The Limits of Limited Liability

RP-Limited-LiabilityCongratulations, you’ve been asked to join the Board of Directors of a corporation.

And in addition to the honor you feel at being asked, you believe you can be a great director; adding significant business value and insuring proper corporate governance.

However, there are some risks that come with the position and a number of legal requirements that you need to be aware of. It is safe to say that being a director of a successful company creates less risk than being a director of a company that is in trouble or on the edge.

It’s Important To Realize …

But regardless of the state of the company, it is important to realize that you are a legal fiduciary to the shareholders and, in some cases to certain creditors. These duties cannot be shirked, delegated or ignored. They remain with you until your resignation is formally accepted.

It is important to note that legal requirements for directors are based on state law and differ from state to state. While there is some version in all of these comments in each state, only an attorney can accurately provide counsel regarding these issues.

 

What Are Your Duties?

Can-you-check-off-your-garage-door-dutiesIn General, these duties include:

  • The duty of care that requires you to exercise good business judgment and use ordinary care and prudence in the guidance of the business.
  • The duty of loyalty that requires you to put the company’s interest ahead of your own. Things such as conflict of interest and breaches of confidentially, even if accidental, breach this duty.
  • The duty of faithfulness that requires you to act with honesty and genuinely good intentions.
  • Poorly conceived or documented decision making can hold you responsible for recklessness or carelessness.
  • Direct or Indirect Personal Interest – Involvement in board matters in which you have a direct or indirect personal interest can create a risk of self-dealing.

A Common Belief Is …

belief-grief-bereavement-mourningCommon belief is that, absent fraud, corporate officers, directors, and shareholders are immune from corporate liability, right?  …. Wrong.

As a general rule, it is true that these persons are not liable for debts of the corporation. This protection is often referred to as the “corporate veil.”   But as our attorneys know, there are almost always exceptions to general rules.  Before we get into the exceptions, we will address one question that might be on your mind: “What about the Business Judgment Rule?”

You may ask, “Doesn’t the Business Judgment Rule protect officers and directors with respect to decisions they make on behalf of the corporation?”  … Sort of.

The Business Judgment Rule Is …

Business_shieldThe “Business Judgment Rule ” is a presumption that officers and directors of a corporation make decisions on an informed basis, in good faith, and with the best interests of the corporation at heart.

The rule primarily applies where a claim of mismanagement is the cause of action. The business judgment rule acts to shield directors who have been diligent and careful in performing their duties from liability for honest errors or mistakes of judgment.  

As with all presumptions, the rule arises as a matter of law.  It can be overcome with evidence that the officer or director “acted fraudulently, illegally, or without becoming sufficiently informed to make an independent business decision.

Not An Absolute Bar Against Liability …

In other words, the Business Judgment Rule is not an absolute bar against liability of officers and directors; rather, it is a presumption which affects the burden of proof required to establish actionable mismanagement by an officer or director.  There are many exceptions to the general rule that officers, directors and shareholders are not liable for the corporation’s debts.

Some Exceptions Are …

exceptions-logoSome of these exceptions might surprise you.

1. Alter Ego Theory. Under this theory, a plaintiff may “pierce the corporate veil” and recover a corporate debt directly from a person who treats the corporation as his “alter ego.

To pierce the corporate veil, a plaintiff must prove that: (1) there is such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, and (2) the circumstances are such that an adherence to the fiction of a separate corporate existence would promote injustice or inequitable consequences.

Courts examine a number of factors to determine whether a corporation is merely an alter ego of one of its principals. Those factors include inadequate capitalization, failure to observe corporate formalities, and several others.

2. Breach of Fiduciary Duty. Individuals who control a corporation have fiduciary duties to the corporation and its shareholders. The fiduciary duties can apply to officers and directors, as well as majority or even minority shareholders in certain circumstances.

The fiduciary duty of loyalty prohibits individuals who control the corporation from (1) actively exploiting their positions within the corporation for their own personal benefit, or (2) hindering the ability of a corporation to continue the business for which it was developed.

Officers, directors and controlling shareholders may be held personally liable if they breach their fiduciary duties to the corporation or the shareholders.

3. tortTorts. A corporate director is not liable for the corporation’s torts simply by virtue of his office. Believe it or not, however, a director may be individually liable for torts of the corporation in which they actively participate. Some corporate torts for which directors may be personally liable include negligence, fraud, willfully inducing breach of contract, and conversion.

4. Crimes. An officer, director, or shareholder can be held personally accountable for conduct which is an element of a criminal offense and which, in the name or in behalf of a corporation, he/she performs or causes to be performed, to the same extent as if the conduct were performed in his/ her own name or behalf.

5. Actions after Dissolution. Even after dissolution, corporations continue to exist for the purpose of winding up and liquidating their business and affairs. They are prohibited, however, from carrying on any business that is not for the purpose of winding-up and liquidating.

Officers can be held personally liable for entering into contracts on behalf of the corporation after dissolution, and for debts incurred by the corporation during a period of dissolution. The Business Corporation Act of 1983 holds directors personally liable under certain specific circumstances, such as (a) assenting to a distribution that causes the corporation to become insolvent; (b) failing to notify all creditors of the corporation’s dissolution; and (c) carrying-on the corporation’s business after dissolution, other than as necessary for winding-up the corporation.

bribe-oo6. Kickbacks and Bribes. Officers or directors who engage in commercial bribery or receive a commercial bribe may be personally liable to the corporation for treble damages and attorneys’ fees. A person commits commercial bribery when “he confers, or offers or agrees to confer, any benefit upon any employee, agent or fiduciary without the consent of the latter’s employer or principal, with intent to influence his conduct in relation to his employer’s or principal’s affairs.

7. Failure to Pay Wages. Corporate officers and directors who knowingly permit the corporation to violate state wage acts may be deemed to be the employer of the employees of the corporation. The effect of this provision is to make an officer or director personally liable to the same extent as the corporation for failure to pay employee wages, among other things.

Tax-Time-Clock8. Failure to Pay Taxes. Corporate officers and directors may be held personally liable for non-payment of corporate taxes. For example, personal liability for a corporation’s payroll, sales or other “trust” taxes may be imposed upon corporate officers, directors or employees who are responsible for the filing of such tax returns and payment of taxes due, and who have “willfully” failed to file such returns or remit such taxes. Persons, who are required to collect, truthfully account for, and pay over any tax are referred to as “responsible persons.

934x264_lessonWhat’s The Real Lesson Here?

The lesson to be learned here is that, while incorporation provides some valuable liability protections to officers, directors and shareholders, those protections are not absolute. 

It is important that in accepting a directorship, you be aware of any potential traps that apply to your situation and do your best to avoid them. And in today’s litigious climate, Directors & Officers (D&O) insurance is something every company, no matter what the size, should carry.