54 RI Bar J., No. 3, Pg. 5 (Nov/Dec 2005). Identity Confusion and the Close Corporation: Do Corporate Formalities Matter?.

• Author: Thomas M. Madden, Esq.

Rhode Island Bar Journal

Volume 54.

54 RI Bar J., No. 3, Pg. 5 (Nov/Dec 2005).

Identity Confusion and the Close Corporation: Do Corporate Formalities Matter?

Rhode Island Bar Journal November/December 2005 pg. 5Identity Confusion and the Close Corporation: Do Corporate Formalities Matter?Thomas M. Madden, Esq.Thomas M. Madden's practice is The Madden Law Firm, P.C. in Providence, RI.

In the practice of counseling corporations in Rhode Island, it is hardly unusual to encounter close corporations: they are ubiquitous. This article is prompted by the practical reality that many Rhode Island corporations are closely held and that many of those closely held corporations dispense with any attention to corporate formalities.

By corporate formalities, I mean two sorts of practices. First, and practically, what I will call Category A formalities include adequately capitalizing a corporation, opening and using a business bank account in the name of the corporation, conducting business in the name of the corporation and maintaining a corporate business location. Second, and more legalistic than practical, Category B formalities include holding annual shareholder meetings, maintaining shareholder and director minutes or written consents, issuing certificates for shares of stock, keeping stock transfer records, filing timely annual reports, and the like.

Does, or should, forgoing Category A or B formalities matter in identifying close corporations apart from their owners, managers, employees, parent corporations or affiliates? The cases discussed below show that, certainly, Category A formalities are meaningful in maintaining any sort of distinct corporate identity - and commensurate liability shield. However, giving attention to Category B formalities, though clearly a best practice, appears to be of less well-settled import and is often disregarded by Rhode Island's courts.

While anyone who has completed a form for Articles of Incorporation for a domestic Rhode Island corporation may be aware that, by practical default, most incorporations in Rhode Island are made as close corporations, (fn1) not everyone may know what this means. (fn2) Under Rhode Island law, "close" means, among other things, that the corporation: (i) has no more than 30 shareholders; (ii) may operate without a board of directors by assigning "any or all of the powers normally vested in the board of directors" to one or more shareholders or provide that there is no board of directors; (iii) may maintain shareholder agreements and/or voting trusts for longer terms than otherwise permitted; and (iv) may, if properly approved, operate with greater restrictions on the transfer of stock than otherwise permitted. (fn3)

Often the same one, two or three people own and manage a close corporation. Also often, when some formalities are attended to, the same one, two or three people hold titles and commensurate duties and rights as stockholders, directors, officers and employees of the close corporation. It is these close corporations that often fail to seek legal counsel (until problems have arisen) and dispense with attention to Category A and/or B corporate formalities.

Perhaps the most problematic corporate identity problem arises where a close corporation has only one owner who pays little heed to doing business in the name of his corporation. Such a scenario can lead to ultra vires claims, agency disputes, and the piercing of the corporate veil. This kind of identity confusion can essentially defeat the principal benefit of maintaining and doing business in the corporate form, by eliminating the liability shield of the legal fiction and exposing the corporation owner to personal liability for actions taken in place of, or with the apparent authority of, the corporation.

While Rhode Island courts are not quick to look beyond, behind or aside the legal fiction of a corporation, there are instances where courts will do just that. Those instances appear to occur most frequently where a corporation's identity is either ignored or confused with: (i) an individual, usually a sole owner; or (ii) another affiliated corporation in a parent-subsidiary relationship; or (iii) another affiliated corporation in a common owner relationship. Attention to corporate formalities, though at times expressly dismissed or forgiven of close corporations by Rhode Island courts, can, none the less, have an impact on whether a Rhode Island court will pierce the corporate veil. Category A formalities are regularly deemed dispositive in Rhode Island courts' decisions on these issues, while Category B formalities, though, again, a best practice, are less determinative and, in some cases, practically ignored.

Piercing the Corporate Veil

Perhaps the most extreme consequence of ignoring corporate formalities, in addition to revocation of a corporate charter, (fn4) is "piercing the corporate veil" in the event of some action against the corporation and, consequently, its principals. Piercing the veil, or reaching beyond the legal fiction of the corporation itself to hold its principals liable is an extraordinary measure for a court to impose. One contributing fact to a court's doing so, is whether corporate formalities have been maintained. (fn5)

There have not been a tremendous number of veil piercing cases in Rhode Island. (fn6) A good general review of Rhode Island cases addressing veil piercing may be found in John Doe v. Louis E. Gelineau. (fn7) In Gelineau, the Rhode Island Supreme Court applied the same rational on veil piercing of for-profit corporations to statutorily created nonprofit corporations. Where the Bishop of the Roman Catholic Diocese of Providence was a member (akin to a shareholder) of multiple nonprofit corporations, the Court refused to pierce the corporate veil based on the rationale from R & B Electric Co. v. AMCO Construction Co. (fn8) that the plaintiff seeking the veil piercing failed to present concrete evidence that a nonprofit corporation was used "to defeat a public convenience, justify wrong, protect fraud, or defend crime." (fn9)

While serving on the Rhode Island Supreme Court, Justice Robert G. Flanders, Jr. set out the general reluctance of Rhode Island courts to pierce the corporate veil in Gelineau;

"[T]he courts are not inclined to perforate a corporation's legal shell merely to stick one or more of its constituent or affiliated entities with liability for the corporation's misdeeds. Rather, respect for the legitimacy of the corporate form and its protective shield of limited liability usually dissuades courts from using their remedial swords to run them through - at least without extreme provocation to do so." (fn10)

Under Rhode Island law, the general standard for piercing the corporate veil is whether it is "unjust and inequitable to consider the subject corporation a separate entity." (fn11) Just what brings a court to pierce the veil is fact specific. Rhode Island courts have addressed veil piercing in three basic categories: lack of separate identity between owner and entity; between parent and subsidiary; and between or among commonly owned corporations.

Owner/Entity

In owner/entity identity cases, Rhode Island courts look to whether the legal fiction of the corporation is being used to defeat a public purpose, justify a wrong or protect a fraud.

Perhaps the earliest Rhode Island Supreme Court case to substantively address the issue of the corporate entity being maintained separate from its sole owner is Vennerbeck & Clase Co. v. Juergens Jewelry Co. (fn12) In Vennerbeck, where a creditor sought recovery...