Maryland Resists Piercing LLC Veil
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.
Real Estate Financing Shared Between Two LLCs Is Not a Usurpation of Corporate Opportunity
Under the long-established corporate opportunity doctrine, a limited liability company manager that takes advantage of an opportunity that under the circumstances should have belonged to the LLC will be in breach of its fiduciary obligations. In a recent Maryland case the manager of a real estate development LLC caused the LLC to participate in a pooled line of credit. The LLC’s real estate was pledged to secure the borrowings not only of the LLC but also of the two other companies participating in the line of credit. The LLC received its portion of the loan proceeds, proceeded with its development, and obtained lien releases as each of its lots was sold.
When the LLC’s principal investor later learned of the pooled line of credit it sued the LLC’s manager. The investor claimed that the pooled line of credit showed that the manager usurped the LLC’s corporate opportunity by developing the second development. The trial court ruled that the manager had not usurped the LLC’s corporate opportunity and had not breached its fiduciary obligations, and the Court of Special Appeals affirmed. Ebenezer United Methodist Church v. Riverwalk Dev. Phase II, LLC, 45 A.3d 883 (Md. Ct. Spec. App. 2012).
Background. Synvest Real Estate Investment Trust formed River Walk Development, LLC (Riverwalk One) in 2001 and contributed undeveloped real estate to it. In 2002 Ebenezer United Methodist Church purchased a 50% interest in Riverwalk One for $250,000. Before completing its investment in Riverwalk One, Ebenezer United learned that Synvest owned a 32-acre parcel and other lots elsewhere in the county.
In 2003 Synvest formed River Walk Development Phase Two, LLC (Riverwalk Two), which acquired the 32-acre parcel. William Green, Synvest’s president and part owner, then caused Riverwalk One, Riverwalk Two, and a third entity known as Green Spring Valley Overlook to collectively enter into a $2.1 million loan agreement with Regal Bank & Trust. Each of the three entities placed liens on its real estate by granting deeds of trust to Regal to secure the collective line of credit.
Riverwalk One developed and sold several units, conveyed the proceeds to Ebenezer United, and in 2006 repurchased Ebenezer United’s LLC interest. Ebenezer United’s profit on its $250,000 investment was between $30,000 and $35,000.
Ebenezer United later learned of the joint loan agreement and the liens that had encumbered the Riverwalk One properties. In 2009 Ebenezer United filed suit against Green, Synvest, Riverwalk Two, and Green’s family trust, claiming breach of fiduciary duties and usurpation of a corporate opportunity.
At trial Green testified that Riverwalk One had required debt financing to complete its construction, that Regal would not extend credit to Riverwalk One unless all its members guaranteed the loan, and that Ebenezer United was precluded from providing a guarantee because it was a non-profit. Riverwalk Two and Green Spring Valley already had a loan agreement in place with Regal, so Green arranged for Riverwalk One to draw on that loan, which required that Riverwalk One grant Regal a lien on its property to secure the three parties’ obligations on the collective line of credit.
The Court’s Analysis. The court began with the fundamental premise that an LLC’s managing member owes fiduciary duties to the LLC and to the other members, including the duty not to exclude the LLC from corporate opportunities. Id. at 886. Maryland analyzes claims of corporate opportunities under the “interest or reasonable expectancy test,” which focuses on whether the LLC could realistically expect to seize and develop the opportunity. Id. at 887.
Ebenezer United, however, did not plead nor discuss the interest or reasonable expectancy test, but instead argued that the collective security agreement automatically established a corporate opportunity. The court characterized Ebenezer United’s argument as conflating financial self-dealing with usurpation of a corporate opportunity. The court saw the question of whether the financing arrangement was self-dealing as independent of whether the defendants excluded Ebenezer United from a corporate opportunity. Because Ebenezer United had failed to argue or prove that there was self-dealing, the court focused on the interest or reasonable expectancy test for corporate opportunities. Id. at 887-88.
According to the court, “a corporate ‘interest or expectancy’ requires something more than the mere opportunity to develop a neighboring parcel of land.” Id. at 888 (citing Dixon v. Trinity Joint Venture, 431 A.2d 1364 (Md. Ct. Spec. App. 1981)). Fiduciaries do not owe their principals a general duty to offer participation in other real estate development opportunities – there must be something more than superficial similarity between the projects. Id.
There was no evidence, said the court, that Riverwalk Two had any effect on the value of the Riverwalk One project. The lien restriction on Riverwalk One’s property was not for the exclusive benefit of Riverwalk Two but was instead an efficient way to benefit the Riverwalk One project. The court concluded: “In short, a reasonable expectation or interest in a corporate opportunity requires something more than mere ‘proximity’ of geography and management, as in Dixon, or of finance, as in this case,” and affirmed the trial court’s conclusion that Green, Synvest, and Riverwalk One had not usurped a corporate opportunity. Id. at 889.
Comment. The court gave such short shrift to Ebenezer United’s argument that one can’t discern the underpinnings of Ebenezer United’s reasoning. But there are cases for the proposition that if a manager uses one LLC’s assets to support a second’s development, then the second development is a corporate opportunity of the LLC whose assets were used. In this case, granting a lien on Riverwalk One’s property to secure borrowings by Riverwalk Two appears to be a use of Riverwalk One’s assets to help develop the assets of Riverwalk Two.
For example, the Illinois Appellate Court, in support of a finding that corporate opportunities were misappropriated, said:
Therefore, when a corporation’s fiduciary uses corporate assets to develop a business opportunity, the fiduciary is estopped from denying that the resulting opportunity belongs to the corporation whose assets were misappropriated, even if it was not feasible for the corporation to pursue the opportunity or it had no expectancy in the project.
Graham v. Mimms, 444 N.E.2d 549, 557 (Ill. App. Ct. 1982) (emphasis added). Similarly, the Bankruptcy Court for the District of Delaware has said: “Thus, a business opportunity falling outside a corporation’s line of business and which would not otherwise be considered a corporate opportunity, nevertheless, will be deemed a corporate opportunity if developed or financed with corporate funds.” In re Trim-Lean Meat Prods, Inc., 4 B.R. 243, 247 (Bankr. D. Del. 1980).
But even so, I think the Ebenezer United facts still fall short of demonstrating a corporate opportunity. One reason is that, as the court pointed out, Riverwalk One’s grant of a lien on its property under the collective loan agreement was for its own benefit. And in fact Riverwalk One was benefited by the joint loan agreement. It was able to obtain its financing even though its 50% member, Ebenezer United, could not provide a guaranty as requested by the bank, and its properties were released from Regal’s lien as they were sold.
The other reason is the lack of direct benefit to Riverwalk Two, given the sequence of events. Riverwalk Two and Green Spring Valley already had a loan agreement in place with Regal when Green arranged for Riverwalk One to be added, so Riverwalk One’s security was irrelevant to Riverwalk Two’s obtaining the Regal credit line.
More States Are Considering Low-Profit LLCs
At least 10 state legislatures are considering bills to authorize low-profit limited liability companies (L3Cs) – all introduced in the last two and a half months:
|
Arizona; Senate Bill No. 1503 |
Arkansas; Senate Bill No. 5 |
|
Hawaii; Senate Bill No. 674 |
Indiana; Senate Bill No. 501 |
|
Kentucky; House Bill No. 110 |
Maryland; House Bill No. 552 |
|
Montana; House Bill No. 415 |
New York; Senate Bill No. 3011 |
|
Oregon; House Bill No. 2745 |
Rhode Island; Senate Bill No. 353 |
These have the potential to more than double the number of states that authorize L3Cs. Currently eight states have authorized L3Cs: Illinois, Louisiana, Maine (effective July 1, 2011), Michigan, North Carolina, Utah, Vermont, and Wyoming.
The L3C is a relatively new type of limited liability company, a hybrid which attempts to combine a charitable purpose with a profit-making motive. An L3C is not a nonprofit and is taxed on its profits like any other LLC. I have previously written about L3Cs, here.
Advocates of L3Cs suggest they will encourage investment by private foundations in L3C enterprises. Typical program-related investments (PRIs) made by private foundations in either for-profit or tax-exempt enterprises include equity investments and loans, on terms more favorable to the recipient than a market rate investment. The purpose of the investment must be to support the foundation’s charitable purpose. L3Cs are promoted as facilitating increased investment by private foundations, because the state statutes apply to L3Cs the Internal Revenue Code requirements for the recipient of a PRI made by a private foundation. IRC § 4944(c). The idea is that because L3Cs automatically apply those standards to L3Cs, private foundations will be more willing to invest in L3Cs.
L3Cs have generated a lot of interest in the non-profit and social enterprise community, and a fair amount of commentary is becoming available. The Vermont Law Review sponsored a symposium on L3Cs and other developments in social entrepreneurship in February 2010. (Vermont was the first state to authorize L3Cs.) Articles related to the Symposium were published in a symposium edition of the Vermont Law Review, Symposium, Corporate Creativity: The Vermont L3C and Other Developments in Social Entrepreneurship, 35 Vt. L. Rev. 1 (2010).
Two articles in the symposium edition caught my eye. The first was Program-Related Investments in Practice, 35 Vt. L. Rev. 53 (2010), by Luther M. Ragin, Jr., Chief Investment officer of the F. B. Heron Foundation. Heron has been an active PRI maker since 1997, and at the end of 2009 had $21 million in outstanding PRIs, in 38 separate transactions. Heron’s PRIs were made to a variety of organizations. Most were to non-profits, but 10 were equity or subordinated debt investments in limited partnerships, LLCs, and corporations.
The critical driver for Heron is not the legal form of the organization seeking capital. Heron has found that it can apply the PRI rules and reach positive decisions on PRIs to various types of for-profit entities as well as non-profits, provided the PRI serves a charitable purpose. (The two other PRI tests – no lobbying, and income from the PRI not being a significant purpose of the foundation’s decision to make the investment – must also be satisfied.)
The other article in the Symposium edition that jumped out was The L3C Illusion: Why Low-Profit Limited Liability Companies Will Not Stimulate Socially Optimal Private Foundation Investment in Entrepreneurial Ventures, 35 Vt. L. Rev. 275 (2010), by J. William Callison and Allan W. Vestal. The article nicely reviews the law of private foundations and PRIs. It then examines the L3C requirements of the state LLC laws and how they attempt to match the PRI requirements. The article concludes that the statutory form does not match well with the PRI requirements and that private foundations will still need to conduct the same due diligence they would conduct before making a PRI to a non-L3C entity.
The experience of the F. B. Heron Foundation buttresses Callison and Vestal’s analysis. The type of entity, and whether it is a for-profit or a non-profit, play little part in Heron’s decisions about making PRIs.
The article concludes with a discussion of why L3Cs are considered harmful. First, smaller, less well-advised foundations may unduly rely on the L3C status of the recipient when making a PRI rather than on their usual due diligence, resulting in non-compliance with tax requirements and possibly endangering the foundation’s charitable status. Second, in an L3C with profit-seeking participants, where the foundation makes a high-risk, low-return investment vis-à-vis the other investors, there is risk that the foundation may run afoul of the “private benefit” doctrine, which is intended to prevent tax-exempt organizations from conferring private benefit on private participants.
Callison and Vestal’s conclusion is succinct: without changes to federal PRI rules there is little or no value to the L3C structure, the existence of the L3C form is a dangerous trap for the unwary, and the form should be shelved.
The article makes a strong case for the states to stop adopting the L3C form, and for the states that currently authorize the L3C form to revise their LLC laws to delete the L3C authorizations.
Will careful legal analysis and commentary take the wind out of the sails of the L3C movement? It’s hard to say. Popular enthusiasms and fads take on a life of their own. And one of the drivers of the L3C movement is the laudable goal of increasing the flow of private foundation money to ventures with charitable purposes. But that goal appears to be blinding the L3C promoters and some state legislators to the legal realities – L3Cs don’t and won’t accomplish that goal unless and until the federal tax rules are changed, which appears unlikely.
