Since its humble beginning in Wyoming in 1977, the limited liability company (“LLC”) type of entity formation has gained rapid acceptance as a way to avoid personal liability and still maintain administrative flexibility. In addition, many lenders now insist that borrowers create a separate single-purpose entity for each project. Thus, most businesses consist of multiple affiliated companies that are each supposed to be treated discretely under the law. However, since non-corporate entities such as partnerships and LLCs are not required to hold regular meetings or even appoint officers, the owners of those entities tend to overlook other company formalities as well. This lackadaisical attitude may inadvertently create a situation where creditors come to rely on assets of affiliates, not just the entity with which they have a contract. In a bankruptcy proceeding, the creditors may go so far as to ask the court to substantively consolidate the affiliated companies.
The following are the most common pitfalls that affiliated companies should avoid in effort to preserve the benefit of each company’s independent existence:
Entangled Finances – If affiliated companies co-mingle their funds or one entity pays the bills for another entity without appropriate inter-company transfer records, it becomes increasingly difficult to distinguish the assets and liabilities of each company. Moreover, many affiliated companies produce only consolidated financial statements that imply that additional resources are available to satisfy an entity’s debts. If the entities share bookkeeping personnel, then mistakes become even more likely.
Reliance on Credit of Affiliates – If affiliated companies pledge any of their assets to secure loans to another entity or guarantee such loans, creditors may be entitled to rely on the credit of all of the entities. Creditors often request financial statements from such affiliates and require joint and several liability among the affiliates. Creditors may press hard for consolidation if some entities are asset-rich while others have major liabilities.
No Separate Stationary and Signatories – Often a group of companies will have one overarching trade name and will not clearly indicate the particular affiliate that is acting with respect to a transaction. Similarly, sometimes multiple entities will be executing the same document. If the same person signs the documents for several different entities, it is very easy to make a scrivener’s error and confuse the entities. Likewise, with modern computer technology, duplicated and revised documents with global changes to names, may not reflect the actual intent of the parties in every cases. These similar, yet different, documents can lead to unintended consequences and may require extra time and expense to audit and correct errors.
Undercapitalization – If a company does not have sufficient assets to pay for its liabilities in the ordinary course of business and is dependent on an affiliate for funding, then creditors may seek recovery against the finding entity too.
If a business is structured with several affiliated companies, the owners must still be diligent about ensuring that each entity is capable of standing alone both financially and contractually. Owners should also make clear to creditors that only that particular company may be relied on for payment. If not, all of the effort put into creating the separate companies may be disregarded in favor of producing more equitable results for creditors of affiliated companies.