Preservation of limited liability is an important issue specific to corporations. The corporate protection of limited liability can be lost through:
- Piercing of the corporate veil
- Defective incorporation
- Improper signing of documents.
Piercing the Corporation Veil
A court may pierce through the veil of liability protection if the corporation does not follow proper corporate formalities, if it is undercapitalized, or if it can be shown that it is a sham that was set up to defraud.
If the corporate formalities are not followed, the corporation may be deemed to not be functioning as a corporation, but rather, as the alter ego of the owners. To prevent the corporate veil from being pierced, it is important to keep minutes of the board meetings and to not co-mingle bank accounts. These measures help to ensure that the corporation will be treated as a separate entity should it be sued.
Case: Edwards Company, Inc. v. Monogram Industries, Inc.
In 1977, Monogram Industries, Inc. acquired Entronic Corporation, a company that produced smoke detectors. Monogram made the puchase through a wholly-owned subsidiary called Monotronics, itself a corporation. Monogram owned 100% of Monotronics' stock. Monotronics then formed the Entronic Company, a limited partnership in which Monotronics was the only general partner. All went well until 1978 when General Electric began dumping smoke detectors on the market. A company called Edwards had extended about $350,000 of trade credit to Entronic, which Entronic was unable to pay, resulting in the liability of the general partner Monotronics. However, Monotronics had only about $10,000 in total assets at the time, so Edwards sued Monogram Industries to recover the debt, attempting to pierce the corporate veil of Monotronics.
Edwards claimed that Monotronics had the same board of directors, same office, same payroll, and the same telephone as Monogram Industries, and therefore Monotronics was simply a piece of paper in Monogram's file cabinet.
The court ruled that Edwards could not pierce the corporate veil. Monogram was not liable for the debt of Monotronics.
The court described a very clear test to determine whether one can pierce the corporate veil. In order to pierce the corporate veil in contract cases, both of the following must be shown:
- There must be fraud or injustice, and
- There must be a lack of separate existence.
The court found no evidence of either of these. There was no evidence of not abiding by corporate formalities, no evidence of co-mingling of money (alter ego claim), and no evidence of under-capitalization. Edwards had not performed adequate due diligence. It used outdated Dun and Bradstreet reports in its research and did not really understand which entity it was doing business with.
Besides cases involving the piercing of the corporate veil, individuals may be held personally liable for a corporation's debt in some cases of defective incorporation and improper signing of documents.
Suppose that a person forms a corporation and convinces two other people to invest. If the corporation later gets sued and it is discovered that the corporation had not been formed properly, the investors may not have limited liability due to defective incorporation.
Individuals may be held personally liable if the corporation is not set up properly but proceeds to do business. In such cases of defective incorporation, one can escape personal liability under certain conditions. For example, if a good-faith effort was made to incorporate and a substantial portion of the incorporation laws were followed, limited liability protection may be granted.
Signing of Documents
When signing documents on behalf of a corporation, both the name of the corporation and the signer's representative position in the corporation must be stated.
By: John Doe's signature
Name: John Doe
Case: Wurzburg Brothers, Inc. v. James Coleman
James Coleman is the president of Coleman American Moving Services, Inc., a publicly owned Delaware corporation. Wurzburg Brothers extended trade credit to Coleman American, and Coleman American was getting behind on its payments. Wurzburg had Coleman American sign a promissary note because it feared that Coleman American would become insolvent. The note read, "Coleman American Moving Services, Inc. promises to pay" $44,419.68. The note was signed, "James H. Coleman" and did not indicate Coleman's representative capacity as president of Coleman American. Coleman American defaulted on payments. Wurzburg then sued Mr. Coleman to personally repay the debt.
The issue here is whether the corporate instrument was properly signed.
The court ruled that Mr. Coleman was personally liable for the debt.
Mr. Coleman did not follow the proper procedure for signing corporate instruments in a representative capacity.
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