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Be Sure to Observe Formalities to Protect Business Assets

February 8, 2017
By: Shep Davidson
When entering into a new venture, it is not uncommon for a new legal entity to be formed in order to insulate an existing company from the liabilities associated with the new business. While the law absolutely permits this, a recent case in the Bankruptcy Court, In Re Cameron Construction & Roofing, is a good reminder that achieving true insulation requires more than simply filing another set of Articles of Incorporation.In 2000, Cameron Construction & Roofing, Inc. (“Inc.”) was formed by Wilfred Cameron, who was the corporation’s President, Treasurer, Clerk and sole Director. Two years later, Mr. Cameron formed Cameron Construction LLC (“LLC”), and he was named its Managing Member. Further, Mr. Cameron owned 99.9% of the equity in LLC, with the remaining 0.1% being held by Inc.By 2014, Inc. had become insolvent, and it filed a Chapter 7 Bankruptcy Petition. A Trustee was appointed to marshal and distribute Inc.’s assets, and LLC was joined as a defendant in the bankruptcy proceeding. Specifically, the Trustee sought to have the Court rule that assets of LLC could be used to satisfy the debts of Inc. LLC objected to this, arguing, that it was undisputed that the two entities filed their own tax returns, had separate employees to whom W-2s were issued, and filed their own Annual Reports. Nevertheless, there also was evidence that:

  1. While Inc. provided 10% of the capital used to launch LLC, Inc. only was given a 0.1% equity stake in LLC.
  2. From 2011-2013, LLC’s 17 employees worked exclusively for Inc., and such work was outside the scope of LLC’s stated business purpose.
  3. While Inc. supposedly leased space from LLC, there was no written lease, the amount of rent paid varied from year to year, and LLC booked these supposed rent payments as payments for the work its employees provided to Inc..

After considering all of the foregoing, the Court ruled that:

The evidence established that there was common ownership of [Inc. and LLC] by Wilfred Cameron, who controlled the two entities and there was intermingling assets. [Inc.] was thinly capitalized, and the two entities observed only minimal corporate formalities by filing separate tax returns and Annual Reports. There [also] was no evidence of other corporate record keeping or payments of dividends.

As such, the Court allowed the Trustee to apply assets of LLC to the debts of Inc.  More generally, and as Cameron and numerous other cases have noted, in evaluating whether one entity can be liable for the debts of another, courts will evaluate the following factors:

(1) Common ownership; (2) pervasive control; (3) confused intermingling of business activity assets, or management; (4) thin capitalization; (5) nonobservance of corporate formalities; (6) absence of corporate records; (7) no payment of dividends; (8) insolvency at the time of the litigated transaction; (9) siphoning away of corporate assets by the dominant shareholders; (10) nonfunctioning of officers and directors; (11) use of the corporation for transactions of the dominant shareholders; (12) use of the corporation in promoting fraud.

So while setting up a new entity may be a prerequisite to insulating an existing business from liability, such protection only will be achieved if continued diligence in keeping the companies separate is exercised.

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