ihwlaw

Law Blog – Business Law & Litigation

Is Your Company Kosher in California? – The Pitfalls of Invalid Entity Status

Did you know that your company or the one that you represent may not have the right to enter into contracts, sue or defend itself against a lawsuit in California?  Well-settled law, ignored by many businesses and even lawyers to some degree, can disqualify a company from entering into contracts or litigating in California if it fails to establish and maintain a qualified status with the Secretary of State (“SOS”) and the Franchise Tax Board (“FTB”), the state taxing authority.

In Silicon Valley and elsewhere throughout the state, a large percentage of start-ups decide to form their company – be it a corporation or an LLC – in a state other than California, such as Delaware.  However, if these foreign companies plan to have a presence or otherwise do business in California, state law requires these companies to register for qualification with the California Secretary of State, pay an annual franchise tax and potentially pay state income taxes the same as an entity that is formed in California.  If foreign companies fail to comply with these requirements, they forfeit all “corporate powers, rights and privileges” in California, which include not only the right to maintain a lawsuit in the state, but also the power to enter into valid contracts with other persons or entities.  See Cal. Corps. Code §§ 2105, 2203 and Cal. Rev. and Tax. Code § 23304.1; and see Neogard Corp. v. Malott & Peterson-Grundy, 106 Cal.App.3d 213, 219-220 (1980) (corporation transacting business in California without qualifying to do so risks a number of sanctions, both civil and criminal, including the right to maintain lawsuit).  Contracts formed while a company’s status is invalid (i.e., unqualified or suspended) are voidable at the option of the other party; this means that the contract remains in effect but the other party may cancel it.  White Dragon Prods. v. Performance Guars., 196 Cal. App. 3d 163, 168-169 (1987) (contract entered into when party was not qualified with state is voidable and remains so even after party qualifies in California).

While a foreign company does have the right to defend itself against a lawsuit in California, service of the lawsuit may potentially be accomplished by serving the Secretary of State instead of the company directly, see e.g. Cal. Corps. Code § 17708.07 (limited liability companies only), so the company may lose before it knows it has been sued.  And, in any event, every unqualified foreign entity is deemed to have submitted to California jurisdiction, which may prevent the entity from claiming lack of jurisdiction even after they qualify with the state.

Further, if your company was formed in California, the loss of rights and powers is even more severe than for a company formed in another state.  The lost “corporate powers, rights and privileges” include not only the voidability of contracts formed during suspension and the right to maintain a lawsuit in the state but also the right to defend against one, too.  Damato v. Slevin, 214 Cal. App. 3d 668, 673 (1989).   For example, if a California entity is suspended for failure to pay taxes due to the FTB or failure to file a Statement of Information (for a prolonged period), the corporation may be entirely “disabled from participating in litigation activities” during the suspension.  See Tabarrejo v. Superior Court, 232 Cal. App. 4th 849, 863 (2014), review denied (Apr. 1, 2015).

Little known to most people, including even lawyers, is that it is a misdemeanor (you read that right– a crime) for any person to attempt to exercise “the powers, rights, and privileges of a corporation that has been suspended pursuant to [Cal. Rev. & Tax. Code] Section 23301 or who transacts or attempts to transact … business in this state on behalf of a foreign corporation.”  Cal. Rev. & Tax. Code s. 19719.  Further, an attorney who knowingly represents a suspended corporation and conceals this fact from the court may be subject to sanctions. See Palm Valley Homeowners Ass’n, Inc. v. Design MTC, 85 Cal.App.4th 553, 563 (2000). Fortunately for insurers and their lawyers, the criminal statute does not apply “to any insurer, or to counsel retained by an insurer on behalf of the suspended corporation, who provides a defense for a suspended corporation in a civil action based upon a claim for personal injury, property damage, or economic losses against the suspended corporation,” and the statute does not “create or limit any obligation upon an insurer to defend a suspended corporation.”

What to do if your company is suspended?  A suspended company may regain its rights by undergoing a process known as revivor, and the steps to accomplish this are outlined on the websites of the SOS and FTB.  Any competent business lawyer or accountant should be able to assist you.  After a company is revived by the State, it regains the power to enter into valid contracts and to maintain and defend against lawsuits.  Damato, 214 Cal.App.3d at 674.  But any contract made during the suspension remains voidable by the other party.

To conclude, whether your company was formed in California or elsewhere, if it wants to do business in California, it must maintain a valid status with the Secretary of State and Franchise Tax Board, or you may find that doing business in California can be perilous and costly.  In most cases, obtaining a valid status is not complicated or costly so, if your company is presently not in good standing with the State, it should act promptly to rectify this and maintain a valid status.

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