When will an LLC or corporation offer no protection of personal liability?

Even though the purpose of a corporation or LLC is to protect its shareholders from liability, that protection is not unlimited.  The so-called “veil” of corporate protection can be pierced and the corporate entity will be disregarded if certain factors are met.  First, there must be a unity of interest and ownership to the point that the separate personalities of the corporation and the individual no longer exist.  Secondly, the circumstances must be such that adherence to the fiction of a separate corporate existence would sanction a fraud or promote injustice.

 

There are certain actions that are taken or not taken which satisfy the first test. Ask yourself: does the company in question fail to maintain adequate corporate records to comply with corporate formalities? Does the company comingle its funds or assets with the funds or assets of an owner?  Is the company undercapitalized? Meaning, does it have a sufficient amount of money to cover its reasonably foreseeable expenses and liabilities?  Does one corporation treat the assets of another corporation as its own?

 

To satisfy second test, the promotion of injustice (which is something less than an affirmative showing of fraud and is difficult to achieve because it requires one to prove intent to defraud), the situation must include some element of unfairness, or must be akin to fraud or deception.   The existence of a compelling public interest must be present in order to disregard the corporate fiction, beyond a creditor’s inability to collect money owed to them.

 

So lets take the example of Jane and John.  Jane contracts with John’s business Supply Depot, LLC, to supply her with a large delivery of supplies for her business.  Jane pays John upfront, but John does not deliver her supplies.  After Jane sues John for the money she paid him, and for damage to her business, it is found that John’s Supply Depot, LLC, the company that Jane contracted with, has no money and Jane is not able to collect from John but is left with a large attorney’s bill.   Despite having no money in Supply Depot, LLC, John has many businesses and lots of LLCs that he uses as he needs.  The corporate veil of John’s Supply Depot, LLC possibly might be pierced, and the corporate entity set aside if John does or does not do some, or most, of the following (depending on your jurisdiction): holds few to no corporate meetings, with few, if any, meeting minutes taken; no articles of incorporation or operating agreements are ever passed; all the businesses are run out of the same office with the same phone line and expense accounts; officers or members “borrow” substantial sums of money from the companies interest free; the companies borrow money from each other, the officers or members use the company bank accounts to pay personal expenses including things like alimony, child support, education expenses for children, maintenance for personal automobiles, heath care for pets, and other similar personal expenses.

 

If John were able to get away with not paying back the money he owed Jane, the result would promote injustice and would unjustly enrich John.  Other situations that may qualify for promoting injustice would be: undermining common sense rules and statutes, permitting individuals to skirt legal rules concerning monetary obligations, causing a subsidiary organization’s liabilities and inability to pay those liabilities, an intentional scheme to hide assets in liability-free corporations while heaping liabilities upon an asset-free corporation.  All of these types of situations would promote injustice and opposing parties may likely be able to set aside the corporate forms and go after individuals directly.

 

Contact your local counsel to discuss ways in which you can protect yourself in your jurisdiction from unscrupulous business partners, as well as how to run your business in a way that will avoid personal liability in the future.

 

Photo By: Moyan Brenn