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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
Back Office was subsequently contemplated but at a lower price than the owners anticipated. Record Breaking The maintenance of proper and thorough corporate records is vital to the ongoing existence of the company. The corporate records provide a historic road map of the company for anyone that may review the records in the future. This does not mean that a company must have a written record of each trip to Office Depot. But, for transactions outside the ordinary course of business or those that enable the company to be in business, appropriate documents should be in the corporate records. Rule of thumb: document anything for which you do not want someone held personally liable. The corporate veil is only as thick as the corporate record book. Keeping corporate records should not be painstaking, and thus it is hard to conceive that the hypothetical scenarios above occur each day. First, actually hold all meetings called for by the bylaws/operating agreement. For all of those meetings, be sure to send out notices as prescribed for in the bylaws/ operating agreement. Second, create succinct minutes of meetings, not a scroll of everyone’s thoughts. Finally, execute and file all appropriate notices, proxies, minutes, resolutions and amendments. Proper and thorough corporate records are essential, and the failure to maintain these records can be detrimental to the company and its owners, as illustrated above. But maintaining corporate records should not be a chore. Rather, think of proper and thorough corporate records as the foundation for the company’s existence. At anytime, you (or anyone) should be able to look at the corporate record book for a historic roadmap of key decisions made and the reasons for those decisions. In addition, the corporate record book should also provide a snapshot of the company’s legal, financial and capitalization health, which will place the company in an advantageous position as you present yourself before providers of capital and exits. Philip Josephson is the founder of the Law Office of Philip Josephson. Philip and the firm deliver corporate legal and business advisory services to clients throughout North America. Philip holds a J.D. from the University of Miami, a M.B.A. from Columbia University; is a member of the Florida Bar, the Arizona Bar, and the Federal Communications Bar; and may be contacted at pjosephson@josephson-law.com. We¹re Green even in a whiteout SUSTAIN - A Collection of Environmentally Friendly Textiles from ASF Group Petroleum is the base of most outerwear fabrics. It is becoming increasingly scarce in the world and its products leave a heavy impact on the environment. By building eco-friendly fabrics, our SUSTAIN Collection takes another step forward towards a cleaner planet. The ASF Group produces technically advanced fabrics that use Recycled Polyester and other Eco-friendly Fibers for performance outerwear. For more info on how we create green fabrics, please contact us. SUSTAIN - Environmentally Friendly Fabric Collection We are the fabric builders—from fiber, to fabric, to factory, to finished. 310-831-2334 www.asfgroup.com Spring 2008 | InsideOutdoor | 41
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