AVOIDING PERSONAL LIABILITY IN BUSINESS

Probably the most frequently stated decision for using a corporation as a business model for doing business is to avoid personal liability if the business fails.

There are certain exceptions to the instances where someone can avoid personal liability in the use of a corporation or, for that matter, in the use of a limited liability partnership or a limited liability company. The courts have ruled that if a business is used as a “cat’s paw” by the principals, to the end that funds are intermingled among business accounts and the corporate formalities are in large measure disregarded, a court can “pierce the corporate veil” and enter judgment against the principals of the corporation directly and ignore the corporate or other business entity which affords a shield against personal liability.

For that reason, it is important that when somebody forms a business that they open separate accounts, do corporate minutes and their billings, correspondence and payments should be made through the corporate accounts with the corporate name on every document. In addition, all contracts and correspondence should bear the corporate name and the individual should sign below the corporate name in whatever corporate capacity that person has next to their name. An example is as follows:

XYZ CORPORATION

By______________________________
James Michael, Treasurer

Even if the corporate formalities are observed, an officer of the corporation can, under certain circumstances, be held personally liable.

In a recent case, the principal of the corporation was sued by a food wholesaler who provided credit to the principal’s poultry company. The poultry company went bankrupt and the creditor sought to hold the officer of the corporation personally liable, claiming that the extension of credit was given based upon financial statements that were not fully accurate. The court pointed out that in order for the creditor to prevail against the individual officer, they had to prove that the officer knowingly, recklessly or at least negligently, failed to include information required by generally accepted accounting standards. On the facts found by the judge in the lower court, the Appellate Court held that the liability of the individual could not be proved. Although the court found that the financial statements might not have been complete, the court held that it was reasonable for the individual to rely on the company’s accountant to provide compiled statements, although not audited, were prepared in the usual course of business and there was no evidence to indicate that the officer induced the accountant to omit any of the claimed information that was relevant.

The lower court found that approximately 10% of the accounts receivable were dubious collectibility. The Appellate Court found that where the defendant company’s practice had been to write off accounts receivable once a year, the inclusion of those accounts was not negligent and did not appear to conflict with industry standards. In order to prove the misrepresentation claim, the creditor had the burden of proving that the officer knew that there was a misrepresentation that was false or could have discovered the falsity through a modicum of diligence.

The lower court found that obtaining a higher line of credit without notifying the creditor was a misrepresentation. The Appellate Court, however, held there was no evidence that, even though there was a higher line of credit, the debtor had in fact used a higher line of credit. Moreover, the court ruled there is no general duty to disclose such information after initial financing information had been provided to a creditor.

So, even here where a corporation did observe the formalities of the corporation, the individual was sued on the basis of having provided fraudulent information. On the facts of this case, personal liability was avoided.

In addition to that theory of liability against an individual officer, Massachusetts General Laws, Chapter 93A provides that any principal of a company that acts in a “unfair or deceptive trade practice engages in a tort for which personal liability can attach.”

Thomas V. Bennett, Esq. (tvb@barronstad.com)

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