Keeping Separate Lifeboats Afloat

How to protect owners and affiliates from related-entity liability

So, we’ll form a new subsidiary to isolate the risk of the new venture. If the new venture fails, our core business will remain unaffected.”

Here’s what’s wrong with that common business sentiment. When related-entity liability sucks in owners and affiliates, it’s a very bad day for everybody. Having your assets seized for your own debts would be bad enough. Having your assets seized and sold for the debts of a company that you own or with which you are affiliated is doubly bad when you and your company were not at fault for the underlying liability.

For the claimant, being able to seize and sell the assets of owners and affiliates of a judgment debtor may constitute the difference between finding a pot of gold rather than an empty tin cup at the end of the litigation rainbow. So, instead of a judgment creditor being able to seize only the assets of its debtor, the judgment creditor may also be able to seize the assets of its debtor’s owners and affiliates. The legal term for this legal asset-grab is “piercing the corporate veil.” While the “piercing” concept originally applied to corporations, the concept today is applied to other forms of business entities, including limited liability companies.

From the standpoint of a creditor of a defunct debtor, seizing related-entity assets is a bonanza. From the standpoint of the owner of those assets, such a seizure may spell catastrophic disaster.

Understanding lifeboats

Entities are often created to limit and separate assets and liabilities of one project or line of business from those of another. If one company fails, the other company will continue in business. By analogy, if one lifeboat sinks, the others remain afloat. While it takes time, money and effort to set up and maintain separate entities, doing so enables a business to undertake opportunities for which the company prefers not to place all of its assets at risk.

So, after spending time, money and effort to set up separate legal entities, we expect those separate legal entities to be recognized by the courts as, well, “separate.” Thus, we are shocked when the assets of owners and affiliates of a debtor are sometimes drawn into the liability vortex of a so-called “separate” related entity that lacks assets sufficient to pay a judgment against it. “[T]he list of justifications for piercing the corporate veil is long, imprecise to the point of vagueness and less than reassuring to investors and other participants in the corporate enterprise interested in knowing with certainty what the limitations are on the scope of shareholders’ personal liability for corporate acts.” (“The Three Justifications for Piercing the Corporate Veil,” Harvard Law School Forum on Corporate Governance and Financial Regulation, https://corpgov.law.harvard.edu/2014/03/27/the-threejustifications-for-piercing-the-corporate-veil). Rather than attempt to explain the legal nuances of those justifications, this article provides straightforward preventive business practices that will help rebut those justifications and preserve separateness.

Lenders and guarantors should take heed, too. Loan documents often lack covenants requiring the borrower to maintain corporate separateness, thus unnecessarily endangering the payback by subjecting the borrower’s assets to collection for the liabilities of an owner or affiliate of the borrower.

INCREASING INSULATION CREATING BOUNDARIES

Six straightforward steps to take — five by entities and one by lenders and guarantors — to increase liability insulation between related entities, and thereby decrease the possibility of spillover affiliate liability.

1. Publicize who you really are Be authentic. Use your own entity’s full legal name where everybody can see it: on contracts and legal documents to be sure, but also on your website, email signature block, business cards, invoices, purchase orders, forms, receipts and copyright notices. Currently in vogue for marketing purposes is the practice of using a trademark or trade name in lieu of an entity name to build brand awareness and to exude an image of collective largeness and credibility. You may use the trademark and trade name for those purposes, but not to the exclusion of your legal name. If you are actively identifying yourself as Really-Happy Enterprises, Inc., with a Really-Happy trademark, you will be far less likely to be held liable for the judgments against an affiliated company also using that trademark than if you were only to use the trademark.The terms “Inc.,” “Corp.,” “LLC” and similar designations are your friends. They clearly identify you as a legal entity responsible for your own liabilities and not the liabilities of others. To promote brand awareness and exude largeness without compromising entity liability insulation, you may want to use something similar to “Vice-President, Really-Happy Enterprises, Inc., an entity of the Really-Happy Group of Companies.” On a website under a tab such as “Who We Are” or “About Us” you may wish to state something such as:
The Really-Happy Group of Companies is composed of companies based upon values and standards of happiness, excellence and quality. Those companies include:
● Really-Happy Enterprises, Inc.
● R-H Marketing, LLC
● Glücklich, GmbH

Such a description identifies the group, not itself a legal entity, as a group of companies, and identifies the companies comprising the group. For multiple companies using the same trademark, use a written trademark license agreement. That is not essential from an intellectual property standpoint, but it provides added related-party insulation. Further, if the licensor is an operating company, the license agreement should permit each licensee to continue to use the trademark even if the licensor becomes insolvent.

2. Don’t allow others to pass themselves off as you. Make sure that related businesses — especially those using the same trademark or trade name as you are using — publicize who they really are by using their full entity name. Not only do you want to hold yourself out as a separate entity, you want to prevent anyone from confusing another company with your company. “Really-Happy Enterprises, Inc.” and “R-H Marketing, LLC” are less likely to be responsible for each other’s liabilities if both use their full names all the time. If you permit a related company to mooch off of your company’s image, then you should expect that company’s creditors may later mooch off of your company’s assets.

3. Pay the initial capital. Really.  At formation, a company must be adequately capitalized for the anticipated needs of the business. (Sometimes, this same rule also applies to an expansion or material change to the scope of the business.) So, don’t automatically select a nominal amount for initial capital. Further, too often the specified amount is not actually paid. Sometimes, the amount is entered on the financial records as an account receivable from the owners or is not entered at all. So, check on it. It should show on the balance sheet. In the event that initial capital has not yet been actually paid, pay it now. Even if the company formed is used solely as a non-operating or holding entity, the company should have a bank account with the initial capital paid into the account. Failure to pay the initial capital may result in the owner being personally responsible for judgments against the entity for that reason alone.

4. Wear the right hat.  If you wear multiple hats, such as serving as an officer in multiple related entities, then be sure to wear the right hat at the right time. If you are negotiating a deal for Really-Happy Enterprises, Inc., then hand out your business card identifying you as an officer of that company. When you sign a letter for those negotiations, sign as an officer of that company, and not of some other company or of no company at all. If you confuse the companies for which you are an officer when you are negotiating a deal, you should expect that the opposing party will later claim that it, too, was confused. So, if the deal fails and the opposing party sues, that party may attempt to seize the assets of all of the related companies. If you sign a document without specifying a particular company, you should expect the opposition to claim that you were signing on behalf of all of the related companies. Similarly, do not sign as “Vice President of the Really-Happy Group of Companies” because the title “Vice President” incorrectly implies a legal entity that may be sued. “Really-Happy Group of Companies” is not such a legal entity. Thus, for liability containment purposes, you want to avoid implying that such a legal entity exists.

5. Maintain separate finances. Don’t share bank accounts between entities. Each entity must have at least one bank account and no entity should share an account with any other entity. If your accountant objects that a separate account for each entity makes things too complicated, overrule the objection. Any shared services, such as accounting, human resources, etc., of affiliated companies should be the subject of a written services agreement that provides for allocations. Create separate financial statements for each related entity. All commercial accounting software for businesses today permits maintenance of separate accounting records for separate companies. Take advantage of that software and engage a competent bookkeeper to maintain separateness. Intercompany loans should be documented in intercompany loan accounts and in promissory notes.Undertake and keep for evidence for seven to 10 years allocation studies or analyses for allocating in a fair way certain costs among related entities. For example, the costs of accounting personnel might be allocated based upon the number of accounting transactions of the various companies for which the personnel provide services. The allocation studies need not be complex or extensive, just reasonable and fair. They are invaluable when refuting a claim of related-entity liability. If you indiscriminately mix money among related companies, you should expect that liability will be indiscriminately imposed among the companies. Good fences not only make good neighbors, they keep the neighbor’s junk out of your yard.

6. For lenders and guarantors, evaluate separateness and require covenants. Absent a pre-transaction evaluation of separateness, you may later find that you have made a loan to a company (or guaranteed a loan of a company) that has by its own sloppiness — and the consequential operation of law — tacitly assumed related entity liabilities beyond those shown on its own financial records. Further, loan documents and guarantees should contain adequate covenants of separateness and practices to maintain separateness to help protect against the possibility of related-entity liability adversely affecting the borrower’s capability to repay.

Conclusion

By adopting the business practices recommended above, you may facilitate and fortify the legitimate purpose of setting up separate legal entities to limit financial risk. Those practices serve to help maintain separateness, send clear messages of separation to potential asset-grabbers and prevent the catastrophic failure of one business from sinking the owners and affiliates of that business.

Bill Maycock is a partner in SGR’s Litigation Practice. He has represented clients in litigation regarding antitrust, energy, telecommunications, intellectual property, property tax litigation and other business litigation. bmaycock@sgrlaw.com.