Another State Pierces the Veil to Reach Managers
Courts will “pierce the corporate veil” to allow creditors of an LLC to assert claims against the LLC’s owners, in a proper case. Marc Ward recently discussed just such an LLC veil-piercing case, in which the U.S. District Court for the Eastern District of Michigan upheld an LLC creditor’s claim against the single member of the LLC.
There are far fewer cases where the LLC’s veil is pierced to allow an LLC’s creditors to reach a non-member manager or officer of the LLC. I recently discussed such a case from Colorado, in which the court held that a manager could be held personally liable for the LLC’s breach of contract even though the manager was not a member, here. Sheffield Servs. Co. v. Trowbridge,No. 08CA0059, 2009 WL 1477003 (Colo. App. May 28, 2009).
Now another state court has held that an LLC’s claimants can pierce the veil and assert their claims against those involved in the management and operation of the LLC, even if the managers are not members. Equity Trust Co. v. Cole, 766 N.W.2d 334 (Minn. Ct. App. 2009).
Equity Trust was a consolidation of eight lawsuits. One hundred and seventy-eight plaintiffs sued a myriad of corporations, LLCs and individuals on theories of breach of fiduciary duty, breach of contract, misrepresentation, conspiracy, civil theft, and violations of the Minnesota Consumer Fraud Act and the Minnesota Securities Act. The plaintiffs alleged a large-scale real estate investment fraud scheme, orchestrated by the individual defendants. Default judgments were entered against the entities, and the plaintiffs sought to pierce the veil and hold the individual defendants personally responsible for the default judgments.
The court’s veil-piercing analysis considered the corporations and LLCs together, without distinguishing one type of entity from the other. The court did not discuss Minnesota’s LLC Act, but its analysis was consistent with the statute. The Act applies the corporate rules on veil piercing to LLCs: “The case law that states the conditions and circumstances under which the corporate veil of a corporation may be pierced under Minnesota law also applies to limited liability companies.” Minn. Stat. § 322B.303 (2008).
The court first applied an alter-ego analysis and found many of the alter-ego factors to be present, including insufficient capitalization, failure to observe entity formalities, insolvency at the time of the transactions, siphoning of funds by those owning or controlling the entity, and the absence of corporate records. Equity Trust,766 N.W.2d at 339. The court then examined the second prong of the test, whether piercing the veil is necessary to avoid injustice or fundamental unfairness. This prong was easily satisfied, “[c]onsidering that the entities were operated in furtherance of a large-scale real estate fraud scheme.” Id. at 340, 341.
The individual defendants argued that the corporate and LLC veils should not be pierced because the individuals were not shareholders or members of the entities. The court held to the contrary: “If veil piercing were solely dependent on a party’s ownership interest in an entity, unscrupulous parties could avoid personal liability under the doctrine by simply acting in a capacity that does not involve ownership.” Id. at 339.
Equity Trust, like Sheffield, involved non-members who dominated and controlled the LLCs, disregarded the LLCs, and used LLC funds for their own individual purposes. In both cases the courts held that in those circumstances equity would intervene and pierce the veil to avoid injustice or fundamental unfairness.
What can managers and owners of an LLC do to forestall the LLC’s creditors from piercing the veil and reaching the assets of the owners and managers? In short, follow the golden rule: If you don’t want the LLC to be disregarded, don’t disregard it yourself. Some specifics are:
- Observe the state LLC filing requirements. These usually include the initial certificate of formation, an annual report, keeping an up-to-date agent for service of process, and paying the state’s annual fee. In most states, failure to comply will ultimately result in the dissolution and termination of the LLC.
- Have a written operating agreement and comply with its requirements for meetings, approvals and other formalities.
- Keep adequate business and accounting records.
- Maintain the records required by the state’s LLC Act. For example, Washington requires that an LLC maintain at its principal place of business the following:
(a) A current and a past list of each member and manager;
(b) A copy of its certificate of formation and all amendments thereto;
(c) A copy of its current operating agreement and all amendments, and a copy of any prior agreements;
(d) Unless contained in its certificate of formation or operating agreement, a written statement of:
(i) The amount of cash and a description of the agreed value of the other property or services contributed or promised by each member;
(ii) The requirements for any additional contributions agreed to be made by each member; and
(iii) Any right of any member to receive distributions which include a return of all or any part of the member’s contribution.
(e) A copy of the LLC’s federal, state, and local tax returns and reports, if any, for the three most recent years; and
(f) A copy of any financial statements of the LLC for the three most recent years.
- Adequately capitalize the LLC. (The courts recite this factor, but unless the Company is grossly undercapitalized or the LLC Act’s limits on distributions are violated, it should not normally have much weight in contract cases, since creditors can adjust credit terms when extending credit. It may be given more weight when tort claims are involved.)
- Keep separate bank accounts for the LLC. Do not commingle personal funds and LLC funds.
Colorado Pierces the LLC Veil for Managers
Two weeks ago the Colorado Court of Appeals held in Sheffield Services Co. v. Trowbridge, No. 08CA0059, 2009 WL 147703 (Colo. App. May 28, 2009), that a manager of a limited liability company could be held personally liable for the LLC’s breach of contract even though the manager was not a member. The Colorado LLC Act provides that when a party seeks to hold a member of an LLC liable for the “improper actions” of the LLC, the court is to apply the Colorado law applicable to piercing the veil of a corporation. Colo. Rev. Stat. § 7-80-107(1). The statute does not mention LLC managers, but the court found that the statute did not preclude applying corporate veil-piercing principles to managers of LLCs as well as to members.
The vast majority of corporate veil-piercing cases involve claims against shareholders, but Colorado has previously extended the corporate veil-piercing doctrine from shareholders to directors. LaFond v. Basham, 683 P.2d 367 (Colo. App. 1984). In LaFond the defendant was not a shareholder, but he was a director, president and general manager; dictated all policy and activity on the part of the corporations; “clearly dominated both his wife and son, the only stockholders, insofar as . . . corporate matters were concerned”; and used corporate assets for his personal gain. Id. at 369, 370. The LaFond court held that on those facts, equity would not stand aside and allow valid creditors’ claims to be defeated by application of the corporate shield.
The Sheffield court extended the LaFond rule to LLC managers, adopting the reasoning of other courts that “LLC managers are similar to corporate officers or directors” and that LLCs should be treated like corporations when considering whether to disregard the legal entity. 2009 WL 1477003, at *6. The court applied to LLC managers the same rules applied to corporations: to pierce the LLC veil, the LLC must be the manager’s alter ego, to recognize the separate existence of the LLC would perpetrate a fraud or defeat a rightful claim, and to pierce the veil would lead to an equitable result.
The first condition for piercing the veil is that the LLC be the “alter ego” of the manager or member. In Sheffield the appeal was on a summary judgment ruling, so the description of the facts was sketchy. But the Sheffield court did describe the various factors relevant to whether a corporation would be viewed as the alter ego of a shareholder, and implied that they would apply to an LLC:
· The entity is operated as a distinct business entity.
· Assets and funds are commingled.
· Adequate corporate records are maintained.
· The nature and form of the entity’s ownership and control facilitate misuse by an insider.
· The business is thinly capitalized.
· The entity is used as a “mere shell.”
· Legal formalities are disregarded.
· Funds or assets of the entity are used for noncorporate purposes.
2009 WL 1477003, at *5.
The Colorado LLC Act, however, removes compliance with legal formalities from the alter ego analysis for LLCs:
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.
Colo. Rev. Stat. § 7-80-107(2). The Sheffield court did not discuss this section’s applicability to an alter ego analysis, but this provision should provide some comfort for members and managers of LLCs that fail to observe all of the applicable “formalities or requirements.” Nonetheless, good business practice and a prudent approach to risk management suggest that Section 7-80-107(2) should not be relied on when establishing and operating an LLC. Practices such as keeping separate bank accounts and accounting records, properly forming and maintaining the LLC under the applicable state law, keeping records of meetings of members and managers, and properly signing contracts in the name of the LLC, are not difficult and should be used at all times.
