Why Are Corporate Formalities Observed So Formally?

Why Are Corporate Formalities Observed So Formally?

by Corie Lynn Rosen, December 2009

Did you have money in the stock market in the last few years? If you did, both you and your wallet know the hellish consequences of corporate fraud. If you had the bad luck of being an officer in one of those corporations, you're probably still in therapy. If you run a corporation but are one of the honest ones, take heed. Even corporate officers and company owners who don't use their employees' retirement funds for vacation money can end up in court - fail to observe corporate formalities and you very well might find yourself bankrupt and dissolved, just like Enron.

The liability protection granted by incorporating is practical and necessary. Lots of people incorporate solely to limit their personal liability when conducting business. What is not legitimate is forming a corporation so you can get away with things that would normally get you in trouble. For example, want to incorporate your taxi service to protect yourself from getting sued if there's an accident while driving a passenger? Okay. Want to incorporate a taxi business to protect yourself from getting sued if you want to, say, run over people on purpose? Not okay.

When the corporation is not managed formally, courts can't tell whether or not the corporation is actually its own entity - separate from its owner and its owner's business assets. If it's not separate, a corporation won't be protected by limited liability. The entire "enterprise" - the owner's assets connected to both that business and any other related business - can be taken in a lawsuit. In other words, in cases against corporations where the formalities are not strictly observed, whoever's doing the suing can "pierce the corporate veil" - break through that mythical shield that protects the corporation's owner from extensive liability.

Keeping the corporate veil intact is relatively simple and straightforward: the key to piercing prevention is strict observance of all corporate formalities. Keep minutes, hold regular shareholder and board meetings, maintain books, issue stock, and adopt a charter and by-laws - these are the essential formalities that you have to observe. Even if you run a tiny mom-and-pop shop, if that shop is incorporated, have a documented board of directors and hold regular meetings. It doesn't mean that you need Michael Eisner to make your business decisions - appoint your neighbors, friends, even children who aren't minors, and your board is complete.

It doesn't matter who is observing the formalities or the degree of pomp with which the formalities are carried out, the important thing is that you do it. Document your corporation thoroughly and show that your observation occurred on a consistent basis. It may seem silly now, but take the extra time and energy to formalize the conduct of your incorporated business and you will keep your corporate liability protection intact. Asking your son to type out the minutes of a meeting you held in the living room just might save you a few million in lawsuits later on down the line.