Kentucky Court of Appeals Reversed the Trial Court, Holds that Veil of LLC Should be Pierced

Kentucky Court of Appeals Reversed the Trial Court, Holds that Veil of LLC Should be Pierced

       In a recent decision, the Kentucky Court of Appeals held that a trial court had misapplied the law of piercing the veil and determined that, in fact, it should in this instance be pierced. Tavadia v. Mitchell, No. 2017-CA-001358-MR, 2018 WL 5091048 (Ky. App. Oct. 19, 2018). At this juncture it is not known whether Mitchell will be filing a petition for discretionary review with the Kentucky Secretary of State.

      Sheri Mitchell, in 2013, formed One Sustainable Method Recycling, LLC (“OSM”), a company that contracted with healthcare providers to recycle healthcare waste such as plastics and sharp metal objects. Mitchell was initially the 99% owner and the acting CEO, of OSM, with Ahmet Matha holding the other 1% total. Shortly after starting OSM, Mitchell approached Behram Tavadia about investing in the company. Within two months of OSM’s founding, Tavadia, acting through his company Tavadia Enterprises, Inc., loaned OSM $40,000 at a 6% interest rate. That loan was to be repaid $1,000 per month. In addition, Tavadia would be paid 5% of OSM’s yearly profits. Mitchell did not guarantee that loan. Not long thereafter, OSM received a $150,000 loan from the Louisville Metropolitan Business Development Corporation (“METCO”). Tavadia personally guaranteed that loan and pledged certain bonds as security thereon.

      Two years later, when no payments had been made to Tavadia under the original $40,000 loan, he agreed to delay repayment. Then, OSM and Tavadia entered into a second loan, in the amount of $250,000, refinancing as well the original $40,000 and another $12,000 loan Tavadia had made to the company in the fall of 2014. That second loan agreement provided that Tavadia would receive a 25% ownership interest in OSM (previously he only had a right to 5% of its annual profits). Again, Mitchell did not execute a personal guarantee on the loan from Tavadia. Mitchell explained that this 2015 loan was needed to purchase certain equipment that Mitchell represented was needed for the business.  No such equipment was ever purchased or even ordered.

      Thereafter, still in a cash flow crisis, OSM received a $20,000 loan from Fundworks, LLC. Without authority from Tavadia to do so, Mitchell signed Tavadia’s name on behalf of OSM and as well signed a personal guarantee in Tavadia’s name. That loan carried an interest rate of 15%.

      Not long thereafter, in October, 2015, OSM ceased operations. Its equipment was sold, and more than half of the sale proceeds were deposited in Mitchell’s personal bank account, the balance going to OSM’s account. Necessarily, OSM defaulted on the Fundworks’ loan, which Tavadia learned about for the first time when Fundworks contacted him demanding repayment. The loan from METCO also went into default, and it contacted Tavadia about selling or redeeming the bonds he had pledged as collateral.

      Tavadia filed suit against OSM and Mitchell asserting claims for breach of contract, fiduciary duty, of misappropriation and conversion of company assets, and failure to afford him access to company records. An amended complaint would add claims for fraud as well as for forgery.

       Mitchell never caused OSM to retain legal counsel, and she sought to represent it pro se. The court rejected that notion, and a default judgment was entered against OSM for $302,000. Thereafter, a bench trial was held as to whether or not Mitchell, individually, could be held personally liable on the judgment against OSM in favor of Tavadia. The trial court concluded that the elements of piercing, namely as set forth in Inter-Tel Technologies, Inc. v. Lynn Station Properties, LLC, 260 S.W.3d 152 (Ky. 2012) had not been met. HERE IS A LINK to my review of that decision. From the determination that the veil of OSM would not be pierced, and that Mitchell would not be held liable on the judgment, this appeal was taken.

      As there was a bench trial, the standard of review was that of “clearly erroneous.”

      Curiously, Mitchell did not file a brief with the Court of Appeals. In consequence, Tavadia had the opportunity to set the tone of the discussion.

       Beginning with the statement, made in reliance upon Pro Tanks Leasing v.  Midwest Propane and Refined Fuels, LLC, 988 F. Supp. 2d 772, 788 (W.D. Ky. 2013), that courts will assess “limited liability companies the same as corporations for purposes of liability analysis.”, the Court of Appeals assessed whether the Inter-Tel test was satisfied, namely were there both “domination of the [LLC] resulting in a loss of [LLC] separateness” and as well “circumstances under which continued recognition of the [LLC] would sanction fraud or promote injustice.” 2018 WL 5091048, *4.

      As to the first element:

While the trial court did, in fact, discuss several of the factors enunciated in Inter-Tel Technologies, Inc. in concluding that Tavadia failed to establish the first prong of domination of the [LLC] resulting in a loss of [LLC] separateness, we must agree with Tavadia that it ignored material facts and evidence in reaching its conclusion. Id. *5

       The Court of Appeals would determine that the permission granted to Mitchell to use OSM funds for living expenses had been abused, once she utilized them for “extravagant personal expenses,” notwithstanding that the total amount withdrawn was less than she would have received had she been drawing a salary. Continuing to the question of co-mingling funds with respect to the sale proceeds and a deposit of more than half in Mitchell’s bank account, “once Tavadia proved that Mitchell deposited OSM monies into her personal bank account, Mitchell was under an obligation to show that she spent those funds on business expenses.” She failed in that obligation. Still:

Concerning some of the other Inter-Tel Technologies, Inc. factors, the trial court found that OSM was grossly undercapitalized, although it noted that Tavadia was aware that it was a start-up company and could have protected himself by requiring Mitchell to execute a personal guarantee or post collateral. We cannot disagree. Nor can there be any dispute that OSM did not follow any corporate formalities, much less pay dividends. Finally, Mitchell and Tavadia both agreed that she was the only functioning member of OSM and had sole control over all day-to-day decisions. Id. *6.

      The court did not, however, provide any protocol by which these factors should be weighed against those where the Court of Appeals had found that Inter-Tel Technologies factors would support piercing.

      As to the second prong, that of “sanctioning fraud or promoting injustice,” the court wrote:

Contrary to the trial court’s conclusion, we believe that Mitchell was unjustly enriched from her use of OSM’s funds while it was insolvent and its creditors remained unpaid. Mitchell went so far as to forge Tavadia’s name on a loan application and personal guarantee to continue a source of funding. To continue to recognize OSM and permit Mitchell to avoid liability would essentially be condoning her personal use of OSM funds to the detriment of OSM and Tavadia, as an investor. Such a result would promote injustice and would excuse what we believe was morally culpable behavior on Mitchell’s part. Id.

      Also at issue was the determination by the trial court that Tavadia had not been injured with respect to the Fundworks loan in that he had paid nothing thereon and had defenses to liability. Tavadia prevailed in the argument that the trial court, having found fraud and forgery, should have considered nominal damages and then addressed Tavadia’s claim for both punitive damages and attorney's fees. “The trial court clearly erred in summarily dismissing these claims.”