In a case of first impression in Illinois, the Second District, in Fontana v. TLD Builders, Inc., 840 N.E.2d 767 (Ill.App.2005), held that a non-shareholder can be held liable when the corporate veil of a for-profit corporation is pierced. The Second District had previously held, in Macaluso v. Jenkins, 420 N.E.2d 251 (1981), that the chairman of the board of a not-for-profit corporation could be liable when the not-for-profit’s corporate existence was disregarded.
The decision on this issue is not surprising. If the corporate existence is disregarded and the “veil” pierced, the issue then becomes what does exist when the court looks past the corporate form. Generally, what does exist is either a sole proprietorship or a partnership. In this case, the court in effect found that the individual defendant, who was the husband of the purported “sole shareholder,” exercised such control over the corporation that there was not a separation of the corporate personality from him personally.
The court cited eleven factors which courts examine to determine whether there is a unity of interest between an individual and a corporation:
(1) inadequate capitalization; (2) failure to issue stock; (3) failure to observe corporate formalities; (4) nonpayment of dividends; (5) insolvency of the debtor corporation; (6) nonfunctioning of the other officers or directors; (7) absence of corporate records; (8) commingling of funds; (9) diversion of assets from the corporation by or to a stockholder or other person or entity to the detriment of creditors; (10) failure to maintain arm’s-length relationships among related entities; and (11) whether, in fact, the corporation is a mere facade for the operation of the dominant stockholders, citing Jacobson v. Buffalo Rock Shooters Supply, Inc., 278 Ill.App.3d 1084, 215 Ill.Dec. 931, 664 N.E.2d 328 (1996); Estate of Wallen, 262 Ill.App.3d at 69, 199 Ill.Dec. 359, 633 N.E.2d 1350. 840 N.E. 2d at 778.
The court’s analysis focused on five factors—inadequate capitalization, failure to observe corporate formalities, nonfunctioning of other officers or directors, absence of corporate records, and commingling of funds. Defendant did not contest the findings that the corporation was insolvent and did not pay dividends. The trial court had found that stock had been issued, which was the only factor it found in the defendant’s favor. There was no discussion of factors 9-11 above.
With respect to the necessity for adequate capitalization, the court, in citing Fiumetto v. Garrett Enterprises, Inc., 749 N.E. 2d 992 (2001), stated:
The consideration of whether a corporation is adequately capitalized is based on the policy that shareholders should in good faith put at the risk of the business unencumbered capital reasonably adequate for the corporation’s prospective liabilities. It is inequitable to allow shareholders to set up a flimsy organization just to escape personal liability. “To determine whether a corporation is adequately capitalized, one must compare the amount of capital to the amount of business to be conducted and obligations to be fulfilled.” 840 N.E.2d at 779
In determining that there was not adequate capitalization, the court ruled that the defendant’s wife was unable to produce the $1,000 check she testified she had written to pay for her 1,000 shares. Defendant argued that he and his wife had made substantial loans to the corporation and that the corporation had a $4 million line of credit at a bank. The court rejected this argument, stating that the loans demonstrate “the inadequacy of TLD’s capitalization” and indicate that “the initial capitalization, if any, was insufficient to conduct TLD’s business of building homes as a general contractor.” Id.
Defendant also argued that the spec homes he built over the years demonstrated adequate capitalization, but the court countered there was no evidence that these homes were unencumbered assets of TLD. Finally, defendant claimed that plaintiffs could have investigated his finances before contracting with him. The court acknowledged that undercapitalization is less a factor in a contract case than in a tort case, which is not a consensual transaction, but nonetheless concluded that this diminished factor did not undercut the judgment.
The court made short shrift of the claim that TLD failed to observe corporate formalities by focusing on the fact that there were no corporate resolutions authorizing the loans the defendant and his wife purportedly made to the corporation. The court also upheld the finding that the wife did not function as a director or officer. Defendant argued that she was active in deciding what properties to purchase, the types of homes to be built, and the selection of amenities for the homes. Again, the appellate court upheld the finding of the trial court which was supported by the fact that the wife knew little about the business and had no real decision making role. She basically did what she was told and had no knowledge of the financial aspects of the business.
Closely related to the corporate formalities issue is the question of whether the corporation maintained corporate records. Defendant argued that “TLD filed corporate bylaws, prepared resolutions and shareholder actions, filed all necessary paperwork with the Secretary of State, filed all tax returns, and maintained a separate bank account and financial records.” 840 N.E.2d at 781. The court responded that “the failure to keep and maintain corporate records is legion,” id., and pointed out that there were no resolutions authorizing the loans that defendant and his wife made to the corporation, nor any record of the terms of the notes, no record of loans in the tax returns, no notes supporting the loans, and no evidence of repayment. Furthermore, there were no records of the amounts borrowed to purchase the properties and build the homes that the corporation built. There were no written contracts with subcontractors or bids from them, no written charge orders or work schedules and no financial records other than draw schedules filed with title companies.
Probably the most damaging evidence related to the commingling factor. Though the count did not focus on this aspect, the loans previously discussed also evidenced commingling since there was a flow of funds back and forth between the two individuals and the corporation, without documentation. However the focus of the court was on the following:
DiCosola argues further that there was absolutely no evidence that TLD’s funds or assets were ever commingled or that the monies earned by the company were diverted to DiCosola and Theresa. We disagree. Teresa testified that TLD has never had any employees and does not pay a salary to anyone. TLD’s income tax returns for the years 1998 through 2002 reflect that no salary or wages were paid to anyone and that no compensation was paid to any corporate officer. Thus, neither DiCosola nor Theresa received any wages, salary, or compensation of any kind from TLD. Theresa also testified that she never received a dividend from TLD, and she admitted that she had testified earlier that she never received a check from TLD for anything. However, Theresa also testified that she had no idea how funds were deposited into her and DiCosola’s personal checking account, but she knew that they “cut a check from the business.” As such, funds from TLD’s accounts went into DiCosola and Theresa’s personal checking account. This money was not salary, wages, dividends, or distributions and, therefore, demonstrates the commingling of TLD’s funds with DiCosola and Theresa’s personal funds. From this and other evidence presented at trial, the trial court could have reasonably concluded that the funds or assets of TLD were with the personal funds and assets of DiCosola and Theresa. Thus, the trial court’s finding as to this factor was not against the manifest weight of the evidence. 840 N.E. 3d at 781.
In addition to “unity of interest,” plaintiffs needed to establish the “fraud, injustice, or inequitable consequences” prong of piercing the corporate veil. While the trial court did not specifically address this issue, the appellate court found there was substantial evidence to support the judgment. The lawsuit was filed September 4, 2001 and TLD had $1.8 million in assets at the beginning of the year and nothing at the end of the year. Defendant claimed that these funds were used to pay down TLD’s line of credit but the evidence showed that some of this money was paid to his wife. In addition, defendant stopped using TLD after the suit was filed and formed a new corporation to build new homes. According to the court, this was done to keep assets out of TLD and away from the creditors.
There are a number of lessons to be learned from this case. The first mistake the defendant made was in having his wife be the sole shareholder. His rationale was probably that he, as general manager of the business might incur personal liability but that his creditor could not reach the assets of the business if the stock were held by his wife. However, the corporation, as principal, would most likely be liable for any loss he caused under respondent superior or under general agency principles. Moreover, by having his wife be the sole shareholder and director when she knew nothing of the legal or economic side of the business, she looked inept when she testified and her lack of knowledge supported the findings of inadequate capitalization, nonfunctioning of officers and directors, and commingling of corporate assets.
The court’s analysis of lack of corporate formalities and failure to keep and maintain corporate records is instructive, not just for a corporation but also for limited liability companies (“LLCs”) as well. Many cases, in looking to the so-called corporate ritual, focus on the failure to hold shareholder and directors meetings. It is generally thought that it will be harder to pierce the veil of a LLC because the governing statute provides that the “failure [of an LLC] to observe the usual company formalities or requirements relating to the exercises of its company powers or management of its business is not a ground for imposing personal liability on the member or managers.” 805 ILCs 180/ 10-10 (C).
However, the focus of the court in TLD Builders was not upon a failure to hold meetings or observe “formalities,” but rather an absence of authorization and documentation. For example, the court referred to the absence of corporate resolutions authorizing the purported loans to the corporation, the absence of any notes or any documentation as to terms, and the failure to list any notes on the federal tax return. Arguably, in a one owner corporation or LLC, “meetings” are superfluous because how does one meet with oneself? However, if the owner lends money to the entity, such loan should be evidenced by a note issued by the entity and it should be reflected on the entity’s financial statements and tax returns. It would also be desirable to have a “consent” or other record executed by the owner on behalf of the entity authorizing the entity to borrow funds.
When proper procedures are not followed, it is also likely that commingling of assets will follow. In the TLD case, no dividends were declared and no salaries were paid. How then did defendant and his wife manage to eat? Apparently, they used the corporate bank account as their personal bank account. The wife testified, “she had no idea how funds were deposited into her and DiCosola’s personal checking account, but she knew that they ‘cut a check from the business.’” 840 N.E. 2d at 781.
In order both to avoid the unity of interested conclusion and to insure that there is not fraud injustice, or inequitable consequences, it is critical that the entitle have a separate economic existence from the owners. To accomplish this, the owners must first adequately capitalize the business. The $1,000 that typically is shown as the initial paid-in capital on the Articles of Incorporation filed with the Secretary of State rarely will be adequate. Then the entity must have a separate bank account and separate financial records. If funds are removed from the corporation, this also must be documented, whether by salaries, dividends, or loan or lease payments.
As the TLD Builders case demonstrates, informality and lack of documentation is a recipe for disaster.
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(N.B. This article is adapted from 7 Charles Murdock, Illinois Practice - Business Organization ‘8.9 ( West Suppl. 2006).
A corporate attorney should avoid getting into a professional dilemma by following a simple rule: KNOW YOUR CLIENT. However, following this advice is not as easy as it may sound, particularly when you do not want to turn away new business or, even worse, be required to introduce a long-standing “client” to another lawyer or law firm. Every attorney must remember that:
An attorney owes to his client an undivided allegiance, and after he has been retained by, and received the confidence of a client, he cannot, without the free and intelligent consent of his client, given after full knowledge of all the facts and circumstances act both for his client and for one whose interest is adverse to or conflicting with that of his client in the same general matter.1
This ethics rule can be particularly challenging when an attorney’s long-standing client wants to start a new business endeavor, along with a new party2 or with a new client who wants to start a business which will be owned by multiple people. What could happen if the attorney decides to set up the business and thereby represents more than one person in the same venture?3 The pitfalls of these scenarios are best illustrated with an example.
Agonizing Attorney has represented several separate companies owned exclusively by Dynamic Dad for ten years. Agonizing Attorney hopes to continue the long-standing relationship. Dynamic Dad calls to set up a new LLC with his Neurotic Nephew to be called Dad And Nephew’s Great Electronic Repair LLC (“DANGER”). Of course, Agonizing Attorney is more than willing to help. Agonizing Attorney meets with Dad and Nephew, organizes a new member managed LLC owned 50% by Dad and 50 percent by Nephew, and prepares DANGER’s Operating Agreement. Both Dad and Nephew are very excited about this venture and the opportunity to make a lot of money. During the next year, Agonizing Attorney routinely advises Dad and Nephew in matters relating to DANGER as it grows. Shortly thereafter, a dispute arises between Dad and Nephew over the operation of their business. The two seek Agonizing Attorney’s assistance to get out of DANGER, yet the dispute grows more acrimonious. Nephew winds up suing Agonizing Attorney alleging breach of duty of loyalty and a conflict of interest because Agonizing Attorney was Dad’s attorney prior to his organization of DANGER. Dad, a long-standing client, also sues Agonizing Attorney because Dad claims Agonizing Attorney is not giving him the best representation since he was also representing Nephew. Agonizing Attorney did not realize that helping out a long-standing client would result in two lawsuits, a loss of legal fees and possible ARDC disciplinary issues. Moral of the story: AVOID DANGER!
While Agonizing Attorney has a lot of trouble on his hands, there are a few simple steps to follow which can minimize Agonizing Attorney’s potential professional exposure in situations like this.
1. Protect yourself from multiple representations. An attorney who does not know who his client is may end up representing one client to the detriment of another client or, worse, multiple clients, which may give rise to an intractable conflict. The end result is a legal malpractice claim against the attorney and possible licensing sanction or, in a “best case” scenario, a refund of the parties legal fees previously paid. An attorney’s representation of two or more clients with adverse or conflicting interests constitutes such misconduct as to subject him to liability for malpractice, unless the attorney has obtained the consent of the clients after full disclosure of all the facts concerning dual representation.4 If a client consists of multiple parties and these parties do not want to hire independent counsel, the attorney must disclose the potential for competing interests and receive written consent from each party prior to commencing work for the parties. Additionally, an attorney must disclose and receive written consent for each new potentially conflicting transaction.5 Agonizing Attorney should have realized he was representing three different clients: Dad, Nephew, and DANGER LLC. As a result, Agonizing Attorney should have written three different consent letters disclosing the potential for possible conflict from the arrangements and corresponding client waivers to proceed. This is a painful process, as no counsel seeks to avoid a new representation or wants to introduce his clients to other counsel, but it is often the best protocol to follow.
2. Recognize the client’s issues and evaluate the scope of representation. An attorney should know exactly what the client expects from the representation and should advise the client as to whether these expectations are plausible. If the client’s business status changes during the course of representation, the attorney should be aware of these changes in order to make the appropriate accommodations. For example, Agonizing Attorney counseled Dad, the long-time client, Nephew, and DANGER LLC from time-to-time. Agonizing Attorney should have realized that trouble between Dad and Nephew may adversely affect his relationship with both parties. Therefore, Agonizing Attorney should have re-evaluated the scope of his representation and may have had a duty to withdraw from representing Dad, Nephew, and DANGER LLC, and just stick to representing Dad.6
3. Write engagement and non-engagement letters. An engagement letter should clearly state who the client is to prevent any questions about the identity of the client. This is especially important when dealing with an entity rather than an individual.7 Even if a client is a long-standing client, an engagement letter for a new matter should be created defining the scope of representation for the specific matter.8 Agonizing Attorney should have created an engagement letter for Dad, even if it was an informal letter summarizing the scope of the new LLC.
A non-engagement letter can be equally, if not more, important than an engagement letter. For example, if an attorney decides not to represent a party because of the potential for a conflict of interest with an existing client, the attorney should send the party a non-engagement letter stating that he is not representing the party and the party should seek different counsel.9 The purpose of the non-engagement letter is to make sure the attorney knows who his client is and to also make certain that a party is not under the misunderstanding that the attorney is representing him. If Agonizing Attorney did not obtain a disclosure and waiver from Nephew regarding the potential for a conflict of interest in the representation of DANGER LLC, he should have sent Nephew a non-engagement letter.
Attorneys can successfully defend against future challenges if they follow the simple rule: KNOW YOUR CLIENT. The key to following this rule is to avoid multiple representations, identify the scope of representations, write engagement and non-engagement letters, and stay away from DANGER.
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1. 7 Am Jur 2d Attorneys at Law § 197 (2006) (citing ABA Model Rules of Prof’l Conduct R. 1.7 cmt. (2006)); see also Ill. Sup. Ct. R. Prof’l Conduct, R 1.7 (2006).
2. Bobbit v. Victorian House, Inc., 545 F. Supp. 1124, 1126 (N.D. Ill. 1982) (holding attorney’s prior individual representation of director was not related to current cause of action and did not cause a conflict of interest when attorney represented incorporators, including the director, in dissolution of corporation).
3. Majumdar v. Lurie, 274 Ill. App. 3d 267, 274 (1st Dist. 1995) (holding that a genuine conflict of interest existed and could support a claim of legal malpractice where an attorney represented a corporate entity and an officer, director and shareholder of the entity).
4. 7 Am Jur 2d § 213 (2006) (citing ABA Model Rules of Prof’l Conduct R. 1.7 (2006); see also Ill. Sup. Ct. R. Prof’l Conduct, R 1.7 (2006).
5. Ransburg Corp. v. Champion Spark Plug Co., 648 F. Supp. 1040, 1045 (N.D. Ill. 1986) (holding that a law firm must completely disclose to a client the intention of undertaking the adverse representation and obtain its consent).
6. See generally, “Multiple Representations Create Conflict Hazards, ISBA Mutual Malpractice Prevention Update” (Anne E. Thar, Vice President and General Counsel ed. 1996) pp. 2 (1996).
7. See generally, “Engagement Letters Can Reduce Malpractice Claims, ISBA Mutual Malpractice Prevention Update” (Anne E. Thar, Vice President and General Counsel ed. 1996) pp. 1 (1996).
8. Sinclair v. Bloom, 1999 U.S. Dist. Lexis 3395, 3399 (N.D. Ill. 1999) (holding that an attorney, who never sent engagement letters in past transactions with the plaintiff’s husband, breached his fiduciary duty when he failed to reveal his personal interests in the current stock transaction he was working on for the plaintiff); see ABA Model Rules of Prof’l Conduct R. 1.3 cmt. (2006); see also Ill. Sup. Ct. R. Prof’l Conduct R 1.3 (2006).
9. ABA Model Rules of Prof’l Conduct R. 1.16 cmt. (2006); see also Ill. Sup. Ct. R. Prof’l Conduct, R 1.16 (2006).