In this episode, Michael and Brad are joined by partner and series regular Jay Reyero. Tune in as we share the story of a client whose failure to follow corporate formalities left them with no choice except shutting down their family business.
Listen to the full episode using the player below, or by visiting one of the links below. Below is the episode’s transcript which has been edited for readability. If you have any questions or would like to learn more, email us at firstname.lastname@example.org.
Intro: [00:00:00] Welcome to Legal 123s with ByrdAdatto. Legal issues simplified through real client stories and real world experiences. Creating simplicity in 3, 2, 1.
Brad: Welcome back to another episode of Legal 123s with ByrdAdatto. I am your host Brad Adatto with my co-host Michael Byrd.
Michael: Thanks Bradford. As a business and healthcare law firm, we are sometimes triggered by certain buzzwords our clients will say in conversation. We know there is potential disaster when we hear these words and we’re immediately on high alert. This season’s theme is red flags.
Brad: Now Michael, because we have red flags this season, I thought we could discuss some tragic moments in history where red flags were completely ignored.
Michael: So Brad, usually that means you’re going to talk about the saints and some woes, whether it be your favorite, which would be the [00:01:00] NFC Saints game versus the Rams, but you probably today would bring up the fact that the Cowboys beat the Saints last night and there were a couple of penalties that I’m sure didn’t feel good.
Brad: Well that and four interceptions didn’t help either. Yes, both were tragic moments in history and as we all know, the saints had a call the pass interference, they would have gone on to the Super bowl and clearly won. So that’s how I feel about it.
Michael: I will say Brad, I think everyone in America agrees the Saints got screwed, including me and you need to move on. So you were a history major in college, but you said you wanted to cover, you alluded to multiple tragic moments.
Brad: Okay. I won’t cover everything in a history that was tragic, we can cover one of the most well-known tragic moments of all time. And of course our audience is like screaming it out. The sinking of the [00:02:00] Titanic. As most people know the RMS Titanic, a luxury steam ship, sank in the early hours of April 15th, 1912 off the coast of Newfoundland in the north Atlantic sea, after swiping an iceberg on its maiden voyage where unfortunately, 1,500 people about died.
Michael: So if there’s anything our audience is going to learn is that we repeat ourselves and particularly Brad. Brad is famous for that. And anyone that listened to the dumpster fire season, of course the Titanic came up again. Brad alleges that he never saw the movie, but I just don’t buy it.
Brad: I saw the making of boat on the HBO series so that’s all I really need to know. That’s pretty cool how they made it, but that’s irrelevant to today’s topic and I’m not going to cover it, we talked about last time in our dumpster fire season. But what’s fascinating about the Titanic was again, the Shipbuilder magazine, which by the way, I think is pretty funny. There’s a Shipbuilder magazine they said that the ship [00:03:00] practically was unsinkable. So you know what? The magazine writers knew all about it because of the state of art, double bottom, and 15 watertight bulkhead compartments that had these electric watertight doors that could be open individually or sealed individually or from the bridge simultaneously.
Michael: Well Brad since you didn’t see the movie, you may not know this, but the ship sank.
Brad: Ah, now I see it.
Michael: So I’m assuming the watertight doors failed.
Brad: The funny part is they actually worked. Which is crazy, right? The watertight compartment is design had a design flaw and the critical reason why it’s sank is they had these bulkheads that were indeed water tight, but the wall separating the bulkheads extended only a few feet above the water line so water could pour in from one component to another. And this is really which led to the downfall of the Titanic. Thus a complete design flaw, which apparently when they looked back at it was known from day one. And so the most tragic, and second to this [00:04:00] was the fact that they didn’t have enough lifeboats. The ship could hold more than 3,000 people with passengers and crew, and that only could accommodate over a little over a thousand people in the lifeboats. So two major designs flaws caused that otherwise the story would have been not as famous. It would’ve been about a ship that hit an iceberg and kept moving forward or a ship that hit an iceberg and sank. And everyone got off on the lifeboats. Neither thing happened because these red flags were ignored and tragedy struck.
Michael: And Leo died.
Brad: Oh no. What?
Michael: If that hadn’t happened, Leo could have survived and Kate could have…
Brad: Been at the top of the world?
Michael: Yes, yes Brad.
Brad: I’m a movie buff. That doesn’t mean I don’t know what he did.
Michael: And that girlfriend from Niagara falls.
Brad: Yeah. That was your girlfriend.
Michael: Oh, I’m sorry. Okay well before we get started, anyone that’s watching our videos probably noticed another human in the camera and that’s, you can’t [00:05:00] call him a guest, our regular and partner, Jay Reyero. Welcome.
Jay: Thanks guys. Good to be actually in the studio this time and I’m excited for this red flags. Michael told me that all I had to do is come on here and say ding every time Brad talks. So I’m excited. Let’s do this, let’s get started.
Brad: This should be…
Michael: Ding! I am still paying you back for episode one, Brad. But okay, we will move on now.
Brad: Okay I’m glad. Anyway, today’s episode involves a family business.
Michael: Okay Jay, you got this pretty quickly. What red flag did you spot?
Jay: Well, we have all heard never do business with family. When we talked about a couple seasons ago, my first professional job selling cell phones, and one summer I had my younger brother come and work with me and let’s just say [00:06:00] he quit after a week, so it didn’t go well.
Brad: Well in our client’s case, this family dynamic wasn’t really the core problem. It’s just part of the story. It was a long running multi-million dollar business selling boats that had been in the family for multiple generations. And they were all either really working there or they owned it and they were very proud of their legacy.
Michael: So why did we become involved?
Brad: Well funny, we got involved because they were looking for new general counsel and so they brought us in and in the beginning we were just trying to understand what we typically do, just understand their corporate structure. So Jay and I remember, we had multiple meetings with them and we kept trying to understand their corporate structure as they explained to it. And it never really came quite clear to us.
Michael: Ding! I was trying to hold myself until then. So while it’s not unusual for clients to be unable to describe legal concepts in detail, but for [00:07:00] them to speak in generalities when we need more specificity as the red flags start popping up.
Brad: Yeah. Jay and I would totally agree with you, Michael. It took Jay and me a ton of time digging through tons of documents, white boarding it ourselves trying to figure out if we’ve seen what we were seeing. And once we did that, we actually brought the clients back in and we did another whiteboard session with them explaining, hey, this is your actual corporate documents, and this is what you had in place. And it seemed like we are more teaching them about their own structure.
Jay: Ding, ding, ding! Yeah, this meeting really signaled to me that there’s a possibility, the real possibility that things that were supposed to happen weren’t happening. We’ve said this before multiple times during podcasts and to clients that form has equal substance. And we’re going to say it again this episode, and we’ll say it again in the future. And we normally say this in the context of healthcare, but it really applies to the corporate form as well and businesses in general. And so [00:08:00] when we were hearing this it was screaming red flags to me.
Brad: Yeah, I see what you did there. Really good foreshadowing there in multiple ways, Jay. We finally knew what the structure was, but that unfortunately opened up new questions.
Jay: Yeah, it wasn’t a simple structure. I mean, we looked at their corporate structure and I had never seen such a complex estate planning set up.
Jay: Incorporating family limited partnerships and multiple trusts and trustees and a wide range of beneficiaries. And since we don’t do complex estate and tax planning, we were really, Brad and I we’re just trying to get a sense of what their plan was, why they set it up this way, you know, just asking simple questions. What we found was there really wasn’t a plan and they still couldn’t describe the structure to us correctly.
Michael: If I didn’t say this earlier, ding! So you and Brad [00:09:00] already explained what the structure was, and so how can you have an estate plan without a plan?
Jay: So, yeah we went through the whiteboard meeting, and even in follow-up, we developed a visual depiction of the corporate structure with a detailed summary of all the moving pieces. We provided it to them and they still didn’t really get it. And so it was again, another red flag signaling to us okay we’ve got a lot of work cut out for us. What we found too, it was so ingrained in their minds the way that they thought it was and the way that they understood it, which wasn’t the case that it really was. It was a difficult task for me and Brad to try to change that perception, to try to get them to switch their thinking and understand what they truly had in place.
Michael: I perceive it is time for another ding.
Brad: Yeah. That’s a good perception there, Michael. And to your second question, Michael, it’s not uncommon that when we meet with the [00:10:00] clients that they heard people talk generally about their use of family limited partnerships, and trust and asset protection planning, and other estate planning. Sometimes even that with their friend or financial advisor, they told them that they should be doing this so they go and do it. And they just think, well, I just need it and they create these few trusts and they think they’re safe.
Jay: Yeah Brad, you’re absolutely right. But what they ended up not realizing is that it takes more planning than that. And in our client’s case, they had basically just worked with a family friend corporate attorney to set the documents.
Michael: Ding! Another red flag. I mean the old buddy thing, I mean, we’ve seen so many failures over the years that you just have to automatically ding it, even if they turn out to be great. But here, I mean, estate and tax planning is a complex area. So you really need to work with sophisticated estate and tax planning attorney. Especially with what they’re doing. This wasn’t like a simple will.
Brad: It is a multimillion dollar business we’re talking about.
Michael: Exactly. [00:11:00] And so not only will they set it up correctly, the sophisticated attorneys, but they’ll also be able to better develop an overall plan that goes with it.
Brad: I agree. And this is where the problem arose because it was clear that no one up until that point had actually walked them through any of the details or worked with them on the planning level acquired for this estate plan or this plan in general, to be closely successful. They clearly didn’t understand what it meant to involve all these different pieces, or the property, or running things through, or any of the things.
Michael: So, I mean, I have to take a little pause and reality check. You started the story with them being a long running multimillion dollar business. And so it doesn’t seem like these issues really had an impact on their success. It’s either that, or they were succeeding despite their structure. So why focus so much attention?
Brad: That’s a great question, Michael, even though we didn’t do the complex estate planning, [00:12:00] the issues made it clear that they were not following what they had in place and when you don’t do this it can have significant impacts down the road. And then we uncovered and demonstrated, we basically saw this common theme come up which is, plan in place not followed.
Michael: How so?
Jay: Okay so fast forward. COVID happens and…
Michael: Ding, ding, ding! If you say COVID, that’s like an auto ding.
Brad: Did you say COVID?
Jay: Yeah, totally agree. And so COVID happens…
Jay: And so like many businesses, it had a significant impact on our client’s business. They were struggling to pay the bills, they had to find funding to just keep riding the wave, to keep their head above water. No pun intended. And they had already taken advantage of all the relief programs out there. Now they were basically just turning to traditional lending from banks and trying to just bridge that gap, trying to ride out this wave until they could [00:13:00] recover.
Michael: And I just want to ding because you alluded to the PPP loan and that is just an inferred ding.
Brad: And as you can imagine, going to a commercial bank, are not lending money out generally, especially during COVID. And so they were very selective given how frequency businesses were having to shut down because of, ding, COVID. So the bank they started talking to wanted to review their financials, books, and records, and that’s what caught up with them.
Michael: What did they find?
Jay: So Brad mentioned the common theme a few minutes ago. Well that theme was “no corporate formalities.”
Jay: And so essentially with this family owned business that had been run like a family owned bank account basically for years. Everyone hold their dings until the end, because you’ve got to buckle up for the things that we found that they had done. There were personal assets that including a home had been purchased by the business using business funds, there were [00:14:00] business assets being used for personal reasons and stored at their personal homes. The business was paying for personal expenses and there was no reimbursement. The family members were running the business expenses through personal credit cards and personal expenses through business credit cards. And again, no reimbursement and no tracking. Money was being transferred in and out of the business involving the various family members. And the biggest issue, there was no detailed accounting. There was no tracking of any of these items, transactions, nothing.
Brad: Michael, I think we could spend the rest of the show just saying ding, just on that because there were so many dings in a given sentence.
Michael: So you’re saying these are all frowned upon?
Brad: These are all, when we call them red flags, you know when you drive by a car dealership you see those giant American flags? It’s that size, but bigger.
Michael: Okay. Well, lots to unpack there. Let’s go into commercial and on the other side we will talk more about corporate formalities and [00:15:00] the possible ways they can sink your business, no pun intended again.
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Brad: Welcome back to Legal 123s with ByrdAdatto. I’m your host Brad Adatto with my cohost Michael Byrd and series regular Jay Reyero still with us. Before the commercial break we talked about this very unfortunate story of a client of ours who failed to follow formalities. And sometimes called corporate formalities that led them to [00:16:00] shut down their business.
Michael: Yeah. And actually corporate formalities is a term of art that we use. Jay, why don’t you explain that a little bit?
Brad: Is that a vocabulary word?
Michael: Maybe it is.
Jay: So in a business whether we’re talking about a corporation, a limited liability company, limited partnership, or any other kind of incorporated entity, it’s a legal entity separate and apart from its owner. So this is precisely why people form entities to run their business, in order to take advantage of this limited liability protection that the entity is going to offer. So corporate formalities then are going to be the things that the business must do in order to ensure that it remains legally separate from its owners.
Michael: And so Brad, what happens if corporate formalities are not followed?
Brad: It blows up.
Michael: Oh, wow. Ding!
Brad: So Jay was referencing the limited liabilities the owners have. Well, if they don’t file it, they don’t have it. It gets blown up and they lose [00:17:00] it. They disregard the entity. So if it’s a lawsuit, the court would disregard the entity as a separate legal person. And it fails because they failed to file the court finales. People refer to this as often, another fun legal term, piercing the corporate veil. That sounds really sexy, right? This is particularly significant in the cases where the company is owned by sometimes one person or a family. And a lot of times it’s often called a closely held entity.
Michael: Okay. Why?
Brad: Corporate formalities are steps meant to apply to all entities regardless of the size. So this could be a fortune 500 company like Apple, the same basic formalities have to be followed by a closely held entity. So as you can imagine, it’s easier for a company owned by one person or a family members to skip, ignore, or not know about these formalities because many times they’re just running things through, this is how we’ve always done it. And it’s very informal.
Jay: And then like in our client’s case, most of the time this isn’t an [00:18:00] issue or question because the people involved are all kind of on the same page.
Michael: I keep thinking about mullets with formal and informal, but I digress. So what are some examples of corporate formalities?
Jay: So I think the biggest one and clearly the one that’s demonstrated by our client’s story is going to be maintaining separation between business and personal assets. So any business has to respect the difference between the bank accounts, the property, the equipment, and other assets of the business. And the personal assets of the business owners, they have to keep these separate and apart. And as you heard in our story, that clearly wasn’t not the case.
Brad: Yeah. One of the problems with closely held corporations is the owners think they actually own the assets of the entity. In reality, this cannot be further from the truth as the entity actually owns it. So an example, Michael imagine if I attempted to give your car to Jay. I don’t own your car so I can’t just freely give it to him. You and I are both distinctly individuals. [00:19:00] I’m better than you, everyone knows that.
Brad: But just because we’re actually business partners, that does not mean I can control your personal assets. The same concept applies to corporations. Owners must recognize that the assets are the property of the business not of the owners of the business. If the business wants to sell a transfer of these assets, it can, but an individual owner just can’t walk in and take the property off the business because they’re an owner of the business. The business is a separate, and this is a term of art, legal person. I’m using quotes for those who can’t tell, listening to my voice. Similarly, an owner should not intermingle or co-mingle personal assets with assets of the business.
Michael: Yeah. And I think one of the things I want everyone to understand is that there are ways to move things when you’re in this kind of family business type scenarios. And so it’s not that some of the things that clients did are [00:20:00] not in of themselves unusual or even wrong. For example, there’s no prohibition on owners funding the business or taking out loans.
Brad: Yeah. And you’re right about that, Michael. But the corporate formalities perspective you’d have to properly track and classify those things that you moved about and you need to document. This is where our client ran in trouble. There was no tracking or documentation at all. It becomes impossible to know from when we’re looking at the books and records, what really happened. It’s just now, well, this is what happened and this is why, versus any documentation proving it.
Jay: And going back to what I said earlier, form did not match substance. And anytime those two things get out of balance, get out of whack, no one knows what to believe. You have contradictory stories and so you’re essentially left not only trying to prove what did happen or what is the truth, but then you’re also trying to disprove the things that the records may reflect that are inaccurate or don’t work or aren’t actually the story that you’re trying to tell. And so this, as you can imagine, [00:21:00] creates a lot of skepticism for anyone who’s trying to think through it, and that sometimes can be difficult to overcome.
Michael: So what should the client have done differently?
Brad: Well, the easiest thing they could’ve done is just to work with their advisors, a legal team, their financial team, their accounting team. It’s important in the beginning to know the baseline rules of what you can and can’t do. But then when it goes on, making sure that those advisors are available to continue to give guidance or catch up on issues before we spot the red flag, when we’re actually reviewing the information.
Jay: The good thing about these types of entities, the closely held, the family businesses, a single owner, even though it’s easier, it’s easy to forget the corporate formalities. It’s not that difficult to fix things when you do find stuff early. Whether it’s reclassifying things internally or developing some base documents, you’re still only dealing with that one person or a family or set of close individuals with the same expectations and interests so it becomes [00:22:00] really easy to fix things once you catch them early.
Michael: And formality is a great word to use, particularly for the small businesses, because I think by nature they tend to be informal. It’s all people that, it’s either one person or if it’s a family, they obviously have a relationship. And so they lean to behaving in informal ways.
Michael: What are some other corporate formality issues that you guys have encountered with clients?
Brad: Yeah, I think the easy answer is bank accounts. Bank accounts should be opened in the name of the entity with all the business funds deposited in that entities bank account. So clarity, you can’t have business funds go directly into your personal bank account or in another entity that you might own. It needs to go into that particular bank account of that particular business. So no other persons or entities funds should be commingled.
Michael: And Brad, did you know that we do healthcare at ByrdAdatto?
Brad: I heard this rumor.
Michael: Yeah. Well, that’s a part of our practice. [00:23:00] This is especially critical in healthcare when we’re dealing with the corporate practice of medicine, particularly with the management services organizations or MSOs. We’ve encountered clients that fail to open up bank accounts for the professional entities or deposit funds belonging to one entity into the account of another entity.
Jay: I see that too, Michael, and to go along with that and similar to the owner issue we discussed earlier, I see a lot of intercompany loans or transactions that aren’t properly documented. So I’ve worked with a lot of clients with multiple entities, multiple holding companies. And if we go back to the basics, each of these are independent, separate, and legally distinct. So anytime you have transfer of funds, assets, et cetera, there’s got to be some documentation about that transaction, why it occurred, how it occurred, when it occurred. And sometimes it’s just simple [00:24:00] for a closely held business, a family business, just to hit transfer on the bank account because the accounts are linked and they don’t think what could happen six seven months down the road when someone’s looking at that transaction.
Brad: And I don’t even think that by pressing that little quick button, Jay, they realize that they’re possibly giving up the protections they put in place of separating each of these entities. And it comes out when there’s a lawsuit filed that all these entities are likely being included because they can’t figure out who’s who at the zoo, basically. Why are they independent? And this goes back to something you said, the form and substance has to match otherwise you end up reducing the whole reason why you built all these entities, reducing your liability and the protection that you were afforded.
Michael: Great points. And it goes to a larger issue in the planning stage when you’re working on the corporate structure, just knowing the corporate formalities that are involved can significantly shape the decisions that are made. And so many times people want to use complex structures thinking [00:25:00] they need an entity for every individual aspect for maximum asset protection. And what they fail to realize is that with each new entity comes more corporate formalities to observe.
Jay: Yeah. And I’ve seen it time and time again, people with multiple different entities at multiple different layers are just unable to keep up with formalities at the end of the day. And so they end up losing that one thing that they thought they were getting and that’s liability protection.
Brad: Yeah. And something we used to see more often, we probably don’t see as much as we used to, Jay and Michael is who signed a contract. And it’s critical that the legal name of the business is used correctly and that the actual authorized person of that business has actually signed the contract on behalf of the business to make sure the right officer or manager is the person signing on behalf of the right business.
Jay: Yeah. I think what I see more commonly is kind of a combo between that and the co-mingling issue that we talked about. People will purchase equipment in their personal name, but then it’s being used by the [00:26:00] business. Now this could be intentional, which brings up the commingling issue. But sometimes though this is unintentional as they sign in an individual capacity rather than as a corporate representative. And so when you look at the contract, it’s not really clear who is legally liable under the contract who actually purchased that piece of it.
Michael: Well, tell us what happened with our client’s business. And if you have any final thoughts.
Jay: Yeah. So going back to Brad’s disaster theme at the beginning, unfortunately they were not able to survive because the bank denied them a loan, basically because of all the issues we uncovered. The bank just at the end of the day didn’t feel comfortable with the lack of formalities and the questions on all these commingling issues. And so, you know, their ship was just too big and it was going to take too long to turn around. And so they made the very difficult decision to shut the business down. As far as final thoughts, I think anytime you have a small business or a family business, it can be very easy to lose sight of the formalities required. I mean, 99% of the time [00:27:00] it’s not going to matter, but it’s the 1% when it does matter, that’s going to have a significant impact and sometimes it can be catastrophic. So Brad, what are your final thoughts from this client story?
Brad: You know, you said earlier in this episode that’s a good point, is the form must match the substance. The whole reason why you develop a corporate entity is to have the personal protections. And if you want to have those personal protections, as you said, it’s a small piece of what you do day to day from your business perspective. You have to follow those corporate formalities. How about you, Michael?
Michael: Well, most of our clients are small businesses and we talked on and on about how they just tend towards the informal. And so I would encourage them all to Don the mullet. Formal in the front party in the back.
Brad: You really wanted to get that in didn’t you?
Michael: Yes. I couldn’t stop thinking about it. But following the formalities and yet still [00:28:00] maintaining the small business culture and vibe is possible. And we have clients that do it all the time.
Brad: Absolutely. Well, Jay, thank you for being with us live in the studio. So for those who want to see what the smartest guy at ByrdAdatto looks like besides me, Jay is sitting across from me. So go to our YouTube channel and you can see us on camera and more importantly, Jay on camera. Well, Michael, that closes out today’s show. A lot of fun as usual and I think the audience will be really excited for next Wednesday when we have “Red Flags – Before And After Pictures.”
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