Corporate Formalities as a Means of Preserving the Corporate Veil and Avoiding Lawsuits

Posted on March 10, 2009

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A benefit of having a corporation is that a corporation is recognized as a legal “person,” separate and distinct from its individual directors and officers and it offers limited liability to these directors and officers.  Clients often ask us if they can sign leases or other contracts before their company is incorporated.  We typically frown on this practice because the corporation should be operated in a manner which maintains its separate identity.  This requires that the corporation abide by certain formal legal requirements, including signing in one’s executive capacity after incorporation and not before.   A recent case, Hugh W. Brown, Jr. and Alabama MBA, Inc. v. W.P. Media, Inc., No 1061314 (Ala. February 20, 2009) decided by the Alabama Supreme Court deals with this issue in a contractual setting.

In 2001, W.P. Media, Inc. and Alabama MBA, Inc. entered into a contract (the “Operating Agreement”) whereby the parties agreed to operate a joint venture named Alabaster Wireless MBA, LLC.  Id. Brown signed the contract, purportedly on Alabama MBA’s behalf as its chairman of the board.  Id. In May 2005, Brown and Alabama MBA filed a complaint in the Jefferson Circuit Court alleging that W.P. Media had breached the Operating Agreement by failing to construct a wireless network as required by the agreement.  Id. In January 2007, W.P. Media moved for a summary judgment on the remaining claim that they breached the Operating Agreement, claiming that the articles of incorporation for Alabama MBA were not filed until 2002, after the operating agreement had been executed, and therefore, the Operating Agreement was void because Alabama MBA lacked capacity to enter into the contract.  Id.

The issue in this case is whether Alabama MBA was properly incorporated at the time the Operating Agreement was executed and when the underlying action was filed.  Hugh W. Brown, Jr. and Alabama MBA, Inc. v. W.P. Media, Inc., No 1061314 (Ala. February 20, 2009).  It is undisputed that the Articles of Incorporation were not filed at the time the Operating Agreement was executed.  Id. Additionally, Alabama MBA did not hold an organizational meeting pay taxes, issue stock or adopt bylaws until early 2007.  Id. Also, before then, Alabama MBA had no bank accounts or employees and company expenses were paid by Mr. Brown personally.  Id. However, under Alabama Code Section 10-2B-2.03(a), “Unless a delayed effective date is specified, then the corporate existence begins when the Articles of Incorporation are filed.”  The plain language of the statute means that the probate judge’s filing of the Articles is conclusive proof that the incorporators satisfied all conditions precedent to incorporation.  Since the Articles were filed in 2002, years before the underlying action was initiated, then the court held that there is no merit in the argument that Alabama MBA was not properly incorporated and thus cannot be a real party in interest in the case.

The Alabama Supreme Court decided to apply the principle of estoppel in this case.  Alabama MPA argued that because W.P. Media treated MCA as a corporation, W.P. Media is estopped from denying their corporate existence.  Hugh W. Brown, Jr. and Alabama MBA, Inc. v. W.P. Media, Inc., No 1061314 (Ala. February 20, 2009).  W.P. Media entered into a contractual relationship with Alabama MBA to operate Alabaster Wireless.  Id. The Operating Agreement identified Alabama MBA as a corporation and was executed in the corporate name and signed by Mr. Brown as the corporation’s Chairman of the Board.  Id.  W.P. Media did not challenge the validity of the Operating Agreement until after it was sued for breaching the agreement.  Id.  Therefore, the court held that W.P. Media’s actions of entering into a contract and participating in the joint venture with Alabama MBA before and after the Articles were filed estopped W.P. Media from denying Alabama MBA’s corporate existence for purposes of challenging the validity of the Operating Agreement.  Id.

Despite the fact that W.P. Media was stopped from denying the corporate existence, we would recommend to clients that the proper formalities are followed in order to avoid a similar claim that the Operating Agreement (or other contract) is void.   One of the principal reasons for using the corporate form and following the legal formalities I will describe below is to preserve the corporate veil and thereby minimize the chance that directors or officers will be held personally liable for corporate debts.  You would not want to rely on a principal of estoppel or equity to protect you under the corporate veil.

Mr. Brown, Chairman of the Board of Alabama MBA, made numerous mistakes when forming the corporation, and we would like to point some of these out and recommend ways to avoid them.  First of all, the Articles of Incorporation need to be filed before any other contracts or leases are entered into on the corporation’s behalf.  This will help to avoid a claim that the contracts are void down the road.  Secondly, any documents that are signed on behalf of the corporation should be done in a way so as to make it clear that you are signing as an agent and officer of the corporation, and not in your individual capacity.  The easiest way to do this is to list your corporate title underneath your name.
Additionally, it is very important that the affairs of the corporation and the personal affairs of its officers, directors, and shareholders be kept separate and distinct.  Mr. Brown made a mistake when he failed to open up a corporate bank account and company expenses were paid out of his personal account.   A good rule of thumb is to never mix the corporate and personal funds.  The assets and liabilities of the corporation should be kept separate from those of shareholders, directors and officers.
In addition to proper formation, the owner must ensure the barrier to personal liability is maintained by following certain corporate formalities.  A corporate veil analysis also includes a review of the following factors: (1) adequate capitalization, (2) filing annual reports, (iii) conducting business in the company name; (iv) not giving personal guarantees; (v) holding annual meetings of the directors and shareholders; and (vi) maintaining books and records.

Therefore, it is important that business owners treat the corporate identity with respect in order to avoid the piercing of the corporate veil and the potential for lawsuits.

Elizabeth Ritter, Goodrich Law Firm, LLC

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