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Saturday, Feb 24, 2024

The Right Business Entity Puts Limits on Liability

Q: Given this challenging business climate, my partners and I are trying to evaluate our risk of personal liability should our company not survive. We are a C-Corporation, incorporated in California. What can you tell me to alleviate my angst? A: Obviously, the general nature of your question allows only for a general answer. As you likely know, shareholders, directors, and officers are ordinarily not personally liable for corporate debts or obligations. In the eyes of the law, the corporation is a separate legal entity, and as such, liable for its own debts and obligations. In fact, limited personal liability is often a significant motivating factor in forming a corporation in the first instance. But (and I bet you knew there was a “but”), the foregoing is subject to exceptions, any one of which may create personal liability for corporate shareholders, directors, or officers: (1) if the corporate veil is “pierced,” which is not always an easy burden, but not altogether uncommon, personal liability will be found. Piercing-the-veil is an equitable doctrine employed by courts to “do justice.” Common piercing grounds include commingling corporate assets with personal assets, undercapitalization, disregard of corporate formalities, to name a few; (2) if the Corporation distributes money or property to the shareholders in excess of the corporation’s retained earnings, the recipients of the money or property are personally liable to the extent they received same; (3) in the process of winding up, shareholders are personally liable to the extent they receive any distributions without first sufficiently providing for payment or adequate provisions for payment of any and all other corporate debts and liabilities; (4) directors and officers have personal exposure for debt or liabilities caused by their tortuous conduct; (5) if any of you have personally guaranteed any corporate debts; and (6) to the extent a director, officer, or controlling shareholder breaches a duty owed to other shareholders (generally, minority shareholders). To better assess your specific situation, you and your partners would be well served to consult with competent counsel in this field. Q: A group of investors and I are starting a new business. We understand the importance of forming a new entity to carry out our venture, but are confused as to which form best serves our needs. Specifically, don’t they all afford us the same degree of protection against personal liability? A: I could understand why you might have that impression, but, in fact, the answer to your question is a resounding “no.” Without knowing anything about your business, partners, or goals, I’m in no position to advise on what entity is best for your new venture, but I can certainly summarize how the risk of personal liability for passive and active investors and managers is impacted based on entity selection. For simplicity purposes, I’ll address the most popular of entity choices and point out (in summary fashion) the general rules impacting personal liability within each: (1) Corporation – actually, the circumstances presenting personal liability for shareholders, directors, and officers beyond their invested capital is summarized in my answer to the first question in this column and does not bear repeating; (2) General Partnership (“GP”) – the partners in a GP are each jointly and severally liable for all partnership obligations. That means that all partners are on-the-hook for all other partners acts and omissions (irrespective of whether one knew or participated in the act or omission) carried out in furtherance of the GP. As such, and all other things being equal, GP formation presents the greatest personal exposure; (3) Limited Liability Partnership (“LLP”) – although partners in a LLP are free to agree otherwise, unlike in GP’s, partners in LLP’s are personally liable only for their own torts (e.g. wrongful acts or omissions). Partners in LLP’s are not liable for the torts of their partners; (4) Limited Partnership – although the general partners of a limited partnership are liable for partnership obligations (just as if a GP), limited partners are normally not liable for partnership debts. As you likely know, however, limited partners can be reclassified as general partners if they assume control in the business; (5) Limited Liability Company (“LLC”) – members of LLC’s are not personally liable for the debts, obligations, or liabilities of the LLC, unless creditors successfully pierce the LLC veil. The grounds and circumstances justifying piercing the LLC veil are the same as the grounds for piercing the corporate veil, with one significant exception. The failure to observe certain formalities required by shareholders and boards of directors in a corporation is not a factor in considering whether a creditor may pierce the LLC veil, unless such notices, meetings, and minutes are expressly mandated in the articles of organization or operating agreement. Q: Since last year, our average days to collect our account receivables has increased significantly. Everyone is paying later and later. I want to revise our credit policy to provide for a 1.5% monthly late fee for invoices not paid in full within 30 days of receipt. Can I do this without running afoul of usury laws? A. Usury laws generally only apply to interest payable “for any loan or forbearance of any money”. In your case, the 18% annual late fee is likely enforceable assuming it was part of your terms and agreements that customers accepted prior to incurring the fee upon which you’re applying the late fee. First, your relationship with your customers do not involve a loan or forbearance of money, but rather a transfer of property or services in exchange for a price. Second, an exception to the usury law known as the “time-price” doctrine appears applicable. The doctrine recognizes a seller’s right to name its price for goods or services. Sellers can ask for a cash price, or a higher price if buyers choose to purchase on credit. When your client chose not to pay the invoices by their due date, they essentially chose to accept your credit terms, which includes the 1.5% monthly late fee. This column contains general information and under no circumstances constitutes legal advice. This information is not provided in the context of an attorney-client relationship and nothing herein creates an attorney-client relationship. Readers should not act upon this general information without first seeking professional advice. Ira Rosenblatt is a business and corporate lawyer and a co-founder and director of Stone, Rosenblatt & Cha, a business law firm in Warner Center. Rosenblatt has earned Martindale-Hubbell’s highest rating (“AV”) for legal ability and ethics and is listed in Martindale-Hubbell’s National Bar Register of Pre-eminent Lawyers. He can be reached at irosenblatt@srclaw.com .

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