Maine news, sports, weather | Kennebec Journal, Augusta, Maine

Court decisions can be cautionary tales for small business

By Dennis Carrillo

Many small businesses in Maine are sole proprietorships, meaning that a single individual owns all of the assets of the business.

On the flip side, a sole proprietor is personally liable for all of the business's obligations -- even when the business is conducted under a different name.

In an effort to avoid personal liability for business debts, sole proprietorships are often eventually converted into other business forms, such as limited liability companies. As the name implies, a limited liability company insulates its owners from personal liability for the business's obligations, without the double taxation consequences of traditional corporations or the restrictions of Subchapter S corporations.

So, it sounds as though every sole proprietor can convert into a limited liability company and enjoy protection from the business debts, right?

Not quite. A recent decision of the Supreme Judicial Court of Maine, Bank of America, N.A. v. Barr, offers a cautionary tale to small businesspeople regarding personal liability for business debts.

The facts of the Barr case may sound familiar to many business people. Constance Barr ran a sole proprietorship called The Stone Scone. To finance The Stone Scone, Barr obtained a $100,000 small-business line of credit from a bank. The line of credit was unsecured, meaning no property rights were given as collateral that could be repossessed and sold to satisfy the obligation, if necessary. Barr, however, had to personally guaranty the line of credit, promising that she would repay it in the event that The Stone Scone failed to do so. The bank provided funds to The Stone Scone pursuant to the line of credit.

A few years later, The Stone Scone was converted into a limited liability company.

The bank was not notified of this change in business form. Soon afterward, with $91,444 in principal owed, The Stone Scone stopped repaying the line of credit. The bank sued both Barr and The Stone Scone. At trial, Barr asserted that she was not personally responsible for the debt, because The Stone Scone had become a limited liability company. The trial court disagreed, entering a judgment against both The Stone Scone and Barr, individually, for the entire amount of the debt. Barr appealed the trial court's decision on a number of grounds, including that she should not be personally liable for the outstanding balance on the line of credit.

The Maine Supreme Judicial Court, which is our state's appellate court, agreed with the trial court, and decided that when a sole proprietorship converts to a limited liability company, "the sole proprietor retains personal liability for all preconversion debts and obligations incurred by the sole proprietorship." This makes sense from a public policy perspective, the court noted, "to protect the interests and expectations of third parties in commercial transactions who contracted with the converting sole proprietorship prior to conversion."

There are two lessons that small businesses can learn from the Barr decision.

First, sole proprietors should not assume that they escape all personal liability from business debts by simply incorporating their businesses.

Inquiring minds may want to know, what if Barr had notified the bank that the Stone Scone was converting to a limited liability company, and the bank had continued to extend credit without altering the agreement in any way? Good question. The court clearly was concerned that the bank had not been made aware of the change in business form, and the outcome might have been different if the bank had known about the change and continued lending money to the new limited liability company without any changes to the lending agreement.

The trial record in this case established that if the bank had been informed about the change, it would have insisted on a new line-of-credit agreement under the limited liability company's name. In any event, a careful business person should keep creditors informed about these types of changes. Then, at least, there is a chance of avoiding liability for post-conversion obligations.

Do not personally guaranty business obligations lightly. If the business defaults, the creditor will pursue your personal assets.

The second lesson is for business people who are owed money by other businesses. These creditors may want to insist on personal guaranties from the owners of the businesses borrowing money. That way, the creditors have grounds to collect from the owners personally, regardless of form or solvency of their business. If the creditors were not notified of their debtor's conversion of a sole proprietorship into another business form, they still are able to pursue the preconversion debt from the former sole proprietor. The former sole proprietor remains personally liable for the debt even though the business form later changed.

The Barr case leaves undecided the question of whether this still holds true if the creditor was notified of the change in form and continues to extend credit without altering the lending documents in any way. Careful creditors should monitor changes in the forms of their borrowers' businesses, insist on entering into new contracts with the new entities and get personal guaranties from owners, regardless of the borrowing business's form.

The Barr decision has answered some questions about personal liability for business debts, but of course other questions remain for future court decisions to sort out. While some areas of the law are well-settled, others are constantly evolving. In the meantime, stay tuned.

Dennis Carrillo is an attorney at Doyle & Nelson, in Augusta, where he represents individuals and businesses in commercial matters. Carrillo can be reached by phone at 622-6124 or by e-mail at dcarrillo@doylenelson.com.