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.
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
Delaware Court Awards Lost Future Earnings to LLC Investors Because of Promoter's Fraud and Breaches of Fiduciary Duty
Many new businesses fail, for a variety of reasons, and that usually means the investors lose their investment. But it’s a bitter pill for the investors when the venture fails because of the promoter’s fraud and breaches of fiduciary duties. In a Delaware Court of Chancery case decided this week, the plaintiffs alleged fraud and breaches of fiduciary duty, and claimed that they had not only lost their investment, but also that their reputations were so besmirched by their involvement in the company’s fraudulent futures-trading scheme that they were effectively unemployable and were therefore entitled to damages for their lost future earnings. Paron Capital Mgmt., LLC v. Crombie, C.A. No. 6380-VCP (Del. Ch. May 22, 2012)(slip op.). The court agreed.
Background. Peter McConnon and Timothy Lyons met James Crombie in 2010. McConnon was a principal of a multi-billion dollar hedge fund based in London, and Lyons had worked as a senior investment professional for a number of financial institutions. Crombie had developed a software-based trading program in futures contracts, and explained that his trading program had annual returns of 25% in 2007 and 38% in 2008. He asserted that he had $30 million in assets under management, and invited McConnon and Lyons to join him in a new company to manage a hedge fund product and to trade futures on behalf of client accounts.
Due Diligence. Before deciding to join Crombie and form the new company, McConnon and Lyons conducted extensive due diligence on Crombie, his history, and his software product. They reviewed marketing materials from Crombie, including an independent verification from accounting firm Yulish & Associates, which certified that the returns claimed by Crombie were actual returns, verified through a third-party clearing broker. They checked references from 10 of Crombie’s former clients and colleagues, including mutual acquaintances. They interviewed Crombie in person and observed the software operate. They searched industry databases, interviewed Crombie’s lawyer about a lawsuit Crombie was involved in, and hired Kroll, Inc., an international risk consulting firm, to conduct a comprehensive background search on Crombie. None of those efforts turned up any red flags.
The New Company. Satisfied with their investigation, McConnon and Lyons entered into business with Crombie. They formed Paron Capital Management, LLC, a Delaware limited liability company, on June 2, 2010. Crombie had a 75% interest and was the initial manager, McConnon had a 20% interest, and Lyons a 5% interest. They commissioned an updated, independent verification of Crombie’s track record from Rothstein, Kass & Company, a national accounting firm, and used its report to begin marketing Paron to potential clients. Paron’s marketing materials were sent to over a hundred of McConnon’s and Lyons’ client contacts.
Fraud Revealed. On March 10, 2011, Paron received an audit request from its regulator, the National Futures Association (NFA). Numerous documents about Paron’s operations and Crombie’s predecessor company, JDC Ventures, LLC, were provided to the NFA. The NFA detected discrepancies and requested additional information. McConnon and Lyons began to investigate and learned that documents provided by Crombie to the NFA and to the accounting firm that had verified Crombie’s track record were false and had been forged by Crombie. After further investigation, McConnon and Lyons removed Crombie as a manager and member of the LLC, and the NFA issued a notice prohibiting Crombie and Paron from accessing, disbursing, or transferring any funds in Crombie’s name or a client’s name without prior NFA approval.
Lawsuits. On April 13 and 14, 2011, McConnon and Lyons filed two lawsuits against Crombie. Crombie entered into a stipulated judgment in the first lawsuit, in which he admitted that he was properly removed as a manager and member of the LLC, and agreed to a permanent injunction against using Paron assets or holding himself out as being affiliated with Paron.
In the second lawsuit, the plaintiffs sought damages for Crombie’s fraud and breach of fiduciary duty. A three-day trial was held in October 2011. Crombie failed to appear and presented no evidence, claiming financial hardship. Crombie filed for bankruptcy in February 2012, and the lawsuit was stayed. Later in February the stay was lifted.
Fraud. The court’s findings of Crombie’s fraud are damning. “[M]any of the representations Crombie made about his track record, employment history, and personal financial situation were outright lies.” Paron Capital Mgmt., slip op. at 10. Crombie forged account statements from multiple sources. Id. at 11. Crombie misrepresented his relationship with a prior employer and his personal financial situation. He failed to disclose another lawsuit against him and numerous personal debts he owed. The court found the plaintiffs’ reliance on Crombie’s representations to be justifiable, which isn’t surprising given their extensive due diligence.
Fiduciary Duties. The LLC’s operating agreement did not limit or exclude Crombie’s fiduciary duties as the manager, so Crombie owed the plaintiffs the traditional fiduciary duties of loyalty and care. Id. Those duties were breached both by Crombie’s preparation of fraudulent marketing materials for the LLC and by his continued concealment of material information about his track record, employment history, and personal finances. The court noted that under Delaware law, a fiduciary who remains silent about false, earlier communications that are relied upon by the beneficiary breaches his duty of loyalty. Id. at 16.
Damages. The court awarded McConnon reliance damages and mitigation costs totaling about $1.5 million. Those consisted of his loans and costs advanced to Crombie and to Paron in reliance on Crombie’s misrepresentations, and legal fees incurred in regulatory proceedings against Crombie and Paron and in foreclosing on collateral pledged by Crombie for the loan.
The vast majority of the damages claimed by McConnon and Lyons were for lost future earnings. “Specifically, Plaintiffs claim that their association with Crombie and Paron damaged their relationships with clients and effectively made them unemployable because they would be required to disclose their association with Paron to future employers, who, in turn, would have to disclose it to investors.” Id. at 20.
McConnon and Lyons provided trial testimony from two expert witnesses, an executive search professional with the financial services industry and a CPA certified in fraud examination and financial forensics. The executive recruiter testified that in his opinion, the clients he represents would not hire McConnon because of his association with Paron. The recruiter stated that his firm would be unwilling to even attempt to market McConnon because marketing an individual associated with fraudulent activity would hurt the recruiter’s business. The recruiter’s expert opinion was that McConnon would be unemployable in his field for the foreseeable future, other than for much lower-paying work only tangentially related to the capital markets.
Based on the recruiter’s expert opinions and on McConnon’s prior average annual earnings of more than $3.4 million, the CPA calculated McConnon’s lost future earnings over a 10-year period using two different methods, averaged the results, and estimated the lost earnings at $39.8 million. The court found the recruiter’s estimate of McConnon’s earnings if he had stayed at his prior firm to be overly optimistic, adjusted the amount downward, and awarded McConnon $32.2 million for lost future earnings.
Lyons’ compensation before leaving his prior employer was much lower, at about $200,000 per year. The executive recruiter and the CPA went through an analysis similar to their McConnon analysis, and after adjusting the CPA’s estimate, the court awarded Lyons $1.9 million for lost future earnings.
Comment. This case does not make new law, but it is a fascinating and odd case to consider. For one thing, the bad acts by the defendant were so egregious that the court’s legal conclusions of fraud and breach of fiduciary duty seem clear cut. Also, the fact that the defendant did not appear at trial would presumably undercut, at least to some degree, the precedential value of the court’s rulings.
The awards for the plaintiffs’ lost future earnings are unusual because they are based on injury to McConnon’s and Lyons’ reputations. Crombie’s fraudulent futures-trading scheme, and the involvement of McConnon and Lyons in Paron Capital Management, LLC, so tarred their reputations that they could no longer work in their former, highly paid capacities. And the facts showed that the effects on their careers would be long-lasting – up to ten years. (If Crombie had participated in the trial and presented experts with different opinions, the court might have reached different factual conclusions.) The long duration of the impact on the plaintiffs’ reputations, and in McConnon’s case the high level of his compensation prior to joining Crombie, led to a breathtakingly large ($32.2 million) award for McConnon.
The case is also a cautionary tale about due diligence. It’s hard to fault McConnon’s and Lyons’ investigation, as reported by the court, yet their due diligence completely failed. The court’s finding was that the plaintiffs acted reasonably in investigating Crombie. Id. at 15. Yet in hindsight, perhaps Crombie’s claim of consistent, high annual returns from his futures-trading program should have called for more probing of Crombie’s prior clients, and more double-checking of the authenticity of documents provided by Crombie.
In the world of commerce, businesses routinely rely on the apparent authority of LLC managers to sign contracts on behalf of their LLCs. Generally that works well. But what happens if an LLC disavows an agreement, claiming the manager who signed the contract had neither actual nor apparent authority?
The Missouri Court of Appeals was recently faced with this scenario in Pitman Place Development, LLC v. Howard Investments, LLC, No. ED94456, 2010 Mo. App. LEXIS 1635 (Mo. Ct. App. Nov. 23, 2010).
Background. According to the court’s statement of the facts, the LLC was formed by three members, one of whom was the sole manager. The LLC’s operating agreement gave the manager authority to manage the LLC’s business, but the consent of the members was required for the manager to cause the LLC to encumber its property or to borrow more than $50,000. The manager, however, wanted to borrow $525,000, and at this point the facts get ugly.
The manager gave the bank a copy of the LLC’s operating agreement, but omitted the pages that limited his authority. On request of the bank’s loan processor, on the day of the loan closing the manager faxed the omitted pages to the bank, but only after fraudulently altering the key provisions. The alterations increased the limit of his authority from $50,000 to $750,000 and authorized him to encumber the LLC’s property. The $525,000 loan was closed, and portions of the loan proceeds were later used by the manager for his own purposes. When the other two members learned what had happened, the LLC sued the bank to set aside the loan and deed of trust.
The trial court found after a bench trial that the manager acted with apparent authority when he executed the loan documents, and enforced the note and deed of trust against the LLC. The LLC contended on appeal that apparent authority was lacking because neither of the other two LLC members took any action to create the appearance that the manager had authority.
Apparent Authority. The Missouri rule is that to establish apparent authority, it must be shown that a principal has either manifested consent to the agent’s exercise of authority or knowingly permitted the agent to assume the exercise of authority. Additionally, the party relying on the apparent authority must have known the facts and believed in good faith that the agent had authority, and must have changed its position in reliance on the appearance of authority. Id. at *12. The Missouri rule is consistent with the Restatement of Agency. Restatement (Second) of Agency § 27 (1958).
The court found that the lender relied on the express language of the LLC’s operating agreement. “Pitman cloaked Burghoff with apparent authority when it manifested its consent for Burghoff to act as ‘Manager’ of Pitman in the Operating Agreement, and gave the ‘Manager’ general authority to enter into transactions such as the Rockwood Bank loan transaction.” Pitman Place, 2010 Mo. App. LEXIS 1635, at *14. Although the manager lacked actual authority and acted to defraud the LLC, the court relied on prior rulings that the act of an agent with apparent authority, even if in furtherance of a fraud on the principal, will bind the principal. Id.
The LLC argued that the manager had no apparent authority here because he fraudulently created the appearance of authority. The court acknowledged that an agent cannot create its own authority and that it was troubled by the manager’s “fraudulent and dishonest conduct.” Id. at *11, 19. But in the end the court found that the LLC’s general statements of authority in the operating agreement vested the manager with the apparent authority to carry out the loan transaction. The LLC was therefore responsible for the manager’s acts and agreements with the bank as if the acts were the LLC’s own. Id. at *19.
The court glosses over the fact that by fraudulently deleting the operating agreement’s limits on his authority, the manager essentially was creating his own authority. The court implicitly treats the fraudulent pages of the operating agreement as a detail that does not impair the members’ broad grant of authority.
Statutory Defense. The LLC also contended that even if the manager did have apparent authority to bind the LLC under agency common law principles, the manager’s conduct did not bind the LLC because the execution of the loan documents was not apparently for carrying on in the usual way of business or affairs of the LLC, as required by the Missouri LLC Act. Id. at *20. The statute provides, in relevant part, that “the act of any manager for apparently carrying on in the usual way of the business or affairs of the limited liability company of which he is a manager binds the limited liability company,” and that an “act of a member or manager which is not apparently for the carrying on the usual way of the business or affairs of the limited liability company does not bind the limited liability company unless authorized in accordance with the terms of the operating agreement.” Mo. Rev. Stat. § 347.065.
The court did not address why the manager’s lack of authority under this statute, if it applied, would trump the manager’s apparent authority. Instead, the court found in the language of the operating agreement and in the LLC’s past practices sufficient evidence that the loan transaction was “carrying on in the usual way of business.” Pitman Place, 2010 Mo. App. LEXIS 1635, at *23-24. The court accordingly rejected the LLC’s argument, and after affirming the trial court’s other rulings, affirmed the lower court’s judgment. Id. at *42.
Protective Steps. What else could the Pitman members have done to prevent the manager from fraudulently having apparent authority in excess of the limits in the operating agreement? Perhaps they could have written their operating agreement so that the language granting broad authority to the manager had the limitations tightly woven into it. If the manager had provided altered versions of those pages, retaining only the broad granting language, what result? Or if the agreement had no broad grant of authority to the manager but instead simply granted certain enumerated, limited powers, what result if the altered pages added some additional powers?
In any event, there are other, practical steps that could be taken to forestall chicanery. For example, the Missouri LLC Act allows an LLC’s articles of organization, which must be filed to create the LLC, to optionally contain provisions from the LLC’s operating agreement. Mo. Rev. Stat. § 347.039.2. The organizers of an LLC could include in the articles of organization the limits on the manager’s authority. Articles of organization are publicly available, and banks and title companies can and often do obtain a copy from the Secretary of State prior to closing a real estate or loan transaction. That would make them aware of the limits on the manager’s authority expressed in the articles.
Alternatively, the LLC could file a memorandum with the county where its real estate is located, referencing the LLC’s real estate and describing the limits on the manager’s authority. Any transaction involving the LLC’s real estate would almost certainly involve a title company and a title search, which would then address the manager’s authority.
The LLC could also require signatures in addition to the manager’s on all checks, or all checks above a limit, in the banking resolutions when it sets up its bank accounts. Once in place, those resolutions would require additional signatures from members other than the manager to change the authorized account signatories. That would result in oversight of withdrawals from the LLC’s bank account.
A structural approach would be for the LLC to have two or more managers, and in their operating agreement’s grant of authority require that the managers act jointly.
These measures are often not adopted, frequently because they are inconsistent with the trust most LLC organizers have in their managers. LLC organizers won’t usually appoint someone to be their manager unless they have substantial trust in them. Lawyers, though, can’t assume that the other (non-client) parties will always act benevolently, and must write agreements to cover contingencies including bad acts. The Pitman Place case is a good example of why lawyers must try to anticipate unauthorized or improper acts by the other parties.