This will be a multi-post blog entry. This third post discusses liability of owners due to inadequately drafted company agreements among the owners.
Post 3 – Personal Liability Due to Improperly Drafted Documents
Corporations and LLCs provide their owners with protection from personal liability as a matter of law. These entities are typically regulated internally in accordance with their governing documents, such as certificate of formation, limited liability company agreement, bylaws, etc., depending on the type of entity. While statutes generally provide for certain default rules regarding governance, it is nonetheless imperative to have customized documents to meet the Businesses’ specific needs. The purpose of the governing documents is to determine the rights, powers, and duties of the owners, officers, and governing authority of the Business, while also providing how business transactions will be voted for and managed. Business owners must ensure certain provisions are appropriately drafted specifically keeping in mind owners’ intent, while also protecting them from liability and losses. Some examples follow.
Indemnity and Insurance: LLCs and corporations are typically permitted by statute to indemnify or reimburse expenses incurred by owners and managers depending on certain circumstances. If the governing documents do not provide for indemnity protection, it may give rise to situations where the owners may become liable in a lawsuit brought by a third party for business debts and may be unable to obtain reimbursement from the Business.
Capital Contributions: Business owners often start out by making initial capital contributions to the Business. There may be a pre-agreed business plan whereby owners infuse additional capital in subsequent calendar quarters or annually. The governing documents may provide for additional capital contribution up to a specific amount or may cross-refer to figures and milestones in the business plan, or in some circumstances even disallow it altogether. If a governing document is improperly drafted, then the owner could be required to keep making capital contributions, even if the Business is failing.
Veil Piercing: Courts have imposed a requirement that Businesses be adequately funded for their intended operations in order to avoid veil piercing claims, e.g. Businesses dealing with hazardous chemicals, materials, or dangerous activity may be required to have appropriate third-party insurance.
Unexpected Change in Control: Improperly drafted documents could allow a creditor or some other third party to take control of the Business, leading to a host of unintended consequences if the Business runs into problems.
Our next post will discuss other provisions, which, if not appropriately drafted, may lead to one owner becoming liable to the Business.
This posting is intended to be a planning tool to familiarize readers with some of the high-level issues discussed herein. This is not meant to be a comprehensive discussion and additional details should be discussed with your transaction planners including attorneys, accountants, consultants, bankers and other business planners who can provide advice for your circumstances. This article should not be treated as legal advice to any person or entity.
About the Author
Shawn McBride – R. Shawn McBride is the Managing Member of The R. Shawn McBride Law Office, P.L.L.C. which helps clients in legal issues related to starting companies, joint ventures, raising capital from and negotiating with investors and outside General Counsel functions. Shawn can be contacted at: (214) 418-0258; firstname.lastname@example.org, or www.mcbrideattorneys.com.
Saurabh Nathany – Saurabh Nathany is a Paralegal at The R. Shawn McBride Law Office, P.L.L.C. Saurabh can be contacted at: (312) 394-9924, or email@example.com.