Alter Ego Cause of Action: The Discovery Equivalent of an “Open Season”?

Corporations are formed to protect its owners from personal liability in the event the company fails or, worse yet, gets sued. Specifically, “[t]he law permits the incorporation of businesses for the very purpose of isolating liabilities among separate entities.” To the extent a corporation is sued, but lacks assets or sufficient insurance, the possibility exists that a Plaintiff may allege a corporation to actually be the “alter ego” of its owner.

Generally, What is an “Alter Ego” Cause of Action?
The “alter ego” doctrine allows a party to pierce the corporate veil and pursue shareholders of a corporation based upon the manner in which the corporation has been managed. It is, however, “the plaintiff’s burden to overcome the presumption of separate existence of the corporate entity.” To establish an alter ego theory of liability, a party must identify a sufficient “unity of interest” between the corporation and the individual such that the separate personalities of the individual and corporation no longer exist. Factors that tend to demonstrate possible alter ego liability include inadequate capitalization of the corporation, the commingling of corporate and personal funds or the failure to observe corporate formalities. The doctrine is designed to prevent fraud and injustice in only certain situations where “bad faith” conduct requires a disregard of the corporate entity. In this regard, the party must further establish injustice will occur if the corporate veil is not pierced.

In performing discovery on this issue, can a Plaintiff demand access to any and all financial records of both the corporation and the individual based upon the mere allegation that an “alter ego” situation exists? Simply put, no. Due to the right to privacy on behalf of both the individual and the corporation, any requests for financial records must be extremely specific and limited to the transaction at issue in the litigation.

“Fishing Expeditions” by Parties Seeking to Pierce the Corporate Veil are Simply Not Allowed
“Under the discovery statutes, information is discoverable if it is unprivileged and is either relevant to the subject matter of the action or reasonably calculated to reveal admissible evidence.” When seeking confidential information, however, the party seeking the discovery must show a particularized need; the Court must be convinced the information is essential to determining the truth of the matters in dispute. Specifically, with respect to financial records, “[p]ersonal financial information comes within the zone of privacy protected by Article I, section 1 of the California Constitution.” Likewise, corporations also have a general right of privacy.

While these rights to privacy are not absolute, overcoming them requires more than the typical “reasonably calculated to reveal admissible evidence” standard.

When the court balances the need for the protection of privileged information against the need of the case, the party asserting the privilege has the initial burden of establishing a privilege exists. The burden then shifts to the party seeking the information to justify the need for the information despite the existence of the privilege.  Should a court find disclosure of financial information is necessary, the request for such a disclosure must be precise and narrowly drawn to insure maximum protection of the privacy right.

Note that application of the alter ego doctrine is limited to the particular case and the particular purpose before the court. The ultimate question posed by an alter ego cause of action is whether it is inequitable to allow the corporate formalities to remain for purposes of the litigation. As explained by the Court, “[t]he issue is not so much whether, for all purposes the corporation is the ‘alter ego’ of its stockholders or officers, nor whether the very purposes of the organization of the corporation was to defraud the individual who is now in court complaining, as it is an issue of whether in the particular case presented and for the purposes of such case justice and equity can best be accomplished and fraud and unfairness defeated by a disregard of the distinct entity of the corporate form.” Because it is a question of equity between the parties based upon a specific transaction, determination of whether the alter ego doctrine is applicable must be limited to the transaction, thereby substantially narrowing the scope of permissible discovery.

ABOUT THE AUTHOR: Elizabeth Terrill is an associate at Tyson & Mendes. Elizabeth specializes in the areas of construction defect and construction injury claims. Contact Elizabeth at 858.263.4113 or eterrill@tysonmendes.com.

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