When and Why Courts Will Allow Veil Piercing

VEIL PIERCING IN THE LLC CONTEXT:

One trademark feature of the corporate business organization is limited liability for shareholders, in which shareholder liability for the corporation’s contract or tort obligations is generally restricted to the amount of that shareholder’s capital contribution. In this regard, a corporate veil protects shareholders’ personal assets from the reach of the corporation’s creditors. A judge, however, can order this veil to be disregarded or pierced when a shareholder engages in certain prohibited conduct. Generally speaking, corporate creditors will not be required to honor the separateness of the corporation from its shareholders if the shareholders themselves fail to honor that separateness. And because piercing the corporate veil can be the only way for a creditor to be paid in some instances, there is a large body of law regarding what is required to pierce the corporate veil.

But as it relates to a limited liability company (“LLC”), which is a hybrid business combining features of both corporations and partnerships, it does not fit quickly and comprehensively into the entirety of existing doctrine from either the corporate or partnership form as it relates to piercing. Is an LLC more like a corporation, with limited shareholder liability, or more like a partnership, with unlimited personal liability for all entity debts? Further, with each state having LLC legislation, is there a disparity in the scope and content from state to state?

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Early scholarship on LLCs focused on the wisdom of importing entire corporate law concepts, like piercing the corporate veil, and applying them to the LLC without questioning whether the concepts were a good fit:

One unanswered question is whether common law doctrines applicable to corporations are applicable to limited liability companies…Determination of whether corporate doctrines apply, or whether corresponding (but different) doctrines of partnership law apply, is difficult because limited liability companies share some attributes of corporations and some of partnerships.  The problem is compounded because most states have neither codified nor, by statute, rejected these common law doctrines for limited liability companies.

Steven C. Bahls, Application of Corporate Common Law Doctrine to Limited Liability Companies, 55 Mont. L. Rev., 43, 45 (1994).

These critical questions were sought to be harmonized by the Uniform Law Commission. The Uniform Law Commission (“ULC”) was established in 1892 and purported to provide “states with non-partisan, well-conceived and well-drafted legislation that brings clarity and stability to critical areas of state statutory law.”  In 2013, the ULC amended the Uniform Limited Liability Company Act and adopted the Revised Uniform Limited Liability Company Act (“RULLCA”), enacted in many states, including Minnesota.

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Minnesota adopted RULLCA effective August 1, 2015, for newly formed LLCs, but previously formed LLCs did not have to convert to RULLCA until January 1, 2018. As it relates to piercing the corporate veil, RULLCA modified Minnesota’s LLC law, which explicitly states that the case law regarding piercing the liability shield of a corporation also applies to LLCs by now providing as follows:

The failure of a limited liability company to observe formalities relating exclusively to the management of its internal affairs is not a ground for imposing liability on the members, managers, or governors for the debts, obligations, or other liabilities of the company.

Minn. Stat. § 322C.0304, subd. 2.

At first glance, this would negate any reliance upon corporate veil piercing law. However, and despite the stated objective of harmonizing Minnesota’s LLC statutes with other states via the adoption of RULLCA, Minnesota made a crucial modification in this regard in response to Minnesota’s Attorney General’s concerns, adding the following:

Except as it relates to the failure of a limited liability company to observe any formalities relating exclusively to the management of its internal affairs, the case law that states the conditions and circumstances under which the corporate veil of a corporation may be pierced under Minnesota law also applies to limited liability companies.

Minn. Stat. § 322C.0304, subd. 3.

HOW TO PIERCE THE VEIL:

Piercing the corporate veil is an equitable remedy. A two-prong test is applied to determine when a creditor will be allowed to pierce the corporate veil of protection from personal liability and hold an owner liable for the LLC’s obligations. The first prong focuses on the owner’s relationship with the LLC to determine whether the LLC was formed as the owner’s alter ego or mere instrumentality. The ultimate question on the first prong is whether the individual(s) treated the LLC as a separate entity entitling him or her to “hide behind it to avoid liability.”  The second prong requires a showing that piercing the corporate veil is necessary to avoid injustice or fundamental unfairness.

If the court finds that the factors are not present under the first prong, the court will not move on to the second prong. The second prong requires the veil-piercer to show that “an element of injustice or fundamental unfairness” would result from not piercing the LLC veil. Injustice or unfairness is present if the owner has used the corporate form to gain “an advantage he does not deserve.”  While proof of strict common law fraud is not required, there must be evidence that the LLC has been operated as “a constructive fraud or in an unjust manner.” This portion of the test is not black and white, is very fact specific, and requires the court to make subjective determinations. The courts are clear, however, that “there can be no piercing of the veil without a showing of improper conduct.”

Situations in which courts have found an element of injustice or fundamental unfairness warranting piercing the veil include:

  • Issuing dividends when the LLC is going to default on its obligations to non-owner creditors;
  • Repaying debts owed to owners in full and defaulting on obligations owed to non-owner creditors;
  • Selling assets at a discount to a related party and thereby leaving the LLC without sufficient cash or assets to repay its obligations;
  • Transferring money or assets to an owner or a related LLC, so the LLC is unable to pay its obligations; and
  • Paying excess and above-market rent to a related LLC renders the LLC unable to satisfy its obligations.

Each of these situations includes intentional conduct made in an effort to escape repaying an obligation in full and in an attempt to benefit the owner personally. Suppose this type of intentional and improper conduct is present. In that case, courts will pierce the veil to avoid the injustice or unfairness that the owner benefit to the direct detriment of the creditor.

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