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Practice Area Commentary
Reverse Piercing of the Corporate Veil
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08-28-2009 | 12:34 PM
Reverse Piercing of the Corporate Veil
The Creditors of a Master Ice Carver Fail to Recover the Melting Debts of His Ice Carving Business through Reverse Piercing of the Corporate Veil
Business people and investors create corporations and their cousins, such as LLCs, for several reasons, but the shield from personal liability is one of the most important, if not the most important reason, to utilize a corporate structure. I first learned about the protection afforded owners and managers by the corporate structure from the late Professor Thomas Dunfee in my first business law class as an undergraduate. The sanctity of the corporate shield was reinforced many more times in law school, while the concept of piercing the corporate veil was not as emphasized. One would think that with the long and important history of the corporation in the fields of business and the law in our economy, the topic of piercing the corporate veil would have become a relic of the past, to be studied only by business and legal historians.
But piercing the corporate veil continues to be an active subject of litigation. Last month I
discussed a decision
of the Supreme Court of Ohio in which the concept of the triangular piercing of the corporate veil was rejected by the Ohio Supreme Court. Just a matter of days before that decision was rendered, a bankruptcy court was required to rule on a similar theory, that of the reverse piercing of the corporate veil.
Schwab v. McDonald (In re LMcD, LLC)
, 405 B.R. 555 (Bankr. M.D. Pa. 2009), a trustee for a Chapter 7 debtor, which was a limited liability company (LLC), sought to directly pierce the corporate veil of the LLC debtor to hold the shareholders liable, and if successful in holding the shareholders liable for the debts of the LLC debtor, then sought to also reverse pierce the veil of another corporation owned by the same shareholders, so that the second corporation was liable for the debts of the shareholders.
The husband shareholder was a successful chef who purchased a restaurant, Damenti’s, in 1977, and he and the wife shareholder incorporated the restaurant in 1989. The husband was also a master ice carver who put on a seasonal display of ice carving art. They decided to expand the ice carving business with the addition of a program to feature other artists as well. They formed a new LLC, named LMcD, for the ice carving business in 2004 and created a program named "ICE 4 U 2 C" to be held in 2005. Unfortunately the 2005 "ICE 4 U 2 C" program failed to generate revenues to cover the substantial debts that were incurred, and the LMcD LLC ice carving business filed a voluntary Chapter 7 bankruptcy petition.
Isn’t this what savvy business people and investors do every day? Create separate corporate structures for separate businesses? Even a cursory examination of the recent General Motors bankruptcy demonstrates how complicated the corporate structure is today for a major corporation. It would seem that the husband and wife shareholders took prudent action, probably upon advice of their legal counsel, when they created the LMcD LLC for the ice carving business. The bankruptcy court describes the theory of the Chapter 7 trustee as he pursued the assets of the restaurant corporation and the personal assets of the shareholders.
“William Schwab was appointed Chapter 7 Trustee for LMcD. After an investigation of the affairs of the company, he initiated lawsuits against Kevin McDonald and his wife, Helen (Adv. No. 5:07-50007), and Damenti's Inc. (Adv. No. 5:07-50098). His theories of liability are founded on the rather loose operations of LMcD and its principal, Kevin McDonald. His argument is that LMcD, as a limited liability company, can be "pierced" in order to seek liability against its members, Kevin and Helen McDonald. The Trustee argues that LMcD and the McDonalds are "alter egos" of each other and are jointly liable for the debts of LMcD. The Trustee further states a claim that the McDonalds' corporate interest in Damenti's Restaurant, Inc. can be "reverse pierced" so as to also hold Damenti's Restaurant liable for the debts of the share holders, Kevin and Helen McDonald, "alter egos" of LMcD.”
The shareholders did make mistakes that supported the Trustee’s arguments. Neither the restaurant corporation nor the LLC had a business credit card account, and credit card purchases for both the corporation and the LLC were made with a personal credit card in the name of the husband and wife. The debtor LLC appeared to be undercapitalized, and the Trustee produced evidence that the shareholders and the restaurant corporation paid many bills of the LLC. There was evidence of confusion of the identities of the corporation, the LLC, and the shareholders by some vendors of the LLC. At the same time, though, the bankruptcy court found that much of the evidence demonstrated that the shareholders had maintained the LLC corporate form as a separate business, and thus were not personally liable for the debts of the LLC.
“I find that there may have been a lack of sufficient communication by Kevin McDonald or ICE 4 U 2 C volunteers as to billing information prior to delivery. Having said that, though, does not make the case for the Trustee. McDonald or Damenti's could very well be liable for these obligations directly as the contracting party. Making the leap to the alter ego/piercing conclusion requires much more than is present on this record. LMcD did uphold its LLC form. It did have a membership agreement. It did register its fictitious name. It maintained separate books and filed tax returns. It had a bank account and did not deposit funds earmarked for personal use into that account. While the McDonalds may not have run their businesses strictly separate, these facts do not seem to overcome the strong presumption against piercing.”
Consequently, the bankruptcy court rejected the reverse piercing of the corporate veil theory of the Trustee. “Since the McDonalds have not been found to be personally liable for the debts of the Debtor, liability cannot be extended to Damenti's by a reverse piercing of the corporate veil. In a 'reverse' piercing, assets of the corporate entity are used to satisfy the debts of a corporate insider so that the corporate entity and the individual will be considered one and the same….
Given the strong presumption against piercing the corporate veil in Pennsylvania and the lack of evidence regarding the corporate practice of Damenti's, this Court will not reverse piercing the corporate veil to extend the liability for Debtor's debts to Damenti's.”
In the present economic climate, creditors are following every avenue to collect from debtors. Reverse piercing of the corporate veil has been upheld in many jurisdictions, and rejected in other jurisdictions. Obviously the shareholders in the instant case sometimes conducted their personal and corporate businesses in a sloppy manner, which only invited the Trustee to pursue them individually and as the owners of the restaurant corporation. But we should not be too critical of these two small business shareholders. Their mistakes are small potatoes compared to the billion dollar corporate shell operation that a federal court has had to deal with in Texas. The court in
Asarco LLC v. Ams. Mining Corp.
, 396 B.R. 278 (S.D. Tex. 2008), found that reverse piercing of the corporate veil would be allowed under Delaware law. If Conan is not making you laugh some night and you are wide awake, spend a few hours trying to dissect the hundred-plus page opinion of this Texas district court dealing with Peruvian copper mines and corporate shells.
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