The Jewel Doctrine; More from Dean Weidner
The Jewel Doctrine posits
that, upon the dissolution of a partnership (and especially a law firm), business that is being performed at the time of dissolution continues to be an asset of the partnership. Hence, the proceeds of that work will be applied to the satisfaction
the balance split amongst the partners (now former partners) in accordance with their respective
sharing ratios. In connection with the breakup of major money center law firms, most precipitated by the 2008 economic crisis, the firms to which those partners went have asserted that the Jewel Doctrine should not apply, and they should keep all of the proceeds of the transferred projects. In contrast, those in charge of the winding up and termination of those failed firms, many having significant
third party debts, have argued that the Jewel Doctrine should
apply. This is a topic that Tara McGuire and I addressed in an article titled Conflicting
Views as to the Unfinished Business Doctrine, 46 Texas Journal of Business Law 1 (2015). HERE IS A LINK to that article.
Most recently, Dean Don Weidner, whose credentials
served as the Reporter on the Revised Uniform
Partnership Act, has published a piece in the Florida Bar Journal
titled Leaving Law Firms With Client Fees: Florida’s Path. In this article, Dean Widener argues
that the Jewel Doctrine is correct, especially as to contingent fee
cases, and that as well it should be applied beyond situations
of a law firm’s dissolution. HERE IS A LINK to Dean Weidner’s article.
Trial Court and Court of
Appeals Puts the Court Before the Horse in Piercing Case
In Albakri v. A& M Oil Co., Inc., No. 2016-CA-000740-MR, 2017 WL
4862510 (Ky. App. Oct. 27, 2017), the Court of Appeals considered and rejected
a trial court’s decision to pierce the veil of a single shareholder
corporation. That decision to pierce had
been granted prior to the time the corporation’s liability was determined and
necessarily prior to the time piercing needed to be considered. The cart, the remedy of piercing, was put
before the horse, that being the joint question of is the corporation liable
and can the corporation satisfy the judgment.
Ahmad Albakri (“Albakri”) was
the sole shareholder/officer/director of Jorusa International, Inc., a Kentucky
corporation (“Jorusa”); Jorusa owned and operated a gas station under the name
of Tony’s Food Mart. A&M Oil Co.,
Inc. (“A&M”) supplied fuel to the gas station. Some payment for the gas was via automatic
receipt of credit card payments on sales with the balance by invoice from
A&M to Jorusa. For reasons not
detailed in the opinion the relationship between A&M and Jorusa ended, and
at that time A&M claimed an account receivable of $19,903.82; The opinion
does recite that “Albakri sold the gas station around the same time the
invoices that are the subject of the instant case went unpaid.” 2017 WL
4862510, *5. A&M filed suit for that amount, plus interest at the rate of
18%, and tendered with the complaint a credit agreement and personal
guarantee. In answering the complaint,
Albakri claimed the signature on the credit agreement and the guarantee was not
his. After an initial round of
discovery, A&M amended its complaint to add Albakri as a defendant,
asserting that he is jointly and severely liable on the amount owed.
And then the cart began to
precede the horse. A&M moved for summary judgment to (1) pierce Jorusa’s veil
and hold Albakri liable for its debt and (2) find Albakri/Jorusa liable to
A&M in the amount sought. The trial
court held that factual questions precluded summary judgment as to the
liability, but granted summary judgment as to the piercing “claim”.
At trial, a handwriting expert
opined that the signature on the credit agreement and the guarantee were not
those of Albakri. An A&M
representative testified that he witnessed Albakri sign the two documents. The court would hold ultimately that Albakri
did not sign those agreements, but held as well that his lack of execution went
only to the enforceability to the 18% interest on late payments. The trial court awarded A&M judgment for
$19,903.82 plus interest at 8%; the 18% interest in the credit agreement and
the provision for attorney fees were rejected as that agreement had not been
signed by Albakri. It denied a motion to reverse its determination that
Jorusa’s veil should be pierced.
The Court of Appeals would
reverse the decision to pierce Jorusa, but on grounds that are at best
Turning to the propriety of the
order piercing the veil, the standard of Inter-Tel
Technologies, Inc. v. Linn Station Properties, LLC, 360 S.W.3d 152 (Ky.
2012) was recited. HERE IS A LINK to my
prior review of that decision. From
there the various elements of the trial court’s decision to pierce were
In what appears to have been a
typo, Albakri had in an answer to an interrogatory said that Jorusa “was ever
capitalized in any amount.” 2017 WL 4862510, *2. The Court of Appeals attached meaning to this
First, the trial court found Jorusa
was never capitalized in any amount.
This finding is erroneous.
Albakri admitted only that “Jorusa International, Inc. was ever capitalized in any amount.”
(Emphasis added). 2017 WL 4862510, *8.
The court thus justified a
determination that the corporation was properly capitalized because over time
it had paid over $300,000 of payments to A&M, and in total they had done
business “likely approaching one million dollars.” On the basis that only $19,903.82 or 2% of
the total transactions had not been paid, “None of this evidence demonstrates
that Jorusa was undercapitalized.” 2017 WL 4862510, *8. It then cited a 9th Circuit
decision, Perfect 10, Inc. v. Giganews,
Inc., 847 F.3d 657 (9th Cir. 2017), in which it was found that a
company with $1.7 million of net assets and equity was not undercapitalized.
Which is entirely beside the
point. The suggestion that the
interrogatory answer was not a typo is disingenuous, and “ever” must mean
“never”; no other reading is possible.
Second, capital and retained earnings are the cushion to satisfy debts
when cash flow is not sufficient. The
mere fact that over a period of time cash flow was sufficient to pay debts as
they came due does not evidence that the venture has any capital, much less
that the capital is adequate.
In effect, the Court of Appeals
reversed a determination of inadequate capitalization by: (i) a let’s just say
curious interpretation of an interrogatory answer that would seem to admit
under-capitalization; (ii) a discussion of cash flow that does not go to the
question of adequate capitalization; and (iii) without any evidence of
The trial court had relied upon
a pair of administrative dissolutions of Jorusa to evidence a lack of respect
for formalities. Relying upon Inter-Tel Technologies, 360 S.W.3d at
157 for the requirement that in order to support piercing disregard of
formalities must be “egregious,” the Court of Appeals wrote that the failure
“to file necessary documents with the Secretary of State twice during the
corporation’s existence…. is hardly egregious.” 2017 WL 4862510, *9.
With respect to the failure to
pay dividends, another point relied upon to pierce, the Court of appeals began
by noting that Albakri never admitted that the corporation never paid
dividends, but rather only that he was unaware whether it paid dividends. 2017 WL 4862510, *9. Even had the corporation
never paid dividends, (which the Court of Appeals treated as a factor in
failure to observe formalities (“But assuming, arguendo, that no dividend as paid, that fact alone does not
demonstrate an egregious failure to follow corporate formalities.”) even though
under Inter-Tel it is its own
factor), the court explained why that could have been proper as whether to pay
dividends is a question left to the board of directors and there are tax
reasons for not declaring dividends. What the court failed to note is that the
double taxation of dividends is a problem only in C-corporations, and dividends
were tax favored in S-corporations vis-a-vis salary. How Jorusa was taxed was
never addressed even as the Court of Appeals wrote:
Here, A&M proffered no proof
that Jorusa was either capable of distributing a dividend or that doing so was
a wise choice in light of the double taxation for dividends. And, most importantly to the veil-piercing
analysis, A&M proffered no proof that Albakri was egregiously ignoring
corporation formalities by exercising his discretion and not making a
distribution. Thus, the trial court’s
reliance on the second factor is erroneous. Id.
Domination of Corporation
The trial court had found that
piecing was justified because Albakri dominated and controlled Jorusa. See
2017 WL 4862510, *3. The Court of
Appeals rejected that conclusion, writing:
After Inter-Tel was rendered, and effective July 12, 2012, the General
Assembly amended KRS 271B.6-220 by adding subsection 3: “(3) That a corporation
has a single shareholder is not a basis for setting aside the rule recited in
subsection (2) of this section.” Thus, it appears the fact that Albakri was the
sole shareholder of Jorusa should not be a consideration in our
piercing-the-corporate-veil analysis. It likewise follows that Albakri, as the
sole shareholder and manager of Jorusa, would also exercise dominion and
control over the company. At minimum, this factor in and of itself does not
justify piercing the corporate veil. 2017 WL 4862510, *9 (footnote omitted).
the court of appeals went too far. The 2012 amendment to KRS § 271B.6-220 was
in response to the Rednour decision
and the piercing of an LLC on the basis that it had only a single member. See Rutledge, The 2012 Amendments to Kentucky’s Business Entity Statutes, 101 Kentucky
Law Journal Online 1, 3 (2012). HERE IS A LINK to that article,
wherein it was observed at footnote 20:
v.Winchester Land Dev. Corp., 584 S.W.2d 56, 61 (Ky. Ct. App. 1979) (“[M]ere
ownership and control of a corporation by the person sought to be held liable is
not alone a sufficient basis for denial of entity treatment.”). These
amendments to the corporate and LLC acts should be read not as removing sole or
near–sole ownership from the list of factors considered in whether a predicate
case for piercing may be made, see
Inter–Tel Techs., Inc. v. Linn Station Props., LLC, 360 S.W.3d 152, 167–68
(Ky. 2012), but rather as precluding piercing on that basis alone.
It remains possible
for a single shareholder corporation to suffer domination jut as a
single-shareholder corporation may not be dominated. Under Inter-Tel, “domination” results in “a loss of corporate
separateness.” Inter-Tel, 360 S.W.3d
at 165. Domination is not itself a factor in support of piercing, but rather a
component of alter ego analysis.
But That’s Not the Problem
Okay, so in the view of the
Court of Appeals the trial court misapplied the Inter-Tel Technologies factors in finding that the veil of this
corporation should be pierced. But that
is not really the problem. Rather, it
did so in the context of reviewing a determination to grant A&M partial
summary judgment, and made its ruling in the context of the rules governing a
review of a grant of summary judgment. 2017 WL 4862510, *8. Except that piercing is a remedy, and a
court’s grant of a remedy is not subject to review under the standard which
governs the grant or denial of summary judgment.
But the Bigger Problem Is
Still, the bigger problem is
that the Court of Appeals did not apply Inter-Tel in determining whether the trial
court’s piercing of Jorusa was appropriate.
Under Kentucky law, piercing may take place under either of two
alternative tests: alter ego or
instrumentality. The various factors are
employed in these tests. As written in Inter-Tel (360 S.W.3d at 165):
A Kentucky trial court may proceed under the
traditional alter ego formulation or the instrumentality theory because the
tests are essentially interchangeable.
Each resolves to two dispositive elements: (1) domination of the
corporation resulting in a loss of corporate separateness and (2) circumstances under which continued recognition of the
corporation would sanction fraud or promote injustice.
While it is true the Court of
Appeals found that none of the Inter-Tel factors
was present (a questionable conclusion as set forth above), it never reviewed
how they would be employed in either an alterego or instrumentality analysis.
But Even Then, the Real
The real problem here is that
summary judgment should never have been requested, much less either denied or
granted, in this dispute. The trial
court, presumably following the lead of the plaintiff, treated piercing as a
cause of action. But it isn’t. Rather, piercing is an equitable remedy
employed to allow a judgment-creditor to collect a judgment against the owners
of a judgment-debtor. This is a central
point made in Phaedra Spradlin v. Beads
and Steeds Inns, LLC (In re Howland),
___ Fed. App’x ___, No. 16-5499, 2017 WL 24750, *4, 2017 U.S. App. LEXIS 222 (6th Cir. Jan. 3,
2017) (HERE IS A LINK to a review of that decision). Indeed, the Inter-Tel decision described piercing as being an “equitable
Piercing should not have been a
point of consideration until (1) the corporation’s liability (if any) was
determined and (2) it was found that the judgment could not be collected from
the corporation. Then and only then
should A&M have sought to pierce the veil of Jorusa in order to hold
Albakri liable for the deficiency.
On this day in 1558 Mary Tudor, who
would later have foisted upon her the moniker “Bloody,” died, leaving the
English throne to her half-sister Elizabeth. Where Mary's reign of just over 5
years was one of tumult at the highest political levels, for at least a
significant and perhaps a majority of the population it was a return to the
preferred old ways, a view put forth expertly by Professor Scarisbrick in his The
Reformation and the English People. Elizabeth's reign would by contrast be
seen as one of peace and growth, later dubbed the Gloriana. Elizabeth would
rule until 1603.
The Importance of
the “Purpose” Clause of the LLC’s Operating Agreement
In an article recently
published in the Journal of Passthrough Entities, I considered the
importance of a customized “purpose” clause in an LLC’s operating agreement
(guidance which is equally applicable to partnership agreements) and the
consequences of a generic “any lawful purpose” provision. That article is Purpose: If You Do Not Know Where You Are Going,
How Will You Know If You Have Arrived, 20 J.
Passthrough Entities 37 (Nov./Dec./2017).
HERE IS A LINK to the article.
Asking a Court to Enforce
an Illegal Agreement is at Best a Waste of Time
In a recent case from New York,
the court rejected efforts by a divorcing spouse to enforce claims on
professional LLCs in which he, the husband, was precluded by law from owning.
Specifically, the suit dealt with a number of dental practices which the
husband served as the business manager. In turn, his wife was the dentist.
Under New York law, only a dentist may own a dental practice. Essentially, he
wanted the court to say that he had a contractual right to one half of the
practices. The court rejected that notion. Savel
v. Savel, short form order, index No. 006375-15 (Sup. Ct. Nassau County May
Peter Mahler, in his blog New
York Business Divorce, reviewed this decision in a posting on November 6
titled Divorcing Husband not Smiling Over
Court’s Rejection of Ownership Interest in Wife’'s Dental Practice. HERE IS A LINK to that post.
IRS Addresses Tax
Treatment of Conversion of LLC into Limited Partnership
In a private letter ruling
released on November 9, 2017, the IRS addressed the tax consequences of the
conversion under state law of a limited liability company into a limited
partnership. Private Letter Ruling
201745005 (August 4, 2017; released November 9, 2017).
In this instance, a state law
limited liability company taxed as a partnership desired to convert into a
limited partnership. The LLC had as its members another LLC, it being taxed as
a corporation, and an LLC taxed as a disregarded entity. In the course of the
reorganization, those member entities, or their ultimate owners, would become
the partners in the limited partnership.
In reliance upon a Revenue
Ruling 84-52 and Revenue Ruling 95-37, as well as application of Section 708 of
the Internal Revenue Code, the IRS found that this transaction would not result
in the termination of the LLC or any of its members recognizing taxable income.
Kentucky Court of Appeals Interprets
and Applies “Or”
a decision rendered at the end of September, the Kentucky Court
of Appeals was called
upon to interpret and apply “or” in an LLC’s operating agreement. In this instance, the reading of the plaintiff, whose expulsion and redemption from the LLC was sought, was rejected, and a more commonsense
the operating agreement was adopted. Rogers v Family Practice
Properties of Lexington, LLC, No. 2015-CA-001557-MR, 2017 WL 4334111 (Ky. App. Sept. 29, 2017).
The plaintiff, Rogers, practiced medicine with and was a shareholder in Family Practice Associates
of Lexington, PSC (“Associates”). The Associates operated
owned by Family Practice Properties of Lexington, LLC (“Properties”), an entity which had overlapping, but not entirely contiguous, ownership with Associates. The operating agreement
of Properties, at Article 16.6, provided a mechanism under
which the interest of a member could be redeemed, including:
event that (a) a Member is no longer employed
by [Associates], or (b) in the case of any Members who are shareholders
in [Associates], such Member is no longer a shareholder in [Associates].
This dispute would turn upon the “or” between subsections (a) and (b) quoted above.
In November, 2012, Rogers was advised by Associates that it was terminated
effective January 18, 2013.
(except Rogers) held a meeting in which they elected to exercise the option to redeem his interest therein. While there was some back-and-forth
to the selection of appraisers, Rogers ultimately
took the position that Properties had
no right to redeem his interest because, while he was no longer employed
by Associates, he remained a shareholder in Associates. On that basis, he asserted no right of redemption could
take place. Rather:
Dr. Rogers argued that the Operating Agreement
is plain and unambiguous
and that the word “or” as used in Article 16.6 of the Operating Agreement
is disjunctive. Accordingly, Dr. Rogers argued that the correct interpretation of
is that a member of Properties
who is not a shareholder of
bought-out of Properties once
Associates was terminated, but a member of Properties was/is also a shareholder of
only be involuntary bought-out when that member ceased to be a shareholder
Finding that the contract was not ambiguous, a position adopted by all the parties hereto, the court began by noting “our interpretation of
limited to the plain meaning of its express terms.” From there it determined that:
As used in Article 16.6, the word “or” denotes that there are two alternatives, either which will give Properties the option to purchase a Member’s interest. Dr. Rogers is undisputedly
a Member of Properties, as defined in the recitals of the Operating Agreement. Therefore, Properties has the option to purchase his membership interest
from him when either his employment
or his ownership interest in Associates is terminated. Dr. Rogers was terminated from
January 18, 2013, triggering Properties’ right to exercise its option under Article 16.6(a). 2017 WL 4334111,*4 (emphasis