FIVE FATAL ERRORS COMMITTED BY BUSINESSES PART II--INADEQUATE CORPORATE RECORDS

By Albert G. Marquis, Esq.

This is the second in a series of articles concerning the five fatal errors committed by businesses which can bring about their downfall: deficient employment manuals; inadequate corporate records; incomplete contracts; inadequate insurance and no buy-sell agreement. Last newsletter we discussed deficient employment manuals. This newsletter we will discuss inadequate corporate records.

Let's begin with a basic question: Why does anyone incorporate? While there are several benefits to doing business as a corporation, the primary benefit is the avoidance of personal liability.

If you operate your business as a sole proprietorship or as a partnership, you are personally responsible for all liabilities of your business. If someone is injured by your product or slips and falls on your floor or is involved in a traffic accident with one of your employees, you can be sued personally for everything you have.

A corporation protects the individual owners of a business from personal liability. After all, if you owned stock in General Motors, which was then hit with a multi-million dollar judgment, no one would come to you asking for payment. The same principle holds true for a small corporation. Even if one person is the sole shareholder, sole director and sole officer, he is not personally responsible for corporate liabilities.

HOWEVER, a creditor can “pierce the corporate veil” and sue the shareholders individually if those shareholders have not adhered to corporate formalities. This is called the alter ego theory, and courts take into consideration three factors when deciding whether shareholders should be personally liable for corporate debts:

1. The corporation must be influenced and governed by the person asserted to be its alter ego;

2. There must be such unity of interest and ownership that one is inseparable from the other; and

3. The facts must be such that adherence to the fiction of separate entity would, under the circumstances, sanction a fraud or promote injustice.

In layman's terms, this basically means: Have you adhered to the corporate formalities or have you simply treated the corporation as an extension of yourself (i.e., your alter ego)?

Whenever a creditor sues individual shareholders, the first group of documents requested are all of the corporate records. If those records are not complete, the creditor is going to argue that the defendants have not adhered to the corporate formalities. To be complete, you need more than that corporate certificate from the Secretary of State. You need articles of incorporation, by-laws, organizational minutes, issued stock certificates for specified consideration, and minutes of regular and special meetings of the board of directors and shareholders of the corporation. It may seem rather silly to prepare minutes for a meeting of one person, or between a husband and wife, but those are the rules, and if you want to be treated like General Motors, you have to act like General Motors.

These documents are not difficult to prepare. Nevertheless, they are neglected by many businesses. And this neglect can undermine the primary purpose of incorporation in the first place: protection against personal liability.

Another factor that will be considered when a creditor is attempting to pierce the corporate veil is whether the finances of the corporation have been kept separate and distinct from the individual shareholders. The corporation can, of course, pay money out to individual shareholders, but those payments should be in the form of salaries or bonuses approved by the Board of Directors. In a case I was involved in several years ago, we discovered that the shareholders had been buying groceries and making their house payments with corporate funds. This fact, along with inadequate corporate records, led to the shareholders being held personally liable.

Most business law firms will conduct a corporate audit--sometimes free of charge. The purpose of such an audit is to determine if the corporate records are complete and up to date. If not, records can be prepared, even minutes and other documents that should have been drafted years ago. Furthermore, the attorney can counsel the owners on how to draft special minutes approving of bonuses and other major expenditures. If you have gone to the trouble of forming a corporation in the first place, why not complete the process and ensure that you have protection against personal liability?