The Colorado Court of Appeals last month liberalized the standard for piercing an LLC’s veil by holding that neither fraud, wrongful intent, nor bad faith need be shown by an LLC’s creditor to reach the assets of the LLC’s single member. Martin v. Freeman, No. 11CA0145, 2012 WL 311660 (Colo. App. Feb. 2, 2012).
Background. Dean Freeman was the single member of Tradewinds Group, LLC, a Delaware limited liability company. Tradewinds contracted to have Robert Martin construct an airplane hangar, but in 2006 Tradewinds sued Martin for breach of the construction agreement. While the litigation was pending, Tradewinds sold its only meaningful asset (other than its claim in the litigation) for $300,000 in 2007. Tradewinds distributed the proceeds to Freeman, and Freeman continued to pay the litigation expenses.
The trial court found for Tradewinds on its breach of contract claim and entered judgment in its favor, and Martin appealed. The Court of Appeals reversed the trial court and remanded with directions to enter judgment in Martin’s favor. On remand, the trial court in 2009 awarded Martin costs of $36,600. Tradewinds was unable to pay, and Martin sued Freeman to pierce the LLC veil and recover the $36,600 from Freeman. The trial court pierced the LLC’s veil and found Freeman personally liable for the cost award. Id. at *1.
The Court of Appeals began by reciting the Colorado requirements to pierce the LLC veil: “the court must conclude (1) the corporate entity is an alter ego or mere instrumentality; (2) the corporate form was used to perpetrate a fraud or defeat a rightful claim; and (3) an equitable result would be achieved by disregarding the corporate form.” Id.
Alter Ego. The court described several factors to be considered in determining alter ego status, including commingling of funds and assets, inadequacy of corporate records, thin capitalization, disregard of legal formalities, and using entity funds for non-entity purposes. The court then listed the trial court’s findings in support of the conclusion that Tradewinds was Freeman’s alter ego:
• Tradewinds’ assets were commingled with Freeman’s personal assets and the assets of one of his other entities, Aircraft Storage LLC;
• Tradewinds maintained negligible corporate records;
• the records concerning Tradewinds’ substantive transactions were inadequate;
• the fact that a single individual served as the entity’s sole member and manager facilitated misuse;
• the entity was thinly capitalized;
• undocumented infusions of cash were required to pay all of Tradewinds’ operating expenses, including its litigation expenses;
• Tradewinds was never operated as an active business;
• Legal formalities were disregarded;
• Freeman paid Tradds’ debts without characterizing the transactions;
• Tradewinds’ assets, including the airplane, were used for nonentity purposes in that the plane was used by Aircraft Storage LLC, without agreement or compensation;
• Tradewinds was operated as a mere assetless shell, and the proceeds of the sale of its only significant asset, the airplane, were diverted from the entity to Freeman’s personal account.
Id. at *2. The list is long, but many of the items amount to disregard of various formalities.
The court quoted part of the section of the relevant Colorado LLC statute that addresses LLC veil piercing, Colo. Rev. Stat. § 7-80-107(2), but did not discuss it. The court also referred to other secondary authorities such as 1 Fletcher’s Cyclopedia of the Law of Corporations § 41.35 (“a sole shareholder will not likely be suspect merely because he or she conducts business in an informal manner”) and 2 Ribstein and Keatinge on Limited Liability Companies § 12.3 (“veil piercing on the ground of inadequate capitalization is even less likely for LLCs than corporations”). The Court of Appeals nonetheless concluded, with no further analysis, that the trial court’s findings supported the conclusion that Tradewinds was Freeman’s alter ego. Martin, 2012 WS 311660 at *2.
The court’s perfunctory treatment of Colorado’s LLC Act is puzzling. The Act provides:
7-80-107. Application of corporation case law to set aside limited liability.
1) In any case in which a party seeks to hold the members of a limited liability company personally responsible for the alleged improper actions of the limited liability company, the court shall apply the case law which interprets the conditions and circumstances under which the corporate veil of a corporation may be pierced under Colorado law.
(2) For purposes of this section, the failure of a limited liability company to observe the formalities or requirements relating to the management of its business and affairs is not in itself a ground for imposing personal liability on the members for liabilities of the limited liability company.
The statute appears to require that most of the Martin court’s alter ego factors be disregarded, which probably would have resulted in failure of the veil-piercing claim.
The court also did not consider what law should apply. Tradewinds was a Delaware corporation, but the court did not discuss whether Delaware law should apply. Although the authorities are split, many jurisdictions apply the law of the state of incorporation to resolve veil piercing questions. 1 Fletcher’s Cyclopedia of the Law of Corporations § 43.72. Application of Delaware law on piercing the veil almost certainly would have resulted in dismissal of Martin’s claim. See Francis Pileggi’s discussion at Delaware Corporate & Commercial Litigation Blog, here.
Perpetrate a Fraud or Defeat a Rightful Claim. The second factor necessary to pierce the veil is that the LLC form was used to perpetrate a fraud or defeat a rightful claim. Martin, 2012 WL 311660 at *3. The trial court’s findings of fact were clear that there was no fraud, wrongful intent or bad faith in Freeman’s actions, so for the Court of Appeals the question came down to whether the LLC form was used to “defeat a rightful claim.” Bearing in mind that the LLC’s sale of the airplane and the distribution of the sale proceeds to Freeman took place in 2007, while the award of costs against the LLC did not occur until two years later in 2009, the Court of Appeals concluded that “defeating a potential creditor’s claim is sufficient to support the second prong…. Any party engaged in litigation is exposed to potential liability.” Id.
The trial court had found as a factual matter, however, that Freeman had fully provided for all known or reasonably possible debts of the LLC at the time of the distribution of the airplane sale proceeds. Id. The Court of Appeals dismissed that finding as irrelevant because it was made in analyzing whether Freeman violated the LLC Act’s restrictions on distributions by insolvent LLCs. One would have thought that facts are facts, though, especially when the Court of Appeals had said at the beginning of its opinion: “We therefore accept the [trial] court’s factual findings and review de novo its application of the law to those facts.” Id. at *1.
As part of its analysis of whether Freeman used the LLC to defeat a rightful claim, the court said it was not aware of any Colorado case establishing that a party must show wrongful intent to pierce the corporate veil. The dissent by Judge Jones, however, cited and quoted numerous prior Colorado cases that appear to require fraud, crime, an illegal act, or conduct that was at the least intended to defeat the creditor’s claim. Id. at *6-7. In any event, the court concluded, “as a matter of first impression, that wrongful intent or bad faith need not be shown to pierce the LLC veil.” Id at *3.
Equitable Result. Having navigated between the Scylla and Charybdis of “alter ego” and “perpetuate a fraud or defeat a rightful claim,” the court sailed to its conclusion that Tradewinds’ veil should be pierced and Martin’s claim against Freeman sustained. Id. at *4. The court never discussed the third prong (that an equitable result would be achieved), because the defendants only challenged the trial court’s conclusions on the first and second prongs.
Comment. Piercing the veil is a “seriously flawed doctrine,” “one of the most befuddled [areas of the law],” and is beset by “uncertainty and lack of predictability.” Stephen M. Bainbridge, Abolishing LLC Veil Piercing, 2005 U. Ill. L. Rev. 77, 77 (2005); Franklin A. Gevurtz, Piercing Piercing: An Attempt to Lift the Veil of Confusion Surrounding the Doctrine of Piercing the Corporate Veil, 76 Or. L. Rev. 853, 853 (1997).
The Martin case illustrates some of the problems that appear in many veil-piercing cases. For example, the court lists 11 alter ego factors but discusses only one, the commingling (which consisted mainly of Freeman using personal assets to satisfy the LLC’s obligations, and receiving a distribution of the airplane sale proceeds after he had provided for all known or reasonably foreseeable debts). Then, after summarizing the defendants’ arguments, the opinion simply cuts to the conclusion that “the court considered the appropriate factors and its findings support a conclusion that Tradewinds was Freeman’s alter ego.” It would be useful to know the extent to which the LLC Act’s maxim, that non-observance of formalities is not grounds for imposing personal liability, applies in a veil-piercing case.
It also would have been helpful if the court had provided guidance on the extent to which the single-member nature of the LLC was considered in the alter ego determination. Because the court found that an LLC’s veil could be pierced even without any wrongful intent or bad faith, it’s hard to escape the conclusion that the court was heavily influenced by the single-member character of the LLC.
The Martin case can be viewed as an example of the uphill battle that single-member LLCs must wage in having their existence and separate nature respected. But the court’s holding that no wrongdoing, wrongful intent, or bad faith of any kind need be shown to pierce the LLC veil and impose personal liability is a hollowing out of the liability protection for LLC members and corporate shareholders, and goes far beyond existing law.