Friday, January 13, 2017

Sixth Circuit Confirms that Piercing is a Remedy; In re Howland


Sixth Circuit Confirms that Piercing is a Remedy; In re Howland

      Last week the Sixth Circuit Court of Appeals issued its opinion in In re Howland, addressing whether a trustee could assert piercing the veil as a mechanism for merging the assets of an LLC into the bankruptcy estate of its members.  As did the Bankruptcy and the District Courts below, the Sixth Circuit rejected this effort. Phaedra Spradlin v. Beads and Steeds Inns, LLC (In re Howland), ___ Fed. App’x ___, No. 16-5499, 2017 WL 24750, 2017 U.S. App. LEXIS 222 (6th Cir. Jan. 3, 2017).  A review of the decision of the Bankruptcy Court is available AT THIS LINK.
      As a point of disclosure, Stoll Keenon Ogden and particularly Adam Back represented the defendants in this action.
      The facts underlying the dispute, as set forth by the Sixth Circuit, were as follows:
Matthew and Meagan Howland are the debtors in this personal bankruptcy case. In June 2007, they entered into a contract to buy a 133-acre farm in Lancaster, Kentucky, for $1.6 million. One month later, the Howlands assigned their interest in the purchase agreement to Meadow Lake Horse Park, a limited liability corporation they had recently formed under Kentucky law. They also personally guaranteed the loan Meadow Lake later obtained in order to purchase the farm.
For the next three years, the Howlands operated a horse farm and bed and breakfast on the property. In November 2010, the Howlands made a $760,000 payment on Meadow Lake's mortgage for no consideration. Then, a month later, Meadow Lake sold the property to Beads and Steeds Inns, LLC, a corporation formed by a third party for the sole purpose of purchasing the farm. The purchase price was $800,000, roughly half of what Meadow Lake paid just three years earlier. Along with the sale, the two parties entered into a $1,000-a-month lease agreement (about one-fourth the market rate), which allowed Meadow Lake and the Howlands to continue operating the horse farm and bed and breakfast.
Two years later, saddled with unmanageable debt, the Howlands filed for personal bankruptcy. The bankruptcy court appointed plaintiff, Phaedra Spradlin, as trustee of the debtors' estate. In her role as trustee, Spradlin filed this adversarial action against Beads and Steeds. Spradlin alleged that the December 2010 transfer from Meadow Lake to Beads and Steeds was fraudulent, done to evade the Howlands' creditors.
Beads and Steeds moved for judgment on the pleadings, observing that the trustee alleged that Meadow Lake—not the debtors, personally—engaged in the 2010 transfer. It argued that the trustee therefore failed to state a claim under the governing fraudulent transfer provisions, both of which required a “transfer of an interest of the debtor in property.” See 11 U.S.C. § 544(b)(1) (emphasis added); see also 11 U.S.C. § 548(a)(1)(B). The trustee responded that she could pierce the corporate veil in reverse and thereby treat Meadow Lake and the debtors as a single entity.
      The Sixth Circuit began by reviewing piercing law generally and noting that the states fall into one of two categories:
     “identity,” in which piercing “expands the debtor’s estate to include the property of its alter ego” by “deeming a corporation and its alter ego to be a single entity.”;  or
     “vicarious liability” which “shifts liability from the debtor to its alter ego.” 2017 WL 24750, *3 (citations omitted).
      Finding that Kentucky utilizes the “vicarious liability” theory (2017 WL 24750, *7), the effort to utilize piercing to enlarge the assets in the bankruptcy estate was doomed. 
The fact that Kentucky endorses the vicarious liability approach to veil piercing, as opposed to the identity approach, dooms the trustee’s fraudulent transfer claims against Beads and Steeds under a veil piercing theory. The Bankruptcy Code permits the trustee to avoid a transfer of property only if the debtor had an interest in the property. 11 U.S.C. §§ 544(b)(1), 548(a)(1)(B). Under the vicarious liability approach, however, veil piercing does not give the pierced entity (i.e., the debtor) an interest in its alter ego’s assets—it gives the pierced entity’s creditor (i.e., the trustee) an interest in the alter ego’s assets in order to satisfy its judgment against the pierced debtor. Compare Garvin, 74 P.2d at 992 (under vicarious liability approach, “[t]he doctrine of alter ego does not create assets for or in the corporation”), with In re Am. Int’l Refinery, 402 B.R. at 744–45 (stating that identity approach to veil piecing gives the debtor “an equitable interest in the assets of its alter ego”) (citation omitted). Under § 544 and § 548, that is not enough. Because Kentucky veil piercing does not transform the alter ego’s property into the property of the debtor, but rather simply allows a creditor to pursue the alter ego under a vicarious liability theory, the trustee has not stated a claim under § 544 and § 548, both of which require that the debtor have an interest in the transferred property. 2017 WL 24750, *5.
      The decisions below, even while they rejected the effort to enlarge the estate via piercing, had addressed at length the question of whether Kentucky would recognize either “insider-reverse” or “outsider-reverse” piercing. Initially determining that piercing was not here possible, it was able to avoid that issue, a point discussed in footnote 2 to the decision:
The parties spend a significant portion of their briefs jockeying over whether Kentucky would recognize “reverse” veil piercing. However, based on the foregoing, we need not address this issue because, regardless of the answer, Kentucky’s approach to traditional veil piercing makes clear it would not use reverse veil piercing to consolidate two entities. We therefore leave for another day the question whether the Kentucky Supreme Court would recognize reverse veil piercing.
      This decision is another square declaration that piercing the veil is a remedy and is not itself a cause of action, a point already made in numerous decisions cited by the Howland court. 2017 WL 24750, *4. 
      Still, I have two small quibbles with and a broader observation as to the decision.  First, it refers to Meadow Lake Horse Park as a “limited liability corporation,” (it is actually a limited liability company), and refers to Beads and Steeds Inns, LLC as a corporation (likewise, it is actually a limited liability company).  2017 WL 24750, *1.
      Of greater import, the Sixth Circuit presumed, without analysis, that the law of piercing that has developed in the context of the law of corporations is equally applicable with respect to LLCs.  On this point there is conflicting authority. In Turner v. Andrew, 413 S.W.3d 272, 277 (Ky. 2013), the Court wrote “The doctrine [of veil piercing] can also apply to limited liability companies.”  Turner was not, however, a piercing case, so this statement is dicta.  Conversely, in Pannell v. Shannon, 425 S.W.3d 58, 2014 WL 1101472, *7 (citations omitted), the Supreme Court observed:
In fact, “limited liability companies are creatures of statute,” controlled by Kentucky Revised Statutes (KRS) Chapter 275,” not primarily by the common law. To the extent that common law doctrines could arguably govern limited liability companies, the Kentucky Limited Liability Company Act “is in derogation of common law,” KRS 275.003(1), and the traditional rule of statutory construction that “require[s] strict construction of statutes which are in derogation of common law shall not apply to its provisions.” Id. Thus, to the extent the statutes conflict with common law, the common law is displaced.
This Court must therefore first look at the controlling statutory law. The obvious place to start, then, is the source of limited liability in the LLC context, KRS 275.150.
      Although this issue was raised in the lower court briefs, it was not briefed before the Sixth Circuit.  Both lower courts summarily found there to be no issue based on Tayloe, 2014 Ky. App. LEXIS 131, and Turner v. Andrew.  Whether and on what terms an LLC may be pierced remains a topic to be addressed by the Kentucky Supreme Court.  The fact that the Sixth Circuit did not undertake that analysis is worth noting only to make clear that In re Howland is not cited as authority that Kentucky LLCs are subject to the common law of piercing.

Sixth Circuit Denies Substantive Consolidation; In re Howland


Sixth Circuit Denies Substantive Consolidation; In re Howland

Last week the Sixth Circuit Court of Appeals issued its opinion in In re Howland, addressing whether a trustee could assert substantive consolidation as a mechanism for merging the assets of an LLC into the bankruptcy estate of its members.  As did the Bankruptcy and the District Courts below, the Sixth Circuit rejected this effort. Phaedra Spradlin v. Beads and Steeds Inns, LLC (In re Howland), ___ Fed. App’x ___, No. 16-5499, 2017 WL 24750, 2017 U.S. App. LEXIS 222 (6th Cir. Jan. 3, 2017).  A review of the decision of the Bankruptcy Court (Judge Schaff) is available AT THIS LINK.  A review of the decision of the District Court (Judge Caldwell) affirming the decision of the Bankruptcy Court is available AT THIS LINK.
As a point of disclosure, Stoll Keenon Ogden and particularly Adam Back represented the defendants in this action.
The facts underlying the dispute, as set forth by the Sixth Circuit, were as follows:
Matthew and Meagan Howland are the debtors in this personal bankruptcy case. In June 2007, they entered into a contract to buy a 133-acre farm in Lancaster, Kentucky, for $1.6 million. One month later, the Howlands assigned their interest in the purchase agreement to Meadow Lake Horse Park, a limited liability corporation they had recently formed under Kentucky law. They also personally guaranteed the loan Meadow Lake later obtained in order to purchase the farm.
For the next three years, the Howlands operated a horse farm and bed and breakfast on the property. In November 2010, the Howlands made a $760,000 payment on Meadow Lake's mortgage for no consideration. Then, a month later, Meadow Lake sold the property to Beads and Steeds Inns, LLC, a corporation formed by a third party for the sole purpose of purchasing the farm. The purchase price was $800,000, roughly half of what Meadow Lake paid just three years earlier. Along with the sale, the two parties entered into a $1,000-a-month lease agreement (about one-fourth the market rate), which allowed Meadow Lake and the Howlands to continue operating the horse farm and bed and breakfast.
Two years later, saddled with unmanageable debt, the Howlands filed for personal bankruptcy. The bankruptcy court appointed plaintiff, Phaedra Spradlin, as trustee of the debtors' estate. In her role as trustee, Spradlin filed this adversarial action against Beads and Steeds. Spradlin alleged that the December 2010 transfer from Meadow Lake to Beads and Steeds was fraudulent, done to evade the Howlands' creditors.
Beads and Steeds moved for judgment on the pleadings, observing that the trustee alleged that Meadow Lake—not the debtors, personally—engaged in the 2010 transfer. It argued that the trustee therefore failed to state a claim under the governing fraudulent transfer provisions, both of which required a “transfer of an interest of the debtor in property.” See 11 U.S.C. § 544(b)(1) (emphasis added); see also 11 U.S.C. § 548(a)(1)(B). The trustee responded that she could pierce the corporate veil in reverse and thereby treat Meadow Lake and the debtors as a single entity. 
      The trustee sought leave to file an amended complaint alleging substantive consolidation. That motion was denied by the trial court on the basis that the tendered complaint failed to adequately plead substantive consolidation. 2017 WL 24750, *2. The Sixth Circuit, in considering the matter, began by noting that “[a]lthough similar in some ways to veil piercing, substantive consolidation is a distinct concept unique to bankruptcy law.” 2017 WL 25750, *6. Whereas veil piercing is a mechanism for imposing vicarious liability, substantive consolidation “brings all assets of a group of entities into a single survivor. Indeed, it merges liabilities as well.” and in effect “treats separate legal entities as if they were merged into a single survivor.” Id.
      In reliance upon In re: Owens Corning, the Howland court wrote that:
To state a claim for substantive consolidation, the trustee must allege:
(i) prepetition [the entities sought to be consolidated] disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or
(ii) post-petition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors. Id.

      Looking to the proposed amended complaint, it was found that it fell “far short of demonstrating a significant disregard of corporate separateness such that the debtor’s and Meadow Lake’s creditors relied on the breakdown and treated them as one.” 2017 WL 24750, *6. Specifically:
Missing are any allegations that the debtors or Meadow Lake distributed misleading financial information to creditors, failed to accurately record their transactions with creditors, or otherwise misled creditors into believing they were dealing with them as one indistinguishable entity. Id.
      Having disposed of the first element of the Owens Corning test, it being focused upon pre-petition activities, the Sixth Circuit turned its attention to the question of post-petition scrambling of assets. In this instance, the trustee was hoist on the petard of the errors identified by the trustee. Specifically:
Moreover, the proposed complaint simply does not allege that the debtors’ and Meadow Lake’s assets are hopeless are “hopelessly scrambled.” Paragraph fifteen alleges that the debtors listed Meadow Lake’s debts as their own, the implication being that even the debtors could not distinguish between their assets and Meadow Lake's. However, the very fact that the trustee can make this allegation - i.e., highlight the debtors’ mistake of listing another entity’s debt as their own - demonstrates that she can, in fact, distinguish the debtors’ assets from Meadow Lake’s. 2017 WL 24750, *7.
      The court went on to note that substantive consolidation does not exist to address the alleged harm that creditors will be injured because of a reduction in the distributions to them.
      In footnote 3 to the decision, the court noted that the trustee argued for the application of the test for substantive consolidation set forth in In re: Owings Corning, and that the defendants responded thereto. On that basis, “Because the parties do not brief the issue, and because the trustee’s claim fails under the standard she proffers, it is unnecessary to decide whether the Owens Corning test sets forth the best articulation of the substantive consolidation elements.” 2017 WL 24750, footnote 3.

Thursday, January 12, 2017

Limited Liability Goes Only So Far


Limited Liability Goes Only So Far

      A recent decision from New Jersey serves as a useful reminder that there are limits to the limited liability enjoyed by corporate officers. Specifically, an officer can be held personally liable for the consequences of their own torts. JT Queens Carwash, Inc. v JDW & Associates, Inc., 2016 N.Y. Slip OP 07295, 2016 WL 6605051 (App. Div. 2 Dept. Nov. 9, 2016).
      Frank Roman and JT Queens Carwash, Inc. sued JDW & Associates and Jay Weiss, its owner and president, asserting that while JDW and Weiss did procure certain insurance policies on behalf of the plaintiffs, they failed, as requested, to have the plaintiff’s landlord named as an additional insured. In addition, Weiss issued false certificates of insurance to that effect that the landlord was names as an additional insured.
      Reviewing a motion to dismiss the claims against Weiss individually, the court observed the general rule that corporate officers are not liable on contracts they enter into on behalf of the corporation, but noted as well that corporate officers “may be held personally liable for torts committed in the performance of the corporate duties.” (citations omitted.) In consequence thereof, it determined that the claim for negligent representation based upon that conduct should not have been dismissed. Rather, it found that the complaint and the evidence already submitted:
Alleged that Weiss personally signed a certificate of insurance falsely stating that the plaintiff’s landlord had been added as an additional insured on a certain commercial general liability insurance policy, and forwarded this certificate to the plaintiffs, knowing that it was required by the plaintiffs’ landlord. This is sufficient … to state a cause of action against Weiss, based on his personal participation in the commission of a tort. 2016 WL 6605051, *3 (citation omitted).

Wednesday, January 11, 2017

A Few Particular Points Out of an Otherwise Uninteresting Decision


A Few Particular Points Out of an Otherwise Uninteresting Decision

      A decision rendered last week by the Kentucky Court of Appeals, it reviewing an effort to in effect relitigate a matter that had already been determined by arbitration, is not particularly noteworthy. There are, however, few nuggets that are worth a bit of attention. Eitel v. Duncan Commercial Real Estate LLC, No. 2015-CA-000506-MR, 2017 WL 65607 (Ky. App. Jan. 6, 2017).
      This dispute arose out of a real property purchase by Robbins. Eitel asserted that she was entitled to a real estate commission on the sale. Duncan, whose involvement in the transaction is not detailed in the opinion, did receive a commission. Robbins, on whose behalf Eitel alleged she had been the realtor giving rise to her right to a commission, “at the closing,… executed an affidavit stating Eitel was not his broker for the transaction.” Still, Duncan was willing to pay to Eitel a referral fee of 25% of the commission he earned. Eitel refused that offer and initiated an arbitration proceeding before the Kentucky Association of Realtors. That arbitration panel awarded Eitel the amount of the previously offered referral fee. After a KAR procedural review of the award, it was affirmed, and Duncan paid over the amount of the referral fee. Eitel then attempted to move this dispute to the courts, an effort that was rejected.
      Initially, Eitel sought to bring the action on her own behalf and also on behalf of Eitel Real Estate Group, a Kentucky business corporation. On the basis that a corporation may be represented in court only by legal counsel, “Thus, insofar as Eitel personally undertook to represent the corporation, as a nonprofessional she was prohibited from doing so.” 2017 WL 65607, *3. Although not addressed the opinion, that Eitel Real Estate Group, Inc. was administratively dissolved in 2002 for failure to file its annual report with the Kentucky Secretary of State.
     One of the tort claims that Eitel sought to allege in court was that Duncan’s actions constituted tortious interference with a contract and business relationship between Eitel and Robbins. This claim failed on the basis that there was no contract at issue. Rather:
However, absolutely no reference appears in the record as to the existence of any brokerage contract between herself and Robbins - whether oral or written, and she even admitted to the arbitration panel no contract existed. There can absolutely be no interference with a contract that does not even exist. Id.
The court also affirmed an award of attorneys fee’s against Eitel, finding they were provided for in the agreement.
[S]he has clearly continued to contest the results of the arbitration as being incorrect. Duncan was therefore required to seek judicial confirmation of the award and, under the express language quoted above, is entitled to recover a fee for its retained counsel.  2017 WL 65607, *4.


 
 
 

Tuesday, January 10, 2017

Delaware Chancery Court Enforces Statute Precluding Fee-Shifting Clause In Bylaws


Delaware Chancery Court Enforces Statute Precluding Fee-Shifting Clause In Bylaws

      In 2014, in response to efforts to include “fee-shifting” provisions in our corporate charters and bylaws, the Delaware Legislature, except with respect to nonprofit corporations, invalidated such provisions. In effect, while some companies had sought to shift liability for defense costs and derivative and similar actions, they were forbidden to do so. In a recent decision, the Delaware Chancery Court applied those new statutes. Solak v. Sarowitz, C.A. No. 12299-CV, 2016 WL 7468070 (Del. Ch. Dec. 27, 2016).
       HERE IS A LINK to a discussion of this decision. 

Delaware Supreme Court Holds That Breach of Limited Partnership Agreement is a Derivative, and Not a Direct, Claim


Delaware Supreme Court Holds That Breach of Limited Partnership Agreement is a Derivative, and Not a Direct, Claim

      In a recent decision from the Delaware Supreme Court, it reversed a holding of the Chancery Court and found that claims by a limited partner challenging a drop-down transaction were derivative, and not direct. Consequent to that classification, a subsequent merger deprived the limited partners of continued standing to pursue a derivative action. El Paso Pipeline GP Company, LLC v Brinckerhoff, No. 103, 2016, 2016 WL 7380418 (Del. Dec. 20, 2016).
      El Paso Corporation (“El Paso”) was the sole member in El Paso Pipeline GP Company, LLC (“GP LLC”), which company in turn served as the sole general partner of El Paso Pipeline Partners, L.P. (the “LP”). El Paso sold certain assets to the LP in a master limited partnership drop-down transaction. Brinckerhoff, a limited partner in the LP filed a derivative action challenging that drop-down transaction. While that matter remained in dispute, El Paso was acquired and the LP was merged out of existence. Thereafter, the defendants moved to dismiss, arguing that Brinckerhoff's claims were exclusively derivative and that standing was lost consequent to the merger. The Chancery Court issued an opinion holding that GP LLC was liable for a breach of the partnership agreement on the basis there was not a reasonable belief that the drop-down transaction was in the best interest of the partnership; damages of $171 million were assessed. The Chancery Court rejected this claim that the injuries were derivative, finding that the limited partners were individually harmed.
      That classification was rejected by the Delaware Supreme Court, it finding that the injuries were suffered exclusively by the limited partnership and then only derivatively by the partners therein. No longer being partners in the LP, the former limited partners lacked standing to continue to pursue the derivative action.
      This is an important decision in that it adds to the line of authority standing for the proposition that the breach of the organizational documents of a limited partnership/LLC will typically be derivative, and not direct, in nature.

Top 10 New York Business Divorce Cases


Top 10 New York Business Divorce Cases

      Peter Mahler, in his excellent New York Business Divorce blog, has compiled a listing of the top 10 New York business divorce decisions from 2016. HERE IS A LINKto that posting.