Spring - InsideOutdoor Magazine

Back Office
On the Records
Remaining safely behind the corporate veil
by Phil Josephson
Corporation: An ingenious device for obtaining profit without
individual responsibility. ~Ambrose Bierce
PCV Equipment LLC and its members are sued for breach of
a distribution agreement, and the court finds against PCV and its
members. Outdoor Advanced Company fails to get the capital
infusion it desperately needed. U.S. Outfitters & Marine Corp.
comes out on the wrong end of an Internal Revenue Service
audit, and the company and its shareholders have to restate
financials and pay penalties. The planned acquisition of HighKing
Systems is postponed, and the acquisition price is reduced.
What do all of these entities and scenarios have in common?
In each case, the entities and their shareholders/members
failed to follow corporate formalities and failed to keep proper
and thorough corporate records.
Business owners choose to get into business and choose
an entity form that suits their situation. The primary concern to
the business owners in choosing the entity form is typically the
protection from risks that a growing business may face. The key
to this protection, however, is in maintaining the independent
existence of that entity going forward. Failure to treat the entity
properly and as an independent entity will erode the shield afforded
by the entity, and personal liability can ensue. Thus, in order for
any entity to preserve its special, limited liability status, it must
observe certain formalities and take certain actions. Formalities
include (minimally) the issuance of ownership certificates,
electing officers and directors, following the company bylaws/
operating agreement, maintaining proper corporate records and
keeping corporate and personal funds clearly separate. If these
formalities are not followed, the entity and its limited liability
status are vulnerable to attack. Here are some examples.
Piercing the Veil
Company shareholders/members generally are insulated
from personal liability for the company’s debts. This limited
liability is known as the “corporate veil.” But the veil is not an
absolute shield. In some cases, a court may pierce the veil and
hold a shareholder/member personally liable. Piercing is most
commonly done when a company is the shareholders’ “alter
ego” or is used to evade creditors.
In our hypothetical example above, PCV Equipment failed to
observe corporate formalities and the court found that the members
were treating the entity as another pocket. Thus, the corporate veil
is pierced, and the three members are held responsible for the
breach and associated damages. To paraphrase a leading authority,
if the shareholders/members or the company disregards the legal
separation or proper formalities of the company existence, then
the law will likewise disregard them.
Growth Plans
Outdoor Advanced Company needed a capital infusion to
help with some upcoming cash flow issues that they anticipated.
The company was not “in trouble” but certainly needed the
additional cash in order to pursue growth plans. Though OAC
had a good relationship with its lenders, the company was
unable to produce certain minutes and resolutions during the
standard due diligence process. The lenders viewed this not
as an “oversight” but rather an egregious failure to operate an
entity. OAC subsequently received lending but months later
from a different, less-friendly source.
Audit
Pursuant to a routine audit, the Internal Revenue Service
came calling to Outdoor & Marine Corp. and its handful of
shareholders. Outdoor & Marine Corp. was unable to timely
produce necessary corporate records, was unable to show
that it was following company bylaws and was unable to show
loan documentation with certain shareholders. As a result, the
IRS forced the shareholders and the company to restate their
financial position and prior tax returns.
Exit Strategies
The owners of HighKing Systems were thrilled to
have a suitor interested in acquiring the company.
The owners stood to profit handsomely from the transaction
based upon the offer price in the letter of intent.
During due diligence, however, the potential acquirer found
discrepancies in the corporate records and associated
capitalization ledger. This led to distrust, months of follow
up and a renegotiation of the purchase price. The transaction
Protecting the Company and the Veil
Document capital infusions
Prepare annual minutes for meetings of shareholders/members and directors
Adopt resolutions reflecting approval of all major company actions
File annual statements and pay necessary fees
Make sure the entity’s structure is correctly documented and well documented
Maintain thorough and accurate corporate records
Properly hold and document shareholder/member meetings
Properly hold and document director/manager meetings
Properly hold and document special meetings of directors and of shareholders/
members
Follow the bylaw/operating agreement
Document loans between the company and shareholders/members
40 | InsideOutdoor | Spring 2008