Veil-piercing law varies widely from state to state, and a recent Maryland case is an example of the member-protective end of the spectrum. Its requirement for a showing of fraud in order to pierce an LLC’s veil creates a high hurdle for a plaintiff wishing to pierce the veil and impose liability on an LLC’s member. Serio v. Baystate Props., LLC, 60 A.3d 475 (Md. Ct. Spec. App. Jan. 25, 2013).
An LLC will normally shield its members from personal liability for the company’s debts and obligations. That liability shield is not impenetrable, though, and can sometimes be pierced in court by the company’s creditors. When an LLC’s veil is pierced, the LLC’s separate entity status is disregarded and the company’s creditors can assert their claims not only against the LLC but also against the members personally.
Veil-piercing claims in lawsuits are common for two reasons. One is that often the LLC has few or no assets and cannot satisfy a judgment if the plaintiff wins its case. The other is that veil-piercing law in many states is unclear and unpredictable, which increases the likelihood of a plaintiff adding a veil-piercing claim in hopes of increasing its ability to collect on a judgment.
Facts. Baystate Properties, LLC contracted in 2006 with Serio Investments, LLC to build homes on two lots owned by Vincent Serio, the sole member of the LLC. The contract required Serio Investments to provide an escrow account from which Baystate was to be paid according to a draw schedule. Baystate also was to be paid an additional $25,000 upon the sale of each of the homes.
Payments to Baystate slowed and Baystate received none of the sale proceeds when the two homes were sold. In 2007 Baystate sued both Serio Investments and Vincent Serio for the amounts owing on the construction contract. After a bench trial in 2009, the court found for Baystate on its breach of contract claim, pierced the veil of Serio Investments, and entered judgment against Vincent Serio individually.
According to the trial court, the evidence did not support a finding of fraud but was sufficient to establish a paramount equity, and there would be an inequitable result if the corporate veil was not pierced. Id. at 484. The trial court based its conclusion on findings that (i) Serio individually owned the two lots that were the subject of the construction contract; (ii) Serio gave assurances to Baystate about impending sales of the lots; (iii) Serio lied about the sale and settlement of the first lot; (iv) Serio Investments had significant debts and no income other than Serio’s deposits, and was virtually insolvent; and (v) an escrow account was never established as required by the construction contract. Id.
Court of Special Appeals. The court first noted that Section 4A-301 Maryland’s LLC Act provides that no LLC member is to be personally liable for the LLC’s obligations solely by reason of being a member of the LLC, and that Maryland law treats piercing the veil of an LLC much like piercing the veil of a corporation. Id.
According to the court, the basic rule in Maryland is that “shareholders generally are not held individually liable for debts or obligations of a corporation except where it is necessary to prevent fraud or enforce a paramount equity.” Id. at 484 (quoting Bart Arconti & Sons, Inc. v. Ames-Ennis, Inc.,340 A.2d 225 (Md. 1975)).
Perhaps as a harbinger of its eventual conclusion, the court stated: “This standard has been so narrowly construed that neither this Court nor the Court of Appeals has ultimately ‘found an equitable interest more important than the state’s interest in limited shareholder liability.’” Id. (quoting Residential Warranty v. Bancroft Homes Greenspring Valley, Inc., 728 A.2d 783, 789 n.13 (Md. 1999) ). (The Maryland Court of Appeals is the state’s highest court.)
The court looked to the analysis of the Court of Appeals in Hildreth v. Tidewater, 838 A.2d 1204 Md. 2006), which concluded that in the absence of fraud, a paramount equity could be based either on preventing evasion of legal obligations, or on the company’s failure to observe the corporate entity (the “alter ego” doctrine). Serio, 60 A.3d at 486. Hildreth indicated that the alter ego rule should be applied only with great caution and in exceptional circumstances, id., and that generally the “evasion of a legal obligation” grounds will not apply if the party seeking to pierce the corporate veil has dealt with the corporation in the course of its business on a corporate basis, id. at 488.
After reviewing the conduct of Serio Investments, the court found that it was a valid, subsisting LLC when it entered into the contract with Baystate, that the addenda to the parties’ contract were all with Serio Investments, that the payments to Baystate were made by Serio Investments, and that other documents related to the project were all in the name of Serio Investments. Baystate understood that it was doing business with Serio Investments, and there was not enough evidence of either an attempt to evade Serio Investments’ legal obligations or of disregard of the entity status of Serio Investments. “In sum, Serio Investments fulfilled the contract with Baystate until, as Serio testified, the collapse of the housing market caused problems.” Id. at 489.
The court concluded that the trial court had abused its discretion in finding Serio personally liable and reversed the trial court’s judgment.
Comment. Maryland LLC members can take comfort that the Maryland courts will not lightly pierce the veil of their LLC, even if it is a single-member LLC. I have blogged about at least 11 different veil-piercing cases, and according to my informal survey Maryland’s case law appears to be the most resistant to piercing the veil.
Serio Investments was a single-member LLC, and the court put no emphasis on that factor. Some other states appear to have been strongly influenced by the single-member character of an LLC when piercing its veil. E.g., Martin v. Freeman, 272 P.3d 1182 (Colo. App. 2012), which I blogged about, here.
The legal doctrine known as “piercing the veil” allows an LLC’s creditor to ignore the separate existence of an LLC and assert its claim directly against the LLC’s member. The veil-piercing doctrine is a matter of state law, and the doctrine’s details vary from state to state.
When the Kentucky Court of Appeals was faced with a veil-piercing claim against the sole member of an Ohio LLC, it first analyzed the choice-of-law question. Did Ohio’s veil-piercing law apply, or did Kentucky’s? The court applied the law of the state of formation, Ohio, and denied the veil-piercing claim under Ohio law. Howell Contractors, Inc. v. Berling, No. 2010-CA-001755-MR, 2012 WL 5371838 (Ky. Ct. App. Nov. 2, 2012).
Background. Charles Berling was the sole member of Westview Development, LLC, an Ohio LLC. Howell Contractors, Inc. provided services and materials to Westview’s real estate development in Ohio, and a payment dispute arose. Howell sued Westview and Berling, and two other companies owned by Berling, in Kentucky for the unpaid amount. Howell asked the court to pierce the veil by disregarding Westview’s status as an LLC, and to hold Berling and his companies liable for Westview’s debt to Howell.
The trial court granted summary judgment and dismissed Howell’s veil-piercing claim against Berling and his companies. The parties then agreed to a judgment in favor of Howell on its claim against Westview, and the appeal followed.
Court’s Analysis. The Court of Appeals first considered which law to apply. The parties apparently had briefed only Kentucky law, because the court noted that “[o]ne aspect of this case which has received scant attention by the parties is that Westview was formed under the laws of Ohio and the real estate development which gave rise to the debt in question is located in Lockland, Ohio.” Id. at *2. The court then quoted the Restatement (Second) of Conflict of Laws for the proposition that the law of a corporation’s state of incorporation applies to determine the extent of a shareholder’s liability to the corporation’s creditors, and applied that rule to LLCs by analogy.
The court also cited several federal cases in support of the rule that the law of the state of formation applies to issues of piercing an entity’s veil. Choice of law for veil-piercing claims was apparently a question of first impression in Kentucky, although the court did not so characterize it. None of the cases cited by the court involved Kentucky law.
The court then applied Ohio’s veil-piercing rule, which requires that for the veil to be pierced there must be fraud or an illegal act against the claimant. The court found that Westview’s conduct did not rise to the level of fraud or illegality, and that Westview had “merely failed to pay an entity debt.” Id. at *3. The court also considered Kentucky’s standards for veil piercing, reached the same conclusion, and affirmed the trial court’s dismissal of the veil-piercing claims against Berling and his companies.
For a more detailed review of the court’s analysis of Kentucky’s veil-piercing law, I recommend Thomas Rutledge’s post on his Kentucky Business Entity Law blog, here.
Comment. The court’s holding on the choice of law is consistent with the majority rule. “[T]he vast majority of jurisdictions addressing this question have applied the law of the state of incorporation to veil-piercing claims.” Tomlinson v. Combined Underwriters Life Ins. Co., 684 F. Supp. 2d 1296, 1298 (N.D. Okla. 2010).
Not all courts have been sufficiently thorough to analyze the choice-of-law issue in veil-piercing cases. For example, last year the Colorado Court of Appeals applied Colorado’s veil-piercing law to a Delaware LLC, without articulating any consideration of whether Delaware law should apply. The court pierced the LLC’s veil and liberalized the Colorado standard for piercing the veil of a single-member LLC. Martin v. Freeman, 272 P.3d 1182 (Colo. App. 2012). The result almost certainly would have been different if Delaware’s veil-piercing law had been applied. For an analysis of the Martin case, see my blog post, here.
The Court of Appeals could have been more economical in its analysis. Consider: it first decided that the law of the state of formation, Ohio, applied to the veil-piercing claim. It applied Ohio law and concluded that the veil-piercing claim failed. The court then examined Kentucky law and concluded that the veil-piercing claim also failed under Kentucky law. Since the result was the same under either state’s law, the court could have avoided deciding the choice-of-law issue, because it was not outcome-determinative.
The U.S. Bankruptcy Court for the Eastern District of Tennessee ruled in August that an LLC’s creditor could not pierce the LLC’s veil to assert its claim against the LLC’s sole member. In a twist, the LLC’s member, not the LLC, was the debtor in bankruptcy. In re Steffner, No. 11-51315, 2012 WL 3563978 (Bankr. E.D. Tenn., Aug. 17, 2012).
Veil-piercing cases arise frequently, but Steffner presents an unusual posture. Veil-piercing claims are often asserted when an LLC’s creditor wants to add a claim against someone with more assets than the LLC, such as a member of the LLC. But when the object of the veil-piercing claim (the LLC member) is in bankruptcy, even a successful attempt to pierce the LLC’s veil will result in the plaintiff being an unsecured creditor in the bankruptcy, likely receiving only cents on the dollar.
Hulsing Hotels Tennessee, Inc. obtained a state court judgment against Sleep Quest Diagnostics, LLC in 2009. Edward Steffner, Sleep Quest’s sole member, filed for bankruptcy in 2011. Hulsing then commenced an adversary proceeding in Steffner’s bankruptcy, to pierce the veil of Sleep Quest and assert Hulsing’s Sleep Quest judgment against Steffner. Hulsing also requested denial of Steffner’s bankruptcy discharge, which would have allowed Hulsing to continue to assert its claim post-bankruptcy.
Hulsing based its veil-piercing claim on the following: (1) Sleep Quest and Specialty Respiratory Services, LLC (SRS), another entity owned by Steffner, shared the same office building, bank, and accountant; (2) on the day that Hulsing served a garnishment on Sleep Quest’s bank account, Sleep Quest transferred $4,886 from the account to SRS, leaving a balance of only 17 cents; (3) when Steffner learned that Hulsing had garnished funds owed to Sleep Quest by two insurance companies, Steffner informed Sleep Quest’s bank, which held a perfected security interest on Sleep Quest’s accounts receivable, and the bank filed a motion in state court to quash Hulsing’s garnishment; (4) there had been numerous transfers of funds between Sleep Quest and SRS; (5) Sleep Quest had filed a number of reimbursement claims with the two insurance companies under a third-party physician’s provider number; and (6) Steffner’s initial filing of the list of his creditors in the Bankruptcy Court included the business debts of Sleep Quest and SRS.
The Bankruptcy Court applied Tennessee law, which will disregard the veil of an LLC’s liability shield and hold its members liable for the LLC’s debts when it “is a sham or a dummy or where necessary to accomplish justice,” when there is misconduct on the part of officers or directors, when the entity is created or used for an improper purpose, or when the entity’s form has been abused. Id. at *4 (quoting Schlater v. Haynie, 833 S.W.2d 919, 925 (Tenn. Ct. App. 1991)). The standards are the same for an LLC as for a corporation, and are to be applied cautiously and with a presumption of corporate regularity. Id.
A number of factors should be considered in determining whether to pierce the veil of a corporation or an LLC: undercapitalization, diversion of corporate assets, and the failure to maintain arm’s-length relations among related parties, among others. No one factor is conclusive, and it is not required that all of the factors weigh in favor of piercing the veil. Id. at *5.
The Steffner court systematically analyzed Hulsing’s contentions. Although Sleep Quest and SRS operated out of the same building (in different suites) and used the same bank, attorneys, and accountants, the two companies were formed at different times and for different purposes. The court pointed out that closely held businesses often use the same professionals for convenience, and the professionals and businesses who dealt with Steffner and the two companies treated them as separate entities. Id.
The transfers between Sleep Quest and SRS were documented as loans in the companies’ internal accounting records. The transfer of $4,886 on the day of Hulsing’s garnishment of the bank account was documented as a loan, with the result shown as a receivable on Sleep Quest’s books. The court saw that the timing of that transfer may have been “more than coincidental” but found that was not enough to pierce the veil. Id.
The court found Steffner’s disclosure to Sleep Quest’s bank that Hulsing had garnished Sleep Quest’s receivables that were the subject of the bank’s perfected security interest to be nonobjectionable. “Merely preferring one creditor over another is not a basis for piercing the corporate veil.” Id. at *6. And Sleep Quest’s use of an identifier number other than its own was not illegal or fraudulent, and did not divert or conceal any funds due to Sleep Quest.
The Steffners had initially listed the debts of Sleep Quest and SRS in their bankruptcy schedules, but the court saw that as a common practice, intended to give notice to all creditors who might have a claim against the debtor. Those debts would normally be listed as disputed, but Steffner made that clear at the meeting of creditors and in subsequent amendments to the schedules.
The court concluded that Sleep Quest was not a sham or a fraud and that the corporate formalities had been observed. Steffner had not used the LLC form of Sleep Quest for an improper purpose, and there was no misconduct by Steffner. Id. at *8. The court therefore dismissed Hulsing’s veil-piercing claim against Steffner.
Comment. Veil-piercing cases are noted for their lack of predictability, and sometimes courts strain to pierce the veil when the LLC has only a single member. For example, earlier this year I posted here about Colorado’s Martin v. Freeman case, where the veil of a single-member LLC was pierced without any showing of wrongdoing.
The Bankruptcy Court in Steffner took a more even-handed approach. The court put no undue emphasis on Steffner’s sole ownership of the LLC and rejected the veil-piercing claim, implicitly recognizing the legitimacy of an LLC’s liability shield even for single-member LLCs.
The court’s analysis also underscores the importance of properly documenting transactions between affiliated companies. There were numerous transfers of cash between the two companies in Steffner, but they were all reflected as loans in their accounting records. If those cash flows had not been properly booked, the case likely would have come out the other way.
Piercing the veil is a legal doctrine that allows a claimant against an LLC to disregard the LLC’s liability shield and additionally assert its claim against a member of the LLC. Plaintiffs are often motivated to raise a veil-piercing claim when the LLC has few or no assets.
Background. In most states the requirements for piercing the veil will include some disregard by the member of the LLC’s separate existence, and some degree of injustice, fraud, or wrongdoing. Veil-piercing cases come up frequently. Just this year I have written about them here (Georgia), here (New York Federal District Court, applying Delaware law), and here (Colorado).
In some situations an LLC member may find itself with direct, personal liability for actions taken on behalf of an LLC, even without piercing the veil. That can happen when the member’s actions on behalf of the LLC constitute a tort against the claimant, such as fraud or breach of fiduciary duty. Then there is no need to pierce the veil – the member is directly liable for its own wrongdoing. For an analysis of such a case, see my article, here, about Sturm v. Harb Development, LLC, 298 Conn. 124, 2010 WL 3306933 (Aug. 31, 2010).
North Dakota Supreme Court. An LLC member can also be directly liable if it turns out that the LLC did not exist or that the claimant was not aware of its existence. The North Dakota Supreme Court recently had such a case in Bakke v. D & A Landscaping Co., LLC, No. 20110308, 2012 WL 3516859 (N.D. Aug. 16, 2012).
In 2006 Andrew Thomas discussed a landscaping project with Randall and Shannon Bakke. They were given Thomas’s business card, which referred to “D & A Landscaping” and “Your front to back landscaping company,” and showed his name with no title. Id. at *1. He later submitted a written proposal to the Bakkes, which indicated that it was “[r]espectfully submitted D & A Landscaping 426-4982 Per Andy Thomas,” and after that a second proposal submitted by “D & A Landscaping Per Andy Thomas.” Id.
In 2008 the Bakkes accepted the proposal and Thomas carried out the landscaping project. The Bakkes claimed that they only learned that D & A Landscaping was a legal entity when they received Thomas’s invoice, which directed payment to “D & A Landscaping, Inc.” Id. They later learned that D & A Landscaping Company, LLC was formed in 2005 and dissolved in 2008. Id.
In 2010 the Bakkes sued D & A Landscaping Company, LLC and Thomas, alleging fraud, breach of contract, and negligence in connection with the landscaping project. At trial the jury found that D & A Landscaping Company, LLC was not liable to the Bakkes, and that Thomas was liable to the Bakkes for breach of contract, negligence, and fraud. Thomas argued on appeal that there were insufficient facts to pierce the veil of D & A Landscaping Company, LLC and hold Thomas personally liable. Id. at *2.
Court’s Analysis. The court pointed out that “[t]he precursor to piercing a legal entity’s veil to impose liability on the owner is entity liability.” Id. Because the jury found that the LLC was not liable to the Bakkes, there was no LLC liability to be transferred to Thomas, and the veil-piercing theory did not apply. The jury had instead found that Thomas acted individually, on his own behalf, when he entered into and then breached the contract with the Bakkes.
The Supreme Court found that there was evidence to support the jury’s finding that Thomas was individually liable. That evidence included Thomas’s business card, the estimate, a drawing, and proposals, none of which showed that D & A Landscaping was an LLC or that Thomas was acting as an agent for the LLC. Id. at *3. Thomas’s veil-piercing argument therefore failed, and the jury’s verdict was affirmed. Id. at *5.
Comment. Lao-tzu says in the Tao Te Ching that “a journey of a thousand miles begins with a single step.” Likewise, starting and running a business without unexpected personal liability should begin with the formation of a corporation or an LLC, and using it correctly. Thomas’s dispute came to a bad end, from his perspective, because he didn’t properly use the LLC he had formed. He used the company name without any indication that it was an LLC, and he never used a title or indicated he was acting on behalf of the LLC he had formed.
The basic rules are straightforward:
1. In printed materials such as contracts, advertising, and business cards, always use the full name of the LLC, including the entity designator such as “LLC” or “limited liability company”.
2. Always use the title of the LLC’s representative in letters, business cards, emails, and other communications from the representative. E.g., President, or Manager.
3. When signing a contract on behalf of the LLC, always use the full name of the LLC, the title of the person signing, and an indicator that the signer is signing in a representative capacity, such as “By” or “Its”. An example would be:
Acme Limited Liability Company
By: Wile E. Coyote, Vice President of Beta Testing
A claimant against a Georgia limited liability company can pierce the veil and assert its claim against the LLC’s members if the members have sufficiently disregarded the LLC’s separate existence and there is some degree of injustice, fraud, or wrongdoing. The Georgia Court of Appeals recently held that a series of real estate and cash transfers back and forth between an LLC and its members did not show enough disregard of the LLC as a separate entity to pierce the veil. Sun Nurseries, Inc. v. Lake Erma, LLC, 730 S.E.2d 556 (Ga. Ct. App. July 12, 2012).
The case involved a dispute over payment for landscaping services rendered by the plaintiff to a golf course owned and managed by two LLCs. The principal claim was for breach of an oral contract for the services, but additional claims for quantum meruit, fraud, attorneys’ fees and conversion were also raised. The two LLCs did not contest the claims and the plaintiff added the LLCs’ members to its complaint, presumably to increase the collectability of the judgment it hoped to obtain.
The trial court ruled in favor of the LLCs’ members on all of the plaintiff’s claims, and in favor of the LLCs on the fraud and conversion claims. The jury returned a verdict for the plaintiff on its remaining claims against the two LLCs. Id. at 560-61. The plaintiff appealed the dismissal of the fraud and conversion claims and the claims against the members.
The Court of Appeal’s discussion of the fraud, fraudulent transfer, and conversion claims is unremarkable, and I will pass on to its veil-piercing analysis. The court began by considering whether the defendants had disregarded the separate existence of the LLCs as legal entities. Id. at 564-65. The plaintiff claimed that a transaction involving a series of property transfers, loans and cash transfers showed disregard of the separateness of the entities.
In the transaction at issue, one of the two LLCs transferred 93 real estate lots to two of its members, who then used the lots as collateral and borrowed $5.2 million from a local bank. The members then transferred the loan proceeds to the LLC, and quitclaimed the lots to the LLC. One of the members testified that he and the other member determined that it was “simpler” to obtain the loans themselves rather than having the LLC borrow the funds directly. Id. at 560. This is puzzling, because with this approach the two members were personally liable to the bank on the loans. A loan to the LLC would have shielded the members from personal liability.
The standard used by the court for disregard of the corporate entity was that “[t]he plaintiff must show that the defendant disregarded the separateness of legal entities by commingling on an interchangeable or joint basis or confusing the otherwise separate properties, records or control.” Id. at 564 (quoting Christopher v. Sinyard, 723 S.E.2d 78, 80 (Ga. Ct. App. 2012)). The court pointed out that:
- the transfers of property to the LLC members were to facilitate a loan for the benefit of the LLC,
- the loan proceeds and the real estate lots were returned immediately to the LLC,
- the members did not make personal use of the loan proceeds,
- the cash flow generated by the loans apparently allowed the LLC to continue operating, and
- the transaction was properly reflected on the LLC’s books and in the public record.
Id. at 565. The court said that on these facts, the transfers and loans did not represent an abuse of the corporate form. Id. The fact that the loan proceeds “may have been used to replenish the company coffers after the 2005 distributions, and thus may have indirectly benefitted the members’ own ends along with the [LLC’s], does not in and of itself constitute abuse of the corporate form.” Id.
The court concluded that the loan and property transfers were insufficient to evidence a disregard by the members of the LLC’s separate identity, and affirmed the trial court’s ruling against the veil-piercing claim. Id.
The result here is not surprising, but I can see why the plaintiff thought that there was some disregard of the entity nature of the LLC. The back-and-forth property transfers don’t appear economically justifiable, because the result leaves the two members with personal liability for the loans. A conventional loan taken out directly by the LLC would have shielded them from personal liability if the LLC defaulted. Plaintiffs tend to bore in when defendants take inexplicable actions such as these loans by the members.
The Federal District Court in New York granted summary judgment to pierce the veil of a Delaware limited liability company in Soroof Trading Development Co. Ltd. v. GE Fuel Cell Systems LLC, No. 10 Civ. 1391(LTS)(JCF), 2012 WL 209110 (S.D.N.Y. Jan. 24, 2012). The court found the LLC to be the alter ego of its members, but did not explain how Delaware’s requirement of unfairness or injustice was met.
Background. This case was a dispute over a distribution agreement made in 2000. The agreement gave Soroof Trading Development Co. Ltd. the exclusive right to distribute fuel cells in Saudi Arabia that were to be manufactured by GE Fuel Cell Systems LLC. Soroof paid the LLC a $1 million, non-refundable distributor fee, and the LLC was obligated to use its reasonable efforts to supply the fuel cells to Soroof. The LLC was unable to complete development of the fuel cells, though, and never delivered any. In 2005 the LLC informed Soroof that it was unable to manufacture the fuel cells, and in 2006 the LLC was dissolved and a certificate of cancellation was filed with the Delaware Secretary of State.
Soroof eventually sued the LLC and its two members for breach of the distribution agreement, misrepresentation, conversion, imposition of a constructive trust, unjust enrichment, and an accounting. The LLC moved for judgment on the pleadings, with the result that the court dismissed all of Soroof’s causes of action but allowed Soroof to replead its claims for breach of contract and misrepresentation.
Soroof desired to pierce the LLC’s veil in order to assert its claims against the LLC’s members, which were not parties to the distribution agreement. (The LLC had been formed as a Delaware LLC with two members, GE Microgen, Inc. and Plug Power, Inc.) Soroof therefore made a two-part motion for partial summary judgment, (a) to nullify the LLC’s certificate of cancellation, and (b) to pierce the LLC’s veil. The defendants made a motion for dismissal of all claims against the LLC.
Dismissal of Claims Against the LLC. When the LLC was dissolved in 2006, a certificate of cancellation was filed, cancelling the LLC’s certificate of formation. See DLLCA § 18-203. Once a certificate of cancellation is filed, a Delaware LLC cannot be sued, unless the certificate is nullified on the ground that the LLC was not properly wound up in compliance with Delaware law. Soroof, 2012 WL 209110, at *13. Soroof alleged that the LLC had not been properly wound up because no provision had been made for Soroof’s claims, but the court pointed out that a dissolved LLC is only required to pay or make provision for claims to the extent of its assets, which in this case were nominal. Id. at *14. Soroof argued that the certificate of cancellation should be nullified because the LLC was the alter ego of the members, but it cited no legal authority to support that argument. The court dismissed all of Soroof’s claims against the LLC.
Piercing the Veil. The court then turned to Soroof’s claim that the LLC’s veil should be pierced, which would enable Soroof to pursue its claims against the LLC’s two members. The court stated the rule as follows:
Delaware law permits a court to pierce the corporate veil where there is fraud or where [the corporation] is in fact a mere instrumentality or alter ego of its owner…. To prevail under the alter-ego theory of piercing the veil, a plaintiff need not prove that there was actual fraud but must show a mingling of the operations of the entity and its owner plus an overall element of injustice or unfairness.
Id. (brackets in original)(quoting NetJets Aviation, Inc. v. LHC Commc’ns LLC, 537 F.3d 168, 177 (2d Cir. 2008)). Interestingly, the court cited no Delaware cases, instead referring only to the NetJets case from the Second Circuit.
The court recited the alter ego factors to be considered (capitalization, solvency, payment of dividends, adequate records, functioning officers and directors, other corporate formalities, siphoning funds off, and the entity functioning as a “façade” for the owner), and pointed out that less emphasis should be placed on LLC formalities than on corporate formalities.
The court then described the undisputed facts relevant to piercing GE Fuel Cell Systems LLC’s veil:
- The LLC had no cash assets at the time of dissolution.
- The LLC had no employees, and the individuals working at the LLC were actually employees of the members.
- The LLC did not lease its office space but used the premises of its members.
- There was no sign on the LLC’s premises indicating its presence.
After describing these factors, the court simply stated that “Plaintiff's uncontroverted proffers demonstrate an extensive ‘mingling of the operations’ of [the LLC] and its owners, such that [the LLC] was a mere instrumentality or alter ego of GE Microgen and Plug Power, as well as an overall element of unfairness to Soroof,” and granted Soroof’s motion for summary judgment piercing the LLC’s veil. Id. at *15. The court was silent as to how the facts showed “unfairness to Soroof,” other than implicitly recognizing that without piercing the veil Soroof’s claim would be unsatisfied. Of course, that is usually why plaintiffs seek to pierce a corporate defendant’s veil.
Comment. The court’s refusal to nullify the LLC’s certificate of cancellation seems unexceptional under the circumstances, even though the result is that all of Soroof’s claims against the LLC were dismissed. That dismissal, though, arguably should have led to dismissal of the veil piercing claims against the LLC’s members as well. That is because piercing the veil is not an independent cause of action, but merely a method of imposing liability on an underlying claim. Cambridge Elecs. Corp. v. MGA Elecs., Inc., No. CV02-8636MMM(PJWX), 2005 WL 927179, at *1 (C.D. Cal. 2005). Piercing the veil is an equitable remedy, not a cause of action unto itself. MidAmerican Distribution, Inc. v. Clarification Tech., Inc., 807 F. Supp. 2d 646, 683 (E.D. Ky. 2011).
In short, the claims against the LLC were dismissed, and therefore there was no underlying LLC liability for which the members should be made liable by piercing the LLC’s veil.
Even ignoring that issue, it appears unlikely that a Delaware court would have pierced the veil of the LLC on the facts recited by the Soroof court. The threshold in Delaware to pierce the veil of a corporation or LLC is high. Generally fraud, illegality, or other egregious facts must be present, and the Delaware courts “have only been persuaded to ‘pierce the corporate veil’ after substantial consideration of the shareholder-owner’s disregard of the separate corporate fiction and the degree of injustice impressed on the litigants by recognition of the corporate entity.” Midland Interiors, Inc. v. Burleigh, No. CIV.A. 18544, 2006 WL 3783476, at *3 (Del. Ch. 2006). See Francis Pileggi’s discussion of Midland Interiors, here.
The Soroof opinion is not an isolated instance of a court straining to pierce the veil of an LLC. Last month I posted here about Colorado’s Martin v. Freeman case, where the veil of a single member LLC was pierced without any showing of wrongdoing. Both cases support Professor Stephen Bainbridge’s thesis that “veil piercing achieves neither fairness nor efficiency, but rather only uncertainty and lack of predictability.” Stephen M. Bainbridge, Abolishing LLC Veil Piercing, 2005 U. Ill. L. Rev. 77, 78.
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.
An LLC member ordinarily is not liable for the debts and liabilities of an LLC simply by virtue of being a member. E.g., Wash. Rev. Code § 25.15.125; Or. Rev. Stat. § 63.165. Many states, however, impose personal liability for unpaid taxes on those within a business who have authority for paying taxes withheld from employee wages, or for paying sales taxes collected from customers. If one of those statutes applies, being a member of the LLC will not shield the employee, manager or officer from the statute’s reach.
Kelly Haugen, a 10% member of an Oregon LLC, was assessed liability by the Oregon Department of Revenue for the LLC’s failure to pay Oregon income taxes withheld from employee wages. Haugen v. Dep’t of Revenue, No. TC-MD 100052C, 2011 Ore. Tax LEXIS 187 (Or. T.C. Apr. 26, 2011). The LLC was manager-managed, and Haugen was not the LLC’s manager. Haugen occasionally signed checks for the LLC, and a form filed by the LLC with the state indicated that Haugen was responsible for hiring and firing employees. Id., at *2-3. The Department of Revenue asserted liability against Haugen because of his part ownership of the LLC and because he signed checks for the business. Id. at *6.
Oregon requires employers to withhold and pay Oregon income taxes from wages paid to employees. Or. Rev. Stat. § 316.167. Personal liability for unpaid tax withholdings is imposed on “[a]n officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee or member is under a duty to perform the acts required of employers by ORS 316.167 ….” Or. Rev. Stat. § 316.162(3)(b).
Finding a paucity of case law on the liability of LLC members, the Haugen court analogized Haugen’s status to that of a corporate officer for the purpose of determining liability. Haugen, 2011 Ore. Tax LEXIS 187, at *6. The court applied prior Oregon case law involving corporate officers, and found that Haugen would be liable if he had the actual authority and control to pay or direct payment of the tax withholdings. Id. at *7. The evidence indicated that Haugen did not have authority to unilaterally sign checks or make important financial decisions – he had authority to sign checks only under the direction of the 90% owner and manager, after obtaining specific consent to sign each check. Also, Haugen did not have general authority as a member, because the LLC was manager-managed, and Haugen was not a manager.
The court concluded that because Haugen “was not in a position to pay the withholdings or direct the payment of the withholdings at the time the duty arose to withhold or pay over the taxes,” he was not an “employer” under Or. Rev. Stat. § 316.162. Haugen, 2011 Ore. Tax LEXIS 187, at *11-12. The court therefore canceled the Department of Revenue’s Notice of Liability against Haugen.
Kelly Haugen escaped liability for the unpaid taxes because of his lack of authority. Had his been a member-managed LLC, or if he had had discretion to sign checks without prior approval, the court presumably would have upheld the tax assessment against him.
Many of the comparable statutes from other states are at least as strict in finding managers and check signers to be personally liable for failure to pay tax withholdings and sales taxes over to the state. The strict approach is not surprising, given that in these cases the business has in effect been a tax collector for the state and (at least in the state’s view) is holding the state’s money. The Haugen case should be a wake-up call for LLC managers and check signers to avoid the temptation of financing the business in troubled times by holding on to tax withholdings or sales taxes.
Claimants against LLCs often go beyond the LLC and seek recovery from individual members or managers of the LLC. They do that because in many cases, to quote Willie Sutton, that’s where the money is. The LLC may not be able to satisfy a claim, but a member or manager who turns out to be liable on the claim may have deeper resources to satisfy the claimant.
Under the state LLC statutes, a member or manager is not liable for the debts of the LLC simply by virtue of being a member or manager, but sometimes the circumstances can result in personal liability for a member or manager. Two recent Connecticut cases dealt with attempts to reach LLC members and managers.
Piercing the Veil. Last month the Connecticut Court of Appeals decided Breen v. Judge, 124 Conn. App 147, 2010 Conn. App. LEXIS 420 (Sept. 28, 2010). In 2006 Breen obtained a judgment against Patriot Truck Equipment, LLC for money loaned to the LLC. In 2007 Breen sued Judge, the managing member of the LLC, on grounds that the corporate veil of the LLC should be pierced in order to hold Judge personally liable for the LLC’s debt. The trial court denied the veil-piercing claim, and Breen appealed.
Usually an LLC is treated as a separate legal person, and its debts are separate from the debts of its members or managers. Piercing the veil is an exception that ignores the legal distinction between the LLC and its members or managers, with the result that a manager or member may be held liable for the debts of the LLC.
Connecticut law allows an LLC’s veil to be pierced under either the “instrumentality test” or the “identity test.” To pierce the veil under the instrumentality test, the plaintiff must show that (1) the defendant completely dominated the LLC’s finances, policies, and business practices, (2) the defendant used that control to commit fraud, waste or a dishonest or unjust act, or to violate a legal duty, and (3) the defendant’s conduct caused the injury or loss complained of. Breen, 2010 Conn. App. LEXIS 420, at * 7-8.
The court listed ten factors relevant to whether an entity is dominated or controlled, and reviewed the relevant factors considered by the trial court. At all times Judge was no more than a 50% owner of the LLC. The LLC was a properly formed company doing business in Connecticut. The LLC followed the various entity-related formalities, such as keeping separate books, filing company tax returns, and filing dissolution documents when it dissolved. The LLC operated a truck-outfitting business with increasing sales for each of its first three years, although it ultimately failed. Based on those factors the court found that neither the instrumentality test nor the control test was satisfied, and therefore affirmed the trial court’s decision not to pierce the LLC’s veil.
Breen is a good example of what an LLC and its members and managers should do to avoid a pierced veil and personal liability for the LLC’s debts. It’s not rocket science: have a legitimate business, properly form the LLC, keep books and records, file tax returns, don’t use the LLC’s bank account as the member’s personal checkbook, and so on.
Tort Claims. Piercing the veil is not the only way a creditor can reach the members or managers of an LLC. The Connecticut Supreme Court in August decided a case where the plaintiff raised tort claims against an LLC member: Sturm v. Harb Dev., LLC, 298 Conn. 124, 2010 WL 3306933 (Aug. 31, 2010). (A tort is an actionable, civil wrong, such as negligently or intentionally causing harm to someone. Examples include negligently causing an auto accident, fraud, and breach of a fiduciary duty. A party injured by a tort may be able to recover damages from the tortfeasor if requirements such as causation and proof of damages are satisfied.)
Harb Development, LLC built a home for Mr. and Mrs. Sturm. The Sturms were unhappy with the result and sued both the LLC and John Harb, a member of the LLC. The Sturms asserted violations of the Connecticut Unfair Trade Practices Act, negligence in the construction of their home, violations of the Connecticut New Home Construction Contractors Act, and fraudulent and negligent misrepresentation.
Harb asserted that the Sturms’ claims against him arose from his membership and management of the LLC and were fundamentally the same as their claims against the LLC. Harb pointed to Conn. Gen. Stat. § 34-133(a), which provides that an LLC member or manager is not liable for the LLC’s debts “solely by reason of being a member or manager.” He argued that therefore the Sturms were required to plead facts adequate to pierce the LLC’s veil in order to state a valid claim, and that they had failed to do so. The trial court agreed and dismissed all claims against Harb in his individual capacity. Harb, 298 Conn. at 129.
The Sturms emphasized on appeal that their claims against Harb were tort claims based on his own actions, that he was personally liable in tort despite being a member or manager of the LLC, and that therefore it was not necessary to pierce the veil to establish his personal liability.
The Supreme Court reviewed the well-trodden case law on the tort liability of an LLC member or manager. Members and managers are not personally liable for the LLC’s torts merely because of their status as a member or manager. But if they commit or participate in the tort, or direct the LLC’s tortious act, they will be liable even if the LLC is also liable. Id. at 132-33. Nowhere in the prior cases was the injured party required to show that the LLC’s veil should be pierced in order to allow recovery against a manager or member who personally participated in or directed the LLC’s tortious act.
The court found Harb’s reliance on Conn. Gen. Stat. § 34-133(a) to be unfounded. The Connecticut LLC Act only excludes liability for the LLC’s debts “solely by reason of being a member or manager.” Conn. Gen. Stat. § 34-133(a) (emphasis added). The court concluded that the statute was not intended to preclude the common-law, individual liability of members or managers who participate in wrongful conduct, and that therefore the trial court improperly denied the claims against Harb for the plaintiffs’ failure to plead the elements of a veil-piercing claim. Harb, 298 Conn. at 137-38.
Harb’s attempt to transmute the Sturms’ tort claim against him into a veil-piercing claim was imaginative, although ultimately unsuccessful. This tactic likely reflects a recognition that piercing the veil is difficult and less predictable than proving a tort claim. As the Breen court said, “Ordinarily the corporate veil is pierced only under exceptional circumstances.” Breen, 2010 Conn. App. LEXIS 420, at *9 (quoting Naples v. Keystone Bldg. & Dev. Corp., 295 Conn. 214, 233, 990 A.2d 326 (2010)). Not only are exceptional circumstances usually required, but predicting the outcome of a veil-piercing case is challenging. As Peter Oh recently indicated in the abstract to a research paper, here, “Exactly when the veil of limited liability can and will be circumvented to reach into a shareholder’s own assets has befuddled courts, litigants, and scholars alike.”
The Washington LLC Act prohibits an insolvent LLC from making a distribution to a member. RCW 25.15.235(1). Either type of insolvency will do – the LLC is unable to pay its debts as they come due in the usual course of business, or the LLC’s liabilities exceed the fair value of its assets. Furthermore, a member who receives such an unlawful distribution and who knows at the time that the LLC is insolvent, “shall be liable to [the] limited liability company for the amount of the distribution.” RCW 25.15.235(2).
How does this rule play out when a third party makes a claim against the LLC? I had always assumed that in this scenario a court would allow an LLC’s creditor to assert the claim against the distribution-receiving member as well, probably by piercing the LLC’s veil. But the analysis of the Washington Court of Appeals in a recent case turned out to be a little more complex.
In Shinstine/Assoc. LLC v. South-N-Erectors, LLC, No. 39277-1-II, 2010 Wash. App. LEXIS 1976 (Wash. Ct. App. Aug. 31, 2010) (unpublished), the defendant LLC stipulated to a judgment in favor of the plaintiff Shinstine for $127,850.58. Shinstine also sought to hold the LLC’s sole member, Roger Hicks, personally liable for Shinstine’s judgment against the LLC. Shinstine claimed the LLC made an improper distribution to Hicks that rendered the LLC insolvent and therefore violated RCW 25.15.235. The trial court agreed and pierced the LLC’s veil, holding Hicks personally liable for Shinstine’s judgment against the LLC.
The Court of Appeals began its analysis with the proposition that generally LLC members and managers are not personally liable for the LLC’s obligations. RCW 25.15.125(1). The Act provides an exception, however: “Members of a limited liability company shall be personally liable for any act, debt, obligation, or liability of the limited liability company to the extent that shareholders of a Washington business corporation would be liable in analogous circumstances.” RCW 25.15.060.
The Shinstine court looked to a case that involved an unlawful corporate distribution, Block v. Olympic Health Spa, Inc., 24 Wn. App. 938, 604 P.2d 1317 (1979), rev. denied, 93 Wn.2d 1025 (1980). In Block, the court had held that an insolvent corporation’s distribution to its sole stockholder and president, who was well aware of the company’s insolvency, did not require piercing the corporation’s veil. Block, 24 Wn. App. at 950. (The corporate rule when a shareholder knowingly receives an unlawful distribution from an insolvent corporation is similar to the LLC rule: the shareholder is liable for return of the distribution to the corporation. RCW 23B.08.310.)
The court in Block refused to pierce the veil because to do so would have allowed the plaintiff to secure a preference over the other creditors of the corporation. Block, 24 Wn. App at 950. The Block court’s reasoning was persuasive to the Shinstine court: “To hold otherwise would permit creditors to get a preference over other creditors otherwise prohibited by law.” Shinstine, 2010 Wash. App. LEXIS 1976 at *12-13. The Shinstine court applied the Block rule and reached the same result on the same reasoning – it held that the LLC’s veil would not be pierced to allow Shinstine’s claim to reach Hicks.
Was Shinstine left with no recourse? Apparently not. The court stated in a footnote:
Shinstine was not without remedy. Without disregard Shinstine could have had a receiver appointed pursuant to RCW 7.60.025(1)(c), which permits any party to request appointment of a receiver after a judgment in order to give effect to the judgment. The receiver could have sought reimbursement from Hicks or South-N-Erectors’ behalf if the distribution was in violation of RCW 25.15.235(1), and then pay those funds to Shinstine.
Id. at *13 n.5. My litigation colleagues tell me that receivers indeed can be appointed under this statute, for this purpose, but counsel for the plaintiff must go to court and make the necessary showing for appointment of the receiver. Doable, but not simple.
Most business people know that if they want to avoid personal liability when they sign a contract on behalf of an LLC, they should use the name of the LLC and their title. A typical example would be:
By: John Smith, Member [For a member-managed LLC]
But what’s the result if language in the contract states that the signing member is personally liable? In Losh Family, LLC v. Kertzman, 155 Wn. App. 458, 228 P.3d 793 (April 12, 2010), the Washington Court of Appeals recently ruled that the language in the contract can overrule the form of signature.
William and Teresa Grover formed Grover International, LLC in 2005 and shortly thereafter acquired a business. In connection with the acquisition they received an assignment of the seller’s real estate lease. Their LLC signed the assignment using a conventional corporate style of signature, as “Grover International, LLC by William Grover member.” Losh Family, LLC, 155 Wn. App. at 461.
So far so good. But the lease assignment said that the lease was assigned to “William and Teresa Grover as individuals, dba Grover International, LLC” (“dba” of course being the customary abbreviation for “doing business as”). Id. The lease assignment in fact referred five different times to the assignee as “William and Teresa Grover as individuals, dba Grover International, LLC.” Id. at 463.
In 2006 the Grovers sold their business, and the new buyer later defaulted on the lease. The owner of the real estate sued the Grovers, the LLC, their seller and their buyer. The trial court ruled on summary judgment that all defendants were liable jointly and severally, including William and Teresa Grover individually.
The Court of Appeals expeditiously determined that the language in the assignment referred to the Grovers personally and that the LLC’s signature did not limit the assignment’s imposition of personal liability on the Grovers. The court referred to the “long established principle that where an agreement contains language binding the individual signer, ‘additional descriptive language added to the signature does not alter the signer’s personal obligation.’” Id. at 464 (quoting Wilson Court Ltd. v. Tony Maroni’s, Inc., 134 Wn.2d 692, 700, 952 P.2d 590 (1998)).
The Losh fact pattern is the sort that lawyers involved in mergers and acquisitions hate to see. Inconsistent agreements tend to be disputed and to yield unpredictable results. The Losh contract was seriously inconsistent, and under one interpretation the Grovers would be personally liable for a lease obligation under a document that they signed only in a representative capacity. And indeed, so ruled the court.
Mr. Grover likely took no consolation from the court’s admonition that if he “did not want to be personally bound on the assignment, he should have insisted on the elimination of the language within the agreement that designated the assignee as ‘William and Teresa Glover as individuals’” (which ignores the balance of the phrase, “dba Grover International, LLC”). Id.
It is puzzling that the Losh court did not analyze the conflicting language in the contract as an ambiguity that would allow the admission of extrinsic evidence. The court ignored the large body of law which recognizes that an ambiguous or contradictory contract may be clarified by the admission of extrinsic evidence to determine the parties’ intent. E.g., Berg v. Hudesman, 115 Wn.2d 657, 801 P.2d 222 (1990).
The court also ignored the fact that the contract’s identification of the parties was not a completely clear statement that personal liability was intended. The contract language did not refer simply to the Grovers individually, but also referred to the Grovers doing business as Grover International, LLC, which at the time was an existing LLC. The phrase “doing business as” is usually used only for situations where a corporation or LLC does business under an alternate name. In Losh, however, the dba referred to an existing and separate entity, not just an alternate name for the Grovers.
The court’s ruling illustrates how simple inconsistencies in a contract quicken the blood of gimlet-eyed litigators and lead to arguable judicial decisions.
The sole manager of a Michigan limited liability company has been held potentially liable for the LLC’s failure to pay assessments due under the Michigan Agricultural Commodities Marketing Act (ACMA). Dep’t of Agric. v. Appletree Mktg., L.L.C., No. 137552, 2010 WL 841173 (Mich. Mar. 10, 2010). The case illustrates that an LLC’s liability shield is not absolute – an LLC manager can be personally liable for some types of nonpayment by the LLC.
The ACMA established the Michigan Apple Committee to carry out marketing programs funded by assessments on apple distributors. Distributors are required to deduct a portion of the purchase prices they pay to apple producers, and to hold the funds in trust and remit them to the Committee. Mich. Comp. Laws § 290.651 et seq.
Appletree Marketing, L.L.C. withheld the required amounts from its payments to apple producers in 2004 and 2005, but failed to remit those amounts to the state. The LLC instead used the funds to pay other debts, and later became insolvent and defunct. The state sued the LLC and Steven Kropf, the LLC’s manager, to recover the unpaid assessments.
The trial court entered judgment against the LLC for the unpaid amounts, but dismissed the state’s claim against Kropf on grounds that the state’s ACMA remedy against the LLC was exclusive. Michigan’s Supreme Court reversed, holding that the ACMA explicitly preserved all other lawful remedies, including claims for common law conversion and statutory conversion. The court then examined the issue of Kropf’s potential personal liability.
Under the ACWA, the funds withheld by the LLC were held intrust for the Committee. When the LLC used those funds for other purposes, it asserted dominion and control over the Committee’s money and therefore committed the tort of conversion.
To decide whether the state could pursue claims for common law and statutory conversion against Kropf, the court looked to existing Michigan law:
Michigan law has long provided that corporate officials may be held personally liable for their individual tortious acts done in the course of business, regardless of whether they were acting for their personal benefit or the corporation’s benefit.
Appletree, 2010 WL 841173, at *7. Corporate officers may be held individually liable when they cause the corporation to act unlawfully. Id.
Kropf participated in the tort by causing the LLC to divert the Committee’s funds to other purposes. Although the prior case law involved officers of corporations, the court applied those cases to the LLC’s manager without discussion, apparently by analogy.
The court made clear that this was not a case of piercing the veil of the LLC. “However, we have never required that a plaintiff pierce the corporate veil in order to hold corporate officials liable for their own tortious misconduct, and thus it is unnecessary to pierce the corporate veil in this case.” Id.
The court concluded that Kropf could be personally liable if the facts established the necessary participation: “There is no question that, if the facts prove either common law or statutory conversion, Kropf can be held personally liable and may not hide behind the corporate form in order to prevent liability for his active participation in the tort.” Id. Because the claim against Kropf had been dismissed on summary judgment, the court remanded the claim against Kropf back to the trial court for further proceedings.
Business people use limited liability companies to shield themselves from personal liability for the companies’ debts and obligations. But the shield is not impenetrable, as Appletree shows.
Normally an LLC manager is not personally liable merely because the manager caused the LLC to breach a contract; breach of contract is not a tort. The contract, however, can establish a relationship where the conduct constituting breach of contract also constitutes a tort.
Assume the parties agree that an LLC will receive property and hold it in trust, or hold it as a bailee. If the LLC misappropriates the property and refuses to return it to the other party, it has probably committed the tort of conversion. Then, the LLC manager who caused the LLC to convert the property will be personally liable for the tort.
Tort remedies can sting. For example, under Michigan’s conversion statute, a person damaged because of another’s theft, embezzlement or conversion may recover three times the amount of actual damages plus costs and reasonable attorneys’ fees. Mich. Comp. Laws § 600.2919a.
Appletree involved an intentional tort by the LLC, but claims against managers can also occur in negligence cases. Sometimes injured parties claim that an LLC manager’s inadequate supervision and management resulted in the company’s negligent injury to the plaintiff. The law is less clear here, although in many of these cases courts do hold managers liable for acts and omissions related to supervision and management. But that’s a discussion for another day.
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.
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.