Limited liability is often trumpeted as a supreme benefit of a corporation. If the corporations defaults on a contractor loan, the agreed creditor cannot go after the shareholders, the directors, or the officers unless they somehow have personally guaranteed the obligation. If a employee while on the job injures someone in an auto accident, for example, the corporation can be held liable for the employee’s actions but the corporation’s shareholders, directors, and officers are not exposed personally. As sweet as the corporate shield may appear, it has its limits and it’s important to have some understanding of those limits.
There are various ways a shareholder of a closely held corporation may have some personal liability exposure to the creditors of the corporation. First, key creditors, banks, lenders, important vendors often require the personal guarantees of the shareholders as a condition to extending credit.
Second, if a shareholder or a director or an officer negligently injures another party, say, in an auto accident, that person can never escape personal liabilities for his or her tort even though the corporation is also legally responsible.
Third, most state corporate statues personally obligate a shareholder to return any dividend or distribution received by the shareholder from the corporation if the shareholder at the time of the distribution knew that the corporation could not pay its creditors or that the corporation’s liabilities exceeded its assets.
Fourth, if a shareholder acting as a promoter before the corporation is formed enters into contracts on behalf of assumed will be a formed corporation and the corporation is never properly formed or fails to adopt or perform the specific contract, the responsible shareholder, the promoter of the entity may have personal liability for those pre-incorporation contracts. But in this case, if the creditor knew the corporation was going to be the responsible party, courts have often used what’s called the “de facto corporation doctrine” to extend the protection of limited liability and prevent a windfall to the creditor.
And finally, sometimes shareholders of a closely held corporation face a pierce in the corporate veil threat or an alter ego threat as it is sometimes called. Here, the creditors seek to pierce through the corporate veil to get to the personal assets of the shareholders arguing that the corporation and the shareholders are one and the same in the particular situation and that there would be an unjust or inequitable outcome if the shareholders escape personal liability.
Now, courts and state laws vary widely in their response to these piercing the corporate veil claims, but it’s never easy to make such a claim stick. Various factors are often considered. Things such as the co-mingling of personal and corporate assets, the failure to observe corporate formalities, the absence of separate offices, situations where the corporation has been treated as a shell and has no assets or employees, grossly undercapitalizing the corporation, drying out of the corporation excessive salaries or dividends particularly when the corporation cannot afford to honor its obligations to creditors.
Using the corporation as an unfunded subsidiary to protect assets and operations of a parent corporation and many more factors of that type, it is never an easy burden of proof for a plaintiff creditor, but in extreme situations where it’s clear that the corporation has been abused by the shareholders as a tool to create problems for creditors, there is always a risk that the creditor will claim that the corporation has simply been an alter ego of the shareholders and that the protective veil should be pierced in order to expose the shareholders to personal liability.
The directors and officers of a corporation may also face personal liability exposure. Directors may be exposed to the shareholders if they violate their fiduciary duties of care and loyalty, the duties we’ve previously mentioned.
Plus, there are various statutory liabilities. Corporate state laws usually make directors personally liable if they approve payments to shareholders when the corporation cannot pay its debts or isn’t solvent. Securities laws impose liability for insider trading or not properly disclosing facts. Antitrust laws impose liability for price fixing, market division schemes and other competitor related activities that hurt the competitive process. Tax laws impose personal liability for the failure to turn over employee withholdings. The list goes on and on.
Bottom line, if one is going to be a certain director of a corporation, that person has to be careful because there is many ways that a personal liability exposure may be triggered. Given the nature and scope of these liabilities, officers and directors generally want some protection from personal liability exposure, and that protection typically comes in 3 forms:
First, most state corporate statutes allow a corporation to include in its articles of incorporation a provision that says that an officer or director will have no personal liability exposure to the corporation and its shareholders unless the action in intentional misconduct or is a known violation of law or was a vote to approve a shareholder distribution when the corporation was unable to pay its creditors or wasn’t solvent, or was an action that was taken to secure a personal benefit for the director or officer that he or she was not legally entitled to receive. This type of limited liability provision included in the articles of incorporation goes a long way to protect officers and directors from claims of negligence or incompetence that may come from the shareholders of the company.
The second protection is the corporate laws permit a corporation to include in its articles of incorporation and its by-laws a provision where the corporation promises to indemnify any director or officer from any personal liability and related costs so long as the person acted in good faith and in the best interest of the corporation and the claim does not involve a personal liability to the corporation.
The third protection is errors and omissions insurance. An insurance policy purchased and funded by the corporation that provides the directors and officers an added layer of protection if they act in good faith but someone tries to attack them for being negligent or incompetent. Many officers and directors want and demand all 3 levels of protection.