Bankruptcy Court Holds Trustee May Not Put the Cart Before the Horse and Strikes Down Effort to Pierce the Veil as a Cause Of Action

Bankruptcy Court Holds Trustee May Not Put the Cart Before the Horse

and Strikes Down Effort to Pierce the Veil as a Cause Of Action

      In a recent bankruptcy court decision, the Court rejected the effort by a bankruptcy trustee to utilize the concepts of “piercing the veil” in order to, ab initio, bring a third-party defendant into the action.  Rather, the Court held that piercing is a remedy, not a cause of action. Spradlin v. Beads and Steeds Inns, LLC (In re Howland), Case No. 12-51251, Adv. No. 14-5019, 2014 WL 4199637, __ B.R. __ (Aug. 22, 2014).

      The facts of this case are recited in the opinion as follows:

The following facts alleged in the Trustee’s Complaint are taken as true for the purpose of this decision.  On or about June 19, 2007, the Debtors formed Meadow Lake Horse Park, LLC (“Meadow Lake”).  On July 20, 2007, Meadow Lake purchased 133 acres of real estate in Garrard County known as 9863 Lexington Road, Lancaster, Kentucky (“Farm”) for $1,600,000 with the proceeds of a mortgage loan from United Bank & Trust Company (“United Bank”).  In late November 2010, the Debtors made a $760,000.00 payment on the mortgage loan to United Bank out of their personal income tax returns.  The Trustee asserts this payment was without consideration. 

On December 28, 2010, Meadow Lake sold the Farm for $800,000 to the Defendant Beads and Steeds Inns, LLC, which is wholly owned by Robert and Susan Hale (“2010 Transfer”).  The Defendant was formed shortly before the 2010 Transfer for the sole purpose of purchasing the Farm.  Defendant financed the full purchase price with a Mortgage Loan from United Bank in the amount of $800,000.

Subsequent to the sale of the Farm, Meadow Lake leased the Farm to the Defendant for $1,000 per month.  Meadow Lake also agreed to pay all insurance and real property taxes.  The Debtors operating the Farm as a horse boarding and training facility and a bed & breakfast and event facility both before and after the 2010 Transfer.

The Debtors filed Chapter 7 Bankruptcy on May 8, 2012.  The Debtors scheduled their interest in Meadow Lake on Schedule B and listed the value as $0.  Phaedra Spradlin was appointed Chapter 7 Trustee.

On May 6, 2014, the Trustee filed the underlying adversary proceeding seeking to avoid the 2010 Transfer as a fraudulent conveyance pursuant to § 548(a)(i)(B).  The Trustee also seeks to avoid the 2010 Transfer pursuant to KRS § 378.020 through § 544(b).  The Trustee further requests that the Bankruptcy Court disallow any claims by the Defendant pursuant to § 502(d).

      Essentially, while the bankruptcy filing was on behalf of the Matthew and Megan Howland, the Bankruptcy Trustee sought to allege that their LLC, Meadow Lake, had engaged in a fraudulent transfer which should be undone, it being posited that they (the Howlands and their LLC) should be treated as one and the same and the LLC “reverse pierced.”

      Although not cited by the Court, a member of an LLC has no ownership interest in the LLC’s property.  See KRS § 275.240(1); id. § 275.250.

      Reverse piercing is a twist on the traditional concept of piercing the “corporate” veil.  In traditional piercing, the plaintiff holding a judgment against a corporation that cannot be satisfied out of corporate assets seeks to “pierce” the corporation and hold the shareholders liable for the corporation’s debt.  In a reverse pierce, a claimant against the individual shareholders (in this case the members of the LLC) aims to access the assets held by the business entity and treat them as if owned directly by the shareholder/member.  Reverse piercing is in turn divided into two categories.  “Outsider” reverse piercing involves a claimant against the shareholder/member.  “Insider” reverse piercing involves the shareholder of the corporation or member of the LLC seeking to claim, for personal benefit, the assets of the LLC.

     After noting, consequent to the unique position of a Trustee, that this effort could be characterized as either outsider or insider reverse piercing, the court determined that categorization to not be necessary in that neither effort would be permitted to proceed.  Initially, relying on Turner v. Andrew (that decision is reviewed HERE) and Williams v. Oates (that decision is reviewed HERE), the Bankruptcy Court acknowledged that it is unclear whether a Kentucky court would accept the validity of reverse veil piercing.  That controversy did not, however, need to be addressed by the Bankruptcy Court in that it held that piercing could not be used in the affirmative approach sought by the Bankruptcy Trustee.  Rather, the court focused upon the fact that, under Kentucky’s piercing law, whatever it might be, piercing is a remedy and not itself a cause of action.  In that the Trustee sought to use reverse piercing as a theory for imposing the initial liability, rather than as a remedy by which to seek collection on primary liability, the effort was dismissed.  Specifically:

The Trustee argues that disregard of the corporate form of Meadow Lake [it was actually an LLC] would mean the 2010 Transfer is treated as if it were made by the Debtors directly.  Under this theory, it does not matter whether the Debtors or Meadow Lake committed the alleged wrongdoing.  The assets and liabilities of both parties are treated as merged both prospectively and retroactively.  This logic is not consistent with veil piercing as a remedy in Kentucky. 

Still, Beads and Steeds Inns, LLC is not off the hook.  The Bankruptcy Court afforded the Trustee the opportunity to file an amended complaint setting forth a traditional substantive consolidation claim.