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Piercing the Veil of a Business Entity

by Herrick K. Lidstone, Jr.

For the Arapahoe County Bar Association Business Law Luncheon
December 8, 2009

Piercing the Veil of an LLC – Sheffield Services Company v. Trowbridge1

Colorado Revised Statutes §7-80-705 provides very specifically 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.” There are only two statutory exceptions to this statement of non-liability: §7-80-107(1) provides that members (not managers) can be held liable under a piercing the corporate veil theory and §7-80-606(2) which provides that members who receive an unlawful distribution may be liable for the amount of the distribution. Notwithstanding this clear statutory guidance, in May 2009 a panel of the Colorado Court of Appeals (the “Panel”) issued its decision in Sheffield Services Company v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). Contrary to the statutory guidance, the Panel held that a non-member manager of a limited liability company (an “LLC”) could be held liable to a creditor under a piercing the corporate veil theory.

The facts of the case are complex and quite important, but a complete discussion of the facts are beyond the scope of this note. Suffice it to say that the manager, Trowbridge was the manager of Colfax Industrial LLC (“Colfax”). He also (through his wife) controlled one of the members of Colfax and took actions that financially benefitted the other member. As a result the trial court found that he may have personally benefitted from his actions as manager. It also appears from the trial court’s opinion that Sheffield (which purchased property for development from Colfax) knew or should have known that the warranties offered in the purchase agreement regarding compliance with Broomfield ordinances were erroneous. Sheffield brought suit against Colfax and a sister LLC (Villa) for breach of contract, and recovered damages of $190,008.53. At trial, the District Court concluded (among other things) that “the level of control that Defendant Trowbridge maintained over the multiple limited liability companies’ assets, using them interchangeably to meet his needs, is highly unusual.” Notwithstanding the clear statement in C.R.S. §7-80-705 protecting members and managers from liability, the Court of Appeals concluded that it could hold a non-member manager liable under a piercing the veil theory, citing the 1984 case of LaFond v. Basham, 683 P.2d 367 (Colo. App. 1984). In LaFond, the Court found that a non-shareholder director could be liable to a creditor under a piercing the veil theory. The director caused the corporation to repay a debt to himself resulting in no further assets to repay another creditor. As an aggravating fact in LaFond, his wife and son were the sole shareholders of record, but in testimony he claimed that he “owned the corporation.” Clearly LaFond was inappropriate precedent for the Panel’s decision. In referring to the La Fond decision, Hon. John W. Madden stated that “[t]he ruling may have been driven by the particular facts of the case” rather than the law.2

In referring the case back to the District Court for additional findings, the Panel also referred to Alexander v. Anstine, 152 P.3d 497 (Colo. 2007). In Anstine, the Colorado Supreme Court imposed a trustee-like duty on directors and officers of a corporation when a corporation becomes insolvent, although stating that the “trustee role with regard to creditors does not encompass the full set of fiduciary duties owed by directors and officers to shareholders of a solvent corporation.” The Supreme Court found it to be a limited duty “that requires officers and directors to avoid favoring their own interests over creditors’ claims.” Anstine is a more appropriate analysis to hold a non-member manager of an LLC liable where it can be shown that he favored personal interests over those of a creditor, rather than the confused application of LaFond where the defendant claimed to own the corporation and a more current analysis, 23 years after LaFond.

The Panel’s application of the “piercing the veil” doctrine to an LLC in the Trowbridge case is inconsistent with Colorado law and inconsistent with the guidance provided by other states. For example, the federal district court for the District of Oregon (BLD Products LTC. v. Technical Plastics of Oregon, LLC, No. 05-556-KI, 2006 WL 3628062 (D.Ore. Dec. 11, 2006)) stated that it would allow the piercing of the limited liability veil of an LLC to hold a member liable where:

• the defendant member controlled the debtor;
• the defendant member engaged in improper conduct; and
• 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.

The Delaware Chancery Court (EBG Holdings LLC v. Vredezicht’s Gravenhage 109 B.V., No. 3184-VCP, 2008 WL 4057745 (Del. Ch. Sept. 2, 2008)) indicated that the circumstances necessary to pierce the veil of an LLC must be pervasive – not just stemming from a single transaction. See NetJets Aviation, Inc. v. LHC Communications, LLC, 537 F.3d 168 (2d Cir. 2008), also applying Delaware law.

The ultimate effect of a continuing application of the “piercing the veil” doctrine as applied by the Panel will be to reduce or eliminate the willingness of LLC managers to take risks – even where they have no direct or indirect personal interest in the transaction at issue and to reduce the attractiveness of LLCs in Colorado. One can only hope that the piercing the veil analysis in Sheffield determining that it may be proper to hold a non-member manager liable is recognized for the aberration that it is. It should also be recognized that the Anstine analysis provides greater justification for the actual result of Sheffield case – that Trowbridge as manager may be liable to creditors of the LLC if it can be shown that he breached the limited trustee-like duty described in Anstine. Piercing the veil is simply not the analysis that should be used to reach the Panel’s conclusion.

McCallum Family LLC v. Winger; More on Piercing the Veil, and
Officers’ and Directors’ Duties to Creditors, if any

In the November 2009 Business Law Section newsletter we discussed the May 2009 case, Sheffield Services Company v. Trowbridge, 211 P.3d 714 (Colo. App. 2009), which held that the common law veil piercing doctrine applies to non-member managers of limited liability companies. In October 2009 a different panel of the Colorado Court of Appeals issued another veil piercing decision - McCallum Family LLC v. Winger, ___ P.3d ___, 2009 WL 3465332 (Colo. App. 10/29/2009), a case involving an individual who did not hold the formal title of officer and director and had no formal shareholder interest. The court adopted the equitable ownership doctrine and ruled that an individual who acts as a de facto shareholder, officer, or director may be treated as an equitable owner and held to be the alter ego of a corporation.

The McCallum district court held that piercing the veil against one not an equity owner was inappropriate. Similar to Sheffield, the evidence in McCallum was clear that the defendant, Marc Winger, “owned” the corporation (“Manitoba”) in all but name and operated Manitoba for his own benefit. In fact, the Court of Appeals panel said that Marc was a corporate insider who “essentially functioned as an owner,” and “managed the whole affair.” The two shareholders of Manitoba were his wife and mother (Karen), and “neither of the nominal shareholders properly supervised his activities.” Furthermore, Marc “took a number of ‘distributions’ from Manitoba even though he was not a shareholder” and he “routinely used corporate funds to pay personal bills for himself and his wife, including payment of his California sales tax obligation and outlays for a boat, cell phone, and personal credit cards.”

In considering the veil piercing claim, the panel applied the “Three Prong Test” established by the Supreme Court in In re Phillips, 139 P.3d 639 at 644 (Colo. 2006). This test requires the court: (i) to determine whether the corporation is the alter ego of the defendant, (ii) to determine whether justice requires disregarding the corporate form because the corporate fiction was used to perpetrate a fraud or defeat a rightful claim, and (iii) to evaluate whether an equitable result will be achieved by disregarding the corporate form and holding the shareholder or other insider personally liable for the acts of the business entity.

Under the first prong, the panel easily disagreed with the Mesa County district court in determining that Marc used the corporation as his alter ego, as evidenced by numerous instances of Marc’s own disregard of the corporate formalities and personal use of corporate funds. The panel concluded that the “undisputed evidence showed that the corporation lacked ‘economic substance.’” The panel significantly extended Colorado’s veil-piercing law by expressly adopting the equitable ownership doctrine and applying the doctrine to hold that a corporate insider such as Marc, who is not a formal shareholder, officer, or director, can be the alter ego of a corporation.

In considering the second prong, the panel first noted that “[t]he mere fact that corporate creditors would go unsatisfied because they cannot reach a shareholder’s personal assets does not, alone, justify piercing the corporate veil.” To satisfy the second prong, the creditor “must show an effect on its lawful rights as a creditor resulting from abuse of the corporate form.” Again, the panel had no trouble reaching this conclusion based on the facts as determined by the district court. The panel determined that the trial court had not considered the third prong – equity – and remanded the case to the trial court for its consideration of this prong.

The McCallum panel did specifically consider the application of C.R.S. §7-108-401(5) in another part of the opinion. §7-108-401(5) provides that a director or officer of a corporation does not have “any fiduciary duty to any creditor of the corporation arising only from the status as a creditor.” There remains an unanswered question whether the limited trustee duty to creditors of an insolvent corporation in Alexander v. Anstine, 152 P.3d 497, 498 (Colo. 2007) survived the adoption of §7-108-401(5). That section was adopted specifically to address the Court of Appeals’ earlier decision in Anstine, and the Supreme Court decision came after the 2006 adoption of §7-108-401(5). In footnote 9 to its Anstine decision, the Supreme Court noted the adoption of §7-108-401(5) but expressed “no opinion on whether [§7-108-401(5)] applies where a corporation is insolvent.”

Karen was a director, officer, and 50% shareholder of Manitoba. By stipulation, the parties agreed that Manitoba was insolvent by September 2004. The panel noted that Manitoba paid Karen a distribution before the September 2004 insolvency date and (therefore) that the payment of that dividend did not disadvantage creditors to her benefit, so even if an Anstine duty still survives, it did not apply because her distribution predated the insolvency. The panel focused on the dividend that Karen received and did not focus on the fact that Karen was a director and officer of Manitoba at the time Manitoba paid Marc distributions after the September 2004 determination of insolvency to the detriment of Manitoba’s creditors.

If Karen participated in the approval of those distributions to Marc and if it could have been shown that she directly or indirectly benefitted as a result of the distributions to her son, Karen would have violated her Anstine duty. Even if Karen had not participated in the decisions to approve the distributions to Marc, the panel could have found her responsible as a result of her total dereliction of duties as an officer and director. While those duties are normally owed to shareholders, arguably the panel could have interpreted them to be part of the limited trustee duties under Anstine. In deciding the case against Karen, however, the panel did nothing except conclude that Karen could escape liability because the distributions she received were before Manitoba’s date of insolvency. The panel did not focus at all on Karen’s role as an officer or director which is the intended focus of C.R.S. §7-108-401(5). Nor did the Court address whether Karen could be liable under C.R.S. §7-108-403, which imposes liability on directors who approve distributions from an insolvent corporation.

1 Originally printed in the Business Law Newsletter published by the Business Law Section of the Colorado Bar Association (November 2009).

2 Madden, “Piercing the Corporate Veil,” in The Practitioner’s Guide to Business Organizations (Reichert and Rozansky, eds.) ch. 32, at 32-5 (CBA Supp. 2008).

 

 

Herrick K. Lidstone, Jr.
For more information, please contact Herrick K. Lidstone, Jr. at (303)796-2626 or . Mr. Lidstone is a senior member of the firm. Mr. Lidstone practices in the areas of business transactions, including corporate law, federal and state securities compliance, mergers and acquisitions, contract law, tax law, real estate and zoning law, and natural resources law.