Business Law Hallstrom, Klein and Ward LLP

Corporate Liability 101

Does incorporating your business eliminate personal liability for your activity in the business? Sometimes, but not always. Let me explain.

Corporate Veil. A corporation is a separate legal person. So, just as you're not responsible to pay my mortgage and I'm not responsible to make your car payment, the shareholders of a corporation are not responsible to pay the corporation's obligations, because it is a separate entity from the owners of the corporation. This concept is commonly referred to as the corporate veil. But, it does not absolutely guaranty that officers, directors, and shareholders of a corporation may not be held liable for their activity involving the company.

Prior Activity. Incorporating a business does not eliminate any personal liability that existed prior to the business being incorporated. This makes sense because the prior activity was the conduct of the owner and/or his agents; while after a business is incorporated, the activity is conducted on behalf of the new legal person, the corporate entity.

Personal Guaranty. Obviously, you are free to personally guaranty the debt of another person, so lenders and landlords often require individuals to personally guaranty the obligations of a corporation or limited liability company. This creates a separate contractual obligation of the guarantor. However, no one is automatically required to personally guaranty a corporate obligation, and the landlords and lenders often will consider other alternatives.

Alter Ego. People often hear the term 'alter ego' and are confused as to what it means. Simply stated, if the persons controlling a corporation fail to treat the corporation like a separate person, then the courts won't either. Instead, the courts will treat the corporation as an extension of these control persons, hence the term, 'alter ego.' That is why it is so important to follow corporate formalities, such as holding annual shareholder meetings, keeping minutes, and not commingling corporate and personal assets.

Fiduciary Duty. Generally, officers and directors of a corporation owe a fiduciary duty of care and loyalty to its shareholders. Consequently, officers and directors need to exercise due care in making business judgments and not engage in any unauthorized self-dealing. Additionally, when a corporation is insolvent, the fiduciary duty shifts from the shareholders to the creditors. This makes sense if you consider that the company is using the creditors' money, and not the shareholders, to conduct its business. Basically, a company is insolvent if it can't pay its bills on time, or if the company's liabilities exceed its assets, so this shift of duty may apply more often than people realize. A recent California court decision held that officers and directors of an insolvent company do not owe a duty of care to creditors, but they do owe them a duty of loyalty so they may not engage in any self-dealing. Various jurisdictions apply this principle differently.

Fraudulent Transfers. No one, including a corporation, may transfer assets without receiving reasonably equivalent value if that person (including a corporation or LLC) is insolvent or becomes insolvent as a result of the transfer, or makes the transfer with the intent to hinder, delay, or defraud any creditor and the business would not have enough remaining assets to conduct its business or pay its obligations. Every person involved in such a fraudulent transfer may be liable for any loss incurred by a creditor.

Statutory Restrictions. Individuals, such as signers on bank accounts, officers and directors, who are in control of "Trust funds," such as withholding taxes and/or sales taxes not submitted (an area where I often see problems in cash-strapped companies) can be held personally liable for the misuse of these funds. Also, control persons can be personally liable for environment violations such as those involved with superfund sites. Additionally, California Corporations Code ยง500 prohibits a corporation from making a distribution to its shareholders or redeeming their shares unless the cash comes from retained earnings or unless the value of the corporation's assets are at least 125% of its liabilities immediately after the distribution or redemption and the corporation's current assets equal or exceed its current liabilities. In other words, the corporation can only distribute money it has earned or it has enough money left over to pay its obligations and still have a 25% buffer.

Joint Tortfeasor. A corporate entity does not insolate a person from liability for his own wrongful conduct done in conjunction with a corporation. For example: if we decide to rob a bank we each are liable. Likewise, just because your partner in crime or other wrongful conduct happens to be a corporation, you still are responsible for your own misconduct. The corporate veil blocks liability for corporate contractual obligations and general negligence of the company, but there are plenty of other ways a corporate officer, director, and even a shareholder can be held liable for their malfeasance. As a consequence, corporate executives are often surprised when they are personally sued along with the corporation for trademark infringement when the executive authorized the corporation to engage in activity violating trademark laws.

Misrepresentations. This is probably the most often litigated subset of the joint tortfeasor category mentioned above. In essence, a person can be held liable for fraud if he knowingly makes a false statement to induce another person to rely on the false statement and then that person justifiably relied on the statement to their detriment. In other words, a corporation does not give a person a license to lie. These types of cases often involve various nuances of the law, so it is difficult to provide a comprehensive summary of the issues that may apply. Regardless, it is always good policy to act in an upstanding ethical manner. We just won a trial where our client, a corporate officer, was sued for fraud regarding statements he made on behalf of the corporation. Fortunately, we were able to show that our client acted truthfully based on the information he possessed. Honesty is the best policy.

This Newsletter provides only general information and should not be construed as legal advice. Each concept involves nuances that have not been addressed which may affect the outcome of various situations depending on their particular fact pattern.

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