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Risk of Personal Liability Despite Incorporation
January 24, 2022
One of the fundamental principles of corporate law is that the owners, directors and officers of a corporate entity generally are not personally responsible for the entity’s debts. Without this insulation from personal liability, individuals would be deterred from taking on risk. However, there are circumstances in which this corporate shield is threatened — sometimes due to statutory or other legal exceptions, but often due to poor decisions and lack of oversight by management. These pitfalls are particularly common among small-to-midsize and family-owned businesses, where the lines between individuals and the corporation may be blurred.
When business is profitable and invoices are being paid in a timely manner, these problems rarely occur; but when a company faces financial distress, creditors begin to search for alternative sources of recovery — owners, officers, directors and related parties. Below are examples of areas where business owners and managers may face personal liability for corporate debts.
Director and officer liability
Claims against officers and directors have become common in bankruptcy cases. Breach of fiduciary duty claims are the most common, but other claims such as claims for unlawful stock repurchases or dividend payments may be asserted as well.
Trust fund taxes
Governmental entities often impose personal liability on “control persons” when certain “trust fund” taxes (sales taxes or payroll withholding taxes) remain unpaid. Therefore, potential control persons — directors, officers, anyone with check-signing authority — should ensure that these obligations are remitted in a timely way.
When a debtor company leases the real estate on which it operates from an entity owned by its shareholders or related persons, creditors review the bona fides of the transaction — whether the lease is a true lease, or a disguised sale or secured transaction; whether the lessor is de facto owner of the real estate (especially where the lessor paid the mortgage or other expenditures typically paid by owners); and/or whether the terms were consistent with market terms.
Using the company’s corporate credit card in resort areas, on excessive airfare or luxury hotels, or at certain merchants, are signs that the executive may be abusing her or his privilege. Creditors may conduct a forensic investigation, and try to have these items repaid or characterized as taxable income.
Loans in lieu of payroll
Giving executives loans in lieu of paychecks reduces expenses of the business, improves the income statement, and creates an additional asset on the balance sheet in the form of a loan receivable. However, such loans may be viewed as tax-free income, and creditors may challenge this practice as artificially inflating a debtor’s financial condition to induce creditors to provide credit or other benefits to the company. In bankruptcy, creditors may try to characterize these insider loans as equity contributions, and the debtor company can be compelled to pursue repayment of the loans.
Pay but no work
Payments made to a family member who does not really work may be recoverable as a fraudulent conveyance because no value was received by the company in exchange for payment.
Free labor and the Employment Retirement Income Security Act (ERISA)
Applicable laws may impose personal liability on owners/principals who fail to pay employees for their services. Additionally, ERISA fiduciaries may be found personally liable for losses to the plan resulting from any breach of fiduciary duties imposed under ERISA related to management of ERISA plans.
Financial statements and statements to induce credit (e.g., credit fraud)
A borrower’s principal who knowingly and intentionally falsifies the borrower’s financial statements in order to facilitate extensions of credit from a lender can be held personally liable for the bank debt and face potential fraud claims. Similarly, if a person knowingly makes false or misleading representations about the financial condition of the company to obtain credit from a vendor, that person may be subject to personal liability.
The bottom line is that personal liability is often sought when insolvency forces creditors and investors to search for sources of recovery. Owners, directors and officers would be wise to take legal steps that shield their assets in such circumstances.
By Kenneth A. Rosen, Wojciech F. Jung and Michael Papandrea
Kenneth A. Rosen is a partner and Chair Emeritus in the Bankruptcy & Restructuring Department of Lowenstein Sandler LLP.
Wojciech F. Jung is a partner in the Bankruptcy & Restructuring Department of Lowenstein Sandler LLP.
Michael Papandrea is an attorney in the Bankruptcy & Restructuring Department of Lowenstein Sandler LLP.
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