Personal Liability In Business Ownership/Operation

by Poyner Spruill LLP
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Common practice for well advised business owners is to operate the enterprise through a chartered corporation or other limited liability entity recognized in the state(s) in which the business will be operated.  The main benefit in this exercise is a significant level of protection from personal liability for the owners and operators of the business.  This has always been perceived as a motivational factor for entrepreneurs and investors.  Operating a business in these challenging economic times is perilous enough, without having to worry about subjecting personal assets to claims from fellow owners, creditors, employees, government agencies and other third parties. Conventional wisdom dictates that limiting liability to the money invested helps stimulate risk taking.  The unfortunate reality is that personal liability exists in many aspects of business operation.  This article will provide direction in looking for some of those legal landmines.  While its focus is limited to close corporations in North Carolina, the same or similar theories should be considered in the use of other types of business entities. 

Traditional theories of personal liability have always been recognized by our courts.  No entity will protect a business owner from his or her own misconduct, fraud, tortious or criminal acts, or those in which he or she participated.  Individuals are always liable for their own conduct, especially if they are pursuing some personal benefit - they should not act with impunity or expect a business entity to unqualifiedly insulate them from liability.  The same personal exposure may result if an individual does not disclose that he or she is acting for a corporation or acts outside the scope of his or her authority.  Business owners proceed at their own peril if they abuse corporate benefits or act as if the entity does not exist.  It is important to follow the requisite corporate formalities and avoid using business assets for personal purposes.   Holding and documenting director/shareholder meetings, developing written agreements, maintaining separate bank accounts and using corporate titles are the types of activities easily overlooked by busy entrepreneurs.  Another oft applied approach is the application of the “alter ego” theory permitting a third party to “pierce the corporate veil.”  Best practice is to recognize the existence of the corporation in all business activities.  Acting as if the corporation does not exist may have that unintended result.  These traditional rules can be applied at any point in the business’ life.  Others are more often used during various phases of corporate existence to seek recovery directly from a business owner or operator. 

Startup

Promoters typically have little to sell other than their vision and ideas.  Initial costs most often are charged to individuals organizing the business.  Personal exposure can also attend the effort to obtain capital for the new venture from others.  Offering and selling securities to prospective investors triggers statutory standards that must be met when making disclosures, financial projections and other statements.  A violation of the law could result in liability, not only to the business entity, but also for any person directly involved in the violation and, in many circumstances, the persons deemed to “control” the entity. 

To cover initial costs, few startups can escape the requirement of having owners provide personal guaranties for debt, leases and other corporate obligations.   With limited net worth and no operating history, business owners must contractually obligate themselves to launch the enterprise.  Efforts to limit or minimize these personal obligations are helpful, but often hard to accomplish.  Personal liability can also result from failure to follow statutory requirements.  As an example, in North Carolina, failure to obtain necessary Workers’ Compensation Insurance by a person with the ability and authority for compliance can subject that individual to criminal prosecution, as well as a monetary penalty up to any amounts due to injured employees.

Operation

Officers and directors have well established duties of good faith, due care and acting in the best interests of the corporation.  In some jurisdictions this personal responsibility may even rise to a fiduciary level.  Personal liability is measured by these flexible standards.  Unlawful distributions can also expose directors to liability for paying, and shareholders for receiving, if done in violation of statutory restrictions. Moreover, those in control of corporate operations can be subject to a myriad of other claims, such as violation of antitrust, securities, political contribution, employment and environmental laws and regulations. 

In North Carolina controlling shareholders must act reasonably when dealing with the corporation and may be held personally liable to other shareholders for exercising their control in an unfair fashion.  Owners that undertake the functions of directors are subject to the same liability.  Failure to withhold and pay employment taxes can be charged against responsible parties, while other statutes expose individuals to the sales, use, and fuel taxes of the entity.  Officers and directors can also be found guilty of a crime for failing or refusing to respond to certain requests of state authorities or filing false documents.  On the employment front, employees have an ever-expanding path to the personal assets of business operators through laws that protect them from acts such as failure to pay proper wages or give advance warnings of plant closings.

Growth and Sale

Operators of a successful business enterprise are no less subject to the vagaries of personal liability.  Controlling individuals should avoid commingling funds, or using corporate assets for personal expenses such as landscaping, personal vehicles or day care. 

Success often brings with it changes in the ownership or assets that typically involve buying or selling of shares in the entity.  This process generally involves making disclosures or sales pitches to others and as noted above, care must be taken in making those statements.  Selling a business most always involves making representations and warranties.  If the seller is a corporation, it is common for buyers to require one or more shareholders to personally join in the sales agreement to stand behind those provisions as well as other contractual terms.  It is important to understand what the individuals are agreeing to and thoroughly review and be comfortable with the terms of the contract.   

Liquidation

Unfortunately liquidation is often the final chapter of many business stories.  This situation should heighten, rather than dull, the focus of an owner regarding personal liability.  If the business is undercapitalized or otherwise unable to meet its obligations as they come due, it is likely that creditors and other third parties will be looking more closely for avenues of recovery.  This becomes of significant concern as the enterprise runs out of funds.  Officers and directors of an insolvent corporation can be liable to its creditors for paying more than a pro rata share on debts owed to or guaranteed by them.  Fraud and fraudulent conveyances are also common concerns of creditors and means of seeking personal assets or avoiding the dischargability of owners with contractual guaranties.  Care should be taken, especially for those responsible for making sales and distributing funds, not to prefer creditors or use funds for personal obligations. It is also important to maintain the formalities of the entity throughout the liquidation process and for some period thereafter.  In North Carolina, a corporation operating with a suspended Charter or under Administrative Dissolution can lose its corporate protection, resulting in personal exposure for individuals acting on its behalf.

Statics vary, but there is little doubt that small and medium sized businesses are the backbone of the American economy and its revitalization.  Entrepreneurs and investors must be willing to risk their time and capital to support these economic efforts.  This requires promoters, majority shareholders, officers/directors, and other responsible/controlling parties to make peace with the delicate balance the law attempts to strike between the rights of business owners/operators and those interacting with them.  Use of corporations, liability disclaimers, indemnity provisions insurance and, most importantly, common sense, will help mitigate potential exposure.  Understanding the legal issues will also facilitate making informed decisions and hopefully, foster an equitable and successful business environment for all involved parties.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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