As the owner of a corporation, when you set up your business, you and your lawyer believed that you had taken all necessary steps to protect your personal assets. After all, the primary reason you set up a corporation was to shield your own assets from your business’s creditors. In order to ensure that your assets are safe from the corporation’s creditors, you need to do more than just fill out the Secretary of State’s paperwork. The corporation must conduct itself as an entity separate and apart from you as the owner.
A recent decision provides a “textbook” example of how an owner of a corporation can put his own assets at risk simply by the way he conducted his company’s business. In Puntillo v. Dave Knecht Homes, the plaintiffs were a married couple who entered into a contract with a home builder, a corporation. The defendants, David and Karen Knecht, were the beneficiaries of a trust that held the home builder’s shares of stock. They were, in essence, the owners of the home-builder corporation. After the home was completed, it was riddled with defects and the couple obtained a judgment against the corporation. Thereafter, the corporation dissolved and the couple was unable to enforce their judgment. In the midst of all of it, a new corporation, Dave Knecht Homes, was created with similar ownership, management, staff, purpose and resources as the now asset-less builder. The defunct builder and the new company used the same line of credit. Beginning in 2006, Dave Knecht’s personal line of credit began funding the now defunct builder’s operations. After the new corporation, Dave Knecht Homes, came along, it also used the same credit line. After being unable to collect on its judgment against the out-of-business builder, the plaintiffs sued Dave Knecht Homes and its owners Dave and Karen Hecht personally. The plaintiffs claimed the new company was merely a successor to the defunct corporation and the corporate veil between the individuals and the successor, Dave Knecht Homes, should be “pierced,” allowing the plaintiffs to go after the individual owners for a corporation’s debt.
Generally, a corporation that purchases the assets of another corporation is not liable for the debts or liabilities of the selling corporation. There are, however, four exceptions to this general rule of successor corporate nonliability: (1) where an express or implied agreement of assumption of the liability exists; (2) where the transaction amounts to a consolidation or merger of the purchaser or seller corporation; (3) where the purchaser is merely a continuation of the seller; or (4) where the transaction is for the fraudulent purpose of escaping liability for the seller’s obligations. In this case, the plaintiffs successfully argued that Dave Knecht Homes is a “mere continuation” of the former company and the court agreed. The continuation exception applies when the purchasing corporation is “merely a continuation or reincarnation of the selling corporation.” In other words, the purchasing corporation maintains the same or similar management and ownership, but merely wears different clothes. The Illinois Supreme Court has made it clear that “[t]he exception is designed to prevent a situation whereby the specific purpose of acquiring assets is to place those assets out of the reach of the predecessor’s creditors.” To determine whether one corporate entity is a continuation of another, courts consider “whether there is a continuation of the corporate entity of the seller—not whether there is a continuation of the seller’s business operation.” Thus, the plaintiffs were permitted to look to the assets of the new company to satisfy their judgment. Unfortunately for the Knechts, it didn’t end there.
The plaintiffs also argued that the out-of-business corporation served as the Knecht’s “alter ego” and that the court should pierce the defunct builder’s corporate veil and impose individual liability against the Knechts. A court may disregard a corporate entity and pierce the veil of limited liability where the corporation is merely the alter ego or business conduit of another person or entity.” This doctrine imposes liability on the individual or entity that “uses a corporation merely as an instrumentality to conduct that person’s or entity’s business.” In Illinois, courts use a two-prong test to determine whether to pierce the corporate veil: “(1) there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist; and (2) circumstances must exist such that adherence to the fiction of a separate corporate existence would sanction a fraud, promote injustice, or promote inequitable consequences.
The court found that the Knechts exercised control over the new builder and treated the company’s assets as their own, causing the company to pay significant sums of money for their own personal expenses including federal and state income tax payments, landscaping for their personal residences; personal life insurance premiums and attorney’s fees. Moreover, the Knechts caused the failed company to pay their personal expenses using David Knecht’s credit line. By causing Knecht’s former company to pay their significant personal expenses, the Knechts treated the company’s assets as their own. The court pierced the corporate veil of Dave Knecht Homes (who it imposed successor liability upon) and allowed the plaintiffs to enforce their judgment against David Hecht Homes and the individual defendants.
In order to insulate yourself from personal liability, as a business owner, the way that you run the business is as important as setting up the corporation in the first place.
For more information, please contact:
Howard Teplinsky at: email@example.com or 312-368-0100.
John, Alexandria, Mary, Martin, and Yvette, formed the Jammy Sleepwear Company over thirty-five (35) years ago. They were equal partners and formed a corporation. On the advice of their attorneys, the entered into a shareholders’ agreement that contained buy-sell provisions. This type of agreement is sometimes referred to as a “buy-sell agreement”.
Their buy-sell agreement contained various provisions, including under what circumstances a departing shareholder’s shares would be purchased, what the purchase price of those shares would be, and the terms of payment. Since the business was in its infancy, they agreed it would be valued at its “book value”, meaning that the value of the assets on its financial statements, less all obligations, would be the business’s value. There was no adjustment for good will or other intangible assets. Also, the increase in value of any assets would not be taken into consideration. The purchase price to a departing shareholder was to be paid in twelve (12) months, in equal monthly payments. The business was required to purchase a departing shareholders shares.
Since they formed the business in 1980, they acquired other businesses and purchased real estate through a separate LLC. They did not think to have a buy-sell for the LLC.
John has announced he would like to retire, but he has objected to the purchase price as being “unfairly” low. He has advised the other owners that he will keep his interest in the real estate, since it will provide him with a “good stipend” during his retirement. Shortly thereafter, Mary announced her retirement.
The remaining owners are concerned that the business will not be able to support payments to John and to Mary. Also, the remaining owners would prefer that John and Mary also sell their interests in the LLC.
Unfortunately, the shareholders (and LLC members) did not regularly review their buy-sell agreement. As the value of the business grew, the amount of the payments increased and would put a strain on the cash flow of the business. If more than one owner were to retire, it would cause a bigger strain. Either the business would have to borrow money, the owners would have to make capital infusions, new investors would be needed, or the business would need to be sold.
Some buy-sell agreements address these types of situations, by limiting the amounts that must be paid out to departing owners on an annual basis. For example, the payments cannot exceed a specific dollar amount or a percentage of gross profits. Also, when the owners buy real estate to be used by the business, they might consider including the real estate as a part of the buy-sell process.
Buy-sell agreements should be reviewed periodically to ensure they continue to meet the needs of the business and its owners. Levin Ginsburg has been advising business owners regarding legal aspects of their businesses, including buy-sell agreements for almost forty years.
Please contact us with any questions you have regarding your business (including any buy-sell issues) at 312-368-0100 or Morris Saunders at firstname.lastname@example.org.