PIERCING THE ENTITY VEIL: INDIVIDUAL LIABILITY FOR BUSINESS ACTS

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1 PIERCING THE ENTITY VEIL: INDIVIDUAL LIABILITY FOR BUSINESS ACTS First Run Broadcast: January 21, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) Business entities corporations, LLCs are not absolute shields against liability for their owners. An individual shareholder s or LLC member s assets can be reached in a surprisingly large number of circumstances to satisfy the claims of creditors, tort claimants, disgruntled shareholders and others. An entity s owners can be held individually liable for improper distributions, certain transfers made before a bankruptcy filing, and for a range of federal and state taxes including for the failure to proper collect state and local sales taxes. This program will provide you with a guide to the circumstances when a veil can be pierced under statutory and common law, ways to defend against individual liability, and how to cure the circumstances giving rising to veil piercing. Statutory and common law principles for piercing the entity veil Fact patterns giving rise to corporate and LLC veil piercing Extent of individual liability after a veil has been pierced and curing veil piercing Liability for improper distributions in closely held companies Owner liability for withheld income taxes, employment taxes, and improper collection of sales/use taxes Piercing considerations when an entity files for bankruptcy Speakers: Allen Sparkman is a partner in the Denver and Houston offices of Sparkman Foote, LLP. He has practiced law for over thirty years in the areas of estate, tax, business, insurance, asset protection, and charitable giving. He has written and lectured extensively on choice-of-entity, charitable giving and estate planning topics. He is the Colorado reporter for the books "State Limited Partnership Laws" and "State Limited Liability Company Laws," both published by Aspen Law & Business. He has also served as president of the Rocky Mountain Estate Planning Council. Mr. Sparkman received his A.B. with honors from Princeton University and his J.D. with high honors from the University of Texas School of Law.

2 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # Fax # Address Piercing the Entity Veil: Individual Liability for Business Acts Teleseminar January 21, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 PAYMENT METHOD: NO REFUNDS AFTER January 14, 2014 Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

3 Vermont Bar Association CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: January 21, 2014 Seminar Title: Location: Credits: Piercing the Entity Veil: Individual Liability for Business Acts Teleseminar 1.0 MCLE General Credit Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

4 PROFESSIONAL EDUCATION BROADCAST NETWORK OWNER LIABILITY FOR DEBTS OF AN ENTITY January 21, 2014 Allen Sparkman Sparkman Foote Minor LLP 1200 Binz St., Ste. 650 Houston TX (office) (mobile) And th St., Ste. 564 Denver, CO (voice) (mobile) I. Veil Piercing A. In General Equitable Doctrine. 1. Veil piercing is an equitable remedy that applies to hold an owner (and, occasionally, non-owners) liable for a debt of the entity. 2. Commentators have summarized the rule this way: The most common veil-piercing test requires a plaintiff to demonstrate that a corporation was an alter ego or mere instrumentality, as evidenced by complete control and domination, of a shareholder used to perpetuate a fraud, wrong, or injustice that has proximately caused unjust loss or injury to the plaintiff. Oh, Veil-Piercing, 89 Tex. L. Rev. 81, 84 (2010). 3. The Delaware Court of Chancery explained the Delaware approach to piercing the corporate 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 consider the following factors, none of which are dominant: (1) whether the company was adequately capitalized for the undertaking; (2) whether the company was solvent; (3) whether corporate formalities were observed; (4) whether the controlling shareholder siphoned company funds; or (5) whether, in general, the company simply functioned as a façade for the controlling shareholder. Delaware courts also must find an

5 element of fraud to pierce the corporate veil [citing Mason v. Network of Wilm., Inc., 2005 WL , at *3 (Del. Ch. 2005)] (other citations omitted). Winner Acceptance Corp. v. Return on Capital Corp., 2008 WL at *3 (Del. Ch. 2008). 4. In McCallum Family LLC v. Winger, 221 P.3d 691 (Colo. App. 2009), the court held a non-shareholder liable in a corporate veil-piercing case where the non-shareholder dominated the corporation and caused its assets to be used for his benefit and the benefit of his family (which included the shareholders). The court applied an apparently new theory equitable ownership. 5. As will be discussed below, limited liability company statutes generally provide liability shields similar to those provided for corporations. Accordingly, case law illustrates that situations that result in LLC piercing resemble those that result in piercing the corporate veil. 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 the LLC veil must be pervasive not just stemming from a single transaction. EBG Holdings LLC v. Vredezicht s Gravenhage 109 B.V., Civil Action No VCP, 2008 WL (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 VG 109 was NIBC s alter ego, as well as specific performance of provisions of the LLC agreement, among other things. The court found that there was not a sufficient showing of fraud or other inequity to disregard the NIBC corporate form. The court pointed out that the fraud or injustice must stem from an inequitable use of the corporate form itself, not merely from the underlying cause of action for breach of contract. The court found that a conclusory statement in the complaint that NIBC knowingly used VG 109 as an instrument to shield itself from liability for tax obligations related to ownership in the LLC was insufficient to support a reasonable inference that NIBC s use of VG 109's limited liability status was fraudulent or inequitable. There also was no showing that VG 109 s capitalization was so minimal as to prove it was a sham entity. 6. In 2009, the Colorado Court of Appeals held a non-member manager (Trowbridge) potentially liable to a creditor, remanding to the trial court to determine Whether it is equitable to hold Trowbridge 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 2

6 the Court of Appeals, among the findings that the trial court will have to make are whether, under the common law, (1) Colfax [the 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 Trowbridge personally liable would lead to an equitable result. In connection with another claim (but arguably related to justice and an equitable result, the Court of Appeals directed the trial court also to determine: Whether the LLCs were or became insolvent when Trowbridge distributed LLC assets to the non-party members and, if so, whether Trowbridge breached the common law duty of an LLC manager to avoid favoring personal interests over the LLC s creditors claims. In reaching its conclusions, the Colorado Court of appeals ignored C. R. S , which provides that [m]embers and managers of limited liability companies are not liable under a judgment, decree, or order of a court, or in any other manner, for a debt, obligation, or liability of the limited liability company. 7. In 2013, the Colorado Supreme Court overruled Sheffield. Weinstein v. Colborne Foodbotics, LLC, 302 P.3 rd 263, 269 (Colo. 2013). Weinstein holds that a creditor of a Colorado LLC may not enforce an obligation of a member to return an unlawful distribution and that the managers of an insolvent Colorado LLC do not owe a fiduciary duty to the LLC s creditors. B. Statutory Provisions re Veil Piercing. 1. Corporations. a. A basic tenant of modern corporate law is that a shareholder is not liable for debts of the corporation. Model Business Corporation Act ( MBCA ) 622(b): Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct. The articles of incorporation may impose personal liability on shareholders. MBCA 2.02(b)(2)(v); Del. Code Ann., tit. 8, 102(b)(6). b. De facto doctrine. (1) All persons purporting to act as or on behalf of a corporation, knowing there was no incorporation under this Act, are jointly and severally liable for all liabilities created while so acting. MBCA

7 (2) 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 and without good faith belief that they have such authority shall be jointly and severally liable for all liabilities incurred or arising as a result thereof. C. R. S (3) See, for example, Adams v. Mt. Pleasant Bank & Trust Co., 355 N.W.2d 868 (Iowa 1984), involving shareholder liability for debts incurred during a two year period following expiration of a corporation s old charter and before reincorporation. The court held that in the absence of a clear statutory mandate to the contrary, limited liability did not exist for liabilities incurred during the interim period. The Iowa statute similar to section 105 of the 1969 version of the Revised Model Business Corporation Act was held not to provide protection against such liabilities. The court also stated that Iowa does not recognize the concept of de facto corporations in the context of an expiration of a corporation s charter. 2. Limited Liability Companies. a. Limited liability company statutes provide liability shields similar to those provided by corporate law. Section 3.04 of the Revised Uniform Limited Liability Company Act ( ReULLCA ) states: (a) The debts, obligations, or other liabilities of a limited liability company, whether arising in contract, tort, or otherwise: (1) are solely the debts, obligations, or other liabilities of the company; and (2) do not become the debts, obligations, or other liabilities of a member or manager solely by reason of the member acting as a member or manager acting as a manager. (b) The failure of a limited liability company to observe any particular formalities relating to the exercise of its powers or management of its activities is not a ground for imposing liability on the members or managers for the debts, obligations, or other liabilities of the company. See also Del. Code Ann., tit. 6, ; Revised Prototype Limited Liability Company Act

8 b. Because limited liability companies developed as entities that are commonly less formal than corporations and depend much more on the owners agreement, several LLC statutes provide that failure to observe formalities is not a basis for piercing the LLC veil. For example, Colorado law states: (1) In any case in which a party seeks to hold the members of a limited liability company personally responsible for the alleged improper actions of the limited liability company, the court shall apply the case law which interprets the conditions and circumstances under which the corporate veil of a corporation may be pierced under Colorado law. (2) For purposes of this section, 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. C. R. S c. If a client does not intend to hold regular meetings or otherwise conduct its business with regular formalities, 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 its economic separateness. d. De facto doctrine applied to limited liability companies. All persons who assume to act as a limited liability company without authority to do so and without good faith belief that they have such authority shall be jointly and severally liable for all debts and liabilities incurred by such persons so acting. C. R. S De facto doctrine in absence of a statute. What if the owners of a planned but not formed corporation or limited liability company begin acting in the 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 , ? Unless a third party dealing with an owner of an unformed entity agrees otherwise, the owner will be personally liable on a contract entered into in the name of the unformed entity: Unless the third party agrees otherwise, a person who makes a contract with a third party purportedly as an agent on behalf of a principal becomes a party to the contract if the purported agent knows or has reason to know that the purported principal does not exist or lacks capacity to be a party to a contract. 5

9 Restatement Third, Agency If the entity has been formed, a related doctrine of agency law may apply to impose liability on the owner if the owner does not indicate that the owner is acting on behalf of the entity. For example, in Water, Waste & Land, Inc. d/b/a Westec v. Lanham, 955 P. 2d 997, (Colo. 1998), the court held that Larry Clark and Donald Lanham were personally liable where they entered into a contract without disclosing that they were acting on behalf of Preferred Income Investors, LLC, a Colorado limited liability company ( Preferred ). Lanham and Clark were members and managers of Preferred. Clark contacted and contracted with Westec for engineering services. Clark s business card included his name, address, and the initials PII, but not the name of the LLC or his title. On Clark s instructions, Westec sent a written proposal to Lanham, but commenced work on Clark s oral authorization. Westec never received the signed contract returned, and, when the work was done, never received payment. Westec sued Clark and Lanham individually as well as Preferred. Preferred admitted liability while Clark and Lanham defended based on the shield provided by Preferred. 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 principal if the principal is not fully disclosed.... If both the existence and identity of the agent s principal are fully disclosed to the other party, the agent does not become a party to any contract which he negotiates. But where the principal is partially disclosed (i.e., the existence of a principal is known but his identity is not), it is usually inferred that the agent is party to the contract. 955 P. 2d at The court went on to say, The duty of disclosure clearly lies with the agent alone; the third party with whom the agent deals has no duty to discover the existence of an agency or... the identity of the principal. As a result, the court reversed the judgment of the District Court and reinstated the judgment of the County Court which had held Lanham and Clark personally liable as agents for (at best) a partially disclosed principal. See Restatement Third, Agency Of particular note in this case is the court s holding that the duty of disclosure lies solely with the agent and is not affected by the provisions of C. R. S : The fact that the articles of organization are on file in the records of the secretary of state is notice that the limited liability company is a limited liability company and is notice of all other facts stated 6

10 therein that are required to be stated in the articles of organization by section II. Other State Statutory Sources of Liability A. Liability to pay for shares. MBCA 622(a): A purchaser from a corporation of its own shares is not liable to the corporation or its creditors with respect to the shares except to pay the consideration for which the shares were authorized to be issued (section 6.21) or specified in the subscription agreement (section 6.20). The Delaware General Corporation Act contains a similar rule. Del. Code Ann., tit (a). B. Improper distributions. MBCA 8.33(a) A director who votes for or assents to a distribution in excess of what may be authorized and made pursuant to section 6.40(a) or 14.09(a) is personally liable to the corporation for the amount of the distribution that exceeds what could have been distributed without violating section 6.40(a) or 14.09(a) if the party asserting liability establishes that when taking the action the director did not comply with section (b) A director held liable under subsection (a) for an unlawful distribution is entitled to: (1) contribution from every other director who could be held liable under subsection (a) for the unlawful distribution; and (2) recoupment from each shareholder of the pro-rata portion of the amount of the unlawful distribution the shareholder accepted, knowing the distribution was made in violation of section 6.40(a) or 14.09(a). See also Del. Code Ann., tit (b). C. Dissolution. 1. MBCA (d) A claim that is not barred by section 14.06(b)[relating to claims by known creditors] or section 14.07(c) [relating to claims by other creditors] may be enforced: (1) against the dissolved corporation, to the extent of its undistributed assets; or (2) except as provided in section 14.08(d), if the assets have been distributed in liquidation, against a shareholder of the dissolved corporation to the extent of the shareholder s pro rata share of the claim or the corporate assets distributed to the shareholder in liquidation, whichever is less, but a shareholder s total liability for all claims under this section may not exceed the total amount of assets distributed to the shareholder. 7

11 2. MBCA 14.08(d) Provision by the dissolved corporation for security in the amount and the form ordered by the court under section 14.08(a) shall satisfy the dissolved corporation s obligations with respect to claims that are contingent, have not been made known to the dissolved corporation or are based on an event occurring after the effective date of dissolution, and such claims may not be enforced against a shareholder who received assets in liquidation. Delaware stipulates that a shareholder who received assets of a dissolved corporation is liable for claims against the corporation to the extent of his pro rata share of the claim, or the amount distributed to him, whichever is less. Del. Code Ann. tit See also United States v.seyler, 142 F. Supp. 408 (W.D. Pa. 1956), holding that the United States can recover unpaid income tax assessments from transferees of the corporate assets who received dividends that reduced assets of the corporation to substantially less than its outstanding liabilities. D. Liability for improper distributions. Del. Code Ann., tit Delaware requires knowledge. Improper distributions in dissolution of an LLC. Del. Code Ann., tit ; ReULLCA 406. Requires knowledge. 2 year s/l; dissolution ReULLCA 704(d)(2). Prototype 405(a)(2); requires knowledge. III. Liability for Unpaid State Taxes and Unpaid Employment and Withheld Income Taxes. A. State Taxes. Several states have adopted statutes that impose liability on the constituent members and managers of an entity when the taxes are not paid by the entity. Rutledge, Limited Liability (or Not); Reflections on the Holy Grail, 51 South Dakota Law Review (2006) 417, 443. B. 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 (a)(withheld employment taxes), 3402(a)(liability for taxes withheld or collected), 6672(a)(100% penalty for failure to collect and pay over tax; exception for volunteer directors of tax-exempt organizations (( 6672(e))), 7501(liability for taxes withheld or collected). 8

12 2. Recent amendments to the applicable regulations have made singlemember LLCs 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 target of the IRS if the LLC fails to satisfy its withholding nd payment obligations with respect to its employees. T.D. 9356, I.R.B at 675. Treas. Reg (c)(2)(iv). IV. Liability for Actions of the Entity s Employees and Agents A. An 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 owner is an agent of the entity and commits the tort while acting for the entity, the entity will also be liable. Restatement Third, Agency 7.03(2), 7.03 cmt. b, 7.03(2)(a), B. An owner may also face liability for negligent hiring, supervision, and retention of employees, contractors, and other agents. Restatement Third, Agency 7.03,