A recent decision from the Illinois Appellate Court for the First District should be a reminder to business owners, executives and advisors of the importance of following corporate formalities and the dire consequences of failing to do so. As most business owners know, the primary purpose of organizing a corporation is to insulate the business’ shareholders, directors and officers in the corporation from liability to third parties. Traditionally, it is only when shareholders, directors and officers fail to treat the corporation as a separate and distinct entity and fail to follow corporate formalities, that courts may ignore the corporate entity and “pierce the corporate veil” to hold the shareholders, directors and officers personally liable. However, in Buckley v. Abuzir, 2014 IL App (1st) 130469, the appellate court held that under certain circumstances, a court may “pierce the corporate veil” and hold someone that not a shareholder, director or officer personally liable for the acts of the corporation.

The corporation at issue in Buckley was Silver Fox Pastries, Inc. The plaintiff had obtained a judgment against Silver Fox but had been unsuccessful in its attempts to collect on that judgment. But believing that Silver Fox had held itself out as a corporation, but had not complied with its legal obligations as such, the plaintiff took an aggressive and creative approach to collect on its judgment. The plaintiff filed a suit to pierce the corporate veil to collect the judgment against the defendant, who was neither an owner nor officer of Silver Fox. The defendant’s sister held herself out as Silver Fox’s owner and his brother-in-law was Silver Fox’s President and registered corporate agent. However, the plaintiff alleged that the defendant funded Silver Fox, made all of the business decisions and exercised ownership control over the corporation. The plaintiff also alleged that Silver Fox never filed any annual reports; its officers were officers in name only; it had no directors; it did not keep corporate records; it did not hold shareholder or directors meetings; it did not hold annual board meetings; it never issued stock; it never paid dividends; and it never had adequate capitalization and was at all times insolvent.

In the decision, the appellate court analyzed case law from throughout the country regarding piercing the corporation veil. The appellate court concluded that while courts are split on whether the veil may be pierced to reach non-shareholders, the majority of jurisdictions that have addressed this issue allow the veil to be pierced against non-shareholders where that person dominated and controlled the corporation to such an extent that the person may be considered the equitable owner.

For business owners, the take away from the court’s decision in Buckley is to remember to follow the corporate formalities. The importance of observing formalities is often (improperly) overlooked in circumstances in which there are several interrelated companies. The transactions among the companies need to be properly accounted for or the distinct status of the separate corporations may be put at risk. Take time to make sure that your corporate minute book is up to date, stock has been formally issued, the appropriate corporate meetings are held and documented, officers and directors are active in the management of the corporation, contractual relationships between interrelated companies are appropriately documented, the corporation is adequately funded and personal funds are not comingled with corporate funds, among other things.

In the face of rising litigation costs, the most valuable benefit of a company’s insurance policy may be its insurer’s duty to defend claims. Often, claims asserted in litigation may include a mixture of covered and uncovered claims with some claims potentially excluded from the coverage provided by an insurance policy. Alternatively, the claims asserted may potentially exceed the coverage afforded under the policy. In these circumstances (and others), an insurer’s first move in response to a claim under an insurance policy is likely to be a lengthy “reservation of rights” letter. The insurer’s response will track the language of your policy identifying the reasons the insurer contends that there may not be coverage for your claim or portions of the claim. But confess: the language used in the policy was so mind-numbing that you may not have read it when you purchased it or were uncertain as to what was actually covered by the policy. So what does a reservation of rights letter mean to you as an insured?

While identifying exclusions to coverage, the insurer’s reservation of rights letter will often offer to provide a defense. Many policyholders draw a deep sigh of relief that the insurer has agreed to provide a defense without grasping the implications of the various exclusions to coverage identified by the insurer in the letter. Do not be fooled because what the insurer “giveth” through the reservation letter, it may later seek to take away through the counsel that the insurance company assigns to “protect” you. But do not despair because in these circumstances, an insured may be entitled to select its own counsel at the insurer’s expense.

In Perma-Pipe, Inc. v. Liberty Surplus Insurance Corp., a recent decision by an Illinois appellate court, the insurer’s initial reservation of rights letter accepted its duty to defend its insured, and at the same time the insurer reserved its right to contest its obligation to defend its insured citing a number of potential exclusions to coverage. The exposure presented by the claim potentially exceeded the coverage afforded by the insurance policy. The policyholder responded to the reservation of rights letter by telling its insurer that in light of the conflicts articulated in the reservation of rights letter, the policyholder would defend itself through its own counsel but at the insurer’s expense. The insurer apparently had second thoughts, and in order to avoid the rates charged by the policyholder’s counsel and to have the opportunity to exert control over the defense, the insurer withdrew its reservations now agreeing to defend without the reservations. The exposure presented by the claim still potentially exceeded the available coverage, and the policyholder wanted to maintain control of its own defense. The insured insisted that it was entitled to engage its own counsel at its insurer’s expense, and the court agreed.

The policyholder correctly recognized that the insurer’s control of the defense posed two risks to the policyholder. First, it presented a conflict between the loyalties owed by the attorney assigned by the insurance carrier to defend the insured and to the loyalties owed to the attorney’s client, the policyholder. The policyholder correctly recognized that it was entitled to a defense by counsel loyal only to its own interests at the insurer’s expense. The other risk presented was that the duty to defend would terminate at the exhaustion of the policy. In such a circumstance, cost of the defense may exceed the coverage, and the insurer may be incentivized to look for ways around providing that defense. When presented with litigation that presented “nontrivial” risk of exposure in excess of the coverage, the court held that the policyholder had a right to independent counsel at the carrier’s expense.

Clearly, there is substantial value in being able to select your own counsel. Frequently, the defense coverage afforded by an insurance policy may be worth much more than the amount sought in the litigation. It is imperative to give close scrutiny to the insurer’s reservation of rights both to understand the insurer’s view of the limits of your insurance coverage, as applied to the claim. And the reservation of rights may give you the invaluable opportunity to select your own counsel at your insurer’s expense so that you can maintain better control of the defense of the claim against you.

The case arises from circumstances in which Rico Industries, Inc. v. TLC Group, Inc., a recent decision by the Illinois appellate court, illustrates the adage pennywise, dollar foolish. A company negotiated an agreement to serve as the exclusive sales representative on behalf of another company. The terms of the agreement that was negotiated were documented by a short contract drafted by the owners of the two businesses without the assistance of counsel. The contract was not for any specific duration and provided that the contract could only be terminated in a writing signed by both parties. The two companies worked together under the contract for a number of years. But when one company sought to terminate the contract, it was unable to obtain the other’s written consent. The company seeking to terminate the exclusive relationship sought and obtained a judicial finding that the termination provision, as drafted, was defective and that the contract was terminable at will.

The objective of including a provision requiring mutual consent to termination may have been to avoid the prejudice and disruption resulting from termination of the relationship without notice. This objective could have been achieved through a variety of approaches. The Court found the contract potentially interminable making the termination provision void and the contract terminable at will. Thus, the contract, drafted without the assistance of counsel, failed of an essential purpose.

Rico Industries drives home two important points. First, it illustrates the value of obtaining legal review of contracts, even seemingly simple, straightforward sales representative contracts, before execution. A fundamental objective of a written contract is to manage and control transactional risk and the costs associated with a transaction. Pragmatic business counsel can help “play through” the circumstances the contract is intended to address to ensure that the contract achieves its intended objectives. The parties in Rico Industries, clearly sought to avoid the prejudice that could result from “at will termination” of the rights and obligations owed under the agreement. The provision could have been drafted in a way to protect against the prejudice and disruption that may arise from an at-will termination. The costs that the parties avoided by drafting the contract without counsel were ultimately incurred (and magnified) in the ensuing litigation.

Another lesson from this case is the importance of playing through the termination and dispute resolution provision of your contracts, even after execution, but before disputes arise. Here, the parties had enjoyed a lengthy relationship with little thought to how the termination provision would play out in practice. But the contract ultimately failed of an essential purpose: the facilitation of a smooth unwinding and termination of the relationship. The termination provision, as drafted, presented the possibility of a “perpetual” relationship. Neither party sought an agreement into perpetuity and, in any event, the courts will not enforce such a provision. Identification of this defect before the dispute arouse would have allowed the parties to negotiate resolution at a time when they were still working together. The incentive to cure the defect was gone when it was identified after the relationship between the parties had soured. The lesson: a periodic review of your contracts, especially your form agreements, can help avoid uncertainty, unintended consequences, and expense of litigation. Critically, this approach helps you to ensure that your contracts (still) meet your objectives.