Avoiding the Horror of Shareholder Liability for Corporate Debt
Under Delaware law, a court may disregard the legal distinction between an owner and the corporation and hold the owner liable for corporate debt, where the owner and corporation operated as a “single economic entity,” and there is an “overall element of injustice or unfairness.
Single Economic EntityThis article briefly describes the conditions under which a shareholder and the corporation may be found to have operated as a "single economic entity."
Factors Looked at by Courts to Determine If an Owner and the Corporation Are a Single EntityInadequate Capitalization of the Corporation at Inception or Later Insolvency Caused by Action of the Shareholder
A corporation may become unable to pay debts as they mature because of inadequate capitalization. As between creditors of a failed corporation, and the shareholder who contributed beginning capital that proved inadequate given the inherent risks of the corporation's business, a court may be persuaded to impose liability for corporate debt upon the tightfisted shareholder.
Similarly, if a corporation that was adequately capitalized upon formation later becomes insolvent as the result of a disastrous and ill-advised change in the risk profile of the business orchestrated by the shareholder, a court may find that the corporation and shareholder constitute a single, unified entity and impose personal liability for corporate debt.
Siphoning of the Corporation's Assets by the Shareholder
Under certain circumstances, the transfer of corporate assets to a shareholder may constitute "siphoning" of corporate assets that supports a judicial finding that the shareholder and corporation were a "single economic entity."
This conclusion is more likely to follow if the transfers of corporate assets to the shareholder occur at a time when the corporation's viability is questionable.
Failure to Observe Corporate Formalities and Absence of Corporate Records
The failure of a corporation to maintain adequate independent records or to observe corporate formalities, including the convening of director and shareholder meetings and the preparation of the minutes of such meetings, suggests a lack of separateness between the corporation and shareholder that may indicate a "single economic entity."
Shared bank accounts and books and records are also indicative of an integrated unity that may support the imposition of shareholder liability for corporate indebtedness.
The Corporation is a Mere Facade of a Domineering Shareholder
If the shareholder exerts a degree of domination and control that precludes the corporation "from having legal or independent significance of its own," a court may conclude that the shareholder and corporation constitute a single economic entity that justifies imposing shareholder liability for corporate debt.
ConclusionThe implications for shareholders of closely-held corporations are as follows:
1. Adequately capitalize the corporation at inception and consider carefully the working and long-term capital implications of any sea change in the nature and character of the corporation's business;
2. Don't treat the corporation's assets as a shareholder ATM and ensure that all distributions to shareholders be properly authorized and documented;
3. Maintain all corporate formalities and corporate records and be ever-mindful of the separateness that must exist between the business and financial affairs of the corporation and shareholder;
4. Consider appointing to the board an independent, non-shareholder director to minimize the risk that the corporation may be perceived to have lost any legal and independent significance of its own.