As seen in Business Black Box
Q3 2011 Edition
Written by Andy Coburn
The Q3 2011 edition of Business Black Box featured an article written by Wyche attorney Andy Coburn entitled “Owning and Running a Business – Liability Can Get Personal.” The full article is included below:
A corporation is supposed to protect you, the owner and principal officer, against personal liability for corporate activities. That’s what your lawyer tells you. That is the primary reason why the corporation was invented. Before the corporation, the owners of a business were all personally liable for its obligations. In the good old days, you and your business partners borrowed money in England to send a ship to buy spices in the Far East. If your ship sank on the trip home, you had to pay the lenders back personally or you went to debtors prison. The whole idea behind the corporation was that if the business did not work out, the owners would only lose what they had invested in the business, not everything they had. As with most things, however, business owners need to remember that reality is not quite so simple. The corporate liability shield is important but has limits.
For example, every small business owner with a line of credit was rolling their eyes by the middle of the first paragraph. That’s because they all have given personal guarantees to their banks – a legally binding commitment that they personally will repay money loaned to their company if the company does not. A personal guarantee to a bank is better than unlimited liability for all corporate debts, but that is little comfort if the bank debt is enough to bankrupt the owner.
If you personally engage in illegal conduct while conducting business, you may get your company in trouble too, but don’t expect to hide behind the corporation and avoid personal liability. You see this in the news – if you run an investment bank and engage in illegal insider trading, the Securities and Exchange Commission is coming after both you and your company. And certain laws expressly place personal liability on officers and directors if the corporation fails to meet its legal obligations. If a corporation fails to withhold income taxes from employee pay, for example, officers and directors can be personally liable to the IRS for the amounts that were not withheld.
And then there is that elusive, shadowy, threatening menace known as “piercing the corporate veil.” The basic idea behind this legal doctrine is that, under certain circumstances, the law will decide that your corporation is just a sham and should be ignored. When the veil is pierced, third parties owed money or harmed by the company can go directly after the company’s shareholders to satisfy the company’s obligations. Veil piercing has always been troublesome for business owners because the tests for determining when it applies are subjective and highly dependent on the specific facts and circumstances. For example, in South Carolina, the two requirements for veil piercing are (i) the dominant shareholders must have failed to observe corporate formalities and (ii) there must be “an element of injustice or fundamental unfairness” if the dominant shareholders are not held liable for the corporation’s obligations. In applying the requirements, courts look at such factors as whether the corporation maintains proper books and records, holds shareholder meetings, has working capital that is grossly inadequate for the business and has officers and directors that are not fulfilling their duties. The good news for shareholders is that the burden of proof is on the party bringing the veil piercing claim, and courts are generally hesitant to apply the doctrine absent compelling facts. Reported cases of veil piercing tend to involve clearly abusive situations such as a small business owner who uses a single bank account for business and personal finances, keeps minimal or no accounting or other typical business records and takes tens of thousands of dollars out of the company each year in dividends, leaving the company with virtually no working capital.
The best defense against veil piercing claims and personal liability generally is to run your business professionally and to take legal compliance seriously.