IV. Piercing the Veil of the Llc

• Library: South Carolina Limited Liability Companies (SCBar) (2020 Ed.)

IV. Piercing the Veil of the LLC

A. South Carolina LLC Piercing Principles

As of the date of the Manual there are no true state-court South Carolina LLC piercing cases.⁴² Throughout the United States there have been many piercing the LLC veil cases. Uniformly, these cases have simply applied the local corporate veil piercing rules to claims that the LLC's veil should be pierced. The tests vary from state to state, but whatever test the state uses to pierce a corporation's veil is automatically applied to the claim that the LLC's veil should be pierced. Essentially, in each such case, the court has simply applied the existing corporate law of the jurisdiction to determine if the LLC's veil should be pierced. (In a few states there are particular LLC statutes that determine how piercing should be handled.)

A recent West Virginia case applying the same statutory language that we have in South Carolina concluded that nothing in the West Virginia version of South Carolina § 33-44-303 prohibited a veil piercing claim.⁴³ Presumably, South Carolina courts will do the same as courts in other states and simply apply existing South Carolina corporate jurisprudence when an LLC piercing claim is asserted. South Carolina generally applies the two-prong Sturke⁴⁴test to pierce a corporation owned by an individual (or multiple) shareholders. Apparently we apply an "alter-ego" test to pierce the veil of a parent LLC or corporation that owns a subsidiary.⁴⁵

One of the most critical aspects about piercing claims is that statistically, the plaintiff often wins. There have been numerous studies that have evaluated how often courts will pierce, and it appears that in 30% of the cases the plaintiff will be successful, and in 50% where undercapitalization (the key South Carolina factor) was involved.⁴⁶

In South Carolina the corporate veil piercing test is derived from the case, Sturkie v. Sifly, 280 S.C. 453, 313 S.E.2d 316 (Ct. App. 1984). The test has two prongs. The first prong requires the court to find a failure to follow "corporate" formalities. The second prong requires there be an element of injustice or fundamental unfairness.

The two-prong Sturkie test requires the plaintiff to first demonstrate a number of the following eight factors (various opinions have declined to state how many must be shown), and second that there is injustice or fundamental unfairness. The "eight" factors have been identified as:

(1) whether the corporation was grossly undercapitalized;
(2) failure to observe corporate formalities;
(3) non-payment of dividends;
(4) insolvency of the debtor corporation at the time;
(5) siphoning of funds of the corporation by the dominant stockholder;
(6) non-functioning of other officers or other directors;
(7) absence of corporate records; and
(8) the fact that the corporation was merely a facade for the operations of the dominant stockholder.

No opinion has defined how many of the eight factors must be shown. One of the more important recent piercing cases is Huntington v. Elders, 359 S.C. 217, 597 S.E.2d 803 (Ct. App. 2004). It reconfirmed that "undercapitalization" is a key factor in determining whether to pierce, and that the company must be adequately capitalized at all times.⁴⁷ (Note that some states only require adequate capitalization at formation.⁴⁸) Sufficient assets or cash flow to meet the company's operating expenses is not enough to demonstrate that the company is adequately capitalized. "Undercapitalization" as a key factor creates real problems for a lawyer trying to advise the members of an eeC how they can avoid a piercing claim.

• Should it be sufficient that the LLC can meet its normal operating costs to be deemed adequately capitalized? (The Huntington opinion suggests that the clear answers is "no.") The facts of this opinion strongly suggest that this corporation had more than sufficient funds to meet its normal operating costs. Although not mentioned in the opinion, the corporation apparently did maintain a limited amount of liability insurance. Was the company's real wrong in failing to carry more insurance? If so, was the real wrong here not "undercapitalization" but a failure of "business judgment" as to how the company should be run - rarely a key factor in determining if a corporation's veil should be pierced.
• Are all South Carolina LLCs required to have adequate capital to meet any inherent risks in operating the business? What is an "inherent risk?" In an infamous older South Carolina case, the operator of a bar ordered one of his employees to shoot a customer who had failed to pay for beer bought on credit. Is this an "inherent risk" of all South Carolina bars and restaurants that must be adequately protected against?
• If the LLC must always have adequate capitalization, what about the company that was adequately capitalized when formed but is going through hard times. Must this LLC close down (with possible loss of jobs and failure to pay existing creditors), less the members be held personally responsible for debts incurred during its bad times? Do we as lawyers need to counsel our clients to have periodic reviews of their capital structure and if an appropriate expert suggests that the business is currently undercapitalized to immediately dissolve?
• What is adequate capitalization? The opinion does not discuss how much insurance was available. If this bar had obtained a $500,000 liability policy would it have been adequately capitalized? Is the insurance counted in the capitalization calculus? Would $500,000 have been enough?

Sturke then narrowly defined the second factor, an element of injustice or fundamental unfairness, as follows:

The burden of proving fundamental unfairness requires that the plaintiff establish:

(1) that the defendant was aware of the plaintiff's claim against the corporation, and
(2) thereafter, the defendant acted in a self-serving manner with regard to the property of the corporation and in disregard of the plaintiff's claim in the property.

This is a fairly narrow test, and often the plaintiff cannot demonstrate that the defendant did anything "wrong" after the actions which triggered the claim have occurred.

Caution. It is unclear if this second prong of the test has been changed, but in a couple of recent opinions the courts have made the following statement: "The second of the two-pronged test used to determine whether a corporate entity should be disregarded 'requires that there be an element of injustice or fundamental unfairness if the acts of the corporation be not regarded as the acts of the individuals.' . . . 'The essence of the fairness test is simply that an individual businessman cannot be allowed to hide from the normal consequences of carefree entrepreneuring by doing so through a corporate shell.'"⁴⁹

Since our South Carolina LLC statute includes the same safe harbor provision found in the Statutory Close Corporation Supplement, which both in essence say that failure to follow corporate (LLC) formalities shall not be grounds for imposing personal liability on LLC members,⁵⁰ many lawyers assumed that this provision would give substantial protection to members of an LLC - that it would be very difficult to pierce. The failure to follow LLC formalities should be excused, and thus no grounds for piercing. However, the court of appeals in Hunting v. Elders, 359 S.C. 217, 597 S.E.2d 803 (Ct. App. 2004), easily got around this defense in a case involving a closely held corporation (and applying the same statutory language found in the LLC statute).

The Hunting opinion states:

The failure to observe the formality "is not a ground for imposing personal liability on the shareholders for liabilities of the corporation." S.C. Code Ann. § 33-18-250 (1990). Indeed, the official comment to section 33-18-250 notes "the purpose of this section is to eliminate the possible argument that the shareholders in a statutory close corporation are individually liable for the debts and torts of the business because the corporation did not follow the

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