In a recent decision, the United States Bankruptcy Court for the Eastern District of Massachusetts sent a reminder to practitioners and family business owners that it is critical to maintain corporate formalities in order to avoid unintended liabilities.  In the case of In re Cameron Construction & Roofing Co., Adv. P. No. 15-1121, 2016 WL 7241337 (Bankr. D. Mass. December 14, 2016), the Bankruptcy Court applied the concept of substantive consolidation and made the assets of a non-bankrupt related entity available to creditors in the bankruptcy proceeding.

In  Cameron, both Cameron Construction & Roofing, Inc. (the “Roofing Company”) and Cameron Construction LLC (the “Real Estate Company”) were controlled by Wilfred Cameron (the “Founder”) prior to his death.  The Roofing Company was a Massachusetts corporation operating as a roofing contractor, and the Real Estate Company was a Massachusetts limited liability company that was formed for the purpose of holding real estate.  Each entity filed its own tax returns, issued separate W-2 forms to employees, and filed annual reports with the Commonwealth.  To the outside world they appeared to be two separate and distinct entities.

The Bankruptcy Court found, however, that the business of the Real Estate Company was so intertwined with the business of the Roofing Company that the assets of the Real Estate Company (which had not filed bankruptcy) could be included in the assets of the Roofing Company (the debtor in the bankruptcy proceeding).  Among other factors, the Bankruptcy Court found that:

• The Founder exercised control over both entities (prior to his death)

• Employees of the Real Estate Company performed services for the Roofing Company, with no documentation of the arrangements between the two entities

• The Roofing Company paid above market rent to operate on real estate owned by the Real Estate Company, with no written lease arrangement

• Neither the Real Estate Company nor the Roofing Company could produce any corporate records such as meeting minutes, votes or resolutions approving any transactions between the two entities

All of these factors led the Bankruptcy Court to agree with the creditors that the assets of the Real Estate Company should be included in the bankruptcy proceeding.  Coming on the heels of the decision of the Massachusetts Appeals Court in  Houser Buick, Inc. v. Philip Houser, Cameron serves a reminder for Massachusetts businesses that operate multiple entities that it is vital to take some steps to avoid having the assets of one business made available to creditors of a related business.

…these factors led the Bankruptcy Court to agree with the creditors that the assets of the Real Estate Company should be included in the bankruptcy proceeding.

Family business enterprises that have multiple entities should establish a separate and distinct board of directors for each entity, ideally with different members.  Operators should also consider adding independent directors to each board, to address any “related party” transactions (this is particularly necessary in situations where any equity is held by non-family members, such as investors or employees).  The board of directors for each entity should have regularly scheduled meetings, and minutes should be taken at each meeting.  The entities should also have regular shareholder meetings as required by statute.  All related party transactions should be formally reviewed, documented, and approved, either in meetings or by written consent.  All arrangements between related entities (such as a real estate lease or an arrangement for “back office” services) should be strictly at market rates, and payments between the entities for such arrangements should be clearly identified. If possible, employees should only perform services for one entity, but to the extent they perform services for more than one their time should be carefully tracked and payments (at their typical hourly rate) should be made to compensate the entity for whom they typically work.

While observing these types of formalities can be time-consuming, as Cameron shows it is necessary in order to protect the assets of the separate businesses from creditors of one of them.