June 18, 2014

Undercapitalization Means Personal Liability


We are all familiar with the undercapitalized construction project. Whether it is the project owner with an inadequate construction loan that invariably leads to the filing of construction liens or the subcontractor with insufficient working capital to pay employees and suppliers during the course of the project, an undercapitalized project creates problems for all involved.

The Oregon Court of Appeals has recently reaffirmed that an undercapitalized corporation means more than headaches for suppliers and contractors. It can mean personal liability for shareholders of the corporation.

It is a basic precept of corporate law that shareholders of a corporation and members of a limited liability company are not personally liable for obligations incurred by the corporation or the LLC. That is why most businesses are operated out of a limited liability entity such as a corporation or LLC. In certain circumstances, however, creditors of a corporation or LLC can "pierce the corporate veil" and impose personal liability on the owners of the entity. InVuylsteke v. Broan, 172 Or. App. 74 (2001), the Oregon Court of Appeals confirmed prior Oregon case law that undercapitalization of a corporation is one of the circumstances where the shareholders of the corporation may be held liable for the corporate obligations.

The Oregon Court of Appeals held that the shareholders' failure to adequately capitalize the corporation, in light of the anticipated expenses of the business, is the type of gross undercapitalization that permits a court to pierce the corporate veil and impose liability on the shareholders. The court noted that the sufficiency of the capital is determined at the time the corporation is formed and at the beginning of its operations. Accordingly, it is important to obtain competent professional advice when forming and capitalizing the new entity. Merely filing articles of incorporation with the Oregon Secretary of State's office and commencing business operations is no longer sufficient. Adequately capitalizing the new business is essential. Determining the capital necessary to cover reasonably anticipated liabilities, given the nature and magnitude of the business, and the normal operating costs of the business must be accomplished at the outset. The court held that a later infusion of capital was not enough to negate personal liability for the corporation's owners.

While there is currently no Oregon case law holding that these same rules apply to members of an undercapitalized limited liability company, it is likely only a matter of time before this happens. LLCs are relatively new entities and there is likely a lawsuit making its way through the system that will attempt to pierce the limited liability of an undercapitalized LLC and impose personal liabilities on the members.

There is no clear standard for assuring that the new corporation or LLC is adequately capitalized. However, a well-prepared business plan with both projections for income and expenses is a good to start. Anticipated operational liabilities and expenses, and providing sufficient capitalization to cover those will go a long way towards assuring that the shareholders of the new corporation or the members of the new limited liability company will obtain the limited personal liability the owners expect when entering into new business venture.

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