Sunday, October 25, 2020

Corporation Protection From Creditors is Difficult to Overcome

LAW MATTERS

 

 

Corporations are a creature statute. They are a far different entity today than when our country was formed.

In the early days of America, corporations followed their English counterparts, where they were bestowed as privilege or used to organize governmental entities. A corporate charter was requested and if sufficient political pressure could be brought, a corporate charter was granted with limited lifespan, limits on finances and even limits on the scope of operation. The charter even specified the manner in which directors were elected. In effect, corporations became small government entities, with the directors representing the shareholders.

These earliest corporations were created to gain special privilege and limited risk. Charters were difficult to obtain, as they generally had to be approved by two state House of Representatives, state Senate and the Governor. Over time, state legislatures desired to open the corporate structure to the masses and remove themselves from having to decide who would be granted the special privilege of limited liability. As corporations became available to general business, states began eliminating restrictions in order to attract and keep business in their state. In 1886 case of Santa Clara County v. Southern Pacific Railroad, the United States Supreme Courts’ reporter, who happened to be a former railroad president, reported the justices confirmed a corporation is a person under the Constitution. That did not appear in the court’s actual decision, but the report started a long line of court cases ruling that corporations have rights of individuals. That broad scope of rights coupled with limited liability made corporations increasingly popular as the Industrial Revolution advanced.

Limited liability provided protection needed to attract capital investors to business ventures. It continues to this day for the same reason. A person can invest money into a corporation, in exchange for stock ownership, with the only risk of loss being the loss of their investment. Partners in a partnership do not have that protection, as each partner is liable for all claims against the partnership. A sole proprietor also faces unlimited liability. Limited liability makes the corporate structure, and later the more flexible limited liability company, a shield which many believe encourages business activity in the public interest.

Virtually everyone understands that dealing with a corporation means you are dealing with an artificial entity and not the shareholders or directors. Claims for breach of contract, warranty or similar issues must be made against the corporation and not against its shareholders. Lawsuits are against the corporation and recovery limited to the corporation’s assets, not those of its shareholders.

When corporate assets are insufficient, some litigants cry foul and try to hold the shareholders personally liable. That effort is known as piercing the corporate veil or disregarding the corporate entity. In Florida, it is a very difficult task.

Florida courts agree that every corporation is organized as a legal entity to do business in its own right, on its own credit and is distinguished from the credit and assets of its shareholders. Allowing someone with a claim against a corporation to reach the pockets of its shareholder would destroy the very reason for incorporation. Piercing the corporate veil is not impossible, just extremely difficult.

Piercing the corporate veil generally requires establishing (1) that the shareholder or small number of shareholders dominated and controlled the corporation so thoroughly that the corporation has no independent existence (it is alter ego of the owner); (2) that the corporation was created or utilized by the shareholders for fraud or some other improper purpose; and (3) that the fraudulent or improper use caused harm.

Establishing status as alter ego is perhaps the easiest of the three criteria. A lot of small business owners do a poor job of observing corporate formalities. They use the business to pay their personal bills, they put money in and out as needed, they do not conduct minutes or keep corporate records and many make only a modest profit that is distributed to themselves in a form salary or otherwise. When they do a bad enough job of observing corporate formalities, a third party can be successful in establishing the corporation as the alter ego of the shareholder, but even poorly addressing corporate formalities is usually not enough.

Poor management and record keeping is not enough to pierce the veil. Florida courts have ruled that corporate formalities not followed or failure to hold formal meetings or keep minutes is insufficient to pierce the veil.

The effort to disregard the corporate entity must also establish that the corporation was created or utilized to accomplish fraud or some other improper goal. That means a lot more than the corporation failed to meet a contractual obligation. Success here has been limited to use of the corporation by shareholders for a fraudulent or misleading purpose or when shareholders have improperly taken corporate assets. Assets of the corporation which are distributed to shareholders in a reasonable manner, including payment of reasonable compensation to a shareholder for services performed or repayment of a loan from the shareholder, will not generally be held wrongful.

Assuming the first two requirements are met, the effort to pierce the corporate veil must ultimately establish that the shareholder control of the corporation and use for a fraudulent or improper purpose is what caused damage to the litigant. Damage does not mean the corporation simply has no assets to pay a judgment. Damage must be result of fraudulent or improper use of the corporate shell.

Florida courts have consistently reaffirmed insulation provided by corporations for shareholders. But, when an injured party has met the difficult tests required to pierce the corporate veil, courts will pierce the veil.

William G. Morris is the principal of William G. Morris, P.A. William G. Morris and his firm have represented clients in Collier County for over 30 years. His practice includes litigation and divorce, business law, estate planning, associations and real estate. The information in this column is general in nature and not intended as legal advice.

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