Another important issue that small business owners should be aware of is the “single business enterprise” (SBE) theory.  In most cases where an investor owns multiple businesses, the various business interests will be separated into different LLCs or other entities.  The primary purpose of that structure is to protect the assets of the other businesses in the event one of the businesses has financial difficulties or faces legal liability.  The SBE theory allows the court to disregard the corporate structure and treat all the entities as one, resulting in all entities being liable for a judgment against single entity.

The SBE theory of liability has been applied in situations where one entity “is so organized and controlled as to make it merely an instrumentality or adjunct” of another entity.  In those cases, the courts have imposed liability on the related entity and rejected the argument that the related entity is free from liability because it is a separately organized or incorporated entity.

In Green v. Champion Insurance Company, the court outlined a set of factors to be considered when determining whether several related entities constitute a single business enterprise:

1. companies with substantial identity of ownership or ownership sufficient to give actual working control;
2. common directors, officers or members;
3. unified administrative control of entities with similar business functions;
4. directors and officers of one entity act independently in the interest of that entity;
5. one entity financing another entity;
6. inadequate capitalization;
7. one entity causing the incorporation or organization of another affiliated entity;
8. one entity paying the salaries and other expenses or losses of another entity;
9. receiving no business other than that given to it by its affiliated entities;
10. one entity using the property of another entity as its own;
11. noncompliance with corporate formalities;
12. common employees;
13. services rendered by the employees of one entity on behalf of another entity;
14. common offices;
15. centralized accounting;
16. undocumented transfers of funds between entities;
17. unclear allocation of profits and losses between entities; and
18. excessive fragmentation of a single enterprise into separate entities.

The court in Green ruled that several related insurance companies could be held liable for the debts and obligations of the others because the entities were operated as a single business enterprise.  The facts the court found important were:

1.     The same family members were the controlling shareholders of all of the corporations;
2.     Two of the shareholders “dominated the affairs of all of the corporations”;
3.     The corporations entered into some transactions without economic justification and solely for the benefit of another related entity;
4.     There was “a tremendous amount of intercompany debt due to the lack of adequate initial capitalization”;
5.     The entities were financed primarily through intercompany debt;
6.     The income of the companies was largely dependent on collecting receivables from the other entities;
7.     There were common employees and at least one entity had no employees;
8.     Some employees received salaries from more than one entity;
9.     Almost all of the business of the entities was given to them by the other entities;
10.  Some employees were compensated by more than one member of the group;
11.  Substantial intercompany debt;
12.  Corporate formalities were not observed;
13.  Centralized offices for the entities; and,
14.  Transactions among the entities were not properly reflected in the accounting records.

All of the entities in Green were liable for the debts and obligations because the court found that the entities “were not operated as separate entities,” but rather “functioned as a single economic entity despite the internal compartmentalization of ownership and operation by means of separate incorporation.”  An important point to note about the factors from Green is that fraud is not identified as a requirement.  Simply operating the entities as one economic unit could be sufficient for the courts to impose liability on all the entities.

The lesson for a small business owner is similar to the lesson learned from understanding the “alter ego/veil piercing” theory (see my previous blog post:  “Why an LLC won’t protect your personal assets (and how to actually protect those assets)”).  While some overlap among related entities is acceptable and obviously efficient, maintaining the distinction among them as truly separate entities is critical to protecting the assets and interests held by the entities. In order to accomplish the ultimate purpose of the corporate structure, keep their dealings separate and treat them as separate companies in all respects.  

As your business grows, you may have the chance to acquire smaller, less profitable businesses as part of your growth strategy.  In most cases, the acquiring entity or newly formed entity intends to purchase only the assets, and not debts and obligations, of the other company.  This is an efficient way to expand operations and increase revenue, but if you aren’t careful, it could lead to unwanted liability related to the business dealings of the company being acquired.  

The legal theory of “successor liability” allows the court to hold  an acquiring entity, or newly formed entity, liable for the debts of the acquired entity if: (a) the new entity expressly assumed the liabilities of the old entity; (b) the formation of the new entity was entered into to defraud the creditors of the old entity; or (c) the circumstances attending the creation of the new company and its succession to the business and property of the old company are such that the new company was merely a continuation of the old company. In Hollowell v. Orleans Regional Hospital, LLC, the court listed eight factors that are used to determine if a new company is a mere continuation of an older company:

1. retention of the same employees;

2. retention of the same supervisory personnel;

3. retention of the same production facility in the same physical location;

4. production of the same product;

5. retention of the same name;

6. continuity of assets;

7. continuity of general business operations; and

8. whether the successor holds itself out as the continuation of the previous enterprise.

The court also pointed out that a finding of fraud is not a prerequisite to establishing successor liability, meaning that the acquiring company could face liability simply by not ensuring that adequate legal measures are taken to distinguish the old company from the new company.

Successor liability was applied in Hollowell to hold a successor company liable based on the fact that it received an assignment of the former entity’s hospital license, medicaid provider numbers, and managed care contracts. The assignments to the new LLC allowed the former entity to avoid an estimated $200,000.00 in liabilities; the new entity hired most of the employees and some of the supervisory personnel from the former entity; and the two entities operated out of the same physical location and used the same phone number. The court ruled that, based on the evidence presented, there was a legally sufficient basis for the jury to find successor liability under Louisiana law.

It’s important for any business considering acquisitions as a growth strategy to be aware of the theory of “successor liability.”  By properly structuring the transaction, you can ensure that your business acquires only those assets it intends to acquire and addresses the outstanding debts and obligations of the old company so they don’t become an unexpected problem as your business continues to grow.

One of the most common issues I see in my practice is small business owners who are facing litigation against their LLCs and who assume that, because they set up an LLC, their personal assets are automatically protected.  Unfortunately, that is not always the case.  There are exceptions to the limited liability offered by an LLC or even an “S corp” that every small business owner should know about.  Following a few basic steps and understanding the theories courts use to impose personal liability could help maintain the distinction between you, as an owner of the LLC, and the LLC itself.  In the long run, this could help you avoid personal liability for activities conducted in the name of the LLC.

An LLC is recognized by the courts as a distinct entity, separate and apart from the members who comprise the ownership.  The courts, however, have developed a theory, commonly referred to as “piercing the corporate veil,” to impose liability on individual members when the owners of an LLC appear to be using the LLC solely as a means to avoid personal liability or operating the LLC as a shell company.  For example, in ORX Resources, Inc. v. MBW Exploration, L.L.C.,[1]  the court ruled that a member of an LLC was personally liable for the debts of an LLC because the member “operated [the LLC] as his alter ego” based on the fact that the LLC was not yet in existence when certain contracts were signed on its behalf, that it never had a bank account, and that debts of the LLC were paid by the member individually and by another LLC controlled by the member.

The court noted that while members of an LLC are generally not personally liable for the debts of the LLC, third parties can bring claims against members and managers individually in certain situations, such as when fraud is present. Courts in Louisiana analyze the following factors to determine if a member of an LLC may be held liable for the debts and obligations of the LLC under an alter ego/veil piercing theory: 

·      Was there commingling of corporate and shareholder funds;
·      Did the LLC fail to follow statutory formalities for incorporating or organizing and transacting corporate affairs
·      Was the LLC undercapitalized
·      Did the LLC have separate bank accounts and bookkeeping records
·      Did the LLC hold regular corporate meetings.

The court in ORX wrote that “one of the primary components which justifies piercing the veil is often present: to prevent the use of the corporate form in the defrauding of creditors.” The member who was sued in ORX basically operated the LLC as a shell entity and, according to the court, “tried to avoid paying a legitimate debt of the LLC.”  After reviewing the facts of that case, the court ruled that the corporate veil of the LLC could be pierced and that the member was personally liable for the debts of the LLC.

There are some simple and basic lessons a small business owner can take away from the ORX case.  First, always treat the LLC (or other corporate entity) as just that – a separate entity, with its own bank accounts, insurance, records and dealings. Commingling of personal and corporate funds is one of the most common ways small business owners unintentionally expose themselves to personal liability.

Second, follow basic corporate formalities: file the necessary documents with the Secretary of State, obtain the required occupational and professional licenses, if applicable, and hold regular owner/shareholder meetings, keeping minutes of the meetings and preparing short corporate resolutions or member consent documents for decisions made on behalf of the company.  Third, when transacting business on behalf of the LLC, always indicate that you are doing so solely in your capacity as a member or manager of the LLC. 

Failing to do so blurs the line between you and the company and could be used against you on an alter ego/veil piercing claim. Following these easy steps won’t guarantee that you won’t get sued one day, but you’ll be much better prepared and more protected if it does happen.