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.