Limited Liability Companies and Voluntary Creditors: Reexamining the Abolishment of Veil Piercing

• Publication year: 2022
• Citation: Vol. 51

51 Creighton L. Rev. 513. LIMITED LIABILITY COMPANIES AND VOLUNTARY CREDITORS: REEXAMINING THE ABOLISHMENT OF VEIL PIERCING

LIMITED LIABILITY COMPANIES AND VOLUNTARY CREDITORS: REEXAMINING THE ABOLISHMENT OF VEIL PIERCING

DANIEL BUCHHOLZ(fn*)

I. INTRODUCTION ................................... 513

II. THE ENIGMA OF VEIL PIERCING AND THE LIMITED LIABILITY COMPANY ................... 515

A. Limited Liability and Its Exception ............ 515

B. The Limited Liability Company ................. 519

1. LLC Basics .................................. 519

2. LLC Fiduciary Duties ........................ 521

3. LLC Veil Piercing ............................ 524

III. VOLUNTARY CREDITORS AND LLC VEIL PIERCING ......................................... 526

A. Statutory Support ............................. 526

B. Difficulty and Confusion with Importing Corporate Law Standards ..................... 530

C. Conflicting Doctrines: Breach of Fiduciary DUTY AND VEIL PIERCING ........................ 532

IV. MOVING BEYOND VEIL PIERCING'S BLANKET APPLICATION ..................................... 534

A. Justifying Unequal Treatment: Involuntary Creditors ...................................... 534

B. Protecting the Veil: Voluntary Creditors .... 535

V. CONCLUSION ..................................... 536

I. INTRODUCTION

Piercing a company's veil of limited liability remains one of the most litigated issues in corporate law and one of the most hotly debated topics among business-law scholars.(fn1) Nonetheless, despite the numerous cases involving veil piercing, courts have hardly defined the doctrine in a coherent or consistent manner.(fn2) Further, this confusion is only enhanced when courts attempt to pierce the veil of a limited liability company ("LLC").

The confusion surrounding LLC veil piercing stems from numerous factors, including some courts' seemingly blind application of corporate standards,(fn3) and worse, some courts' misunderstanding that the corporation and the LLC are not the same entity.(fn4) Indeed, the LLC is a different entity than the corporation in both structure and purpose. Most notably, the LLC is primarily a creature of contract, thereby making it a highly customizable business entity. Further, the contractual nature of the LLC is also ideal for voluntary creditors because, by default, many LLC statutes, such as the Delaware Limited Liability Company Act ("DLLCA"), provide voluntary creditors with numerous contractual avenues to ensure repayment. Moreover, there are other important doctrinal differences between the corporation and the LLC, such as those involving fiduciary duties. Nonetheless, courts ignore many of the LLC's special features in veil-piercing cases.

This Article argues that courts and legislatures should prevent voluntary creditors from piercing the LLC veil. LLC statutes-including, most notably, the DLLCA-encourage freedom of contract, yet allowing voluntary creditors to pierce an LLC's veil allows them to bargain for protection ex post. Moreover, the differences between the corporation's and the LLC's doctrines, structures, and purposes further support repeal. Section II of this Article provides the necessary background on veil piercing and LLC law. Next, Section III argues that LLC veil piercing for voluntary creditors is contradictory to both LLC statutes, such as the DLLCA, and LLC law in general. Section III also points out the important differences between the corporation and the LLC that should not be ignored by courts and legislatures. Finally, Section IV argues the difference in treatment for involuntary creditors is warranted and calls for courts to stop piercing the LLC veil for voluntary creditors.

II. THE ENIGMA OF VEIL PIERCING AND THE LIMITED LIABILITY COMPANY

A. Limited Liability and Its Exception

Metaphors in law are to be narrowly watched, for starting as devices to liberate thought, they end often by enslaving it.(fn5)

-Judge Benjamin Cardozo

Entity separateness is a longstanding "bedrock principle"(fn6) in business law.(fn7) As a separate entity from its owners, an entity (such as the corporation or the LLC) has its own "legal rights, obligations, powers, and privileges different from those of the natural individuals who created it, who own it, or whom it employs."(fn8) Accordingly, an owner's liability is limited to the amount of its investment in the enterprise.(fn9) In other words, barring exceptional circumstances, the firm's creditors cannot recover any unpaid business debts from the owners them-selves.(fn10) As a result, entity separateness encourages entrepreneurial activity by founders, risk-taking by management, and investment by passive investors.(fn11) Not surprisingly, entity separateness-and its resulting limited liability-is the "the primary benefit" of the corporation and the LLC.(fn12) Better stated, a firm's "most precious characteristic" is the "privilege of limited liability."(fn13) In short, limited liability is "sacrosanct."(fn14)

Nonetheless, like any privilege granted by the law, there is a risk of abuse or unfairness. Accordingly, there is an equally fundamental principle in business law that carves out an exception to limited liability.(fn15) Under the equitable(fn16) doctrine of "piercing the veil," a court may disregard a firm's limited liability shield and hold the owners personally liable for the obligations of the firm.(fn17) Piercing the veil is a logical and predictable complement to limited liability: who else would creditors seek payment from when a firm stops paying the bills?(fn18)

Veil piercing has become more popular in recent years, and despite courts' contentions that veil piercing is a "difficult task,"(fn19) nearly fifty percent of veil-piercing claims are successful.(fn20) Notwithstanding the numerous veil-piercing cases, courts have failed to identify a universal standard to apply.(fn21) The confusion stemming from veil piercing is, undoubtedly, "the existence of incoherent and inconsistent multifactored tests."(fn22)

Nonetheless, as a starting point, courts generally pierce the veil if two requirements are met: first, there must be a unity of interest between the entity and its owner(s); and second, there must be a wrongful or fraudulent act by the owner(s), such that allowing the lack of separateness between the entity and its owner(s) to continue would promote fraud or injustice.(fn23) Further, some courts also require a sufficient nexus between the abuse of the limited liability form and the alleged misconduct. That is, the owner's wrongful conduct must be tied to the manipulation of the limited liability form to make veil piercing justifiable on grounds of equity.(fn24)

To assist in their analyses, courts somewhat haphazardly apply numerous factors to determine if each requirement is met.(fn25) Despite the myriad of factors enumerated by courts, the most persuasive factors for piercing the veil include injustice or unfairness, misrepresentation or fraud, domination by a single owner, commingling of assets, and undercapitalization.(fn26) It should be noted, however, that these factors are often applied inconsistently.(fn27)

It is also worth noting some of the practical realities of veil piercing. First, courts will only pierce the veil of closely held entities because ownership in publicly held entities is too widely dispersed, which prevents adequate control of the firm to justify veil piercing.(fn28) Second, veil piercing is more common when the entity is owned by individual shareholders or members rather than parent companies.(fn29)Third, involuntary creditors are more successful than voluntary creditors in piercing the veil.(fn30) Fourth, while the procedural components of veil-piercing claims are often misunderstood,(fn31) "[i]nsolvency is a natural complement to veil-piercing," as it would make little sense to seek recovery from a firm's owners when the firm can satisfy the amount owed to its creditors.(fn32) Fifth and finally, despite the fact that courts(fn33) and commentators(fn34) contend veil piercing is an equitable remedy, the doctrine does not appear to be rooted within concerns of inequitable bargains.(fn35) Indeed, courts do not appear to sufficiently analyze the sophistication(fn36) of the contracting parties in veil-piercing claims brought by voluntary creditors.(fn37)

Not surprisingly, the inconsistent and sporadic application of veil piercing has prompted some commentators to seek reform and even abolishment of the doctrine.(fn38) Others, however, have sought a simpler approach by attempting to clarify the doctrine. Specifically, commentators have argued the first prong of the veil-piercing analysis (i.e., lack of separateness) is merely a proxy for the actual reason courts pierce the veil.(fn39) In fact, despite veil piercing's purported confusion, commentators have established that courts will pierce the veil in predictable circumstances, such as to achieve the goals of a specific regulatory scheme, to avoid fraud or misrepresentation by owners attempting to obtain credit, or to promote bankruptcy values (i.e., resolving insolvency problems as efficiently as possible).(fn40)

Avoidance of fraud or misrepresentation by owners is the most compelling justification identified, as fraud and misrepresentation are the most frequently cited rationales by courts for piercing the veil.(fn41) Like most veil-piercing...