS, (T. Morey & Son1927); Cathy J. Krendl & James R. Krendl,Piercing the Corporate Veil: Focusing theInquiry, 55 DENVER L.J. 1 (1978); Robert B.Thompson, Piercing the Corporate Veil: AnEmpirical Study, 76 CORNELL L. REV. 1036 (July1991).

B. The Krendls' 1978 study

The Krendls published a superb case summaryentitled Piercing the Corporate Veil: Focusing theInquiry, cited above, which contains a list offactors that should be used when "attempting tokeep the corporate veil intact." The factors aresupported by the pertinent cases in their articleand are summarized below.

• The shareholder is not a party to thecontractual or other obligations of thecorporation.

• The subsidiary is not undercapitalized.

• The subsidiary does not operate at a deficitwhile the parent is showing a profit.

• The creditors of the companies are not misledas to the company with which they aredealing.

• Creditors are not misled as to the financialstrength of the subsidiary.

• The employees of the parent and subsidiaryare separate and the parent does not hire andfire employees of the subsidiary.

• The payroll of the subsidiary is paid by thesubsidiary and the salary levels are set by thesubsidiary.

• The labor relations of the two companies arehandled separately and independently.

• The parent and subsidiary maintain separateoffices and telephone numbers.

• Separate directors' meetings are conducted.

• The subsidiary maintains financial books andrecords which contain entries related to itsown operations.

• The subsidiary has its own bank account.

• The earnings of the subsidiary are notreflected on the financial reports of the parentin determining the parent's income.

• The companies do not file joint income taxreturns.

• The subsidiary negotiates its own loans orother financing.

• The subsidiary does not borrow money fromthe parent.

• Loans and other financial transactionsbetween the parent and subsidiary areproperly documented and conducted on anarm's-length basis.

• The parent does not guarantee the loans of thesubsidiary or secure any loan with assets ofthe parent.

• The subsidiary's income represents a smallpercentage of the total income of the parent.

• The insurance of the two companies ismaintained separately and each pays its ownpremiums.

• The purchasing activities of the twocorporations are handled separately.

• The two companies avoid advertising as ajoint activity or other public relations whichindicate that they are the same organization.

• The parent and subsidiary avoid referring toeach other as one family, organization, or asdivisions of one another.

• The equipment and other goods of the parentand subsidiary are separate.

• The two companies do not exchange assets orliabilities.

• There are no contracts between the parent andsubsidiary with respect to purchasing goodsand services from each other.


• The subsidiary and parent do not dealexclusively with each other.

• The parent does not review the subsidiary'scontracts, bids, or other financial activities ingreater detail than would be normal for ashareholder who is merely interested in theprofitability of the business.

• The parent does not supervise the manner inwhich the subsidiary's jobs are carried out.

• The parent does not have a substantial vetopower over important business decisions ofthe subsidiary and does not itself make suchcrucial decisions.

• The parent and subsidiary are engaged indifferent lines of business.

Cathy J. Krendl & James R. Krendl, Piercing theCorporate Veil: Focusing the Inquiry, 55 DENVERL.J. 1 (1978).

C. Thompson's 1991 study

Robert B. Thompson's study, Piercing theCorporate Veil: An Empirical Study, shows howalter ego was used by various courts to pierce thecorporate veil. His study comprised 1,583 cases ofalter ego, and found that certain factors tended tobe associated with the courts' decisions to invokealter ego and thus pierce the veil. The factorsinclude.

• The subsidiary is an "instrumentality" of theparent.

• The subsidiary is the alter ego of the parent.

• The subsidiary is the "dummy" of the parent.

• The case involved misrepresentation ofcorporate separateness.

Robert B. Thompson, Piercing the CorporateVeil: An Empirical Study, 76 CORNELL L. REV.1036 (July 1991).

Interestingly, Thompson found that when alterego was not granted by the court, the plaintiff hadmost often failed to prove misrepresentation.ROMAN L. WEIL ET AL., LITIGATION SERVICESHANDBOOK: THE ROLE OF THE FINANCIAL EXPERT§ 38.3 (3d ed. 2001).

VI. Alter ego jurisdictional examples

A. Federal alter ego

In general a corporation is viewed as a legalentity separate and distinct from its shareholders,directors, officers, and affiliated corporations.Accordingly, as indicated in a recent U.S.Supreme Court ruling, a parent corporation willordinarily not be held liable for the acts of itssubsidiaries. See United States v. Bestfoods, 524U.S. 51, 60 (1998).

Despite the disparity among jurisdictions, thestandard for piercing the corporate veil isgenerally stated as having two aspects.

• The parent dominates a subsidiary's finances,operations, policies, and practices such thatthe subsidiary has no separate existence, but ismerely a conduit of the parent. See Craig v.Lake Asbestos of Quebec, 843 F.2d 145, 149(3d Cir. 1988).

• The parent has abused the privilege ofincorporation by using the subsidiary toperpetrate a fraud or injustice, or otherwisecircumvent the law. See, e.g. Bestfoods, 524U.S. at 62; Craig, 843 F.2d at 149 (statingNew Jersey law); In re HillsboroughHoldings, 176 B.R. 223, 231 (M.D. Fla.1994).

Richard M. Cieri, Lyle G. Ganske & HeatherLennox, Breaking up is Hard to Do: Avoiding theSolvency-Related Pitfalls in Spinoff Transactions,THE BUSINESS LAWYER 533-05 (Feb. 1999).

Certain federal alter ego matters use similarcriteria. The United States Court of FederalClaims has adopted a three-part test in cases ofcorporate disregard wherein three questions mustbe considered.

• Whether one corporation completelydominates the other so that it is merely analter ego.

• Whether such domination is used to commitfraud or injustice.

• Whether such domination proximately causesthe unjust loss.

Twin City Shipyard v. United States, 21 Cl. Ct.582 (Ct. Cl. 1990); BLH v. United States, 13 Cl.Ct. 265 (Ct. Cl. 1987).


B. State alter ego

State courts have built upon the twocharacteristics of control and improper conduct(and injury) by constructing alter ego criteriaranging from two to eleven parts as indicatedbelow.

Under California law and other statejurisdictions a two-part test may result in thedisregard of a corporate entity.

• Where there is such unity of interest andownership that separate personalities of thetwo entities no longer exist.

• Where an equitable result would follow if thecorporations were treated as separate entities.Slottow v. American Casualty, 10 F.3d 1355,1360 (9th Cir. 1993).

Plaintiffs in California are not required todemonstrate causation between improper conductand harm to the plaintiff. An inequitable result issufficient.

Oregon's strict requirements are more specificand perhaps more challenging to satisfy than thetwo-prong test used in California and otherjurisdictions. Specifically, the Oregon SupremeCourt has ruled that: "[t]he disregard of a legallyestablished corporate entity is an extraordinaryremedy which exists as a last resort, where there isno other adequate and available remedy to repairthe plaintiff's injury." AmFac Foods. v. Int'l.Systems & Control Corp., 654 P.2d 1092, 1098(Or. 1982).

In Oregon's seminal alter ego case, AmFac,the court listed as three indicia of improperconduct.

• Inadequate capitalization.

• Milking.

• Misrepresentation, commingling, and holdingout.

• Violation of statute.

Id. at 1102. However, the court explained thatthese indice were only examples and that otherindicia might apply in other cases. The court didnot list specific indicia or elements of alter ego.Oregon courts require the plaintiff to prove thefollowing three elements by a preponderance ofthe evidence in order for the court to invoke alterego.

(1)[T]he shareholder must have actually controlled or shared in the actual control ofthe corporation; (2) the shareholder must haveengaged in improper conduct in the exerciseof control over the corporation; and (3) theshareholder's improper conduct must havecaused plaintiff's inability to obtain adequateremedy from the corporation.

Salem Tent & Awning Co. v. Schmidt, 719 P.2d899, 903 (Or. Ct. App. 1986).

The state of Washington generally holds thatshareholders will not be personally liable for theacts of their corporations. R.C.W. 23B.016.220;Barnett Brothers v. Lynn, 118 Wash. 308, 203 P.387 (1922). That is, a corporation as an entity isconsidered separate and distinct from itsshareholders. Truckweld Equip. Co. v. Olson, 26 Wn. App. 638, 618 P.2d 1017 (1980).

Consequently, certain general principles arecontained within Washington case law. Forexample, the condition that a corporation's assetsare insufficient to cover its obligations does not,in and of itself, persuade the courts to disregard itsseparate corporate existence. Likewise, parentcorporations owning all of a subsidiary's stock,loaning money to the subsidiary, or having thesame president will not, by themselves,demonstrate the parent's domination over thesubsidiary.

When Washington state courts invoke"piercing the corporate veil" they have applied the"doctrine of corporate disregard" based upon twoelements. First, "the corporate form must beintentionally used to violate or evade a duty."Second, the "disregard must be necessary andrequired to prevent unjustified loss to the injuredparty." Meisel v. M&N Modern Hydraulic PressCo., 97 Wash. 2d 403, 410, 645 P.2d 689, 692(1982) (quoting Morgan v. Burks, 93 Wash. 2d580, 587 (1980)).

The first factor requires a showing of abuse ofthe corporate form, typically involving fraud,misrepresentation, or other action(s) by thecorporation that harms the creditor and benefitsthe shareholder. The second factor requires thatharm must actually occur (i.e. causation) so thatcorporate disregard becomes necessary.

Although Washington courts have notproffered a comprehensive list of actionsconstituting intentional abuse of the corporateform, they have identified several types of actions


that may meet the requirement, such as strippingcorporate assets and undercapitalization.

Finally, Alaska has adopted an eleven-parttest to show whether a subsidiary is acting as themere instrumentality of its parent. The testsvirtually mirror Powell's eleven circumstances setforth in section VI. A. of this article. See Jacksonv. General Electric Co., 514 P.2d 1170, 1173(Ala. 1973).

In summary it is clear that although broadguidelines of alter ego evaluation are common, thestate-by-state and jurisdictional specifics varysignificantly.

VII. The challenges of alter egoinvestigation

Despite the disparity discussed above, a moredaunting challenge in alter ego matters lies inestablishing the sufficiency of evidence in supportof the indicia either for or against an alter egoconclusion. Despite broad guidelines of indiciawithin respective jurisdictions, there is generallyno clear checklist of items comprising the indicia.Note, for example the following reference.

There is no single approach, nor coherent setof principles that exists to govern thesituations where alter ego should apply, butall the approaches bear similarities. . . . As ageneral rule, the courts have required that theparty seeking to pierce the corporate veilsatisfy a two-prong test: (a) such unity ofinterest and ownership exists that thecorporation and the individual shareholders nolonger have separate personalities; and (b)viewing the acts as those of the corporationalone will result in inequity.

ROMAN L. WEIL ET AL., LITIGATION SERVICESHANDBOOK: THE ROLE OF THE FINANCIAL EXPERT§ 38.1 (3d ed. 2001).

A. Indicia of alter ego

Alter ego is decided based upon the extent ofthe evidence in support or rebuttal of the indicia.Such indicia of alter ego are sometimes comprisedof four categories summarized below. Note thatno priority is inferred by the sequence of theirlisting.

Financial dependence behaviors are behaviorsthat would cause another to infer that the parentcorporation provides the majority of financial

support or maintenance for the subsidiary(ies).The question to address is whether the subsidiaryis financially dependent on its parent?

Confusion about corporate identity reflectsbehaviors that would cause difficulty indetermining the nature and relationship of theparent corporation with the subsidiary(ies). Thequestion to address is whether the subsidiary'sidentity is commingled with its parent?

Lack of separateness reflects behaviors by thesubsidiary(ies) which would cause another to inferthat it is not separate from the parent corporation.The question to address is whether the subsidiaryfunctions parallel with its parent?

Dominance and control reflect behaviors bythe parent corporation that would cause another toinfer that the subsidiary(ies) operate based on thebest interests of the parent corporation. Thequestion to address is whether the parent exercisesinordinate authority over the subsidiary(ies)?

B. Principles of investigation for alter ego

Due to the complexities and lack of specificguidance in alter ego doctrine, it is essential thatthree principles be applied during theinvestigation. First, the party(ies) conducting theinvestigation must be deeply and broadlyexperienced in the financial, marketing,operational, and legal aspects of the subjectentity's industry and business. Second, eachevidentiary item must be measured against twoindependent criteria: itself and its peer group, thusaccommodating a continuum of evaluation.Finally, all of the evidence gleaned must beconsidered within the context of the facts andcircumstances surrounding the alter ego claim.

Deep and broad experience is a must. Thecollection of evidence to be considered in alterego investigations is a relatively straightforwardprocess, but the assessment of such evidence isanother facet entirely. For example, evidence ofcontrol is often cited as the portal through whichimproper conduct can be determined. Control canpermit dominance, but control does notnecessarily signify dominance. A person withnominal professional experience can readilydetermine that a party held control in a parententity, which likewise held control in subsidiaries.Mere control, however, in and of itself, is not anindicator of alter ego. The control must be linkedthrough improper conduct and causation(depending upon the jurisdiction) to opine on alter


ego. For example, the presence of intercompanyaccounts (due-to/due-from) between the parentand subsidiary is sometimes considered asevidence of alter ego. However, a professionalwill recognize the extensive labor required tocontrol and maintain intercompany accounts,which is more likely an indication of distinctseparateness than alter ego.

Alter ego evidence is evaluated usingtechniques similar to those used in financialanalysis. The evidence is compared against itselfand its peer group. Measuring the pattern ofevidence over a company's history will highlightanomalies that are often proximate to triggeringevents.

The same evidentiary item, when comparedwithin two different matters, may lead to differingalter ego conclusions. For example, closely heldbusinesses often pledge assets incross-collateralization to acquire operating debt.Cross-collateralization is a formal lendingagreement among borrowers to pool collateral,thus providing the lender recourse to all theborrowers' collateral. Typically, closely heldbusinesses have little choice in the matter as thebankers insist on limiting their lending risk. Onthe other hand, cross-collateralization has beenexercised in the form of a poison pill similar topublicly held companies attempting to avoidhostile takeovers. In such instances,cross-collateralization may be an indicator of alterego. In other words, alter ego requires drill-downassessment, which is an investigative process thatmoves from top-to-bottom. It starts with summaryinformation and moves downward throughsuccessively more detailed supporting data tofocus on the pertinent component parts. Alter egoalso requires a build-up conclusion, which is aprocess employed during a drill-down assessment,wherein the respective findings resulting fromsuccessively more detailed analysis are aggregatedupwards in a manner demonstrating thepreponderance of evidence in support of aconclusion.

Derivation of a self-evident alter egoconclusion is driven by the preponderance (ordearth) of evidence. Procedurally, it is achievedby assessing the unique elements that collectivelycomprise the respective indicator. Therefore, theevaluation and assessment process drills down tosuccessively deeper layers as necessary,subsequently aggregating upward to a conclusion.See the alter ego "Report Card" from the article by

Darrell D. Dorrell, The Valuation Report Card, 16AM. J. FAM. L. 2 (2002), set forth at Exhibit 2.

Bear in mind the preceding commentsregarding the "continuum" of alter egoinvestigation. With regard to evidence "more isbetter," criticality notwithstanding. However, thisapproach is provided as a benchmark forinvestigation regardless of evidence detail. Notethat the author has successfully employed theentire continuum of evidence, ranging from"smoking gun" to comprehensive "scorecards" ofmeasurement.

Once the indicia are determined, criteria,elements, and sub-elements can then be applied topertinent legal, financial, operational, and relatedevidentiary documents. During the screening ofevidence, any and all items which could impactalter ego indicia are considered regardless of thelikely result. This insures that the universe of datais assembled and evaluated without bias (to theextent possible).

Once any/all material items potentiallyaffecting alter ego indicia have been selected,each evidence item is individually investigated,evaluated, and assessed within the context of thefacts and circumstances previously determined.

Naturally, the evaluation and assessmentcriteria must be comprised of objective andcomprehensive components. Consequently, eachindicator's foundational elements are constructedwith regard to objective methods and techniques.For example, the elements of financialdependence are drawn (at least in part) frommethods used to determine solvency analysis.

Then, based upon the preponderance ofconclusions, aggregating upwards from the sub-elements, to the elements, to the criteria, to theindicia, and in concert with professional opinion,an overall conclusion can be formed for eachindicator.

Each indicator may overlap other indicatorsand even a preponderance of conclusions one wayor the other does not necessarily lead to anirrefutable conclusion. That is why it is necessaryto develop a deep understanding of the nature andhistory of the business, and its financial,operational, marketing, management, and relatedelements.

Since the decomposition of indicia can lead toquite complex and detailed data, it is critical toorganize the process into hierarchical categories.


Further, each category may require additionalanalysis and even cross-referencing to othercategories and data.

Just as no checklist of criteria exists, nochecklist of categories exists. However, Exhibit 2illustrates a logical descending structure. Theexample demonstrates the decomposition offinancial dependence. In practice, of course, thestructure will vary depending upon the facts andcircumstances of each matter.

For purposes of this simplified example, thefinancial dependence indicator is decomposed intotwo basic "criteria" legal criteria and financialcriteria. The legal criteria is decomposed into two"elements" legal formation and legal continuation.Finally, legal formation and legal continuation aredecomposed into six and four "sub-elements,"respectively. The financial criteria is likewisedecomposed into the respective elements and sub-elements. See Exhibit 2.

Each indicator is decomposed into threesuccessively detailed levels, consisting of criteria,elements, and sub-elements. Note that criteria maybe comprised of one or multiple elements.Likewise, each element may be comprised ofmultiple sub-elements. Sub-elements can continueindefinitely with the decomposition process toprovide as much detail as the facts andcircumstances of the matter warrant.

Once all the factors have been "scored," thenthey can, in the aggregate, lead to a conclusion (orrebuttal) of alter ego. For example, if forty-threeof fifty-two elements and sub-elements, or 83%,indicate alter ego conditions, then such conclusionwill be relatively self-evident. Note that thisassumes that each factor has similar weight withregard to the conclusion. (See the explanatorycomments below regarding relative weights.)

C. Self-evident conclusion

In theory, the determination of alter egomerely requires demonstrating how eachindicator's underlying criteria drives a self-evidentconclusion leading to one of four determinations.

• Preponderance of criteria substantiating analter ego conclusion could persuade the courtto grant the claim of alter ego.

• Preponderance of criteria rebutting an alterego conclusion could persuade the court tohonor the corporate structure.

• Absence of criteria substantiating an alter egoconclusion could persuade the court to honorthe corporate structure.

• Absence of criteria rebutting an alter egoconclusion could persuade the court to grantthe claim of alter ego.

D. Complexities inherent in the indicia

The criteria comprising the indicia are notwell defined and often vary by jurisdiction.Further, each matter contains unique facts andcircumstances that frame the context and shapethe analytical approach, which compounds thedifficulty of evaluating the criteria.

Alter ego determination goes one step further.There are inherent complexities andinterdependencies in alter ego determination thatcompound the assessment. The key complexitiesare set forth below, but bear in mind that despitetheir discrete listing, they can, and often are,synergistic and interactive within/among oneanother.

Business relationships between otherwisenonrelated entities may exhibit alter egocharacteristics. Personally owned entities withinfamily relationships may transact business withone another in a manner not complying withcorporate governance requirements. Analysis ofthe entity's business history can yield revealingpatterns of corporate behavior and can clarifydecisions. For example, did an economicdownturn or perhaps an acquisition, or evenlenders, force the parent to cross-collateralize?Triggering events and their attendant corporatetreatment (accounting recognition) can becompared against an entity's business history todetermine if the event resulted in differenttreatment, potentially indicating alter ego.

The factual scenario set forth in Exhibit 1 isillustrative. A large multi-entity had an acquisitionguided by financial and legal advisors whoprovided extensive due diligence with regard tothe purchase price. Upon acquisition, thetransaction was diligently measured and recordedin the parent's various audited financialstatements, income tax returns, and relatedsources. The due diligence identified a contingentliability of the acquisition target in the form of acompany-backed guarantee of a customer's long-term lease. The likelihood of triggering thecontingency was deemed remote since it requiredinsolvency on the part of the customer.


Approximately one year post-acquisition, thecustomer declared insolvency and defaulted on thelong-term lease, thus triggering the acquisition'starget guarantee. The resultant cost to the multi-entity of the guarantee exceeded the purchaseprice of the acquisition target. Seeking advicefrom the same pre-acquisition attorneys andaccountants, the multi-entity company tried torewrite history by soliciting new valuations andlegal opinions that asserted the originalacquisition had been vastly overvalued.Consequently, the multi-entity attempted to bookcomplex accounting entries that obfuscated theactual transaction and appeared to reflect a zerobalance for the acquisition purchase price. Afterforensic accounting analysis exposed the fraud,the case settled in favor of the plaintiff during trialand the disposition was sealed by a protectiveorder.

Two key trial exhibits (exhibits 3 and 4)illustrate the flow. Exhibit 3 gives a summary ofthe accounting transactions necessary to disguisethe overall intent. Although such a schedule maybe useful only to a duly qualified CPA, it presentsa clear trail of the flow and journal entries thatmirror the attorneys', outside CPAs', and advisors'guidance in order to avoid creditors' actions.Exhibit 4 is a pictorial representation of theaccounting flows. Although less technical, itmirrors the trail of activities and also includesthose items not necessarily reflected within theaccounting records.

A detailed history of diligent corporategovernance, board minutes and resolutions, timelycorporate filings, and outside legal advice, amongother things, can demonstrate a history ofmaintaining corporate distinction andseparateness. Extensive business records spanningeither short or long-term time periods canaccommodate a comprehensive and detailedevidentiary analysis balanced againstcost-effectiveness and practicality. Very limitedbusiness records preventing detailed analysis mayrely upon extrapolated assumptions driven byavailable evidence. Note that routine businesspractices regarding discarding records maylegitimately create gaps in the records trail.

The analysis of business records usuallyrequires a balance between page-by-page andhigh-level document analysis to obtain the mostcost-effective conclusion based upon optimallevels of evidence for the time periodsinvestigated.

An entity's past practices can do much todemonstrate intent. A long history of acquiring,maintaining, or disposing of entities couldindicate intent of separateness. Likewise, a longhistory of a single entity interrupted by formationof a new entity proximate to an event couldindicate an attempt at diversion. It bears repeatingthat interdependencies and complexities, despitetheir discrete listing, often are synergistic andinteractive within/among one another.

The evidence evaluation method must beestablished before conducting the investigation toavoid confusion of indicia. Common forensicaccounting techniques summarized below canaccommodate such a need.

• The nomenclature encountered in alter ego,particularly for nonparent entities, is oftenpointed out as indicative of control. The merelabeling, however, of an entity as a subsidiary,affiliate, division, or branch, may or may notbe indicative of alter ego.

• Certain indicators may tend to overwhelmother indicators despite the preponderance ofevidence. Compelling evidence of financialdependence might carry more weight than theother indicators combined.

• Specific records might carry more weight thanmany of the other records within respectivecategories. Reliance upon outside legal oraccounting advice could demonstrate anowner's intent to conduct due diligence withinthe various entities.

• The various factors may carry differingweight(s) regarding alter ego conclusions. Asingle bank account for the parent andsubsidiaries may have little bearing if thevarious entities separately account fortransactions. A truly commingled bankaccount, however, may carry a great deal ofweight.

• Smoking gun evidence may carry moreweight than more ordinary indicators.Smoking gun evidence can result in afavorable settlement during trial, immediatelyprior to expert testimony.

• The weighing of indicators is highlydependent upon the facts and circumstancesof each matter.

A single piece of evidence can be socompelling that it might overshadow all otherevidence in support or refutation of alter ego.


Alternatively, the preponderance of evidence canbe so compelling that it might overshadow evenan extreme example in support or refutation ofalter ego. In reality, most cases fall somewhere inbetween. See Exhibits 3 (spreadsheet) and 4(pictorial of The Acquired Subject & Sons, Inc.transaction).

Exhibit 3 is the sort of schedule that causes anaccountant's heart to race. It demonstrates (to anaccountant) how, through the creative accountingprocess, an entity valued in excess of $9 millioncan be made to disappear on the financialstatements, thus purportedly thwarting creditors.The disappearance is demonstrated by the twoovals at the right-hand side of the schedule. The$9,249,968 in entity assets is ultimately reportedas "zero" on the consolidated financial statements.Consequently, an unsuspecting reader of thefinancial statements would overlook thedisappearing entity assets.

Exhibit 4 is the same set of accountingtransactions contained in exhibit 3, but isconstructed using a step-by-step "pictorial"technique. Exhibit 4's legend in the lower left-hand corner can be used to trace the transactionsthat we sequentially executed in the acquisition ofthe subject entity.

Following the legend, "A" refers to thevarious points at which the Revolving SweepAccount (flexible line of credit) was used duringthe transaction. Step one refers to "CDX assignsrights to XYZ" and can be seen in the oval justbelow the ball and chain symbol on the left-handside of the exhibit. Steps two through eleven canbe followed in a similar manner, thus tracing thetransaction through the various entities.

Exhibit 4 avoids the mind-numbingcomplexity of a convoluted accounting scheduleand illustrates the business and accountingtransactions in a story-line manner. This exhibitwas actually used to demonstrate to the court howdefendant's claimed transaction was quitedifferent from how they actually booked theentries within their financial records.

E. Contradictory implications

Factors used to decompose alter ego indiciamay have contradictory implications. Using thesame law firm to advise both parent andsubsidiary may indicate a lack of separateness, butcould be a prudent business decision. Likewise, asubsidiary's operations residing in the parent's

facilities could indicate lack of separateness, butpaying market-based rent to the parent couldnegate the lack of separateness indication.

Factors used to decompose alter ego indiciamay also have overlapping application to theindicia. Using a common chart of accounts torecord accounting transactions is a prudentbusiness practice, but could conceivably serve asan indicator of a lack of separateness.

Some factors are subject to legitimatealternative interpretation. Consequently, amethodology by which to score the overall resultsbecomes critical. (Refer to the precedingprinciples of alter ego investigation.) Further, suchmethodology provides compelling evidence for anobjective and critical analysis, persuasive to thecourt.

F. Varying measurement standards

The measurements standards used in assessingwhether or not financial dependence is presentwill vary. A few examples follow.

• Book value–This standard of measure rarelyreflects anything beyond the nominaldifference between assets (typically reportedat cost) and liabilities (typically reported atfair market value).

• Checkbook management–E

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