Piercing the Veil of an Llc or a Corporation

• Jurisdiction: Colorado,United States
• Citation: Vol. 39 No. 8 Pg. 71
• Pages: 71
• Publication year: 2010

39 Colo.Law. 71 Colorado Bar Journal 2010.

2010, August, Pg. 71. Piercing the Veil of an LLC or a Corporation

The Colorado Lawyer
August 2010
Vol. 39, No. 8 [Page 71]

Articles Business Law

Piercing the Veil of an LLC or a Corporation

by Herrick K. Lidstone, Jr

Business Law articles are sponsored by the CBA Business Law Section to apprise members of current substantive law. Articles focus on business law topics for the Colorado practitioner, including antitrust, bankruptcy, business entities, commercial law, corporate counsel, financial institutions, franchising, and securities law.

This article provides an overview of three recent Colorado Court of Appeals decisions regarding piercing the corporate veil of a limited liability company or a corporation. It also discusses relevant provisions of the Colorado Business Corporation Act and the Colorado Limited Liability Act, as well as case law from other jurisdictions.

Piercing the veil of a corporation allows a court to use its equitable powers to hold equity owners liable for the obligations of an entity. Courts make it clear that disregarding the corporate form should be considered a "drastic remedy,"(fn1) and "corporate veils exist for a reason and should be pierced only reluctantly and cautiously."(fn2)

In 2009, panels of the Colorado Court of Appeals issued two decisions addressing issues related to piercing the veil of a limited liability company (LLC) and a corporation. Sheffield Services Company v. Trowbridge(fn3) applied the piercing the veil theory to limited liability companies (LLCs), and McCallum Family LLC v. Winger(fn4) applied the theory to corporations. Another opinion relating to LLCs, Colborne Corp. v. Weinstein,(fn5) was issued in 2010. Although Colborne does not use the term "piercing the veil," this opinion also results in the possibility that members may be held personally liable for the debts of an LLC.

In these cases, the respective panels also determined that the theory could be used to hold persons who were not equity owners liable to creditors, although in McCallum the panel adopted a theory new to piercing the veil cases and determined that the defendant had "equitable ownership" of the entity and thus could be held liable under a piercing the veil theory. The Sheffield and Colborne panels reached no such conclusion in holding nonequity owners potentially liable to creditors.

This article provides an overview of the opinions in these three cases. It also discusses certain points regarding the panels' application of the law to the facts.

Statutory Background

The Colorado Business Corporation Act (CBCA)(fn6) and the Colorado Limited Liability Company Act (LLC Act)(fn7) specifically protect equity owners from liability. The CBCA states:

Unless otherwise provided in the articles of incorporation, a shareholder or a subscriber for shares of a corporation is not personally liable for the acts or debts of the corporation; except that such person may become personally liable by reason of the person's own acts or conduct.(fn8)

Directors and officers of a corporation are held to a standard of care (generally referred to as the business judgment rule(fn9) and the duty of loyalty(fn10)), although the CBCA specifically provides that a director's liability for monetary damages can be limited.(fn11) Section 7-108-401(5) of the CBCA specifically provides that directors and officers have no fiduciary duty to a creditor arising from that person's status as a creditor.(fn12) The CBCA also provides that directors-and in some cases shareholders-can be liable for wrongful distributions.(fn13)

The LLC Act is even more specific in its protection of members and managers of a Colorado LLC. Section 7-80-705 of the LLC Act provides:

Members 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.

The LLC Act expresses two exceptions to this statement of nonliability by which members, but not managers can be expressly liable: § 7-80-107(1)(fn14) and § 7-80-606(2).(fn15)

Prior Corporate Cases

Although Colorado had not, prior to Sheffield, seen a case for piercing the veil of an LLC, Colorado has seen a number of cases seeking to pierce the veil of a corporation to hold shareholders liable for corporate debt.(fn16) In the corporate context, the veil may be pierced where the subsidiary is merely an alter ego of the principal or where the corporate shield is being used by shareholders to defraud creditors.(fn17) In Colorado, the corporate entity may be disregarded and the corporate veil may be pierced "if not doing so would defeat public convenience, justify wrong, or protect fraud."(fn18)

In In re Phillips,(fn19) the Colorado Supreme Court answered a question certified to it by the U.S. District Court for the District of Colorado and set forth the "three-prong test" to determine whether piercing the corporate veil is appropriate. In reviewing the question, the court must:

1) inquire into whether the corporate entity is the alter ego of the shareholder;(fn20)

2) inquire whether justice requires recognizing the substance of the relationship between the shareholder and corporation over the form because the corporate fiction was used to perpetrate a fraud or defeat a rightful claim; and

3) evaluate whether an equitable result will be achieved by disregarding the corporate form and holding the shareholder personally liable for the acts of the business entity.

LaFond v. Basham(fn21) is a 1984 case where a Colorado Court of Appeals panel applied a piercing the corporate veil theory to hold a corporate director personally liable to creditors where the court determined that equity required.(fn22) In LaFond, the facts were clear that the director, Basham, did not own stock in the corporation in question

but, as president and general manager, he clearly dominated both his wife and son, the only stockholders, insofar as corporate policy, activities, funds, and other corporate matters were concerned. In fact, Basham testified, "The rule was, that I owned the corporation. . . ."(fn23)

When the corporation was insolvent, Basham demanded and received payment of obligations to him to the detriment of other creditors. Because of Basham's preferential payments to himself, the court of appeals found him liable for those payments under a piercing the veil theory.(fn24) In referring to the La Fond decision the Honorable John W. Madden stated that "[t]he ruling may have been driven by the particular facts of the case" rather than by the law.(fn25)

The Law in Other Jurisdictions

Several other jurisdictions have addressed the question of piercing the veil of an LLC, in each case finding that the target of piercing the veil also must be a member. The U.S. District Court for the District of Oregon stated that it would allow the piercing of the limited liability veil of an LLC where:

1) the defendant member controlled the debtor;

2) the defendant member engaged in improper conduct; and

3) as a result of the improper conduct, the plaintiff either entered into a transaction that it otherwise would not have entered into, or the plaintiff was not able to collect a debt against an insolvent entity.(fn26)

In that case, the court found that the defendant, who was the sole manager and member, clearly controlled the LLC. The court also found "improper conduct" where there was "commingling assets and a general disregard of [the LLC's] form and status as a separate legal entity."(fn27) The trial court could not determine the third factor on motions and left it for determination at trial.(fn28)

In another case, the Delaware Chancery Court indicated that the circumstances necessary to pierce the veil of an LLC must be pervasive. According to the court, that means that the circumstances do not stem merely from a single transaction.(fn29)

In a detailed Second Circuit Court of Appeals decision discussing the piercing of a veil of a Delaware LLC,(fn30) the plaintiffs sought to hold the sole member of the LLC liable for breach of contract by the LLC on the basis that the member was the LLC's alter ego. The trial court granted summary judgment in favor of the member on the ground that the plaintiffs had not set forth sufficient evidence to pierce the veil of the LLC. The Second Circuit discussed Delaware corporate veil piercing principles and concluded that such principles are generally applicable to an LLC.

In reaching the conclusion that the defendant was not entitled to summary judgment, the court examined the evidence that the LLC and its sole member operated as a single entity and found that the evidence, viewed most favorably to the plaintiffs, showed:

Lack of corporate formalities. Although corporate veil piercing principles are generally applicable to an LLC, somewhat less emphasis should be placed on whether the LLC observed internal formalities in an alter ego analysis of an LLC. However, if two entities with common ownership "'failed to follow legal formalities when contracting with each other[,] it would be tantamount to declaring that they are indeed one in the same.'"(fn31)

Inadequate capitalization. The LLC was started with a capitalization of no more than $20,100, and then proceeded to invest millions of dollars supplied by its member.(fn32)

Treating the LLC's funds as if they were the member's funds. The member put money into the LLC as needed and took money out as the member needed it.

Lack of financial segregation with other entities. The LLC had only one officer other than its member, and the officer was paid by the member or one of his corporations. The LLC shared space with other companies owned by the member and shared employees with the member or other companies owned by the member with no...