Recent Court of Appeals Case Emphasizes Importance of Following Corporate Formalities

A 2015 unpublished Minnesota Court of Appeals decision reiterates the importance of following corporate formalities in order to avoid personal liability for the obligations of a business entity.

Corporate-Records-Computer-FilesIn Langford Tool & Drill Co. vs. The 401 Group, LLC, et al., Court File No. A14-0507, Lommen Abdo attorneys Barry O’Neil and Kay Nord Hunt successfully defended an individual owner of The 401 Group, LLC with regard to alleged personal exposure for a real estate development in the North Loop. The general contractor had entered into a contract with the 401 Group to renovate the property. Loans were obtained from Mainstreet Bank to finance the redevelopment. Mainstreet Bank secured the loans with collateral, personal guaranties and mortgages. Mainstreet Bank ceased funding the draws for the renovation, alleging that the scope and type of renovations had drastically changed. Subcontractors ceased working. The FDIC closed Mainstreet Bank and all its assets were purchased by Central Bank. Because of the problems with the banks, the individual owner began making payments on behalf of 401 Group – close to $700,000 to the general contractor and its subcontractors – as bridge loans. He believed he would eventually be reimbursed from Central Bank under the terms of the loan agreement, as he had in the past. The litigation began when a subcontractor sued the 401 Group, Uppal Enterprises and Mainstreet Bank and other subcontractors in a mechanic’s lien action. Others got involved and counterclaims and cross-claims ensued. Central Bank foreclosed on the property and bought it at a sheriff’s sale and then obtained a deficiency judgment against the individual owner on a personal guaranty. By the time this case got to trial, all the claims had been resolved, except those of the general contractor against the individual owner personally. The general contractor was claiming that the individual owner owed it money on either a breach of contract claim or an unjust enrichment claim. The jury found that there was no contract between the individual owner and the general contractor. But the district court found that the individual owner had been unjustly enriched in the amount of $1,267,814. On appeal, the Court of Appeals reversed the trial court, holding that the individual owner was not unjustly enriched in his status as a member of an LLC or as a guarantor, and because there was no other evidence in the record establishing that he benefitted in his personal capacity by the general contractor’s work, the Court of Appeals reversed the trial court’s decision.

A key factor in the Court’s reversal of the district court’s finding of unjust enrichment against the individual owner of the LLC was the fact that grounds did not exist to “pierce the corporate veil.” Although the general rule for corporations and LLCs is that an individual owner may not be held personally liable for the obligations of the entity, in certain situations, courts can ignore the limited liability status of a corporation or LLC and hold its officers, directors and shareholders or members personally liable for its debts. When this happens, it is called piercing the corporate veil.

If a court pierces a company’s corporate veil, the owners, shareholders or members of a corporation or LLC can be held personally liable for corporate debts. This means creditors can go after the owners’ home, bank account, investments and other assets to satisfy the corporate debt. But courts will impose personal liability only on those individuals who are responsible for the corporation or LLC’s wrongful or fraudulent actions; they won’t hold innocent parties personally liable for company debts. The most common factors that courts consider in determining whether to pierce the corporate veil are:

  • Whether the corporation or LLC engaged in fraudulent behavior;
  • Whether the corporation or LLC failed to follow corporate formalities;
  • Whether the corporation or LLC was inadequately capitalized (if the corporation never had enough funds to operate, it was not really a separate entity that could stand on its own); and
  • Whether one person or a small group of closely related people were in complete control of the corporation or LLC.

It is highly advisable to have your corporate documents, contracts and operating procedures reviewed from time to time to ensure that you are following all corporate formalities such that you are not at risk to incur personal liability for the obligations of your company. The attorneys at Lommen Abdo are happy to review and advise as necessary if changes are in order.