Asset Protection

Faithfulness to the formalities is the price paid to the corporation fiction, a relatively small price to pay for limited liability .” -as quoted by the court in Labadie Coal Co. v. Black

Liability protection for LLC and corporation owners is not absolute. In a legal sense, corporations and LLCs are legal entities separate from their owners. This separation, as we will learn, must be vigilantly maintained. Legal errors, personal dealings between owners and the entity, ignoring formalities, failure to pay taxes, and other misdeeds and missteps can destroy the legal protection afforded to LLC and corporation owners, thereby exposing owners to liability.  Piercing the corporate (or LLC) veil, as the name implies, means that in some cases a creditor can ask a court to ignore the company liability shield and reach its owners.

 

Without question, you want to focus on running your business. Yet, paperwork is a part of every business. Like death and taxes, it is unavoidable. Get started on the right foot by building recordkeeping into the routine of your business.

This article explores several legal theories and concepts which have been used to impose liability on individual owners of LLCs and corporations. The term most often used to describe this process is “piercing the corporate veil.” Don’t be confused by the reference to corporations in this article—the doctrine of piercing the corporate veil applies to both corporations and LLCs. Because LLCs have only been around for a few decades, there simply hasn’t been time for a thorough body of law to develop around the doctrine of piercing the LLC veil. Just in the past few years however, some legal cases have emerged, and the phrase is starting to take hold as a doctrine separate (but by any measure nearly equivalent to) “piercing the corporate veil.”

The doctrines of alter ego liability and piercing the corporate veil give courts the power to disregard the corporate or LLC liability shield and impose liability on owners in extraordinary cases of owner misconduct. These two doctrines (different in name, but essentially the same) will apply universally to LLCs and corporations. The states offer dozens of individual tests for alter ego liability. One common theme, however, is that a unity of interest and ownership, a lack of separateness, between the entity and its owners can erode liability protection.

Separateness is the key to maintaining entity liability protection. No single concept is more essential than the legal separation between owner and entity.

The alter ego theory says, in effect, that if the owners of an entity disregard the legal separateness of the entity or disregard proper formalities, then the law will also disregard the LLC or corporate form if required to protect the entity’s creditors. The instrumentality rule has three components, including:

• The owner(s) must completely dominate the finances, policy, and business practices of the entity to the extent that the entity at the time of the transaction had no separate mind, will, or existence of its own. Ownership of all or substantially all of the stock of the entity, alone, is not complete domination.

•  The control or domination is used to commit fraud or wrong, to cause the violation of a statute, breach a legal duty, or commit a dishonest or unjust act in violation of the claimant’s legal rights.

• The domination and violation of legal rights must have proximately caused the injury to the claimant.

Disregarding the Corporate or LLC Entity

An LLC’s separateness or corporation’s separateness must be recognized and acknowledged by the acts of the owners and managers. Courts recognize the distinct legal status of an entity, and courts are reluctant to disregard an entity’s separate status to reach an owner’s property. Although reluctant, courts will pierce the veil in appropriate circumstances.

Courts examining a veil piercing case will begin with an evidentiary presumption that a corporation or LLC maintains its liability shield. The presumption is a benefit to you, the business owner, and a disadvantage to a plaintiff. This presumption, however, can be challenged by plaintiff using the doctrines and concepts found in this article.

A number of different legal theories have been used to impose personal liability on individuals or parent entities in the case of subsidiaries. Some of these theories require that the court disregard the corporate entity or pierce the corporate veil. Not all claims against individuals require that the corporate status be disregarded, however.

Claims can be asserted against managers and owners without disregarding the corporate veil. For example, federal and state tax laws generally impose personal liability on those individuals responsible for preparing and filing income and sales tax returns. The government agency can bring civil and criminal tax claims against the LLC or the responsible individual, or both. There is no reason to examine LLC formality or attempt to disregard the LLC entity.

The same is true for criminal acts and intentional torts. If the manager or owner knowingly and voluntarily participated in any aspect of the crime or tort, he or she can be personally liable without piercing the corporate veil. Of course, an aggressive plaintiff’s attorney will probably bring claims against the individuals and the LLC using a number of legal theories, including ones which would seek to pierce the veil.

Alter Ego Liability in Contract and Tort Claims

Courts are more apt to pierce the veil in a tort case than they are in a contract case. A tort is any action or failure to act (when there is a duty to act) that causes damage to another. Examples of tort actions include personal injuries, fraud, misrepresentation, negligence, battery, assault, trespass, and invasion of privacy. In a general sense, any claim not based on a contract could be a tort claim.

Once again, a policy decision of the courts comes into play. It is presumed that contract creditors entered a contract voluntarily with an opportunity to find out for themselves about the entity. If a contract creditor was not diligent in protecting itself at the time of contract, courts are not likely to pierce the corporate veil in the absence of extreme circumstances. Of course, many contract claimants will include a claim for fraud and seek recovery directly from the individuals allegedly involved in the fraud. Unlike contract creditors, tort claimants rarely volunteer or have an opportunity to find out about the corporation or LLC in advance. Thus, a stronger argument can be made in tort cases that the liability veil be set aside.

As you review the cases described below, keep in mind that no single criteria is controlling. In almost every instance, the entity had failed to satisfy a number of criteria. For example, a single individual owning all of the membership units of an LLC, alone, is not enough to expose that LLC to being pierced. The same is true where one individual serves as sole officer and director as well. Look for several factors—such as absence of entity records or minutes, inadequate capitalization, a serious harm to third parties, commingling of personal and entity assets, etc.—working in combination.

In my law practice, I experienced several examples where a corporation was sued, and the corporation’s owners were also named as defendants to the suit—even though the owners did nothing wrong and the veil could not have been pierced to reach them. This is a legal strategy that plaintiffs use to bring as much pressure on the defendants as possible, but does not necessarily mean that the owners can ultimately be found liable.

It is also important to note that most piercing the veil cases involve corporations and LLCs where the owners are also the directors or managers. Control of the entity is an important concept in these cases. Legal theories commonly used against directors or managers who are not owners or who only own small amounts of stock involve breach of the duties of due care or loyalty; these cases are very rare.

In Geringer v. Wildhorse Ranch, Inc., a widow sued for the wrongful death of her husband and children who were killed in a paddleboat accident at a Colorado ranch. The action was filed against Wildhorse Ranch, Inc. and its principal owner.

The court pierced the corporate veil and attached liability to Wildhorse Ranch’s principal owner noting:

•  No corporation stock had been issued in the corporation and no record of the stock existed (absence of records and formality).

•  No corporate minutes existed even though the defendant testified that informal board meetings had been conducted (absence of records and formality).

•  The principal owner operated several corporations out of one office (absence of separation between corporations).

•  Debts of one corporation were frequently paid with funds of another corporation or from the principal owner’s personal funds (commingling of funds; no arm’s length dealings).

•  The principal owner had purchased the paddleboats with funds from another corporation (commingling, related party transaction).

•  No record of loans or ledgers existed (no loan documentation).

•  Corporate records were so muddled that no clear picture of accountability or organization could be shown (poor recordkeeping).

•  Business cards listed the principal owner as the “owner” of the corporation (improper way to hold corporation out to public).

•  Employees of the corporation believed that the principal owner was in control (agency, public perception).

•  The principal owner knew that the paddleboats leaked and became unstable and overruled employee recommendations that the boats be repaired (active wrongdoing on the part of owner).

Contract Creditors In Corporate Liability Cases

Although a court is more likely to pierce a corporate or LLC veil in a tort situation, it will pierce the veil in an appropriate contract situation. Stone v. Frederick Hobby Associates II LLC, is an illustrative example, and one of the first cases applying the traditional corporation veil test to an LLC. The facts: the Stone family was the dissatisfied purchaser of a $3,300,000 home constructed and sold to them by defendant Frederick Hobby Associates II, LLC. As part of their legal claim, the Stone family asserted that defendant Hobby II’s LLC form should be disregarded so as to reach the assets of Hobby II’s two owners and a related limited liability company called Hobby I. The Stones charged that the defendant builder had breached the construction contract. The Stones sought to hold Hobby II’s two individual members and Hobby I responsible for their losses. They argued that Hobby II was a shell company with no assets and no ability to pay any potential damage award. The court agreed with the Stones on the underlying contract claim against the owners of Hobby II, and against Hobby I. The Connecticut court further recognized that the corporate veil doctrine would also be applicable to the LLC. Connecticut law authorizes individuals to be held personally liable for entity obligations under either the “instrumentality rule” or the “identity rule”, and the court held that the criteria for application of both rules had been satisfied.

The facts that the court recognized when applying the instrumentality test were:

* The LLC’s two members each held a 50% ownership interest in Hobby II and had full authority to manage Hobby II’s affairs.

* Hobby II’s office was located in one owner’s home, on a rent-free basis.

* Hobby II had no assets other than the residence it sold to the plaintiffs.

* The defendant’s attorney had remarked during a meeting that the defendant had no assets.

* Several documents used by Hobby II in connection with the subject premises listed entities or individuals similar to and easily confused with Hobby II as the operative actors (for instance, in the Connecticut real estate conveyance tax return, it is unclear whether the seller is Hobby II or its member Frederick Hobby III).

* There was also an allegation by plaintiffs that the defendants, shortly following the closing date on the Stones’ new residence, had transferred substantially all of Hobby II’s assets (including the sale proceeds) to the two members and Hobby I.

The court concluded that the members had complete control over the LLC, that the control was used as a shield to evade contractual obligations to plaintiffs and that the plaintiffs’ losses emanated, at least in part, from the control the defendant members exercised over Hobby II, and, accordingly, imposed personal liability on the members.

The case of Labadie Coal Co. v. Black is another illustrative example. There, creditors were able to pierce the veil of a trading corporation and recover against controlling owners. The court examined these factors:

•  The controlling owners owned all of the corporation stock and controlled corporation decisions.

•  The corporation failed to maintain corporation minutes or adequate records, including articles of incorporation, corporation operating agreements, or a current list of directors.

•  No formalities pertaining to the issuance of corporation stock were followed.

•  Funds were commingled with funds and assets of other corporations.

•  Corporation funds were diverted to the personal use of the owners.

•  The corporation and the owners used the same office for different business activities.

•  The corporation was inadequately capitalized. The court noted that fraud was not required to pierce the corporation veil. All that was required was the presence of an unjust situation. The court also stated: “Faithfulness to the formalities is the price paid to the corporation fiction, a relatively small price to pay for limited liability. Furthermore, the formalities are themselves an excellent litmus of the extent to which the individuals involved actually view the corporation as a separate being.”

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