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BUSINESS PRACTICES: LIMITING PERSONAL LIABILITY (Part II)

This is a continuation of our discussion regarding the breakdown of liability protection afforded to owners and officers as a result of the economic crisis and business scandals in the US and around the world.  It is true the American legal system is set up to shield owners/officers from corporate liabilities, but nothing draws public outcry like an executive who fills his pockets through misdeeds and then hides behind the corporate skirt.  

It is the perception of corrupt business practices with no punishment that leads judges and legislators to weaken corporate protections and put officer heads on the chopping block.

So, in this climate of suspicion, what can a business owner do to limit liability for company activities? in this section, we will focus first on what not to do.

I. Shell Companies

By “shell company,” we mean a company that is set up for specific business transactions but which has no significant assets.  In Florida, where our firm is headquartered, it is extremely cheap and simply to set up a new company.  That is intended to encourage entrepreneurship, which is a good thing.  What is sometimes not a good thing is the ease of setting up a new company also lends itself to creating “throw away” companies.

So, if an unscrupulous person wants to rip people off, he or she can open a company, do bad things and then abandon the company.  And repeat . . .

Judges are wise to this tactic.  If your company is accused of misconduct, a judge will be curious to see how vested you are in the company.  Was the company properly capitalized at the start, or was it run on a shoestring?  There is nothing wrong with running a company on a tight budget, but you do not want it to seem like you were never serious about building a viable business.

Consider other countries around the world, such as European countries, where it is not nearly so quick and easy to start a new company. In fact, the process is rather involved and requires significant capitalization upfront.  This tends to have a chilling effect on startups and, perhaps, reduces the likelihood of abuse.

Of course, many small businesses will be started with minimal capital and grow organically. There is nothing wrong with that. It is one of the things that makes the United States an attractive destination for the entrepreneurial-minded.

If you are starting your company on a small budget, then consider purchasing an insurance policy (such as an “errors and omissions” policy).  Judges tend to view that as a good-faith attempt to be a responsible business owner.

II. Alter Ego

Another important consideration is whether the business owner treats the company as a separate entity, rather than just an extension of himself.  As a small business owner, it is easy to form bad habits — such as using the company card to pay personal expenses, commingling company funds with personal funds, using your personal card to pay company expenses, making company decisions with no semblance of corporate process, etc.  These are very common practices, which Florida courts tend to view as reducing the company to a mere “alter ego.”

Many small business owners think: “What difference does it make? It’s all my money, anyway.”

Of course, there is some truth to that. That is why in business litigation we refer to the “corporate fiction.”  After all, it is a fiction . . . one that you should foster, not disregard.

Think about it this way. If your company gets itself into a situation where it cannot pay its bills or is being sued, then you are going to want to separate yourself from the company’s creditors as fully as possible.  If someone gets a judgment against the company, you do not want him coming after your personal property, your personal bank account, etc.

Should that situation come up, your argument will be “Hey, that is the company’s debt, not mine.”  By and large, that is a good argument, and the courts will support it.  However, you can’t really have it both ways.  If you want the judge to treat your company as a separate entity that is responsible for its own obligations, then you need to have treated the company that wayall along.

More on Business Law

To protect against corporate liability, you want to avoid weakening the corporate fiction. So, you do not want to give the impression that you were planning to “tank the company” all along, and you do not want to make the company your alter ego.

Next week, we will discuss affirmative measures you can take to foster a strong corporate fiction, thereby strengthening your protection against corporate liability.

~ Jeff Harrington, Esq.