Piercing The Corporate Veil: Minimizing Alter Ego .

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Presenting a live 90-minute webinar with interactive Q&APiercing the Corporate Veil:Minimizing Alter Ego Liability forSubsidiaries, Affiliates and Related EntitiesTHURSDAY, FEBRUARY 13, 20141pm Eastern 12pm Central 11am Mountain 10am PacificToday’s faculty features:Steven S. Scholes, Partner, McDermott Will & Emery, ChicagoAllen Sparkman, Sparkman Foote Minor, Denver and HoustonEdward P. Yankelunas, Partner, Underberg & Kessler, Buffalo, N.Y.The audio portion of the conference may be accessed via the telephone or by using your computer'sspeakers. Please refer to the instructions emailed to registrants for additional information. If youhave any questions, please contact Customer Service at 1-800-926-7926 ext. 10.

Tips for Optimal QualityFOR LIVE EVENT ONLYSound QualityIf you are listening via your computer speakers, please note that the qualityof your sound will vary depending on the speed and quality of your internetconnection.If the sound quality is not satisfactory, you may listen via the phone: dial1-888-601-3873 and enter your PIN when prompted. Otherwise, pleasesend us a chat or e-mail [email protected] immediately so we can addressthe problem.If you dialed in and have any difficulties during the call, press *0 for assistance.Viewing QualityTo maximize your screen, press the F11 key on your keyboard. To exit full screen,press the F11 key again.

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February 13, 2014Piercing the Corporate Veil: Minimizing Alter Ego Liability for Subsidiaries,Affiliates and Related EntitiesAllen SparkmanSPARKMAN FOOTE MINOR LLP1616 17th St., Ste. 564Denver, CO 80202303.396.0230 (voice)303.748.8173 (cell)1.303.500.6894 (fax)[email protected] Binz St., Ste. 650Houston, TX 77004713.401.2922 (voice)713.859.7957 (cell)1.713.357.6636 (fax)www.sfmlawgroup.com

VEIL PIERCING Veil piercing is an equitable remedy that applies to hold an owner (and,occasionally, non-owners) liable for a debt of the entity. Commentators have summarized the rule this way:The most common veil-piercing test requires a plaintiff to demonstrate that acorporation was an ‘alter ego’ or ‘mere instrumentality,’ as evidenced by completecontrol and domination, of a shareholder used to perpetuate a fraud, wrong, orinjustice that has proximately caused unjust loss or injury to the plaintiff. Oh, VeilPiercing, 89 Tex. L. Rev. 81, 84 (2010).5

The Delaware Court of Chancery explained the Delaware approach to piercing thecorporate veil as follows:This Court will disregard the corporate form only in the “exceptional case.”Determining whether to do so requires a fact intensive inquiry, which may considerthe following factors, none of which are dominant: (1) whether the company wasadequately capitalized for the undertaking; (2) whether the company was solvent;(3) whether corporate formalities were observed; (4) whether the controllingshareholder siphoned company funds; or (5) whether, in general, the companysimply functioned as a façade for the controlling shareholder. Delaware courts alsomust find an element of fraud to pierce the corporate veil [citing Mason v. Network ofWilm., Inc., 2005 WL 16539954, at *3 (Del. Ch. 2005)] (other citations omitted).Winner Acceptance Corp. v. Return on Capital Corp., 2008 WL 5352063 at *3 (Del.Ch. 2008).6

POTENTIAL LIABILTY OF NON-OWNERIn McCallum Family LLC v. Winger, 221 P.3d 691 (Colo. App. 2009),the court held a non-shareholder liable in a corporate veil-piercing casewhere the non-shareholder dominated the corporation and caused itsassets to be used for his benefit and the benefit of his family (whichincluded the shareholders). The court applied an apparently newtheory—“equitable ownership.”7

VEIL PIERCING IN LLCSAs will be discussed below, limited liability company statutes generally provide liabilityshields similar to those provided for corporations. Accordingly, case law illustrates thatsituations that result in LLC piercing resemble those that result in piercing the corporateveil. Netjets Aviation, Inc. v. LAC Commc’ns., LLC, 537 F.3d 168, 176 (2d Cir. 2008).The Delaware Chancery Court has indicated that the circumstances justifying piercing theLLC veil must be pervasive—not just stemming from a single transaction. EBG HoldingsLLC v. Vredezicht’s Gravenhage 109 B.V., Civil Action No. 3184-VCP, 2008 WL 4057745(Del. Ch. 2008). In this case, a Delaware LLC sued one of its members, a Dutch LLC(“VG 109”), and the member’s parent corporation (“NIBC”), seeking a declaration that VG109 was NIBC’s alter ego, as well as specific performance of provisions of the LLCagreement, among other things. The court found that there was not a sufficient showingof fraud or other inequity to disregard the NIBC corporate form. The court pointed out thatthe fraud or injustice must stem from an inequitable use of the corporate form itself, notmerely from the underlying cause of action for breach of contract. The court found that aconclusory statement in the complaint that NIBC knowingly used VG 109 as aninstrument to shield itself from liability for tax obligations related to ownership in the LLCwas insufficient to support a reasonable inference that NIBC’s use of VG 109's limitedliability status was fraudulent or inequitable. There also was no showing that VG 109’s8capitalization was so minimal as to prove it was a sham entity.

A Weird LLC Case In 2009, the Colorado Court of Appeals held a non-member manager (Trowbridge) potentiallyliable to a creditor, remanding to the trial court to determine “Whether it is equitable to holdTrowbridge personally liable for the LLC’s improper actions by piercing the corporate [sic] veil.”Sheffield Services Company, et al. v. Trowbridge and Mason, 211 P.3d 639 (Colo. Ct. App. 2009).For a criticism of the Sheffield case, see Lidstone, “Piercing the Veil of an LLC or a Corporation,”39 The Colorado Lawyer, no 8 at 71 (August 2010). According to the Court of Appeals, among thefindings that the trial court will have to make are “whether, under the common law, (1) Colfax [theLLC] is Trowbridge’s alter ego, (2) justice requires recognizing the substance of Trowbridge’srelationship with Colfax because he used Colfax to perpetuate a fraud or defeat a rightful claim,and (3) disregarding the relationship’s form and holding Trowbridge personally liable would lead toan equitable result.” In connection with another claim (but arguably related to “justice” and “anequitable result”) the Court of Appeals directed the trial court also to determine: “Whether theLLCs were or became insolvent when Trowbridge distributed LLC assets to the non-partymembers and, if so, whether Trowbridge breached the common law duty of an LLC manager toavoid favoring personal interests over the LLC’s creditors’ claims.” In reaching its conclusions,the Colorado Court of appeals ignored C. R. S. §7-80-705, which provides that “[m]embers andmanagers of limited liability companies are not liable under a judgment, decree, or order of acourt, or in any other manner, for a debt, obligation, or liability of the limited liability company.”9

Weird LLC Case OverruledIn 2013, the Colorado Supreme Court overruled Sheffield. Weinstein v.Colborne Foodbotics, LLC, 302 P.3rd 263, 269 (Colo. 2013). Weinsteinholds that a creditor of a Colorado LLC may not enforce an obligation ofa member to return an unlawful distribution and that the managers ofan insolvent Colorado LLC do not owe a fiduciary duty to the LLC’screditors.10

Statutory Provisions re Veil PiercingCorporations.A basic tenant of modern corporate law is that a shareholder is not liable for debts of thecorporation. Model Business Corporation Act (“MBCA”) §622(b):Unless otherwise provided in the articles of incorporation, a shareholder of a corporationis not personally liable for the acts or debts of the corporation except that he maybecome personally liable by reason of his own acts or conduct. The articles ofincorporation may impose personal liability on shareholders. MBCA §2.02(b)(2)(v); Del.Code Ann., tit. 8, §102(b)(6).11

De Facto Doctrine“All persons purporting to act as or on behalf of a corporation, knowing there was no incorporationunder this Act, are jointly and severally liable for all liabilities created while so acting.” MBCA §2.04.Several states have similar provisions, e.g. Colorado:All persons purporting to act as or on behalf of a corporation without authority to do so andwithout good faith belief that they have such authority shall be jointly and severally liable for allliabilities incurred or arising as a result thereof. C. R. S. §7-102-104.See, for example, Adams v. Mt. Pleasant Bank & Trust Co., 355 N.W.2d 868 (Iowa 1984), involvingshareholder liability for debts incurred during a two year period following expiration of a corporation’sold charter and before reincorporation. The court held that in the absence of a clear statutory mandateto the contrary, limited liability did not exist for liabilities incurred during the interim period. The Iowastatute similar to section 105 of the 1969 version of the Revised Model Business Corporation Act washeld not to provide protection against such liabilities. The court also stated that Iowa does notrecognize the concept of de facto corporations in the context of an expiration of a corporation’scharter.12

LLC Statutes Typically Provide that Failure to Follow Formalities, without More, isNot a Ground for Veil PiercingSee, e. g., Revised Uniform Limited Liability Company Act §304(b); Prototype Limited Liability Company Act§304; Del. Code Ann title 6, §18-103; C.R.S. §7-80-107(2).If a client does not intend to hold regular meetings or otherwise conduct its business with regularformalities, it is best not to put formal meeting, etc. requirements in the LLC Agreement. Also,statutory ignoring of formalities does not prevent veil piercing if the owners of an LLC disregard itseconomic separateness.13

De Facto Doctrine Applied to LLCs by StatuteAll persons who assume to act as a limited liability company withoutauthority to do so and without good faith belief that they have suchauthority shall be jointly and severally liable for all debts and liabilitiesincurred by such persons so acting. C. R. S. §7-80-105.14

De Facto Doctrine in Absence of StatuteWhat if the owners of a planned but not formed corporation or limited liability company begin acting inthe name of the unformed entity in a state that does not have a statutory provision like that of RMBA§2.04 or C. R. S. §§7-80-105, 7-102-104? Unless a third party dealing with an owner of an unformedentity agrees otherwise, the owner will be personally liable on a contract entered into in the name ofthe unformed entity:Unless the third party agrees otherwise, a person who makes a contract with a third party purportedlyas an agent on behalf of a principal becomes a party to the contract if the purported agent knows orhas reason to know that the purported principal does not exist or lacks capacity to be a party to acontract. Restatement Third, Agency §6.04.15

Another Theory of Agency Law May Apply Even if the Entity has been ValidlyFormedIf an owner of the entity (or someone else acting on behalf of the entity) doesn’t disclose that they areacting on behalf of an entity, the person so acting may be liable under the theory of undisclosedprincipal.in Water, Waste & Land, Inc. d/b/a Westec v. Lanham, 955 P. 2d 997, (Colo. 1998), the court held thatLarry Clark and Donald Lanham were personally liable where they entered into a contract withoutdisclosing that they were acting on behalf of Preferred Income Investors, LLC, a Colorado limitedliability company (“Preferred”). Lanham and Clark were members and managers of Preferred. Clarkcontacted and contracted with Westec for engineering services. Clark’s business card included hisname, address, and the initials “PII,” but not the name of the LLC or his title. In reaching its decision in this case, the court said that agency law applies in the LLC context,“notwithstanding the LLC’s statutory notice rules,” continuing: Under the common law of agency, an agent is liable on a contract entered on behalf of a principalif the principal is not fully disclosed. . . . If both the existence and identity of the agent’s principalare fully disclosed to the other party, the agent does not become a party to any contract which henegotiates . But where the principal is partially disclosed (i.e., the existence of a principal isknown but his identity is not), it is usually inferred that the agent is party to the contract. 955 P. 2dat 1001.16

Undisclosed Principal (continued)The court went on to say, “The duty of disclosure clearly lies with the agent alone; thethird party with whom the agent deals has no duty to discover the existence of an agencyor . . . the identity of the principal.” As a result, the court reversed the judgment of theDistrict Court and reinstated the judgment of the County Court which had held Lanhamand Clark personally liable as agents for (at best) a partially disclosed principal. SeeRestatement Third, Agency §6.03. Of particular note in this case is the court’s holdingthat the duty of disclosure lies solely with the agent and is not affected by the provisionsof C. R. S. §7-80-208:The fact that the articles of organization are on file in the records of the secretary ofstate is notice that the limited liability company is a limited liability company and isnotice of all other facts stated therein that are required to be stated in the articles oforganization by section 7-80-204.17

Other Statutory Sources of Liability Liability to pay for shares.MBCA §622(a): A purchaser from a corporation of its own shares is not liable to thecorporation or its creditors with respect to the shares except to pay theconsideration for which the shares were authorized to be issued (section 6.21) orspecified in the subscription agreement (section 6.20). The Delaware GeneralCorporation Act contains a similar rule. Del. Code Ann., tit. 8 §162(a). Improper DistributionsMBCA §8.33(a) A director who votes for or assents to a distribution in excess ofwhat may be authorized and made pursuant to section 6.40(a) or 14.09(a) ispersonally liable to the corporation for the amount of the distribution that exceedswhat could have been distributed without violating section 6.40(a) or 14.09(a) if theparty asserting liability establishes that when taking the action the director did notcomply with section 8.30.18

(b) A director held liable under subsection (a) for an unlawful distribution isentitled to:(1) contribution from every other director who could be held liable undersubsection (a) for the unlawful distribution; and(2) recoupment from each shareholder of the pro-rata portion of theamount of the unlawful distribution the shareholder accepted, knowing thedistribution was made in violation of section 6.40(a) or 14.09(a). See alsoDel. Code Ann., tit. 8 §174(b).19

Dissolution.MBCA §14.07 (d) A claim that is not barred by section 14.06(b)[relatingto claims by known creditors] or section 14.07(c) [relating to claims byother creditors] may be enforced: (1) against the dissolved corporation, to the extent of its undistributedassets; or(2) except as provided in section 14.08(d), if the assets have beendistributed in liquidation, against a shareholder of the dissolved corporationto the extent of the shareholder’s pro rata share of the claim or thecorporate assets distributed to the shareholder in liquidation, whichever isless, but a shareholder’s total liability for all claims under this section maynot exceed the total amount of assets distributed to the shareholder.3. See also United States v.Seyler, 142 F. Supp. 408 (W.D. Pa. 1956),holding that the United States can recover unpaid income tax assessmentsfrom transferees of the corporate assets who received dividends thatreduced assets of the corporation to substantially less than its outstandingliabilities.20

Liability for Improper DistributionsLiability for improper distributions. Del. Code Ann., tit. 6 §18-607.Delaware requires knowledge. Improper distributions in dissolution ofan LLC. Del. Code Ann., tit. 6 §18-804; ReULLCA §406. Requiresknowledge. 2 year s/l; dissolution ReULLCA §704(d)(2). Prototype§405(a)(2); requires knowledge.21

Liability for Unpaid State Taxes and Unpaid Employment and WithheldIncome TaxesState Taxes. Several states have adopted statutes that impose liability on the constituent membersand managers of an entity when the taxes are not paid by the entity. Rutledge, “Limited Liability (orNot); Reflections on the Holy Grail,” 51 South Dakota Law Review (2006) 417, 443.Federal Employment and Withheld Income Taxes.1.“Any person required to collect, truthfully account for, or pay over” taxes,who willfully fails to do so, faces liability not only for the amount of the tax but a 100%penalty as well. Internal Revenue Code of 1986 §§3102(a)(withheld employment taxes),3402(a)(liability for taxes withheld or collected), 6672(a)(100% penalty for failure tocollect and pay over tax; exception for volunteer directors of tax-exempt organizations((§6672(e))), 7501(liability for taxes withheld or collected).2.Recent amendments to the applicable regulations have made single- memberLLCs the responsible party for employment and withheld taxes on employees of the LLC.The owner is still treated as a self-employed person and presumably will be the first targetof the IRS if the LLC fails to satisfy its withholding and payment obligations with respect toits employees. T.D. 9356, I.R.B. 2007-39 at 675. Treas. Reg. §301.77012(c)(2)(iv).22

Liability for Actions of the Entity’s Employees and AgentsAn owner who is active in the entity’s business is responsible for his or her own actions,including torts. Valley Dev. Co. v. Weeks, 364 P.2d 730, 734 (Colo. 1961). If the owneris an agent of the entity and commits the tort while acting for the entity, the entity will alsobe liable. Restatement Third, Agency §§7.03(2), 7.03 cmt. b, 7.03(2)(a), 7.07.An owner may also face liability for negligent hiring, supervision, and retention ofemployees, contractors, and other agents. Restatement Third, Agency §§7.03, 7.05.23

Piercing The CorporateVeil WebinarEdward P. Yankelunas, Esq.Underberg & Kessler LLP(716) [email protected]

Table of Contents The Alter Ego TheoryRequired Proof/FactorsFraud Not Required (New York)Classic Indicia of Fraud (New YorkHarm to Third PartyReverse Piercing Doctrine (New York)Courts Will Not Place Form Over SubstanceLimited Liability Companies262830313233353925

The Alter Ego Theory Business entity is so dominated by the individualbusiness owner that it conducts the owner’s personalbusiness Rohmer Assoc. v. Rohmer, 36 A.D.3d 990, 830N.Y.S.2d 356 (3d Dept. 2007) Issue – is the entity being used for purely personalrather than corporate purposesIf the business (corporation or LLC) is being dominatedand abused by the owner for personal purposes, eachwill be deemed the alter ego of the other26

The Alter Ego Theory (cont.) If abuse of the corporate or LLC form is used tocommit a wrong against a third party, thecorporate form will be disregarded – i.e.,corporate veil will be pierced Business owner will be held personally liablefor corporate obligations27

Required Proof/Factors Heavy burden of proof Difficult to convince Court to use equitablepower to pierce corporate veil Factors relied upon (New York):––shuttling funds in and out of personal andbusiness bank accountsusing corporate funds and property for personalpurposes and obligations28

Required Proof/Factors (cont.)corporation or LLC is under-capitalized–

Feb 13, 2014 · LLC] is Trowbridge’s alter ego, (2) justice requires recognizing the substance of Trowbridge’s relationship with Colfax because he used Colfax to perpetuate a fraud or defeat a rightful claim, and (3) disregarding the relationship’s form and holding Trowbri