Mountain Law: The limits of limited liability
The availability of “limited liability” is one of the primary reasons people choose to operate businesses in the form of corporations, limited liability partnerships (LLPs), or limited liability companies (LLCs) that provide it. But what is limited liability and what are its limits?
Limited liability in no way limits the liability of a business itself. (For example, if an LLC signs up for a lease, it is liable for paying the lease to the extent it has assets to do so.) Instead, limited liability reduces the exposure of business owners to business liabilities. The idea is that people who invest in a company may stand to lose their investment, but, to the extent that they are protected by limited liability, their personal assets should not be at risk.
As an illustration, a shareholder in British Petroleum might stand to lose the value of shares held in the company, but generally speaking has no exposure to personal liability for the recent oil spill. If this wasn’t the case, it would discourage investments out of fear for liability – nobody would buy stock in companies – and our capitalistic system would not work as well.
An unfortunate consequence of limited liability is that it can sometimes be used by business owners to avoid paying their creditors. To address this issue, courts must decide in certain circumstances whether the owners of a company should bear losses instead of the company’s creditors. There are three main circumstances in which this happens:
1. Assumption of liability under contract law. As a condition of extending credit to a limited liability entity, a lender may require the owners of the entity to assume personal liability for the debt. For example, a landlord may require the owners of an LLP to personally guarantee a lease if the lease is not paid by the company. In this situation, the court will enforce the agreement and hold the owners liable under principles of contract law.
2. Liability under tort law or criminal law. The owners of a company can also be liable for torts or crimes committed in the course of the company’s business. (For a general discussion of torts, see my April 7, 2010, article titled “Torts are a piece of cake”). For example, the owner of an LLC will be personally liable for injuring a pedestrian while driving the company truck, and Martha Stewart was found guilty for committing certain corporate crimes.
3. Piercing the corporate veil. The owners of a limited liability entity can also be found personally liable for company obligations if the company’s creditors can do a mysterious thing called “piercing the corporate veil.” Courts allow creditors to pierce the corporate veil in unusual circumstances when they believe it is required to avoid injustice. Unfortunately, because the availability of this relief is up to a judge’s discretion, it is not easy to predict when it will apply. Generally speaking, a court will allow creditors to pierce the corporate veil based on the following factors:
a. The company is grossly under-capitalized (i.e. the owners did not put enough money into the company in the first place for it to reasonably meet its obligations);
b. The company does not keep records required by law or fails to observe formalities (such as keeping personal accounts separate from business accounts) so that the company is clearly separate from its owners; or
c. The owners have siphoned away company assets.
Business owners and creditors should recognize that limited liability is a tool, but they should also recognize that it has its limits. Owners should take reasonable precautions to avoid a creditor piercing the corporate veil, and creditors should be aware that there are potential opportunities to collect debts directly from business owners.
Noah Klug is principal of The Klug Law Firm, LLC, a general law practice in Summit County emphasizing real estate, business law and litigation. He may be reached at (970)468-4953 or Noah@TheKlugLawFirm.com.
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