When going into business—whether cannabis or otherwise— the first step is to create a business entity. (This seems obvious but still eludes many in the cannabis industry.) One of the principal purposes of establishing a business entity to limit the personal liability exposure of the founders. Typically, the business entity itself and not the investors, owners, or managers of the entity, is liable for the debts of the business in nearly all circumstances. One exception is the alter ego theory of liability.
The alter ego theory of liability attempts to reach pockets beyond the putatively liable business entity. Doing so is known at piercing the corporate veil. The alter ego theory of liability is not limited just to piercing a company to reach into the pockets of the owners. It may also be used to reach into other entities. And veil piercing may be accomplished in few different ways.
- Vertical piercing refers to piercing the veil between a subsidiary and its parent to hold the parent company liable.
- Horizontal piercing refers to using the alter ego theory of liability to hold sister company’s liable.
- Reverse piercing refers to using the alter ego theory of liability to hold a company liable for the conduct of its owners.
A recently filed Oregon cannabis case demonstrates uses of the alter ego theory in its traditional and horizontal forms. The plaintiff is a well-known purveyor of cannabis candies, licensed by the OLCC. The plaintiff markets its candies to licensed marijuana dispensaries throughout Oregon. The dispensaries sell the candies to their customers. Since 2019, plaintiff has done business with a set of dispensaries that operate under the same brand and have the same or substantially the same owners. (In other words, this brand operates numerous dispensaries throughout Oregon which have the same owners.) Each dispensary operates is its own entity. But each is under the common control of the same two individuals.
According to the complaint, defendants failed to pay for approximately $390,000 of cannabis candies. The candies allegedly were delivered by plaintiff to the various defendants, who accepted the candies without complaint and sold them to retail customers. After demanding and not receiving payment, plaintiff filed suit against more than 20 companies and their two principals. In the absence of an alter ego theory of liability, each defendant is liable only for the candies for which it did not pay. So the plaintiff’s recovery for each dispensary is limited.
But the plaintiff pleaded a traditional and horizontal claim for alter ego liability. In other words, plaintiff seeks to hold each defendant—all of the dispensaries and the two owners—liable for the candies purchased by the other. A claim for alter ego liability is not typically available to an aggrieved party. A claim for alter ego liability is also not available just because the same individuals own multiple companies. Similarly, a claim for alter ego liability is not available just because all of the companies all operate under the same brand or operate in the same industry.
So in what circumstances can a plaintiff allege a claim for alter ego liability?
Well, the specifics differ from state to state. But generally, for the horizontal alter ego theory, a plaintiff needs to allege that the defendants had common supervision, control, management and unity of interest. For all theories, a plaintiff usually must allege the defendants failed to follow corporate formalities. That’s a way of saying that the owners/companies did not act as though the companies were separate entities or separate from themselves. This conduct may include failing to hold board meetings, comingling business and personal monies, or comingling between companies earnings, expenses, and losses. It may also include owners treating company accounts as mere “piggy banks” rather than properly issuing dividends or distributions. Other factors may include insufficient capitalization, insolvency at the time of the transaction in question, siphoning funds by one or more owners, the absence of corporate records, or non-functioning officers or directors.
As the name suggests, the “alter ego” theory of liability ultimately concerns whether the members or shareholders have treated the corporate entity as a “mere instrumentality” or “alter ego” of themselves. Typically the bar to pierce the veil is high, and a court’s use of its equitable powers is exercised only when there is clear evidence that those in control of a company have used the corporation for improper means such as fraud.
Keep in mind that a plaintiff must have a reasonable good faith belief that its allegations are true. Oftentimes a plaintiff does not have enough information to allege a claim for alter ego theory liability. But where a plaintiff does have such information, a claim for alter ego liability is a powerful one. It allows the plaintiff to reach past the ordinary limitations of liability into the pockets of shareholders, members, or sister or parent companies.
For more and related information, see:
Cannabis Litigation: What is “Alter Ego” liability? on Harris Bricken Sliwoski LLP.