When are you Personally Liable for your Corporation’s Debts and Obligations?
You’ve done your homework, consulted with your accountant and lawyer, and have decided that it is the right time to incorporate your small business. You want to take advantage of some of the main benefits of incorporation: potential tax savings and limited personal liability. This latter benefit is a result of the fact that corporations are considered separate legal persons under the law. This means that they are distinct from their shareholders (i.e., owners), and therefore can shield their shareholders’ personal assets from creditors of the corporation. This corporate separateness is the entrenched rule established in the 1800s to keep shareholders immune from personal liability; it is codified by legislation, such as the Ontario Business Corporations Act (OBCA). As such, the courts are very reluctant to “pierce the corporate veil”; that is, they will rarely look behind the corporation to its shareholders, directors and officers for holding such persons personally liable for the acts of the corporation. However, there are some exceptions created by case law (albeit each requiring a high burden of proof), where a court will deem it just and equitable to pierce the corporate veil. These exceptions should be understood by small business owners who have incorporated their business, as well as by legitimate creditors looking to recover money owed to them.
Incorporation for Illegal, Fraudulent or Improper Purpose
When a court determines that a corporation was formed to commit an illegal act, perpetrate a fraud or for some other improper purpose, it will seek to hold those behind the corporation accountable. A good example is as follows: John has recently been fired from his job as a plumber in a plumbing business. Immediately after, he decides to perform the same business activities as his former employer, contrary to the non-compete clause he had in his employment contract with his previous employer. John thinks he can avoid breaching this clause and any resulting liability by running his competing business through a recently incorporated company with no real assets (i.e., a shell corporation) and not in his own capacity, since it will technically be this corporation competing against his former employer, not John. A court, however, would likely rule that this sham corporation was created to clearly avoid liability – in other words, for an improper purpose. Accordingly, a judge would permit John’s previous employer to sue John personally for breach of contract.
Person(s) in Control Expressly Direct Corporation to Commit Wrongful Act
The Court of Appeal in the case of 642947 Ontario Ltd. v. Fleischer set out the leading test on when the corporate veil may be pierced. The Court in this case noted that it “will disregard the separate legal personality of a corporate entity where it is completely dominated and controlled and being used as a shield for fraudulent or improper conduct”. Thus, if an individual, acting through his corporate entity, knowingly and directly commits an illegal act, such as misappropriation of funds or misrepresentation, then such individual cannot hide behind the corporation. This is why piercing the corporate veil is much more common with small, privately held corporations, where the corporation has a small number of shareholders/directors/officers and limited assets. Where such corporations act wrongly, it is easier for a court to determine as to who is the directing mind of the improper or illegal act, and will hold such individual(s) personally liable.
So, given the above, how can you as a shareholder, director and/or officer of a small business protect yourself from personal liability? Besides obviously refraining from perpetrating a fraud, committing a wrongful act or doing anything illegal vis-à-vis the corporation, you should ensure that all your affaires are kept detached and apart from the corporation. For example, you should maintain your personal bank account separate from the corporate account and avoid commingling any funds. You should ensure that all legally binding agreements with respect to your business contain the corporation’s name alone. In addition, you should rarely agree to personally guaranteeing debts or indemnifying losses on behalf of the corporation, and make sure it is expressly understood that you are acting through your corporation without personal liability. As a director or officer of a corporation, you should consider obtaining director and officer liability insurance, and always consult with professionals before exercising any sort of discretion or making decisions on behalf of the corporation (otherwise known as the “due diligence defence”).
If you are in the unfortunate situation of being personally sued by creditors of your corporation, or alternatively if you are an unpaid creditor of a corporation who is concerned about recovering your money from a financially-troubled small business, it would of course be prudent to consult a corporate litigation lawyer on your rights and options. We would also highly recommend that, as an owner of a successful small business, you seek the assistance of a corporate lawyer who can provide advice on arranging your affairs to best protect your personal and business assets from creditors in a legally permitted manner.