Assuming your company does not have 20 billion dollars stashed away in money reserves like BP Energy, many companies risk inadequate capitalization, or what is also referred to as “thin capitalization.” Inadequate capitalization generally means funding resources that are very small in relation to the nature of the needs of the business or the risks which are inherent in such a business. The adequacy of capitalization is generally characterized at the time the entity is formed, but can occur subsequent to formation. It is a fact question that turns on the nature of the business. It is clear that every business entity has a different financial background. It is also clear that every business, regardless of the entity structure, requires adequate capitalization. The risk associated with not having adequate capital is that creditors may be able to reach your personal assets despite your corporate or limited liability company structure.
Many new entrepreneurs assume that a business entity, such as a corporation or LLC, will provide limited liability and shield their personal assets from liability associated with their company. The problem rests in the legal fiction that a corporation or an LLC creates a separate legal entity that is separate and apart from the person organizing the business. Unfortunately, this theory does not always become a legal conclusion for the courts. Courts in some cases have been willing to disregard the entity structure in furtherance of the ends of justice by treating the individual owners and the business entity as one and the same. The entity is referred to by the courts as the “alter ego” of the owners. In such cases, the court finds that the individual owners are using the corporate structure as a shield for fraud upon the public. Thus, the courts allow the creditor or plaintiff to “pierce the corporate veil,” regardless of whether the entity is a corporation or an LLC.
Under Missouri law, the existence of a corporate entity will be disregarded entirely when the corporation is operated while undercapitalized or if its assets are stripped to avoid the demands of creditors. Moreover, Missouri courts have found that inadequate capitalization is circumstantial evidence tending to show an improper purpose or reckless disregard for the rights of others. In other words, having a company that is undercapitalized will create evidence of reckless conduct on the part of the company’s owners. This conduct could then open up the owners to personal liability for all of the company’s debts.
Under Illinois law, aside from the indicia of corporate form and control, undercapitalization is the single most important factor in the veil-piercing analysis. While there is no hard and fast percentage of equity required, courts generally look at whether the capital in the business was adequate, given the possible liabilities of the company. Illinois courts determine whether or not a corporation was adequately capitalized by comparing the amount of capital to the amount of business to be conducted and the obligations to be fulfilled. Therefore, absent adequate capitalization, a corporation becomes a mere liability shield, rather than an independent entity. Unfortunately, sometimes this shield works about as well as British Petroleum’s Deepwater Horizon well one mile below the Gulf of Mexico.
Three other corporate tactics that have come under increased scrutiny by the courts in tending to show undercapitalization are: 1) “disappearing assets”; 2) “milking”; and 3) “commingling of funds.” Disappearing assets refers to shareholders transferring corporate assets to themselves for little or no consideration. Any such transfers are seen as improper and generally found to be fraudulent. Milking is similar to disappearing assets in that milking involves the payment of excessive dividends or diversion of corporate assets to its owners. These dividend payments typically go well beyond the payment of normal dividends or salaries. Finally, the commingling of funds involves the owners of the company disregarding the corporate or LLC form and mixing personal funds with the company’s funds, or more likely, paying personal expenses with company funds. Again, the failure to keep funds segregated results in the courts being more likely to allow outside parties to pierce the corporate veil.
Many years ago, we represented an international company that was obviously unaware that self-help in resolving business disputes was frowned upon in this country. Our client, before they were our client, forced open the doors of a company and removed a substantial piece of industrial equipment over the course of a weekend. By the time the owners of the business opened on that following Monday, the equipment was in a shipping container at an east coast dock waiting to be shipped back to Europe. The business owner filed for bankruptcy and obtained an order against our soon-to-be client to return the equipment or face a fine of $10,000 per day! Our client, besides being outraged that it had to return what was “theirs,” retained us to fight back. We did by reviewing the bankrupt entity’s check register for the past year and discovered payments to credit cards without substantiation for what those payments included (e.g., dinners, clothes, entertainment, etc.), a single St. Louis Rams Personal Seat License (“PSL”) (which pretty much negated the idea that the seat was used for client entertaining), and college tuition payments (which were for the owner’s son). The Bankruptcy Court judge, after hearing of these facts, highly suggested to our counterpart to settle this case, as the use of these company funds for personal expenses would likely result in a decision not in accordance with what the bankrupt company had hoped. We settled the case.
Because most start-up companies rely on debt to provide their initial operations financing, their corporate protection may look fragile. There are, however, a couple of bright spots. First, courts in both Missouri and Illinois do not take these types of cases lightly and will narrowly construe attempts to pierce the corporate veil. Second, many courts will often take insurance into account when measuring adequate capital. Therefore, if a business has $1,000,000 of liability insurance, then the court will see that business as having made $1,000,000 available to tort creditors and not permit the creditor to attack personal assets.
Overall, there are many ways in which a new business can protect itself. As is often the case, having a sound written business plan can ensure that all liabilities are understood from the entity’s formation. Also, having a firm understanding of the type of business, the initial cash flow needs and the risks inherent in such a business is important in understanding the amount of needed capital.