Ward on Iowa Limited Liability Company Law

Creditors of an LLC can Collect from Members in Certain Cases

In Colborne Corporation v. Weinstein, 2010 WL 185416 (Colo. App. 2010), the plaintiff creditor in this case brought suit against two members of the LLC debtor pursuant to the Colorado LLC Act, alleging that the members authorized and received a distribution that rendered the LLC insolvent, thereby frustrating the plaintiff’s efforts to collect.  

The Colorado LLC Act, like Iowa’s, barred LLCs from making distributions to members if the LLC is insolvent or if the distribution will make the LLC insolvent.  The Colorado Act set forth that a member who knowingly receives a distribution in violation of the Act is liable to the LLC to return the distribution, but does not explicitly state that there is any liability for the same to the creditor themselves. The court in noted that when the LLC members who authorize the distribution are the same members who receive the distribution, they have no interest in suing themselves to “recover”, and thus the creditors of the LLC are possessed with the right to sue the members directly for the return of the improper distribution.  The court further ruled that managers of LLCs owe a limited fiduciary duty to creditors of the LLC and accordingly are prohibited from favoring their own interests over those of the creditors.    

The court found a statutory remedy for LLC creditors, even though the language of the statute only obligates the members to return unlawful distributions to the LLC.  The Colorado Supreme Court granted certiorari for further review of this ruling so stay tuned.    

-Ben Bruner, Dickinson associate

Courts Continue to Ignore Independent Status of LLCs

Look out!  Another SMLLC is effectively disregarded by the court, seemingly for no other reason other than the composition of the members.  In Rossignol v. Rossignol, 2011 WL 723041 (N.Y.3d Dept., Mar. 3, 2011) the Supreme Court, Appellate Division in New York, affirmed a decision that found when spouses are the sole members of an LLC, the divorce action could provide complete relief.  The court found that since the spouses were the sole members of the LLC and both spouses were parties to the divorce action, the consolidation of the divorce action and the action to dissolve the LLC was proper as there would be no issues left for resolution after the distribution of the marital property.  Not only does the court disregard the entity itself, the court implies that through the divorce action the court has the power to dissolve the LLC due to the court’s empowerment to provide complete relief under the local Domestic Relations law and through the equitable distribution of marital property.  

There has also been an interesting comparison to the Olmstead v. FTC case, where the Florida Supreme Court expanded the rights of personal creditors of the single-member of an LLC. (See Professor Rosins blog posting on Unincorporated Business Entities Law).  We will just have to wait to see how far Rossignol actually opens the door to Olmstead’s expansive view.

-Allison M. Lindner/Dickinson Business Law Associate

 

Right End, Wrong Means

The issue of a parent company's liability for the debts of its wholly-owned subsidiary arises once again in 17315 Collins Avenue, LLC et al v. Fortune Development Sales Corp., 2010 Fla. App. LEXIS 201 (Fla. App, January 15, 2010).

Wavestone Properties, LLC owned all of the membership interests of 17315 and was its managing member.  Wavestone, like so many parent companies, did not conduct any operations, have employees or bank accounts (this last point is a little unusual).  Based on these fact the court concluded that the parent and subsidiary were alter egos and met the first prong of the two-prong test to pierce the corporate veil.

The second prong, an improper purpose or wrongdoing was met when Wavestone transferred escrow funds that were being held for a third-party creditor of its subsidiary to the subsidiary for operating capital.  In doing so Wavestone clearly committed a wrong, but it should have been held liable for this misconduct alone and not for all of the debts of its subsidiary.  A claim of conversion, fraudulent conveyance or third-party beneficiary would have done the trick. 

Holding the parent company liable for the debts of its subsidiary because it is a shell entity goes too far and further undercuts the notion that corporations and LLCs provide a shield from liability.

-Marc Ward

Reverse Piercing is a Flawed Theory

PIP, Inc. v. Kaswa Corporation, 77 Cal Rptr. 3d 96 (Dist. 4, 2008) highlights the problem with the theory of reverse piercing.  As you know, piercing the corporate veil is an equitable theory applied to pierce the liability protections of a corporation to get at the assets of the shareholder to satisfy a corporate debt.  It is an appropriate remedy when a shareholder uses the corporate form to evade personal liability or to commit a wrong. 

Legal theories should follow a certain logic.  A leads to B which leads to C.  Imagine a spear piercing through the corporation to hit the shareholder.  When piercing the corporate veil is applied it is a straight shot.

In a reverse pierce the spear is not straight and that is the problem.  Reverse piercing is used to apply corporate assets to satisfy the debt of a shareholder.  No abuse of a statutory privilege (e.g. limited liability created by the corporate form) or wrongdoing is alleged.  Rather a second defendant is brought in merely because of its connection with the individual.  A does not lead to B, they sit side by side.

Courts recognizing reverse piercing miss two key points.  First, innocents are put at risk.  Because no showing of abuse of the distinction between a shareholder and the corporation is necessary (e.g. alter ego, commingling of assets, etc.) there may be other innocent shareholders whose investments are now at risk.  And corporate creditors, particularly unsecured trade creditors, may have the assets they were counting on to satisfy their legitimate debts swept up by the shareholder’s creditor.  It is arguable that even a secured creditor may see its security vanish because the assets are deemed personal to the shareholder.

Second, there are adequate legal remedies available to the creditor such as conversion and fraudulent conveyance.  This is true even in the most obvious case for applying reverse piercing; when a sole shareholder tries to hide personal assets in a corporation to avoid a personal obligation.  Even in this case there is no need to create another remedy that is not based on sound legal reason.

 

-Marc Ward

Another Worrisome Piercing Case

This time it's the US District Court for the Southern District of Georgia that is the culprit.  Let's hope the context of this ruling is important.  The issue was one of venue, not liability.  Here are the relevant facts.

Rayonier Wood Products bought a lumber grading system from ScanWare. FinScan, a Finnish company, was not a party to the contract  and at the time was only a minority owner of ScanWare.  About 15 months later FinScan acquired 100% of the stock of ScanWare. 

As you might imagine, Rayonier was not happy with the performance of the grading system and sued ScanWare and FinScan.  Because the contract between Raynoier and ScanWare contained a choice of law provision, Rayonier filed the action in Georgia.  I'm going to skip over the procedural details to tell you simply that there was a dispute over the proper venue for the case and the question came down to whether FinScan was bound by the choice of law provision in a contract it didn't sign and at a time when it was only a minority shareholder to one of the signatories.  Of course, I wouldn't be writing this if the answer was anything but YES.

The court in Rayonier Wood Products. LLC v. ScanWare, Inc.,2009 U.S. Dist. LEXIS 110753 (Ga., 11/30/09) gave short thrift to the fact that at the time of the contract FinScan was just a minority shareholder.  What the court found dispositive instead were these facts:

1. FinScan later became the sole shareholder of ScanWare;

2. Rayonier and FinScan employees regularly communicated with each other (presumably regarding ScanWare business, but not clear);

3. FinScan's president was also ScanWare's president and he tried to resolve Rayonier's concerns with the ScanWare product;

4. The system sold by ScanWare was basically a FinScan product.

Based on these facts, the court held that "ScanWare was an instrumentality or alter ego of FinScan when the contract was signed.  Although it was not a signatory to the contract, FinScan is bound by the terms of the contract."

Keep in mind that each of these facts occurred after the contract was signed.  Like I said at the outset, let's hope the standards are lower for piercing the veil to find the proper venue than to impose monetary liability.

-Marc Ward

A Way Around the Successor Liability Doctrine?

Our sagging economy is resulting in a lot of business foreclosures.  This will mean a lot of litigation and quite a bit of new law.  Tredit Tire & Wheel Co. Inc. v. Regency Conversions, LLC et al, 2009 US Dist. LEXIS 50323 (E. D. Mich, June 12, 2009) is one example.

Tredit Tire supplied specially designed and manufactured tires to Regency for the conversion vans it created.  Regency was owned by TAG, its sole member.  TAG defaulted on its loan from WB Automotive Holdings, Inc. ("WBAH").  WBAH foreclosed and became the owner of all of TAG's assets including its membership in Regency.

WBAH loaned Regency $1 million and replaced its president with its own employee.  Its efforts to save Regency failed, however, and Regency ceased making payments to its vendors.

One of those vendors was Tredit Tire.  It sued Regency and WBAH for breach of contract alleging that it was holding $350,000 of inventory made specifically for Regency and was owed $195,000 for tires already delivered to Regency.  It sued WBAH on several theories including piercing the corporate veil.

The piercing claim was based on the fact that WBAH exercised control over Regency (replacing the president with its own employee) and made all of the tactical and strategic decisions for the company, including the decision to liquidate Regency and which vendors to pay and which to stiff.

WBAH contended that the Tredit Tire allegations were defeated by the successor liability doctrine which holds that a successor to another company's assets does not assume responsibility for its liabilities unless done so expressly or implicitly.

The court applied Michigan law which will pierce the corporate veil if (1) the subsidiary is a mere instrumentality of its parent, (2) the parent committed fraud or wrong, and (3) the plaintiff suffers an unjust loss.

The court concluded that the allegations, if proven, could show that Regency was a mere instrumentality of WBAH due to the control the parent asserted over its new subsidiary.  It also held that breach of contract was a sufficient "wrong" to meet the second test.  Finally, the third prong, an unjust loss, could be proven if the facts bear out plaintiff's contention that it was led to believe that its debts would be repaid by Regency once WBAH took over.

The defendant's contention that the successor liability doctrine should apply was turned aside by the court.  It found that the allegations, if proven, would mean that the piercing the corporate veil doctrine tests were met and liability could be imposed on WBAH.  In effect, the court said that the piercing doctrine trumps the successor liability doctrine.

This is dangerous ground for creditors.  If a creditor takes over 100% ownership of a debtor's subsidiary, who else is to make the tactical and strategic decisions for the subsidiary but its only owner?  A lot of the focus of this case suggests that installing its own employee as president of Regency was a mistake.  An outsider might have been a better choice.  But what if the outsider doesn't do what the sole owner expects?  Will replacing him or her also result in liability?  Scary stuff.

-Marc Ward

Reverse Piercing Used to Defeat Fraud Claim

In a relatively novel approach, defendants in a bankruptcy proceeding asserted reverse piercing as a defense to a claim of fraudulent conveyance brought by the bankruptcy trustee.  The trustee was attempting to cause a third-party to pay $450,000 to the estate. In re Freelander Capital Management Corp., 2009 Bankr. LEXIS 1195 (US Bkrptcy. Ct., SD Fla, April 29, 2009).

The relevant facts are these.  On March 14, 2001 the debtor corporation loaned Designs, Inc. $500,000.  The debtor corporation was wholly-owned by Burton Freelander.  The sole shareholder of Designs was the debtor's second ex-wife.  On April 11, 2001 the ex-wife withdrew $500,000 from a Designs account and deposited the money in a joint account owned by Burton and this ex-wife.  A short time later Burton transferred $50,000 to the debtor's account.  In a nice twist, Burton used $375,000 of the money to pay off a judgment involving his first ex-wife.  All parties agreed that the second ex-wife thought the loan was from Burton and repaid to Burton.

The debtor filed Chapter 7 bankruptcy in 2003.  All involved agree that the second ex-wife never withdrew funds from the joint account, never deposited any more funds into the account, and believed the payment of the $500,000 was a repayment of the loan.  Nevertheless, the trustee asserted that the payment was a fraudulent conveyance and the second ex owed $450,000 to the debtor corporation.

The defendants, the second ex-wife and her corporation, Designs, Inc., asserted the doctrine of reverse veil piercing as their defense, claiming that the payment to the individual joint account was payment to the debtor corporation.  The bankruptcy court agreed.

Applying Connecticut law because the debtor was a Connecticut corporation, the court found that there was such a unity of interest between Burton and the debtor and dominance by Burton over the corporation that the independence of the corporation had ceased to exist.  The court further found that applying the doctrine of reverse piercing would achieve an equitable result and avoid unfair prejudice to the second ex-wife.  The point being that she had already made the payment, she would not be retaining anything of value, and the loss to the creditors (who had already received restitution or had weak claims) was outweighed by the hardship to her if she had to make a second payment of $450,000.

Key to the court's decision, it appears, is the fact that the trustee had little use for the money given the status of the creditors' claims.  Had there been substantial creditors with strong claims for the funds, the equities of the case might have caused a different result.

This as another example of the willingness of the courts to ignore the corporate form when it suits the equities of the situation.  Is that what the law is supposed to be about?

- Marc Ward

Missouri's Piercing Formulation

The Missouri courts have developed a nice formulation for applying the piercing the veil to corporations and LLCs.  It's a three-part test: (1) A showing of control, complete domination of not only finances, policy and business practices (the alter ego test); (2) a breach of the duty of the controlling party not to use such control to perpetrate a statute or commit a dishonest and unjust act; and (3) the breach was the proximate cause of the plaintiff's injury or unjust loss.  See Carpenters' District Council of Greater St. Louis v. J&J Contractors, LLC, 2009 US Dist LEXIS 36607 (April 29, 2009) quoting Mobius Management Systems, Inc. v. West Physician Search, LLC 175 SW 3d 186, 188-89 (Mo. Ct. App. 2005).

Unfortunately, there is a reference in the Mobius quote to undercapitalization that suggests undercapitalization at the time of the wrong doing may be a breach of this duty.  Such a holding would upset the concept of limited liability.

Although the court doesn't identify it as such, a good example of the application of this formulation to the parent-subsidiary relationship from another jurisdiction can be found in Transition Healthcare Associates, LLC v. Tri-State Health Investors, LLC, 2009 US App. LEXIS 636 (6th Cir. January 9, 2009).

-Marc Ward

Another Reason to Stay Off the High Seas

Federal Maritime law appears to take an expansive view of the piercing the corporate veil doctrine.  The standard is to pierce the veil when to do so would "achieve an equitable result." Williamson v. Recovery Ltd. P'ship, 542 F.3d 43, 53 (2d Cir. 2008).  Ugh.  So its all about fairness?

In In re Rickmers Genoa Litigation, 2009 LEXIS 30430 (SDNY Mrch 31, 2009), the court applied a very inclusive and loose 15-factor test to determine whether to pierce the veil.  See if you recognize any of your clients here:

"(1) common or overlapping stock ownership between parent and subsidiary; (2) common or overlapping directors and officers; (3) use of same corporate office; (4) inadequate capitalization of subsidiary; (5) financing of subsidiary by parent; (6) parent exists solely as holding company of subsidiaries; (7) parent's use of subsidiaries' property and assets as its own; (8) informal intercorporate loan transactions; (9) incorporation of subsidiary caused by parent; (10) parent and subsidiary's filing of consolidated income tax returns; (11) decision-making for subsidiary by parent and principals; (12) subsidiary's directors do not act independently in interest of subsidiary but in interest of parent; (13) contracts between parent and subsidiary that are more favorable to parent; (14) non-observance of formal legal requirements; (15) existence of fraud, wrongdoing or injustice to third parties."

Ten out of 15 can easily apply to the most innocent of corporate structures.

Now watch how the court applies these factors.  The parentheticals are my commentary:

"Here, the evidence presented raises triable issues as to whether piercing the corporate veil is warranted. The Non-Moving Parties have pointed to the facts that: ESMT is a wholly-owned subsidiary of ESM Group and may have been created to circumvent U.S. import laws or obtain lower prices for certain materials previously imported by ESM Group ("circumvent" is a loaded term, how about minimize impact?  And lower prices are bad?); ESM Group directors sit on ESMT's board, sometimes constituting the entire ESMT board (not uncommon in small companies, particularly Iowa bank holding companies); ESM Group provides substantial financing to ESMT (a common reason to create a holding company is to raise capital); ESM Group designed ESMT's plant to manufacture SS-89 and supplied the capital, machinery, and expertise necessary to start the operation (sharing resouces); ESM Group developed the specifications for SS-89, gave that formula to ESMT (capital contribution), and instructed ESMT personnel on how to make SS-89; ESM Group conducts oversight of ESMT production facilities and procedures (sharing resources again); a significant majority of ESMT's output is sold to ESM Group, and ESM Group fulfills its SS-89 needs from ESMT (division of labor); although apparently sufficiently capitalized, ESMT's net profits were comparatively small in 2004 and 2005 (bad times?  poor management?). This evidence tends to show that ESMT was transacting ESM Group's business rather than its own business. Taking this evidence as a whole, it is sufficient to create a triable issue as to whether veil piercing is warranted in this case."

These cases give me the willies.

-Marc Ward

Another Eerie SMLLC Piercing Case

Fortunately, most piercing the veil cases include a member/shareholder who deserves to be punished.  As a matter of fact I think most piercing cases are decided based on how badly the court wants to nail the SOB.

Alan Kosinski operated a night club on Salisbury Beach in Massachusetts called "Boston Waves."  He used greatly exaggerated projections of profit and misrepresented the term of the night club lease as 20 years instead of two in order to con $75,000 out of poor Mr. Douglas.  Needless to say "Boston Waves" didn't do so well.  Troubles with keeping a liquor license and a disastrous non-appearance by Snoop Dogg (but a SWAT team showed up) did the club in.  Mr. Douglas sued in Bankruptcy court to hold Kosinski personally liable on his loan to Boston Waves, LLC.

Now it was evident that Kosinski could be seen as a con artist.  He ran some of the dubious real estate seminars where everybody is told they can make a fortune.  His financial projections were probably fantasy, although in his defense the club did not take off as anticipated and the term of the lease turned out to be irrelevant because the club folded within a single summer season.

Nevertheless, after citing the usual litany of factors a court will consider in deciding whether to pierce the veil of an LLC (including the rather frightening "insolvency at the time of the litigated transaction") the court held Kosinski personally liable for the debt to Douglas.

The court stated as reasons for piercing the veil "Kosinski's persuasive control of Boston Waves, the absence of corporate [sic] record, and thin capitalization or insolvency, as well as use of the limited liability company to promote fraud."  In re Alan D. Kosinski, 2009 Bankr. LEXIS 192 (US Bankr. Ct. Mass. 2/4/09).

Here is the rub.  There was no evidence presented in the opinion to suggest that there was an absence of business records or thin capitalization or insolvency.  It is not even clear that Kosinski was the only member of the LLC. The court's conclusion turned on, albeit, a rather dubious set of profit & loss statements and the misrepresentation of the term of the lease.  However, P&L statements don't reflect the capitalization of the company, particularly ones that are projections not a reflection of past or current performance.

This case seems to have been decided purely on the basis of the judge wanting to stick it to a perceived con man.  That is not to say the outcome is wrong, but the reasoning is shaky.

-Marc Ward

Finally, Some Piercing Sanity

In Aekyung Co., Ltd. v. Intra & Company, Inc, et al, 2008 U.S. Dist. LEXIS 96942 (SDNY Nov. 19, 2008), the federal district court considered piercing the corporate veil of corporation owned by a single shareholder.  In his decision, which is applicable to single member LLCs, Judge McKenna brought some sanity to the unpredictable world of veil piercing.

A judgment had been entered against Intra & Company, Inc., a corporation with only one shareholder.  Apparently, Intra did not have $1.8 million in its bank account so the plaintiff sought to pierce the corporate veil and obligate the sole shareholder to pay the judgment.

Under New York law to pierce the corporate veil there must be a showing that (1) the owner exercised complete domination of the corporation and (2) such domination was used to commit a fraud or wrong against the plaintiff resulting in injury to the plaintiff.

To show dominance of Intra by the sole shareholder the plaintiff alleged, among other things, (1) the rent on the shareholder's residence was paid from a corporate account, (2) Intra was administratively dissolved for over a year, (3) the corporation had no officers other than the sole shareholder and no minutes of shareholder or board meetings, (4) a single person was the sole shareholder, director and officer, and (5) this person was the only person who had the authority to bind the corporation or represent Intra.

Judge McKenna was dismissive of these claims noting that given the fact that this was a single shareholder corporation "it comes as no surprise that [he] was the only person with authority and the capacity to bind Intra...."

The fact that "a corporation is 'controlled or dominated by a single shareholder' cannot, by itself, cause veil piercing." (cite omitted).  More importantly, domination and fraud is not enough to pierce the corporate veil unless "the corporate form was itself used to effectuate the fraud." 

The court also noted that points (1) through (3) listed above were an insufficient basis to grant summary judgment.  This is important because it means that sloppy bookkeeping, inattention to corporate filings and formalities should not lead to personal liability.  To conclude otherwise would render the ability of a single person to own a corporation (or an LLC) for purposes of limiting liability a nullity.  While not to be condoned, the conduct must be connected to the fraud alleged in order to lead to a veil piercing.

-Marc Ward

Louisiana Appellate Court Destroys the "LL" in LLC

In an abominable decision that better be overturned quickly, the Second Circuit Court of Appeal of Louisiana affirmed a trial court's conclusion that a contractor, John Cash, who owned an LLC was personally liable for the faulty construction of a "water feature" on the lawn of an art center because he personally designed and helped to install the feature.  It is not clear from the opinion if Cash is the sole owner of the LLC or how much work he personally did on the project; the opinion makes references to a supervisor and other employees on the job site.

The court's conclusion was not based on an alter ego theory or any traditional piercing factors or even on the basis that it was necessary to avoid a fraud or injustice.  It was based on the fact that Cash "was engaged in his profession while building the water feature and was not acting solely in his capacity as a member of the limited liability company."

Louisiana Statutes Annotated Section 12:1320(B) says "Except as otherwise specifically set forth in this Chapter, no member, manager, employee, or agent of a limited liability company is liable in such capacity for a debt, obligation, or liability of the limited liability company."

That sounds fair enough.  Now read LSA Section 12:1320(D): Nothing in this Chapter shall be construed as being in derogation of any rights which any person may by law have against a member, manager, employee, or agent of a limited liability company because of any fraud practiced upon him, because of any breach of professional duty or other negligent or wrongful act by such person, or in derogation of any right which the limited liability company may have against any such person because of any fraud practiced upon it by him.

Again, not a surprise if "professional" means a doctor, a lawyer, an architect or any of the other generally understood professions.  But in this case, Cash was "a licensed horticulturist, landscape contractor and irrigator."

The court of appeals concluded that Cash was "engaged in his profession" and therefore personally liable under the exception created in 12:1230(D).  The dissenting judge saw it differently.  Concerned that the majority opinion might destroy the liability shield.  This case was a breach of contract claim against the LLC to whom Cash owed a duty, not a tort claim against him personally.

In a nutshell, the majority saw the case as a tort claim (negligence) and the dissenter viewed the case as a breach of contract of claim (failure to satisfy contract).  What do you want to bet the LLC has no assets?

 

Piercing Thyself: The De Facto Merger

The facts of 24/7 Records, Inc. v. Sony Music Entertainment, Inc., 566 F. Supp 2d 305 (S.D.N.Y. 2008) should not come as any surprise to a business lawyer with a few years of experience.  A corporation is formed to produce records.  It enters into a contract with a record distributor.  Later, because a new investor would bust the corporation's S election, the owners form an LLC.  It is the LLC that continues the business and the corporation falls into disuse and was eventually administratively dissolved for failure to file its annual report.  Competent counsel would not have allowed this, but who wants to pay for a lawyer?

So when there is an alleged breach of the contract by the record distributor (and tortious interference claim by a third party to boot) how does the LLC have the right to bring the claim?  The district court helped out the recalcitrant plaintiffs and concluded that a de facto merger had taken place because there was continuity of ownership (well, not quite, there was a new investor), cessation of the business of one entity, continuity of the business including assumption of liabilities, and most important of all in this case,the defendants also disregarded the technical distinction and treated the entities as one in the same.

Another Example of the Changing Piercing Landscape

Courts, like water, move through the path of least resistance when trying to find a way to pierce the veil of an "evil doer."  In Anderson v. Stewart, 234 SW 3d 295 (Ark. 2006) the Arkansas Supreme Court concluded that simply failing to follow the record-keeping requirements of the state's Check Cashier's Act was enough.  Other events were cited, but this failure in bookkeeping was found to be enough.

-Marc Ward

Distressing Trend in Limited Liability Piercing Cases

There is a distressing trend in veil piercing cases.  Courts sometimes become so intent on finding a wrong-doer that they do not let the evidence or the pleadings stand in they way.  Here are two recent examples.

In McCarthy v. Wani Venture A.S., 251 SW 3d 573 (Tex. App. 2007) the Texas Court of Appeals, First District, found the individual defendant liable for the debts of an LLC even though, as the dissent points out, there was no evidence introduced at trial to pin the debt on her.

And in In re Burwell v. Burwell Family Limited Partnership and RHFP, LLC, 2008 Bankr. LEXIS 2097 (8th Cir. August 7, 2008), the court essentially performed a reverse piercing to snare the assets of a partnership and an LLC despite the lack of pleading such a claim.  As in McCarthy, the dissenting opinion is informative.

-Marc Ward

You've Heard of Piercing and Reverse Piercing, Now there is Self-Piercing

In a novel New York case, an organizer of a corporation and an LLC tried to convince a court to disregard one entity and allow the other one to succeed to the legal remedy the disregarded entity was claiming against the defendant in the case.  And it might have worked, if only the disregarded entity could have proved damages.  You got to read it yourself. 24/7 Inc. v. Sony Music Entertainment, Inc., 2008 U.S. Dist. 49993 (NY July 1, 2008).

-Marc Ward

Single Member LLCs and Piercing the Veil

As reported in earlier blogs, it appears that it is becoming easier in some states to pierce the veil of limited liability.  Take the case of Network Enterprises, Inc. v. APBA Offshore Productions, Inc., 264 Fed. Appx. 36,2008 U.S. App. LEXIS 2961 (2nd Cir. February 11, 2008).

In this case the Second Circuit Court of Appeals looked at the veil piercing requirements of the states of New York and Florida.  In New York to pierce the veil it takes (1) a showing of complete domination over  the corporation/LLC with respect to the transaction at issue and (2) such "domination was used to commit a fraud or wrong that injured the party seeking to pierce the veil." (underline added)

In Florida, it takes a showing that the corporation/LLC is the mere instrumentality or alter ego of the owner and the owner "engaged in improper conduct."  (underline added)

The Second Circuit concluded that the defendant completely dominated the LLC and was its alter ego (meeting both standards) because (a) he formed the company,  (b) he was the sole member, (c) he conducted all of its business, signed the checks, and signed the contract that was the center of the controversy, and (d) hold on to your hat, "operated the company from the same address where he maintained his law practice."

These characteristics describe the vast majority of single member LLCs in existence (modifying the last one to fit the circumstances).  In other words, according to the Second Circuit all one has to do is prove that a "wrong" has been committed or the defendant engaged in "improper conduct" in order to pierce the veil of a single member LLC.  Whatever happened to piercing being an extraordinary remedy that courts were reluctant to impose?  Whatever happened to fraud being a necessary element to pierce the veil?  Is a single member safe from personal liability only when they do right?  What of the risk-taker, the gambler, the fool?

Fortunately, Iowa looks at piercing a little differently.  Rather than focusing on domination or alter ego tests, the Iowa courts apply a six-factor test: (1) the corporation/LLC is undercapitalized, (2) it lacks separate books, (3) its finances are not kept separate from individual finances or individual obligations are paid by the corporation/LLC, (4) the corporation/LLC is used to promote fraud or illegality, (5) corporate formalities are not followed and (6) the corporation/LLC is a mere sham.

The six-factor test is certainly preferred.  Let us hope Iowa continues to apply it.

-Marc Ward

Insolvency at the Time as a Consideration for Piercing the Veil

As I have appointed out in an earlier post, some states (Texas and Idaho, for two) have as an element for piercing the veil of limited liability the nonsensical notation of insolvency at the time of the event giving rise to the cause of action.  South Carolina is another state in this column.  See Ashley II of Charleston, LLC v. PCS Nitrogen, Inc., 2008 US Dist. LEXIS 47262 (June 13, 2008).

The problem, of course, is that this seems to imply that members have a continuing duty to maintain the capitalization of an LLC.  This is contrary to the statutory concept of limited liability as well as the provisions of most LLC operating agreements. 

Unfortunately, Iowa may be one of these states since the Supreme Court has been less than clear in articulating its position.

-Marc Ward

When Fraud or Injustice Need Not be Shown

Iowa is typical in claiming to pierce the corporate or LLC veil only "where the corporation is a mere shell, serving no legitimate business purpose, and used primarily as an intermediary to perpetuate a fraud or promote injustice.  See e.g. Briggs Transp. Co. v. Starr Sales Co., 262 NW2d 805, 810 (Iowa 1978).

A recent Connecticut case throws doubt on the need to show fraud or injustice to pierce the veil.  In Double G.G. Leasing, LLC v. Underwriters at Lloyds, 2008 Conn. Super. LEXIS 1305 (May 16, 2008), the Connecticut Superior Court concluded that the "Identity Theory" does not require a showing of fraud or violation of a legal duty (as opposed to the "Instrumentality Theory" which does require such a showing.)  It is vague and contradictory on the matter of proving an injustice.

In Double GG the plaintiff brought an action against Lloyd's of London to recover on an insurance policy.  The plaintiff was an LLC whose sole member and manager was Carl Glatzel, Jr.  The LLC's only asset was a duplex purchased on February 25, 2005.  The LLC obtained an insurance policy against loss or damage to the property by fire on March 19, 2005.  Less than 5 weeks later, on April 24, 2005, the duplex was destroyed by fires "of incendiary origin that were ignited at two separate locations at the rear of the building with the use of flammable liquid accelerant."

How does this case become a piercing the LLC veil case?  Because Lloyd's sought Glatzel's personal tax returns and denied the claim when he refused.  His refusal was based on the theory that the policy only requires the LLC to turn over financial records including tax returns.  The Court agreed that the policy only applies to the LLC, but then pierced the LLC veil under the Identity Theory and held that duties under the insurance policy are imposed on Glatzel as well as the LLC.

The sole fact that caused the court to reach this conclusion was the fact that when his wife was threatening divorce Glatzel had, on the advice of counsel but without his father's knowledge, transferred his interest in the LLC to Glatzel, Sr., but continued to manage its affairs, and had his father reconvey the LLC interests to him once marital harmony was restored.

The court concluded that such facts revealed "a unity of interest and ownership between Glatzel and the company and a complete lack of independence of the latter" sufficient to pierce the veil.  The court also made some noise to the effect that recognizing a separate identity for the LLC would "defeat justice" but that can be said in just about every case; why else is there a dispute?

To guard against such outcomes members of single member LLCs need to be sure that separate books are kept, commingling of funds prohibited, and other distinctions between the LLC and the sole member are observed.

-Marc Ward

Balmer v. 1716 Realty LLC and 1716 Realty Corp: A New Twist on the Pierce

Balmer v. 1716 Realty LLC and 1716 Realty Corp, 2008 U.S. District LEXIS 38113 (E.D. N. Y. May 9, 2008) is a clever twist on the traditional piercing the veil cases. For one thing, unlike most piercing cases, this one succeeds.  More important, it's a case of an affiliate piercing the veil of other affiliates.  Intriguing,  no?

Balmer is the receiver of Olympia Mortgage Corporation, a company best known for defrauding Fannie Mae of millions of dollars.  Olympia was owned by six individuals who also owned all of the equity interests in 1716 Realty LLC and 1716 Realty Corp.  To make a long story short, these dudes capitalized the affiliates with Olympia's money, paid the affiliates' expenses with Olympia's money, transferred Olympia's real property to the affiliates and repaid the mortgage loans with Olympia's money, and used Olympia's employees, offices, addresses, stationary, and phones as if they were their own.  There was no evidence that these affiliates abided by any corporate formalities or even elected directors or managers.  In other words, they had no existence separate from Olympia.

Ordinarily, plaintiffs seek to pierce the veil to get at the assets of the owners of the entity.  In Balmer, Olympia's receiver sought the assets of the affiliates. The receiver argued that the assets of 1716 Realty LLC and 1716 Realty Corporation should be used to pay off Olympia's creditors rather than benefit the mutual owners of the affiliated entities.

The court agreed and declared Olympia the legal owner of the assets of 1716 Realty LLC and 1716 Realty Corporation.

-Marc Ward   

Recent Indiana and Texas Veil Piercing Cases and How They Affect Iowa

A couple of recent cases highlight attempts to pierce the parent-subsidiary corporate veil.  There is no reason not to apply the reasoning in these two cases to LLCs.

In a case arising out of a 2004 natural gas explosion in Evansville, Indiana, Williams v. Iowa Pipeline Assoc., Inc, et al, 2008 U.S. Dist. Lexis 35679 (April 29, 2008), Vectren Corporation,a supplier of natural gas to homes and businesses, sought indemnification from Semco Energy, Inc. and its wholly-owned subsidiary, Enstructure Corporation for the construction work that resulted in the death of two individuals (I'm ignoring a complex set of mergers and acquisitions that resulted in Semco Energy,Inc. and Enstructure Corporation as the defendants in the case).  Vectren claimed that Semco and Enstructure were the alter ego of Iowa Pipeline and consequently their corporate veils should be pierced.

The federal district court made the point emphatically that the veil will be pierced under Indiana law only to protect a party from fraud or injustice; the presence of the indicia of an alter ego (undercapitalization, commingling of assets, absence of corporate records, etc.), is not enough.  According to the court, the alter ego analysis is only undertaken after fraud or injustice has been found. Sometimes it is unclear which comes first, the fraud/injustice or the ability to pierce the veil, so this case is helpful for this reason alone.

The court is also helpful in clarifying three things that do not permit a court to pierce the parental veil:  (1) undercapitalization at the time of the alleged fraud/injustice is irrelevant, the test for undercapitalization must be made at the time of incorporation; (2) a loan by a parent to a subsidiary is not commingling of assets; and (3) common directors and officers between the parent and subsidiary without more does not indicate an alter ego.

A Texas case involving patent infringement differs with the Indiana court with respect to the first two of these three observations.  In TIP Systems v. SBC Operations, Inc., 536 F. Supp.2d 745 (S.D. Tx. 2008) and citing US v. Jon-T Chems., Inc., 768 F. 2d 686 (5th Cir. 1986), the court noted that a corporate parent financing a subsidiary and a subsidiary operating with grossly inadequate capital were factors to  be considered in piercing the corporate  veil.  These two factors were 2 of 12 factors listed by the court. (Among the 10 other factors two are rather meaningless, bordering on silly: the  parent and subsidiary file consolidated tax returns and the parent incorporated the subsidiary.)

Because there was nothing untoward in the business relationship, the Texas court concluded, like the Indiana  court, that the veil should not be pierced.  Like the Indiana decision, the Texas court views corporate veil piercing cases as a two-step analysis:  if a fraud or injustice has been perpetrated, an alter ego determination will be made. 

In Iowa the corporate form (and the LLC form per the Cemen Tech case discussed in an earlier post) will be disregarded only "where the corporation is a mere shell, serving no legitimate business purpose, and used primarily as an intermediary to perpetuate a fraud or promote injustice."  Briggs Transp. Co. v. Starr Sales Co., 262 NW2d 805, 810 (Iowa 1978).  Briggs, as well as C. Mac Chambers Co. v. Iowa Tae Kwon Do Academy, Inc., 412 NW 2d 593 (Iowa 1987) and In re Ballstaedt, 606 NW 2d 345 (Iowa 2000), cite six factors the existence of which would support piercing the corporate veil.

The six factors are (1) the corporation is undercapitalized, (2) it lacks separate books, (3) its finances are not kept separate from individual finances or individual obligations are paid by the corporation, (4) the corporation is used to promote fraud or illegality, (5) corporate formalities are not followed and (6) the corporation is a mere sham.

A couple of observations.  Iowa sides with Texas and looks at the capitalization of the LLC at the time of the alleged fraud or injustice, not when the entity is organized, as Indiana courts do, but I have to wonder if the court has thought about it very carefully.  The concept is contrary to the notion that the "debts, obligations or other liabilities of a limited liability company, whether arising in contract, tort, or otherwise...are solely the debts, obligations, or other liabilities of the company." Iowa Code 489.304.

The Iowa Court's use of the word "is" it implies that members have an ongoing responsibility to maintain the capitalization of the LLC, and if they don't they could be held personally responsible.  This is contrary to Iowa Code 489.304(1)(b) (such debts "do not become the debts, obligations, or other liabilities of a member...solely by reason of the member acting as a member...."). Talk about an injustice! This could be a dangerous concept for Iowa businesses.

The second and third factors are consistent with other jurisdictions, but the fourth one does not make sense (if there is fraud the corporate veil will be pierced if there is fraud). The fifth factor is not applicable to Iowa LLCs (489.304(2)). And the sixth factor states a conclusion that would be reached if the other factors are found, it is not an element to be proved.

So, in Iowa we are really down to a three factor test.  The veil of an LLC will  be pierced if it is being used to perpetuate a fraud or promote injustice if (1) the LLC is undercapitalized, (2) it lacks separate books, and (3) its finances are not kept separate from individual finances or individual obligations are paid by the corporation.  It is not clear if all of these factors must be present, but that would be the right view.

-Marc Ward 

Iowa Supreme Court Applies Piercing the Corporate Veil Factors to an LLC

Last week, probably without realizing it was doing so, the Iowa Supreme Court applied its piercing the corporate veil factors to a limited liability company for the first time.  In Cemen Tech, Inc. v. Three D Industries, L.L.C., 2008 Iowa Sup. LEXIS 63 (May 2, 2008), the Court reaffirmed its 6-factor piercing test and applied the factors with respect to two Iowa LLCs.

The six factors are (1) undercapitalization of the LLC, (2) lack of separate books, (3) commingling its finances with individuals or paying obligations or debts owed by individuals, (4) using an LLC to promote fraud or illegal activity, (5) not following LLC formalities, and, the catch-all, (6) the LLC is a sham.

The Court failed to acknowledge that the fifth factor is inapplicable to Iowa LLCs because neither current law, Iowa Code Section 490A.603(2), or the new law, Iowa Code Section 489.304(2), permits a court to impose liability on the members of an LLC for failure to observe such formalities as holding periodic meetings.

The Court also needs to clarify whether the undercapitalization test is applied at the time the business is organized or at the time of the events giving rise to the litigation.  As I will be writing about in a future blog, courts around the country view this issue differently.

-Marc Ward