Hastings Business Law Journal Volume 12 Article 2 Number 3Spring 2016 Spring 2016 Will Your Veil be Pierced? How Strong Is Your Entity’s Liability Shield? -- Piercing the Veil, Alter Ego, and Other Bases for Holding an Owner Liable for Debts of an Entity Allen Sparkman Follow this and additional works at:https://repository.uchastings.edu/ hastings_business_law_journal Part of theBusiness Organizations Law Commons Recommended Citation Allen Sparkman,Will Your Veil be Pierced? How Strong Is Your Entity’s Liability Shield? -- Piercing the Veil, Alter Ego, and Other Bases for Holding an Owner Liable for Debts of an Entity, 12 Hastings Bus. L.J. 349 (2016). Available at: https://repository.uchastings.edu/hastings_business_law_journal/vol12/iss3/2 This Article is brought to you for free and open access by the Law Journals at UC Hastings Scholarship Repository. It has been accepted for inclusion in Hastings Business Law Journal by an authorized editor of UC Hastings Scholarship Repository. For more information, please contact [email protected]. Will Your Veil Be Pierced? How Strong Is Your Entity’s Liability Shield? — Piercing the Veil, Alter Ego, Ego, and Other Bases for Holding an Owner Liable for Debts of an Entity Allen Sparkman I. INTRODUCTION Courts, commentators, and attorneys describe corporations and limited liability companies as limited liability entities, but limited liability is not always the end result. While debts of a separate legal entity ordinarily would not be considered those of the owners1 even if the statutes applicable to these entities did not contain limitations on the owners of the entities,2 exceptions exist. For example, courts developed piercing the veil in corporate cases over a century ago as an equitable remedy to prevent perceived misuses of the corporate form.3 In the corporate context, courts  Sparkman + Foote LLP, Houston, TX and Denver, Colo., © The Author October 19, 2015. The author thanks Herrick K. Lidstone, Jr., of Burns, Figa & Wills, P.C., in Denver, Colorado, for his helpful and thoughtful comments. Any mistakes are of course the responsibility of the author. 1. BAYLESS MANNING & JAMES G. HANKS, JR., LEGAL CAPITAL 16-17 (4th ed. 2013). 2. See, e.g., 6 DEL. CODE § 18-303: (a) Except as otherwise provided by this chapter, the debts, obligations and liabilities of a limited liability company, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the limited liability company, and no member or manager of a limited liability company shall be obligated personally for any such debt, obligation or liability of the limited liability company solely by reason of being a member or acting as a manager of the limited liability company. (b) Notwithstanding the provisions of subsection (a) of this section, under a limited liability company agreement or under another agreement, a member or manager may agree to be obligated personally for any or all of the debts, obligations and liabilities of the limited liability company. 3. See United States v. Milwaukee Refrigerator Transit Co, 142 F. 247, 255 (E.D. Wis. 1905) (“A corporation will be looked upon as a legal entity as a general rule, and until sufficient reason to the contrary appears; but, when the notion of legal entity is used to defeat public convenience, justify wrong, protect fraud, or defend crime, the law will regard the corporation as an association of persons.”). A notable early veil-piercing case arose in Berkey v. Third Ave. Railway Co., 244 N.Y. 84, 155 N.E. 58 (1926). Plaintiff was injured on a street car operated by Forty-Second Street Railway Co., but she sued Third Avenue Railway Co., which owned substantially all of the stock of Forty-Second Street Railway Co. Although the court declined to pierce the corporate veil of Forty-Second Street Railway Co., which had its own bank accounts and employees as well as assets in excess of its 349 350 HASTINGS BUSINESS LAW JOURNAL Vol. 12:3 may pierce the veil where a subsidiary corporation is merely an alter ego or agent of the corporate parent, where the corporation is merely the alter ego of the shareholder, or where the corporate shield is being used to defraud creditors.4 An owner of an entity may also incur direct liability for debts of the entity or otherwise become liable on grounds other than veil piercing or alter ego. These grounds, which will be discussed later in this Article, include acting in the name of an unformed entity,5 acting for an undisclosed principal,6 liability to return improper distributions,7 liability for unpaid employment taxes,8 liability under other federal and state statutes,9 and liability for one’s own actions and the actions of agents.10 The author was prompted to write this Article in part by his experiences as an expert witness in veil-piercing cases. The author’s research did not find any analysis of veil-piercing cases that appeared aimed at assisting practicing attorneys who needed a resource to help them liabilities, Judge Cardozo (who wrote the opinion) stated “[w]e say at times that the corporate entity will be ignored when the parent corporation operates a business through a subsidiary which is characterized as an ‘alias’ or a ‘dummy.’” 155 N.E. at 61. Senter Construction Company, Inc. v. Deka Investments, LLC, 2013 WL 3272487 at *7 (Ill. Ct. App. June 24, 2013) (“The doctrine of piercing the corporate veil is an equitable remedy that permits a court to impose liability on an individual or entity that uses a corporation merely as an instrumentality to conduct that individual’s or entity’s business.”). 4. Great Neck Plaza v. Le Peep Rests., 37 P.3d 485, 490 (Colo. App. 2001). See also Fish v. East, 114 F.2d 177 (10th Cir. 1940). In determining whether the subsidiary was an alter ego or a mere instrumentality, FREDERICK J. POWELL, PARENT AND SUBSIDIARY CORPORATIONS, LIABILITY OF A PARENT FOR THE OBLIGATIONS OF ITS SUBSIDIARY (Chicago, Callahan & Company 1931) listed eleven factors that should be assessed: (a) Does the parent own all or most of stock of the subsidiary? (b) Do the parent and subsidiary corporations have common directors or officers? (c) Does the parent corporation finance the subsidiary? (d) Did the parent corporation subscribe to all of the capital stock of the subsidiary or otherwise cause its incorporation? (e) Does the subsidiary have grossly inadequate capital? (f) Does the parent pay the salaries and other expenses or losses of the subsidiary? (g) Does the subsidiary do no business except with the parent or does the subsidiary have no assets except those conveyed to it by the parent? (h) Is the subsidiary described by the parent (in papers of statements) as a department or division of the parent or is the business or financial responsibility of the subsidiary referred to as the parent corporation’s own? (i) Does the parent use the property of the subsidiary as its own? (j) Do the directors or executives fail to act independently in the interest of the subsidiary, and do they instead take orders from the parent, and act in the parent’s interest? (k) Are the formal legal requirements of the subsidiary not observed? 5. See infra notes 632-38 and accompanying text. 6. See infra notes 639–54 and accompanying text. 7. See infra notes 632–38 and accompanying text. 8. See infra notes 672–85 and accompanying text. 9. See infra notes 687–88 and accompanying text. 10. See infra notes 687–97 and accompanying text. Spring 2016 WILL YOUR VEIL BE PIERCED? 351 advise clients on how to avoid being subject to a successful veil-piercing claim or who needed a resource to help them pursue or oppose a veil- piercing claim.11 This Article draws from materials prepared for a program presented at the 2014 Annual Meeting of the Business Law Section of the American Bar Association. The program was titled “Piercing the Unincorporated Veil” and was sponsored by the Committee on LLCs, Partnerships and Unincorporated Entities. The program was chaired by Professor Stephen B. Presser of the Northwestern University College of Law, and the additional panelists were Elizabeth S. Fenton12 and Thomas E. Rutledge.13 The program materials included a 100 plus page summary of LLC veil-piercing cases prepared by Professor Elizabeth Miller of Baylor University School of Law from her comprehensive summaries of LLC cases that she has prepared for many years. This Article focuses on limited liability companies. This Article also discusses corporate cases to an extent because courts developed the veil- piercing and alter ego doctrines in corporate cases and much of the reasoning in corporate veil piercing and alter-ego cases will be applicable to limited liability companies as well. Veil piercing claims also arise in what are known as reverse veil piercing cases. This Article discusses reverse veil-piercing cases after discussing traditional veil-piercing.14 II. VEIL PIERCING IN GENERAL Some commentators have asserted that veil piercing “seems to happen freakishly. Like lighting, it is rare, severe, and unprincipled.”15 Indeed, Stephen Bainbridge thought veil piercing as applied by the courts to be so “rare, unprincipled, and arbitrary” that it should not be applied to LLCs and 11. In the course of working on this Article, the author found an excellent recent article reporting on the use of modern quantitative machine learning methods to analyze the full text of 9,380 judicial veil-piercing opinions. Jonathan Macey & Joshua Mitts, Finding Order in the Morass: The Three Real Justifications for Piercing the Corporate Veil, 100 CORNELL L. REV. 99 (2014). Macey and Mitts will doubtless be cited in many briefs in veil-piercing cases in the future and will be referred to in this Article at several points. 12. Ms. Fenton practices law with Saul Ewing LLP in Wilmington, Delaware. 13. Mr. Rutledge practices law with Stoll Keenon Ogden PLLC in Louisville, Kentucky. 14. See infra notes 601-32 and accompanying text. 15. Frank H. Easterbrook & David R. Fischel, Limited Liability and the Corporation, 52 U. CHI. L. REV. 89, 89 (1985). Macey and Mitts state: “Large swaths of veil-piercing doctrine make no sense and do not promote any sensible policy goals such as limiting opportunistic risk-taking.” Macey & Mitts, supra note 11, at 106. As to how veil-piercing doctrine is applied in practice, however, Macy and Mitts assert that “judges have in fact decided veil-piercing cases in a highly-disciplined and structured way when one analyzes the actual outcomes of the cases in isolation from the reasoning displayed in the decisions themselves.” Id. 352 HASTINGS BUSINESS LAW JOURNAL Vol. 12:3 should be abolished in the corporate context.16 Although Professor Bainbridge presented cogent arguments, he faced a Sisyphean task in attempting to dissuade courts from extending veil-piercing to LLCs — even more so was his attempt to see veil-piercing abolished in the corporate context. More recently, Jonathan Macey and Joshua Mitts17 have argued that their analysis shows that, although the rationales stated by courts in veil-piercing cases may be confusing and contradictory,18 the actual results can be classified into three categories of cases that they believe are appropriate for veil-piercing. Macey and Mitts argue that their analysis shows that whatever rationale may have been stated in opinions, “the entire universe of piercing cases can be explained as judicial efforts to remedy one”19 of three problems:  Courts pierce the corporate veil “to bring corporate actors’ behavior into conformity with a particular statutory scheme;”20  Courts “also pierce to remedy what appears to be fraudulent conduct that does not satisfy the strict elements of common law fraud;”21  The third ground on which courts pierce the corporate veil is “the promotion of what” Macey and Mitts term “accepted bankruptcy values.”22 Macey and Mitts further state: [W]e believe that our taxonomy can produce a coherent account of veil-piercing cases, and are thus more optimistic than Stephen Bainbridge, who famously called for the abolishment of the doctrine. Unlike Bainbridge, we believe that there are strong public policy rationales for retaining veil piercing in certain situations. We hesitate to conclude that a century of jurisprudence represents a colossal mistake 16. Stephen M. Bainbridge, Abolishing LLC Veil Piercing, 2005 ILL. L. REV. 77, 78 (2005) (hereafter “Bainbridge LLCs”) and Stephen M. Bainbridge, Abolishing Veil Piercing, 26 J. CORP. LAW 479 (2001) (hereafter, “Bainbridge Corporations”). 17. Macey & Mitts, supra note 11. 18. Id. at 100 (“[W]e argue that there is a rational structure to the doctrine of corporate veil piercing not only in theory, but in practice as well. Our idea is that, despite the fact that courts are inarticulate to the point of incoherence in their reasoning in particular ‘piercing’ cases, a rational taxonomy can be derived from this morass.”). 19. Id. at 101. 20. Id. 21. Id. 22. Id. Spring 2016 WILL YOUR VEIL BE PIERCED? 353 on the part of the courts in all 50 states. Rather, we suggest that three public policy rationales provide a systematic justification of veil piercing and that courts regularly decide in accordance with these rationales, even if they do not say so expressly.23 This Article posits that case analysis shows that, although veil piercing may be rare and severe, as Macey and Mitts argue,24 there are principles that are, or should be, applied by courts in these cases. Veil piercing should be rare because limited liability and the separateness of entities and their owners are intended purposes of corporate and limited liability company statutes. An observation by an early corporate commentator is equally applicable to corporations and limited liability companies today: The policy of our law to-day sanctions incorporation with the consequent immunity from individual liability. It follows that no fraud is committed in incorporating for the precise purpose of avoiding and escaping personal responsibility. Indeed, that is exactly why most people incorporate, and those dealing with corporations know, or at least are presumed to know, the law in this regard.25 Veil-piercing may be severe, as in Federal Trade Commission v. Bronson Partners, LLC,26 which held the defendants jointly and severally liable for $1,942,325 in restitution and Martin v. Freeman27 and Axtmann v. Chillemi,28 which are opinions standing for the dubious proposition that an entity’s capitalization must at all times be sufficient to allow the entity to respond to large claims that could not have been reasonably foreseen when the entity was formed. As this Article discusses above and in its analysis of cases below, veil- piercing claims succeed when the entity is nothing more than the alter ego 23. Macey & Mitts, supra note 11, at 113. 24. Id. 25. See I. MAURICE WORMSER, DISREGARD OF THE CORPORATE FICTION AND ALLIED CORPORATE PROBLEMS 18 (1927). 26. Federal Trade Commission v. Bronson Partners, LLC, 674 F. Supp. 2d 373 (D. Conn. 2009), discussed infra notes 238-40 and accompanying text. See also United States v. Jon-T Chemicals, Inc., 768 F.2d 686 (5th Cir. 1985), discussed supra notes 121-36 and accompanying text (holding a parent corporation liable for a $4,787,604.20 debt of its subsidiary). 27. Martin v. Freeman, 272 P.3d 1182 (Colo. App. 2012), discussed infra notes 272-80 and accompanying text. 28. Axtmann v. Chillemi, 740 N.W.2d 838 (N.D. 2007), discussed infra notes 312-29 and accompanying text. 354 HASTINGS BUSINESS LAW JOURNAL Vol. 12:3 of the owner and has been wrongfully used to the detriment of third parties. However, a person who establishes an entity and respects its existence may properly use the entity to protect the founder from personal liability from the entity’s obligations and, in some cases, accomplish a purpose that the person could not achieve individually. Courts recognize that someone who forms a limited liability company to avoid personal liability is pursuing a legitimate business goal29 and that a person who creates a limited liability company to minimize tax liability is not pursuing a nefarious purpose but is taking advantage of legally available tax planning opportunities to lower the person’s tax liability.30 On the other hand, an entity will be ignored if it is a sham formed for the fraudulent and illegal purpose of evading a judgment creditor.31 Several federal tax benefits are available to corporations but not to other entities.32 Wormser33 described an interesting 1908 case, People’s Pleasure Park v. Rohlede,34 in which a creative attorney used a corporation to avoid racially motivated deed restrictions: In People’s Pleasure Park Co. v. Rohlede, a large tract of land was divided up into a number of lots, each deed of a lot containing a covenant providing that title to the real estate should never pass into a person or persons of African descent or into a colored person or persons. Thereafter, a corporation was organized “composed exclusively of negroes.” It took title to a number of the lots and proposed to establish an elaborate amusement park for colored people. The corporation knew, when it purchased the land, of the title restriction. Suit was brought in equity by an owner of other [adjoining] lots to have the deed to the corporation cancelled and set aside. The court rendered judgment for the 29. See, e.g., MFP Eagle Highlands, LLC v. Am. Health Network of Ind., LLC, No. 1:07-cv- 0424-DFH-WGH, 2009 WL 77679, at *10 (S.D. Ind. Jan. 9, 2009). 30. Thomas v. Bridges, 120 So.3d 338, 342 (La. App. 2013). See Macey & Mitts, supra note 11, at 129. 31. See, e.g., Devan Lowe, Inc. v. Stephens, 842 So.2d 703 (Ala. Civ. App. 2002) (Commission based salesman for auto dealership formed LLC and requested that dealership begin paying commissions to the LLC. The testimony in the case did not show any reason for forming the LLC other than to attempt to avoid a garnishment action filed against the dealership with respect to the salesman’s commissions.). See also Macey & Mitts, supra note 12-25 and cases discussed infra notes 336-71 and accompanying text. 32. For example, only C corporations may have tax-favored medical reimbursement plans (I.R.C. § 105 (2014)) or provide tax-free group life insurance (I.R.C. § 79 (2012)). Only corporations (C and S) may engage in tax-free reorganizations under I.R.C. § 368. 33. See WORMSER, supra note 25, at 26–27. 34. People’s Pleasure Park v. Rohlede, 109 Va. 439, 61 S.E. 794 (1908) aff’d on reh’g, 109 Va. 439, 63 S.E. 981 (1909). Spring 2016 WILL YOUR VEIL BE PIERCED? 355 corporation, holding that though all its members were negroes, yet the corporation was a legal personality entirely separate, apart and distinct from its stockholders, and that therefore the covenant was not breached. The court said, in effect, that the corporation was not colored, because it “is a person which exists in contemplation of law only, and not physically.” In addition to the case law and statutory provisions determining when veil-piercing is appropriate, this Article also looks at issues that do not appear to have been addressed much in the existing literature: (1) what state’s law should apply to a veil-piercing claim and what effect, if any, does a contractual choice of law provision have on this analysis and (2) does imposition of the veil-piercing remedy depend on the existence of a causal relationship between the harm allegedly suffered by the plaintiff and the actions, or failure to act, that forms the basis for treating an entity as the alter ego of its shareholders or members? These issues are discussed below.35 III. FACTORS IMPORTANT IN LIMITED LIABILITY COMPANY VEIL- PIERCING/ALTER-EGO CASES The cases discussed in this Article teach that the veil of a limited liability company may be pierced in unusual circumstances if: (i) the owners of the LLC dominate the LLC to such an extent that there is no meaningful separation between the LLC and its owners; (ii) the funds of the LLC and its owners are commingled to such a degree that it is not possible to determine what funds belong to which person; and (iii) the owners favor themselves over third-party creditors when causing the LLC to make payments.36 The first two factors often accompany poor recordkeeping. If one person dominates an entity and doesn’t have to seek approval of others, or ignores a requirement to seek approval,37 he or she is probably not inclined to be concerned about recordkeeping. A person who fails to maintain accurate and separate financial records is more likely to fail to pay much 35. See infra notes 458-600 and accompanying text. 36. Liability is sometimes imposed on nonowners. See infra notes 65-82 and accompanying text. 37. See Tzovolos v. Wiseman,51 Conn. Supp. 532 (2007) aff’d, 300 Conn. 247 (2011), discussed infra notes 205-26 and accompanying text. 356 HASTINGS BUSINESS LAW JOURNAL Vol. 12:3 attention to properly documenting decisions of the LLC’s owners or managers. Another factor in some cases that is usually related to the owners improperly favoring themselves over third-party creditors is often described as inadequate capitalization.38 Note, also, that Macey and Mitts argue that, no matter what factors a court may discuss, all cases approving veil piercing may be classified in one of three categories.39 Several of the cases discussed in this Article are relevant to more than one factor and are discussed under each relevant factor with cross-references. In all cases, the factors determined to be present must have led to the harm suffered by the plaintiff.40 Moreover, to hold a particular owner of an entity liable under a veil-piercing claim, the owner must have participated in or had knowledge of the conditions that established the factor justifying veil-piercing. Provosty v. ARC Construction, LLC41 arose out of the following facts: Following Hurricane Katrina, in December 2006, Henry and Gloria Provosty entered into a construction contract with ARC Construction LLC (“ARC-LA”). ARC-LA was a Louisiana LLC formed to do construction work in Louisiana after Hurricane Katrina. ARC-LA had four members: (1) American Restoration Contractors, LLC, a Missouri LLC (“ARC-MO”), the members of which were Hyun Sung, Christopher P. Schmitt, Jamey Schmitt, and Richard Drevet; (2) Icehouse Capital Management, LLC; (3) Errol Glasser; and (4) Kestenbaum & Associates, LLC (“Kestenbaum”). The court affirmed the trial court’s judgment piercing the veil of ARC-LA and imposing personal liability on its members other than Glasser and Kestenbaum. The court responded to plaintiffs’ argument that the trial court erred in not imposing liability on Glasser and Kestenbaum as follows: Plaintiffs contend that the jury found that this was a closely held corporation42 and that all of the members either committed the fraud or knew of the other members’ fraud. While such a contention is a possibility, Glasser was not found liable for fraud and further operates over a thousand 38. Macey & Mitts, supra note 11 at 128, 139, 148. 39. See supra notes 17-23 and accompanying text. 40. See cases cited infra notes 499-600 and accompanying text. 41. Provosty v. ARC Construction, LLC, 119 So.3d 23 (La. App. 4 Cir. 2013). 42. Unfortunately, this use of the term “corporation” in reference to a limited liability company is too frequent in judicial opinions and even among practitioners, especially among attorneys who pursue and defend cases against limited liability companies. An LLC is not a “corporation” no matter how many corporate characteristics it may have. The distinction is important because, for example, corporate laws impose formalities that LLC statutes do not. Accordingly, a court that does not fully appreciate that it is dealing with an unincorporated entity such as an LLC may apply an erroneous analysis. For a particularly egregious instance, see Adams v. McFadden, 296 S.W.3d 743 (Tex. App. 2009), discussed infra notes 605-07 and accompanying text. Spring 2016 WILL YOUR VEIL BE PIERCED? 357 miles away in New York. To assume that the jury found that Glasser knew of the fraud is speculative at best.43 The court further stated as to Glasser: There is no doubt in this Court’s mind that the jury found that Christopher Schmitt, Jamey Schmitt, Richard Drevet, Matt LaMora, and IceHouse Capital, LLC through its Managing Member Marc Winthrop were heavily involved in ARC-LA’s shell game and in defrauding their customers and that this alone warrants the piercing of the corporate veil. But based upon the initial investment of $500,000 by the New York members, no evidence that Glasser deliberately took money from ARC-LA, and no evidence introduced concerning what initial capital would be required to start up ARC-LA, there is no way reasonable minds from the Jury could have determined that Glasser undercapitalized ARC- LA.44 Also see Estate of Hurst v. Moorehead,45 holding that the imposition of personal liability on a member of an LLC requires “a finding that [the member] . . . personally engaged in certain conduct, such as fraud or misrepresentation.”46 In Sun Nurseries, Inc. v. Lake Erma, LLC47 the accountant for the defendant LLC had evidently made several misrepresentations to the plaintiff, but plaintiff “presented no evidence to demonstrate that any of the individual defendants personally participated or cooperated in any of [the accountant’s] representations or that they directed [the accountant] to make such representations with the intent to mislead [plaintiff].”48 Provosty and Sun Nurseries appear to be cases that Macey and Mitts would classify as cases properly decided because there was no frustration of reasonable creditor expectations — the creditors did not deal with the 43. Provosty, 119 So.3d at 34. 44. Provosty, 119 So.3d at 36. 45. Estate of Hurst v. Moorehead, 748 S.E.2d 568 (N.C. App. 2013) 46. Id. at 574. See also infra notes 598-600 and accompanying text, where an additional quote from the court’s opinion explains this quote by adding that an actual fraud by the member is not required; “[r]ather, the requisite element for piercing the corporate veil under the instrumentality rule requires a finding that the individual member used his control over the entity ‘to commit fraud or wrong, to perpetrate the violation of a statutory or other positive legal duty, or a dishonest and unjust act in contravention of [the] plaintiffs’ legal rights[.]’ Id. at 575, citing Glenn v. Wagner, 313 N.C. 450, 454, 329 S.E.2d 326, 330 (1958) (emphasis in original). 47. Sun Nurseries, Inc. v. Lake Erma, LLC, 730 S.E.2d 832 (Ga. App. 2012). 48. Id. at 838.