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Springfield Business Journal Articles
Sarah Delano Pavlik and Tom Pavlik write a monthly column on legal and business issues for the Springfield Business Journal.


Their columns will be added here each month after publication.
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Owning, developing or managing real estate is not without its share of hazards. Unknown to an owner, environmental liabilities may loom just around the corner. Or, as sometimes happens, a deal may just not work out, or development work may be done incorrectly. In an attempt to protect assets, most professionals in the real estate field operate as some sort of entity – whether as a corporation or as a limited liability company. The general rule is that a shareholder cannot be held liable for the entity’s debts or obligations. As a further level of protection, some even opt not to own shares in their entity, and instead elect to have a spouse own the shares. However, in a worst-case scenario, don’t think that you can simply walk away from the mess without any personal liability. In either or both instances, the general rule of no personal liability can be disregarded by “piercing the corporate veil.”

Piercing the corporate veil means that a court will impose liability on an individual for an entity’s liabilities when the entity has been operated as a dummy or sham. Or, as lawyers say, the veil of limited liability may be pierced where the entity is merely the alter ego or business conduit of another person or entity.

A recent case helps shed some light on this issue. In that case, a property owner contracted with a builder to construct improvements. The builder was a corporation; although 100 percent owned by the wife, the corporation was actually operated by the husband. Unfortunately, the builder did its work so poorly that the entire structure had to be demolished. The court ultimately awarded the property owner a multi-million dollar judgment. The property owner, faced with the prospect of collecting that judgment against a corporation with no assets, sought to hold the builder’s president (but not shareholder) liable.

The court agreed. Yes, that’s right -- a non-shareholder officer was held liable for the entire judgment. The court’s rationale was that although the wife was the sole shareholder, her involvement in the company was minimal. The husband, on the other hand, was solely responsible for running the corporation. In other words, the court found that the corporate structure was a sham.

Under what circumstances, then, can a court pierce the corporate veil? Entire books have been written on the topic, but it’s important that you know the basic concepts so that you can avoid personal liability. Two prongs must be met. First, a court will analyze whether there was “unity of interest and ownership.” Essentially, the court will determine whether separate personalities for the corporation and individual exist. A court will examine the following factors: (1) was the entity was adequately capitalized, (2) was stock ever issued, (3) were corporate formalities observed (such as annual meetings), (4) were dividends ever paid, (5) was the entity insolvent, (6) did officers and directors actually perform duties, (7) were corporate records kept, (8) were individual and corporate funds commingled, (9) were funds diverted from the entity at the expense of creditors, (10) were there arm’s length transactions between related entities, and (11) was the entity a mere façade for the dominant owner.

As a business owner or officer this should be your laundry list of things not to do. Failure to meet one of the elements doesn’t mean that personal liability will be imposed – instead it’s a totality of the circumstances test. Nonetheless, prudent real estate professionals (or other business owners) will want to review their operations to make sure they don’t run afoul of these guidelines.

The second prong analyzes whether refusing to pierce the corporate veil will sanction fraud or otherwise promote injustice. This is a somewhat amorphous test, and there is no hard and fast rule. In the case described above, purported shareholder loans owed to the wife were paid by the corporation during the litigation process – resulting in an empty shell of a corporation. Also, the husband and wife began other construction work under a newly formed corporation during the litigation such that profits from those endeavors would not go to the “old” corporation. The court found this was sufficient evidence. In short, if it smells fishy a court will probably find that the second prong has been satisfied.

The lessons are simple: form your entity correctly, adopt bylaws or an operating agreement, keep your entity’s books and records separate from yours, never commingle company and personal assets, properly document all major business decisions, hold your annual meeting, follow prudent accounting procedures and don’t take actions with the intent to defraud creditors or to allow fraudulent activity (duh!). These general principles, of course, aren’t exhaustive, so contact your legal counsel if you are at all worried. Better to be prepared now than to face the possibility of massive personal liability.

by Thomas C. Pavlik, Jr.
Posted in: February, 2006
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