You’re Damned if You Don’t Respect Corporate Formalities

Posted: March 15, 2011 in Choosing a Lawyer, Corporate Formalities, Lawsuits

Business people who incorporate often think that the corporate form protects them from lawsuits. That is true only to a point (you are not protected for wrongful acts that you personally commit), and only if you respect corporate formalities. If you do not, you could unwittingly be inviting personal liability, or liability for a parent or sister company. The whole point of incorporating (including forming an LLC) is to limit exposure for that specific corporation. But your effort to limit exposure doesn’t end on the date of corporation. Even taking simple steps can go a long way toward limiting this exposure. Here are some simple things you can do.

1. When you sign any contract, proposal, purchase order, invoice, letter, etc, be clear that you are signing in your corporate capacity. Don’t ever simply sign “Joe Smith.” If you do, you could get personally sued and your opponent will claim that they thought they were doing business with you personally. The claim could be total b.s., but shame on you for exposing yourself like that. How should you sign it? Easy: “Joe Smith as President of J.S. Corp.” You can even add “and not personally,” to make it clear. In fact, your company should be clearly identified as the contracting party.

A short war story makes the point. I defended a law suit a few years ago where three business people started a business, duly incorporated their new business, and hired a contractor to put up a substantial commercial building. The owners then did not heed the above advice; they referred to one another as “my business partner.” The also failed to make clear that contracts were in their corporate capacity. When the corporation eventually ran out of funds, the contractor sued the business “partners” personally, claiming that he thought it was a partnership and did not know about the corporation. The claim had enough traction to make it all the way to a jury trial. We convinced the jury that the contractor knew who he was dealing with because he received checks from the corporation and some of his own invoices listed the corporation. But you don’t want to rely on a jury’s good judgment.

2. If you operate more than one corporation, such as a parent or sister corporation, or even if you have corporate partners, be very clear with whom a third party is contracting. Do not use shorthand names to describe your company. Make it clear to corporate partners and clients that each corporation is separate and one cannot bind the other, and that a contract with one does not bind the other. How you do this in practice depends on precisely how you do business.

Another short war story makes this point. I defended a company called Jones Plumbing Systems, Inc. (names changed to protect the innocent). The owners of Jones Plumbing Systems, Inc. decided to go into business with a supplier named Smith, and together they formed a new corporation called Jones Plumbing Supply, Inc. All well and good. To give the new company some recognition, they referred to the two companies collectively as “Jones Plumbing Group.” This would not really be a problem if they had followed Rule No. 2. However, Smith got sloppy and started entering contracts as “Jones Plumbing Group,” even though it was not a legal entity. Smith turned out to be a poor businessperson, and the owners of Smith Plumbing Systems cut their ties with him. However, the damage was done. Jones Plumbing Group could not pay its debts, so a creditor sued Jones Plumbing Systems, Inc., claiming that it thought it was doing business with Jones Plumbing Systems, or with a joint venture called Jones Plumbing Group. Here, the jury found for the creditor, undoubtedly thinking that this was merely a corporate shell game on behalf of Jones Plumbing. We were able to convince the trial judge that Jones Plumbing Systems committed no violation of c. 93A, so the damages were limited to single damages and the plaintiff had to pay its own attorneys’ fees.

3. Follow corporate formalities. There is a theory in Massachusetts and other states called “piercing the corporate veil.” That’s a fancy way of saying that a plaintiff can get at the assets of a stockholders or a parent corporation if the corporation did not follow corporate formalities. This theory is too complicated to explain in detail here, but generally you need to make sure that you are keeping business accounts separate and not commingling monies or assets, that the corporation has adequate insurance or assets and is not just an empty shell, and that you keep corporate records and books like one would expect of a corporation. There are twelve factors in all that a court will look to, but the key is whether the corporation is a sham and has perpetrated some wrong or fraud on a third party.

By Adam P. Whitney, 617.338.7000.

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