© 1997, 1998 by M. Kathleen O'Blennis and M. Lorin Castleman
© 1999 - 2009 by M. Lorin Castleman
The Castleman Law Firm
A Professional Corporation
5870 Stoneridge Mall Road, Suite
207
Pleasanton, CA 94588
(925) 463-2221F
FAX: (925) 463-0328
This memorandum has been developed by The Castleman Law Firm as a guide to help closely held corporations and their shareholders and directors preserve the corporate identity and avoid personal liability to the extent possible. In this memorandum, we describe the various corporate formalities which you will need to observe.
Although individual shareholders of a corporation can never avoid liability for their own wrongful or tortuous acts, or for their own contractual defaults, doing business in the corporate form will, in many cases, limit the liability of shareholders to the amount of their investment in the corporation. For example, if a corporation is held liable for a wrong committed by one of its agents, or for a breach of contract, the corporate form will act as a shield to protect the individual shareholders from personal liability (unless the individual shareholder(s) personally guaranteed a corporate obligation or is in some manner responsible for the damages to the injured person). But protection from personal liability is lost if there is a basis for invoking the "alter ego" doctrine. Under this doctrine, the law will disregard the legal fiction of a corporation's separate existence and "pierce the corporate veil", thus exposing shareholders to personal liability for corporate debts and obligations arising from tortuous or other acts if the court finds that it would be inequitable not to pierce the corporate veil.
The California Supreme Court has stated that the two basic requirements for application of the alter ego doctrine are: ..."(1) that there be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist and (2) that, if the acts are treated as those of the corporation alone, an inequitable result will follow." Another California court produced the following list of fact patterns which are helpful in serving as a checklist in determining whether the alter ego doctrine might be applicable. These factors are:
[1] Commingling of funds and other assets, failure to segregate funds of the separate entities, and the unauthorized diversion of corporate funds or assets to other than corporate uses;
[2] The treatment by an individual of the assets of the corporation as his own;
[3] The failure to obtain authority to issue stock or to subscribe or to issue the same;
[4] The holding out by an individual that he is personally liable for the debts of the corporation;
[5] The failure to maintain minutes or adequate corporate records, and the confusion of the records of separate entities;
[6] The identical equitable ownership in two or more entities; the identification of the equitable owners of multiple entities with the domination and control of the entities; identification of the directors and officers of multiple entities in the responsible supervision and management of all; sole ownership of all of the stock in a corporation by one individual or the members of a family;
[7] The use of the same office or business location by multiple entities; the employment of the same employees;
[8] The failure to adequately capitalize a corporation; the absence of sufficient corporate assets;
[9] The use of a corporation as a mere shell, instrumentality, or conduit for a single venture or for the business of an individual or another corporation;
[10] The concealment or misrepresentation of the identity of the responsible ownership, management and financial interests; concealment of personal business activities;
[11] The disregard of legal formalities and the failure to maintain arm's length relationships among related entities or individuals;
[12] The diversion of assets from a corporation by or to a stockholder or other person or entity, to the detriment of creditors, or the manipulation of assets and liabilities between entities so as to concentrate the assets in one and the liabilities in another;
[13] The contracting with another with intent to avoid performance by use of a corporate entity as a shield against personal liability, or the use of a corporation as subterfuge of illegal transactions; and
[14] The formation and use of a corporation to transfer to it the existing liability of another person or entity.
Of the above, there are three areas which deserve special comment. The first pertains to the source and adequacy of corporate funding. Initial funding of a corporation is often difficult, and many clients try to fund a corporation with a bare minimum of assets. Unfortunately, under funding (also called "undercapitalization") is commonly found in alter ego cases. Generally speaking, if the initial shareholders have made an equity investment or provided other sources of funding for the corporation's initial operations so that it can operate for a sufficient period of time to develop to the point of economic viability, the "adequacy of funding" test is ordinarily considered to be met. For each corporation, the amount of capitalization required will be different. There is no magic test as to the exact amount needed nor is there any specific test as to the ratio of debt funding to equity funding. Many people have said that debt to equity ratio of four to one is all right. We generally advise clients to have a ratio which includes the smallest amount of debt and largest amount of equity that is feasible under the circumstances.
The second primary areas of concern is the segregation of personal and corporate affairs. It is very important for shareholders to keep their personal and own business activities carefully segregated from the corporation's business. Shareholders should never commingle personal funds or other assets with those of the corporation. All dealings between a shareholder and a corporation must be properly documented and must be at arm's length. There are specific provisions in the California Corporations Code dealing with conflict of interest transactions. Generally speaking, an interested shareholder, officer or director should refrain from voting on any transaction in which that person has an interest; additionally the transaction should be just, fair and reasonable to the corporation. Obviously, in sole shareholder corporations, the meeting of these tests is less of a problem than in corporations where there are two or more shareholders. If a corporation has more than one shareholder, the interested person should refrain from participating in the approval of the transaction, and the transaction should be just, fair and reasonable to the corporation.
A third major area of concern is that of observing corporate formalities. An unfortunate trap that is all too common is the neglecting of corporate formalities. In many cases, a sole or a majority shareholder will run the corporation as if it were a sole proprietorship or a partnership, and the corporation will fail to hold meetings and fail to keep adequate books and records. Operating a corporation in that manner will make the shareholder particularly vulnerable to the alter ego doctrine. If a corporation which has not observed corporate formalities becomes unable to meet its obligations promptly, creditors can use the slipshod manner in which the corporation was run as a significant factor in convincing a court to invoke the alter ego doctrine and obtain a personal judgement against a shareholder.
Although we seldom recommend that corporate clients initially set up their corporations as special "statutory close corporations", some clients are aware of the California Corporation Code provision (Section 300(a)) which provides that the failure of a statutory close corporation to observe corporate formalities relating to meetings of directors or shareholders shall not be considered a factor tending to establish that the shareholders have personal liability for corporate obligations. (A statutory close corporation is one which has elected that status by a specific provision in its articles of incorporation.)
We caution those clients who have elected statutory close corporation status that Corporations Code Section 300(e) should not be read out of context as indicating that close corporations status can insulate shareholders from liability for corporate obligations. Corporations Code Section 300(d) provides that as long as the discretion or powers of the board in its management of corporate affairs is controlled by a shareholders agreement (which must be used by all statutory close corporations), the liability for managerial acts that would otherwise be imposed on the directors is imposed instead on each shareholder who is a party to the agreement. Since most shareholders of statutory close corporations are parties to the required shareholders agreement, those shareholders are personally liable for the managerial acts of the corporation.
Finally, we call your attention to the following checklist for avoiding alter ego liability. This list of "do's" and "do not's" is intended to serve as a checklist to help you maintain the limited liability of your corporation's shareholders. It can also be used as a checklist to establish other good practices for doing business in the corporate form.
DO:
Your bylaws call for an annual board of directors' meeting to be held immediately afterwards. Your bylaws may also call for other regular directors' meetings to be held throughout the year. Review your bylaws carefully for the requirements pertaining to directors' meetings and do not fail to hold those meetings. Additional special meetings of the board should be held when matters of importance come up such as:
a. Entering into a lease of new premises;
b. Entering into a substantial funding commitment;
c. Entering into a substantial leasing commitment;
d. Entering into any other significant contractual agreement;
e. Changing an officer's salary;
f. Filling a vacancy in the board or officer complement;
g. Entering into a significant new venture;
h. Considering the sale, in whole or in part, of the assets or the dissolution of the business.
a. Review each year's activities during the final month of the fiscal year.
b. Budget ahead for the longest period reasonably possible and review and analyze results at least semi-annually.
c. Review the results of (a) and (b) with your CPA to ensure tax planning is properly emphasized.
d. Begin to develop formal long range planning capacities beyond budgeting if not already in place.
XYZ , Inc.
By
John Doe, President
By
Jane Roe, Secretary
DO NOT:
In all corporations where there are two or more shareholders, the interested shareholder should not participate in approving the transaction and the transaction should be just, fair and reasonable to the corporation.
We recommend that you keep this memorandum with your copies of the corporate minute book and that it be circulated to all shareholders, directors and officers of the corporation. We recommend that it be reviewed at each shareholders' meeting and at each regular meeting of the board of directors.