Can A Shareholder Be Liable For Corporate Debt?
Although the personal liability
of shareholders is generally limited to their investment in a corporation,
there are circumstances under which corporate protection from personal
liability can be set aside by the courts.
The basis for setting aside such protection is known as the alter ego
doctrine.
Under the doctrine of alter ego,
the courts may disregard the concept that a corporation's separate existence is
distinct from that of its shareholders, and "pierce the corporate
veil" thereby exposing the shareholders to personal liability for
corporate debt.
There are two requirements that
must be met in order for the courts to invoke The alter ego doctrine and create
shareholder liability for corporate debt.
These requirements are, in the words of the Court of Appeal in
California, "(1) that there be such unity of interest and ownership that
the separate personalities of the corporation and the individual no longer
exist and (2) that, if the acts are treated as those of the corporation
alone, an inequitable result will follow."
In an action arising out of
Northern California some years ago, the Court of Appeal enumerated a number of
circumstances under which a trial court could conclude that the disregard of a
corporate entity would be appropriate.
These factors were listed as follows:
1. Commingling of funds and other assets in the
unauthorized diversion of corporate funds or assets to other than corporate
uses.
TRANSLATION: You pay your home mortgage, utility bills and
gardener out of corporate funds.
2. The failure to obtain authority to issue
stock or actually issue stock.
TRANSLATION: You fail to file the appropriate notice with
the Department of Corporations and also fail to prepare and sign the stock
certificates.
3. The failure to maintain minutes or adequate
corporate records.
TRANSLATION: You haven't held or prepared minutes for an
annual meetings of shareholders and directors in a decade and haven't
documented any dealings which have occurred between shareholders and the
corporation.
4. The failure to adequately capitalize a
corporation.
TRANSLATION: You formed your corporation with an initial
capitalization of $12.
5. The diversion of assets from a corporation by
or to a stockholder, to the detriment of creditors.
TRANSLATION: You owe $175,000 to creditors; however, you
purchased the corporate Lear jet for what you consider to be good and adequate
consideration, namely, the sum of $5.
6. The use of a corporation as a subterfuge of
illegal transactions.
TRANSLATION: You take bets for the Mob.
The Court of Appeal concluded in
the above matter that "The purpose of the doctrine is not to protect every
unsatisfied creditor, but rather to afford him protection, where some conduct
amounting to bad faith makes it inequitable . . . for
the . . . owner of a corporation to hide behind its corporate
veil."
Many owners of small businesses
such as dry cleaners, coin laundries, restaurants and clothing stores, form
corporations, execute leases and purchase equipment under the name of the
corporation and assume that they are protected against any personal
liability. Although many pay attention
to ongoing corporate responsibilities, others do not. Those who fail to do so occasionally become
subject to personal liability.
You may have incorporated by the
filing of Articles of Incorporation with the Secretary of State and received a
minute book and stock certificate book from the attorney or agency which
provided the service, but you have not necessarily complied with all of the
requirements for corporate formation so as to protect you from personal
liability.
Corporate obligations frequently
overlooked at the time of incorporation are the following:
(1) The requirement that an appropriate notice be
filed regarding the issuance of stock with the California Department of
Corporations;
(2) The actual preparation and execution of stock
certificates;
(3) The filing of any necessary Fictitious
Business Name Statement.
(4) The preparation of minutes of the first
meeting of the Board of Directors which customarily includes many important start-up resolutions.
There are occasions when an
individual will maintain two corporations, one with substantial assets and one
which operates at the poverty level. The
monied corporation will sometimes be deemed to be the alter ego of the
impoverished corporation under the alter ego theory. Courts look to the following factors to make
such a determination:
(1) Whether there is identical, equitable
ownership in the two entities;
(2) Whether the same directors and officers of the
two entities are responsible for supervision and management;
(3) Whether there is sole ownership of all of the
stock in a corporation by one individual or the members of a family;
(4) Whether the corporations use the same office
or business location;
(5) Whether the corporations employ the same
employees and attorney.
The moral of the
story? Just because you own a minute
book, stock certificate book and a corporate seal, doesn't mean that your
corporate responsibilities are satisfied.
The involvement of an attorney at the time of incorporation and an
annual corporate check-up by your lawyer may prove to be invaluable in
protecting your assets, whether corporate or personal.
[This column is intended to provide general information only and
is not intended to provide specific legal advice; if you have a
specific question regarding the law, you should contact an
attorney of your choice. Suggestions for topics to be discussed
in this column are welcome.]
Reprinted from Fabricare
Myles M. Mattenson © 2006
