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Shielding shareholders from liability for corporate acts and omissions

So you incorporated, and now the shareholders are protected from individual liability for acts of the corporation, right? Not exactly.

Filing articles of organization in California or a certificate of organization in Delaware is a the necessary first step, but it is just that: the first step in protecting founders and other shareholders. To achieve limited personal liability for acts and omissions of the corporation, founders, acting as the newly organized corporation’s board of directors, should also:

  • adequately capitalize the corporation;
  • observe corporate formalities and respect the separateness of the corporation from its founders in the course of its operation; and
  • as soon as it is feasible, cause the corporation to purchase third-party liability insurance

While corporate status generally shields the shareholders of the corporation (called “stockholders” in a Delaware corporation) from individual liability for the acts of the corporation, courts allow this corporate privilege to exist only as long as the corporation remains properly organized, adequately capitalized, and appropriately separate as a legal entity from its owners. If a court finds that the corporate privilege has been abused, the corporate entity may be disregarded for the purpose of remedying the specific abuse and the corporate shareholders may be liable for the corporation’s acts relating to that abuse.

Piercing the corporate veil

The legal theory upon which shareholder liability is based is generally called the “alter‑ego doctrine.” An individual attacking the corporate status to achieve shareholder liability will try to “pierce the corporate veil” and prove that the corporation is merely an agent of the individuals behind it. Proving the alter‑ego doctrine generally requires two components: first, that there is a unity of interest and ownership between the corporation and the shareholders, such that the corporation and the shareholders are no longer separate or individual; and second, that an injustice or fraud will occur if the corporation’s actions are treated solely as the acts of the corporation.

Reducing exposure to alter ego liability

A corporation can reduce the possibility that its shareholders will be subject to liability for the corporation’s actions by following some basic guidelines:

(a) Adequately capitalize the corporation to enable it to carry on its business responsibly.

A corporation is capitalized through equity investments. Equity is purchased through the sale and issuance of shares. It is best that upon incorporation, shares are sold promptly to the corporation’s founders and, as applicable, to other investors, pursuant to appropriate stock purchase agreements consistent with all appropriate approvals by the corporation’s board of directors. In boot-strapped startups, however, most founders contribute the intellectual property in development and just enough cash to organize the corporation and set up its accounts in exchange for their shares. This can, effectively, leave the corporation without assets to account for the risk of foreseeable, but unintended, injury to third parties. An example of this is when a founder/officer in the course of performing a business task – perhaps conducting a business phone call while driving – causes an accident from inattention, resulting serious third party injuries. The individual actor in this circumstance is always personally liable for injury to others from her inattention or other lack of exercise of due care to prevent foreseeable harm to others. But where the negligent corporate agent is personally underinsured, there is a risk for a thinly capitalized startup. The corporate objective is to protect its other shareholders from individual liability in such circumstances. Corporate liability insurance can provide protection.

(b) Acquire liability insurance for the corporation.

To protect the other shareholders from possible alter ego liability in a thinly capitalized startup founders are wise to contribute enough cash up front to fund not only the incorporation and basic accounting functions, but also to obtain appropriate liability insurance to cover foreseeable risks of injury to third persons by corporate agents. It is suggested that the corporation consider purchasing general business premises liability insurance and non-owned, or, as applicable, owned, auto insurance coverage, and, if the corporation provides services, errors and omissions insurance. Having sufficient liability insurance to make a third party claimant whole generally reduces the incentive for the claimant’s attorney to attempt to jump through the hoops of piercing the corporate veil to get to individual founders and shareholders, and, as a practical matter, makes it less likely a court would find it or just to pierce the corporate privilege. The same can be said of the corporation complying with its statutory obligations to purchase and maintain workers’ compensation insurance. If the corporation did not properly insure itself against the risk of injury to its own employees, the risk, particularly for a startup without material resources, of alter-ego liability for shareholders can be material if an employee sustains injury in the course of performing services to the corporation. Because some startups believe they have no non-owner/manager employees, only independent contractors, little thought is often given to why the corporation might need worker’s compensation insurance. Some such startups, however, do not always properly document their service provider relationships, which can lead to ambiguities as to whether services providers are employees or independent contractors. This can potentially leave the corporation, and its shareholders, quite exposed.

(c) Observe post-formation corporate formalities.

The startup corporation should observe post‑formation corporate formalities, including but not limited to:

  • holding shareholders’ meetings (at least annually to elect or re-elect directors) and holding formal directors’ meetings (at least annually to appoint or reappoint officers and ratify important contracts, such as leases, etc.);
  • keeping minutes of such meetings and clear records of all corporate activities;
  • maintaining up‑to‑date bylaws at the corporation’s executive offices – which may initially be the residence of one of the founders;
  • maintaining separateness and arm’s‑length dealings between the corporation and the directors and/or principal shareholders and requiring full disclosure of any competing interests; and
  • assuring appropriate board of director approval of material corporate transactions (accepting a bridge loan, or entering into a facility lease, for example).

Arm’s-length transactions need to be documented. For instance, if one or more shareholders transfers monies to the corporation other than in exchange for purchasing shares, such transfer should be documented with a written promissory note from the shareholder to the corporation.

(d) Sign all contracts in the name of the corporation.

The officers and other authorized persons should execute all letters, contracts or other documents, signed on behalf of the corporation, in the corporation’s name rather than in their individual capacity. To do this, a signature should give the name of the corporation and then the officer’s signature, name, and title. The signature block is generally drafted as follows:

“ABC Inc.

By: _________________________

Arivali Kaur, President”

Founders and shareholders are not to sign contracts for the corporation under their individual names; the corporation signs its own contracts through a duly identified and authorized officer. Further, individual board members should not generally sign contracts. The board of directors acts as a whole. It approves, for example, a material contract, and then authorizes and directs the appropriate corporate officer (generally its president) to sign the contract on behalf of the corporation. Avoid commingling corporate funds with personal funds.

Corporate funds should not be commingled with the funds of individual shareholders or any other entity involved with the corporation. Also, do not use corporate funds for person expenses, and vice versa. Monies should not be received by the corporation from shareholders except (i) in exchange for the purchase of shares, or (ii) as a properly documented loan from a shareholder. Similarly, corporate funds should not be paid or used by a shareholder except (i) in exchange for corresponding consideration (the arm’s length purchase and sale of equipment for instance), (ii) as dividends approved by the Board of Directors and paid consistent with the corporation’s articles of incorporation (or certificate of organization in Delaware) and other contractual agreements between the corporation and shareholders, or (iii) in connection the redemption or repurchase of such shareholder’s shares.

In summary, taking the necessary time to think through and establish appropriate corporate protocols for the corporation’s operation as an entity separate from its founders and other shareholders—along with taking some minimum precautions to protect third parties from the risk of negligent acts or omissions by corporate agents—increases the likelihood that a startup’s corporate status will shield shareholders and stockholders (in a Delaware corporation) from individual liability for the acts or omissions of the corporation.

Authored by Drew Piunti, drew@dpalawyers.com, ©2015

Categories: Blog

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