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Are You the Wizard Behind the Curtain? (Corporate Formalities)

A case decided in March of 2012, is a complicated, though fascinating, study in corporate law. Shredding away the layers, it exposes a lesson to be learned for anyone who has incorporated a business, a risk that threatens small corporations much greater than large ones.

A primary reason people use the corporate form of business is to protect themselves from exposure to personal liability for business debts and liabilities. If everything is done right, a corporation is considered a legal “person” separate and distinct from the shareholders who “own” the corporation. That legal reality allows a corporation to enter into contracts and to incur liabilities without those contractual obligations and liabilities attaching to the individual shareholders. That is why individual shareholders of BP Amoco were not required to reach into their own pockets to pay for the gulf oil spill.

The principle works with small corporations as it does with large corporations – even one shareholder corporations. The risk to the shareholder is the loss of the capital they put into the corporation. With some exceptions, a shareholder is not liable for the debts, liabilities and obligations of the corporation – the corporation is liable for those things – even when there is a single shareholder.

Many business people do not appreciate the legal difference between a shareholder and his/her corporate business. This is especially true with small, one or two shareholder corporations. It also can be true with large, sophisticated operations.

The case of Wachovia Securities, Inc. v. Banco Panamericano, Inc. involved a complex maze of loan structures including arbitrage, margin debt and participation agreements in lines of credit among related entities calculated to leverage large bank loans while interposing related entity creditors with priority over the large bank, effectively insulating the borrower corporation from direct collection efforts of the bank. It was a shell game.  When the onion was peeled, there was little in the borrower corporation for the bank to go after.

The relevant facts reflect that the total paid in capital was $1000. All of the assets of the corporation were encumbered by loans to the corporation from the shareholders or entities controlled by the shareholders. The shareholders failed to observe the formalities of the corporate form of business and did not keep corporate records. The Corporation obtained a $9.9m line of credit and borrowed against it.

When the $9.9M equity line of credit came due, the corporation defaulted. The Bank found there was nothing in the corporation from which to recover what was owed. The loans from the shareholders and related entities were first in time, and the collateral (the corporate assets) were all pledged to the shareholders and related entities as security that predated the Bank’s security. Funds from the corporation were “loaned”, invested, or otherwise moved to other entities essentially owned by the same shareholders. Two of the owners received $210,500 in “compensation” but were never issued W-2’s.

The federal court found the owners personally liable for a $2,478,418 judgment! How did this happen?

The Bank asked the Court to “pierce the corporate veil.”  Piercing the corporate veil means attacking the separate existence of the corporation and treating the corporation and the shareholders as one to impose liability on the shareholders for the obligations and liabilities of the corporation.

This is a scary proposition for any owner of an incorporated business. Personal liability for business debts is the exact thing a business owner hopes to avoid by incorporating.

The good news is that courts will honor the separate existence of a corporation and do not take piercing the corporate veil lightly. A court will only look past the corporation shell if the owners, themselves, failed to respect the separate existence of the corporation. Courts will look behind the corporate veil when the shareholders do not treat the corporation as a separate “person” from themselves.

The last thing a business owner who has established a corporation wants is for the curtain to be drawn back, exposing the owner to the liability of the corporation like the Wizard of Oz

The lessons to be learned from this case are many.

One criterion a court looks at when considering whether to pierce the corporate veil is whether the corporation is undercapitalized. In the Wachovia case, all but $1000 of the funds put into the corporation by the shareholders was in the form of loans with security and collateral pledged that had priority over the Bank. In this way, the shareholders thought that they had insulated themselves from having to pay back the Bank, making loans to the corporation (instead of capital contributions) that had seniority and, therefore, would be paid back to themselves in front of the Bank.

Although this family corporation transacted business in big numbers, it is not unlike thousands of small family businesses that are incorporated. The typical paid in capital reflected in typical articles of incorporation is $1000. Many people operating an incorporated business do not ever pay in more capital. When money is needed, it is reflected as “loans” on the books, if it is accounted for at all. There usually are no promissory notes or other documentation. If shareholders pay themselves back without paying other debts, that is one fact that can trigger a court to consider piercing the corporate veil.

In the Wachovia case, the shareholders failed to observe the corporate formalities and to keep corporate records. Thousands and thousands of small corporations do the same thing.

Many people incorporate by filing articles of incorporation themselves, or the accountant does it, and they do nothing else; or they prepare bylaws that are never signed or approved by corporate actions; or they do the initial corporate documentation but never follow up from year to year with annual meetings or corporate actions. Sometimes people do not even issue the stock and have nothing but blank stock certificates in an empty corporate record book.

When a business is chartered under the Business Corporation Act, it is bound to follow the formalities of the corporate form of business. Those formalities include shareholders who have shareholder meetings, who appoint directors who have directors meetings, who appoint officers who run the business on a day to day basis.

The Act allows written actions in lieu of meetings, but those actions must reflect the same formalities: annual shareholder actions appointing directors (at a minimum); and annual director actions appointing officers (at a minimum). There should bylaws approved by appropriate actions. Certain things should be authorized and approved by actions (like approval of the financial institution holding the corporate accounts, establishing authority to sign checks and other documents to bind the corporation; approval of loans, large purchases (like real estate or bulk purchases), large sales (like real estate or bulk sales), stock options, qualified plans and all the things that a larger corporation might approve only through shareholder or director action.

All of these actions should be reflected on paper signed by the shareholders and directors and maintained in a corporate record book. If these things are not done, the corporation form of business is not being observed, and a court may be inclined to ignore the corporate veil that would otherwise shield the shareholders from corporate liabilities. In other words, if the shareholders do not treat the business like a corporation, a court will ignore the fact that the business was incorporated. The court will consider the corporation an empty shell. The wizard behind the curtain will be exposed.

All of these principles apply even if you are a sole shareholder. In fact sole shareholders often fail to grasp or appreciate the difference between the corporate business and themselves for the very reason that they were all the hats (shareholder, director, officer, employee). It seems like a fiction, like playing house; but it is a fiction only if the reality is ignored. The reality is created in the Business Corporation Act, and the reality (and respecting that reality) is what protects an erstwhile business owner from the liabilities of the business.

Many small business people incorporate and apply for Subchapter S recognition from the IRS. An “S corporation” is a pass through entity, meaning that the consequences of the taxes flow through to the shareholder(s). There is no tax at the corporation level and then tax at the individual level (double taxation) in an S corporation. There is only tax at the shareholder because the profits and losses of the corporation flow through to and are counted in the shareholder’s estate.

Many people falsely assume that flow through tax reality of an S corporation means that they do not need to observe or respect the separate nature of the corporate entity for other purposes. That assumption is wrong! The separate nature of a corporation still applies for all other purposes and ignoring the difference between the corporation and the shareholder(s) can result in the exposure of the shareholder(s) to personal liability that is otherwise avoided.

The court summarized the interactions in the Wachovia case as “a convoluted web of entities, insider transactions, and sham loans all designed to avoid financial responsibility.” They shareholders in that case intentionally pushed the envelope, and they did so at their peril. It does not matter, however, what a person intends; if a person fails to observe the corporate formalities and respect the difference between the corporate form of business and a sole proprietorship, the incorporation of the business may not provide the protection from liability that is intended by incorporating.


Kevin G. Drendel
Drendel & Jansons Law Group
111 Flinn Street
Batavia, IL 60510
630-406-6179 fax
[email protected]