The “LLC Veil”: Thinner than it Appears?

In two recent court cases, one in New York (applying Delaware law) and one in Colorado, the courts allowed the “veil” of an LLC to be pierced on the basis that the LLC was the “alter ego” of the owners.  Notably, there was no evidence or allegation of fraud or misconduct in either case.  This raises some interesting questions: would the result have been the same if the entities had been corporations rather than LLCs?  Does the absence of corporate formalities in the life of an LLC make it easier for judges to perceive a LLC as an “alter ego of its members, particularly when there are only one or two members, as in the two cases discussed below.

 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)

In this recent case, the Federal District Court in the Southern District of New York, applying Delaware law, granted summary judgment to the plaintiff, Soroof Trading Development Co. Ltd., allowing the plaintiff to pierce the veil of a Delaware limited liability company, GE Fuel Cell Systems LLC.  The court found the LLC to be the “alter ego” of its two members, GE Microgen, Inc. and Plug Power, Inc.  Surprisingly, however, the court gave very little attention to a requirement of Delaware law that a Delaware court would undoubtedly have analyzed rigorously and applied in a strict manner, i.e., an element of unfairness or injustice.

Briefly, the Soroof case involved an alleged breach of a contract that was entered into by Soroof and GE Fuel Systems in 2000.  The defendant LLC was unable to meet the contract requirements and was dissolved in 2006 through the filing of a certificate of cancellation in the Delaware Secretary of State’s Office.

Soroof sued the LLC and its two members, alleging breach of contract and several other claims.   Soroof made a motion for summary judgment on two grounds: to nullify the LLC’s certificate of cancellation, which was denied, and to pierce the LLC’s veil so that its two members could be held liable for the alleged breach of contract by the LLC.  This part of the motion was granted.

Regarding the motion to nullify the certificate of cancellation, Soroof alleged that the LLC had not been properly wound up because no provision had been made for unpaid claims, specifically, Soroof’s loses under the contract.  The court correctly pointed out that under the applicable Delaware statute a dissolved LLC is only required to pay or make provision for claims to the extent of its available assets. In the case, the LLC had no assets at the time of its dissolution.   Accordingly, the court dismissed this part of the motion for summary judgment.  (The court seems to have ignored the fact that if the dissolution of the LLC was valid, there was no remaining “Veil” to be pierced.)

The court then addressed Soroof’s claim that the LLC’s veil should be pierced, thereby allowing Soroof to pursue its claims against the LLC’s two members. The court quoted the following language from a Second Circuit Court of Appeals opinion (notably, the court did not cite any Delaware court decisions dealing with the corporate veil):

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.

(from NetJets Aviation, Inc. v. LHC Commc’ns LLC, 537 F.3d 168, 177 (2d Cir. 2008)).

The court then recited the following factors as support for a finding that the LLC was the “alter ego” of its two members:  (i) the LLC had no cash assets at the time of dissolution, (ii) the LLC had no employees but instead was staffed by employees of the members, (iii) the LLC did not lease its own office space but used the premises of its members and (iv) there was no sign on the premises used by the LLC to indicate it was there.

It is remarkable that a court could make an “alter ego” finding on these facts.  As anyone with experience in the business world knows, single-purpose entities are typically staffed with employees of a parent company or joint venture partners, not with their own employees.  Similarly, such entities commonly have no address of their own.  They simply exist “on paper” and use the office address of an operating company, usually a parent or other shareholder or member.  Moreover, many companies have no assets when they dissolve.  That’s why they dissolve.  And finally, in over 200 years of American jurisprudence, there does not appear to be a single precedent from any state to support the proposition that the absence of signage is a factor in piercing the corporate veil.  Signs are primarily for the retail public.  Single-purpose entities seldom have signs.

The factors usually mentioned by courts when they make a finding of an alter ego are those suggesting that the owner or owners of a legal entity consistently ignored the entity’s separate legal existence, factors such as co-mingling of funds, failure to maintain separate financial records, failure to pay the owner for services or resources provided by the owner (e.g., employee time and office space), failure to execute relevant contracts in a way that identifies the legal entity as the contracting party, and failure to maintain corporate formalities, which show that management of the legal entity was controlling its own affairs.   The Soroof court did recite any of these factors.

After finding that Soroof had alleged sufficient facts to establish that the defendant LLC was a mere instrumentality or alter ego of GE Microgen and Plug Power, the court then found that there was “an overall element of unfairness to Soroof”, although what exactly the element of unfairness was we are left to guess about since the court did not elaborate. Presumably, the judge felt that it would be unfair to effectively deny a remedy to the plaintiff by upholding the LLC veil.  Of course, that’s what the veil doctrine is all about.   If a legal entity has enough asses to cover a plaintiff’s claims, there is no need to pierce the veil to obtain a recovery.

It is very unlikely that a Delaware court would have reached the same result on the facts in the Soroof case.   Indeed, it is not surprising that the Soroof court did not cite any Delaware cases to support its decision.  Only a few Delaware cases have allowed piercing and those case all involved a finding of fraud, illegality, or other egregious conduct resulting in an injustice.

There is perhaps a lesson to be learned from the Soroof case.  That is, corporate formalities (meetings with notice and a written agenda, and minutes of the meetings to record decisions taken) can be a shield.  And while LLCs are not required to observe such formalities—indeed, the absence of formalities is considered by many commentators to be an advantage of a LLC over a corporation—such meetings and records can be used to support an argument that the LLC was not merely the alter ego of its member or members.

Martin v. Freeman, No. 11CA0145, 2012 WL 311660 (Colo. App. Feb. 2, 2012)

In this case, the Colorado Court of Appeals, applying Colorado law, affirmed the decision of the trial court to pierce the corporate veil of a single-member Delaware LLC.  Surprisingly, the appellate court allowed the LLC’s veil without a showing showing of fraud, wrongful intent, or bad faith, despite the words of the relevant Colorado statute,.

Dean Freeman was the single member of Tradewinds Group, LLC, a Delaware limited liability company. Tradewinds entered into a contract with Robert Martin for the construction of an airplane hangar.  In 2006 Tradewinds sued Martin for breach of contract.  One year later, while the litigation was pending, Tradewinds sold its only asset and made a distribution of the sale proceeds to Freeman.  Freeman thereafter paid the litigation expenses from his own funds.  The trial court found in favor of Tradewinds on the breach of contract claim, but Martin appealed and the judgment was reversed on appeal.  On remand, the trial court awarded $36,600 of costs to Martin costs. Tradewinds had no funds to pay the $36,600 so Martin brought an action against Freemen to pierce the LLC veil. The trial court allowed the LLC veil to be pierced and found Freeman personally liable for the costs.  On appeal the Court of Appeals affirmed.

The appellate court recited the requirements to pierce the veil under Colorado law: “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.”   On each of these three elements the Court’s opinion is less than illuminating.

On the element of Tradewinds acting as the “alter ego” of Freemen, the court listed several factors to support its conclusion, all of which can be reduced to three categories: the absence of corporate formalities, commingling of Freemen’s and the LLC’s funds and inadequate capitalization of the LLC.

As to the absence of formalities, this is characteristic of a LLC, and the Colorado Limited Liability Company Act expressly states, “. . . 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.”    §7-80-107

Regarding the commingling of funds and the inadequate capitalization of the LLC, these factors were hardly compelling under the facts of the case.  The LLC sold its only asset for $300,000 after filing the lawsuit against Martin and distributed these funds to Freeman.  Thereafter, Freeman paid the litigation costs.  While it is true that the LLC had no assets during the term of the lawsuit, it also had no liabilities and, notably, was the plaintiff in the suit and therefore not subject to liability from an adverse judgment (except as to costs).  The trial court had expressly found as a factual matter that Freeman had fully provided for all known or reasonably possible debts of the LLC at the time of the distribution of the proceeds from the sale of the LLC’s sole asset.  The appellate court dismissed this finding as irrelevant but offered no facts in opposition to the trial court’s finding of fact on this point.   

Most surprising of all is that the appellate court glossed over the requirement of Colorado law that the legal entity was used to “perpetrate a fraud or defeat a rightful claim” thereby leading to an “inequitable result”.   The trial court had stated in its findings that there was no fraud, wrongful intent or bad faith in Freeman’s actions.  Therefore, the Court of Appeals focused on the question of whether LLC form was used to “defeat a rightful claim.”  Looking at the sale of the LLC’s only asset and distribution of the proceeds two years before the trial was over, 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” and that “as a matter of first impression, that wrongful intent or bad faith need not be shown to pierce the LLC veil.”  One wonders how this could be a matter of “first impression”.  A dissenting judge on the court wrote an opinion that cited and quoted numerous Colorado cases requiring fraud, crime, an illegal act, or conduct intended to defeat the creditor’s claim, before piercing will be allowed.  And, as in the Soroof case, if not have having enough assets to cover potential liabilities (under the rubric, “under capitalized”) is a basis for piercing the corporate or LLC veil, then the doctrine has little meaning.

Some Thoughts

The Soroof and Martin cases appear to be further examples of a growing trend in which courts find the application of the corporate or LLC veil to be “unjust” because it has the effect of depriving the plaintiff (or counter-claiming defendant) of a remedy.  This is a classic example of turning a doctrine on its head because the “injustice” is then cited by the court as a factor in its conclusion that the veil can be pierced.

LLCs and especially single-member LLCs are more vulnerable than corporations to veil piercing because they typically do not observe “corporate formalities”, the absence of which traditionally has been a factor in veil piercing cases involving corporations.   To be sure, the state statutes authorizing the formation of LLCs do not require the formalities normally associated with a corporation but that is not necessarily persuasive in a piercing case.  The absence of formalities may not be a negative factor but neither can the LLC point to the observance of formalities as a positive factor to demonstrate the separate legal identity of the LLC.  Generally, the only evidence an LLC can produce to show its separate legal existence is the filing of the articles of formation, the filing of annual reports, signing of contracts in the name of the LLC, separate financial accounting, and the segregation of funds  (i.e., separate bank account, with all LLC revenue and payments going into an out of the account).  As recent cases suggest, the last of these factors offers little comfort if the court finds that the inability of a LLC to pay its debts or other claims is evidence of “under-capitalization”.

Is this recent tendency of some courts to pierce the LLC veil an indication of a fundamental shift in perspective?   Are judges influenced by the fact that it is so easy to create and maintain a LLC, i.e., is there a perception that owners of a business should not be able to avoid personal liability with such a simple edifice?  True, the very purpose of corporations (and now LLCs) is to insulate shareholders (and LLC members) from the debts and liabilities of a business enterprise, thereby facilitating investment, but is there a point at which the courts will view the separate business enterprise, especially the LLC and even more so the single-member LLC, as a vehicle that can be unfair to creditors and claimants while not actually resulting in the creation of businesses that would not otherwise have been created?   It’s possible that courts are applying a different policy for LLCs than they do for corporations.  In the case of corporations, if a court pierces the corporate veil of a small corporation, the rationale applied by the court can be used by future plaintiffs in other cases to pierce the veil of much larger corporations and this could have serious ramifications.  In contrast, piercing the veil of an LLC does not such broad implications.   This is all just speculation, of course, but trends—assuming we are seeing a trend—have underlying causes and those causes, while often obscure, may call into question our assumptions about how courts will behave when confronted with certain facts.   The strength of the “veil”, particularly in the case of a LLC, and more particularly in the case of a single-member LLC, may be one of those widely held assumptions that is now open to question.

This entry was posted in Uncategorized. Bookmark the permalink.

One Response to The “LLC Veil”: Thinner than it Appears?

  1. Dean Freeman says:

    I am Dean Freeman and thought I should point out that my llc. “Tradewinds Group llc.” was also a Delaware registered corporation.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s