Outsider Reverse Piercing of a Delaware LLC: The Fourth Circuit Court of Appeals Says It Can Happen

Outsider Reverse Piercing of a Delaware LLC: The Fourth Circuit Court of Appeals Says It Can Happen

In a recent decision from the Fourth Circuit Court of Appeals, it applying Delaware law, it was held that, on the facts presented, a single-member Delaware LLC may be reverse pierced with the effect that the assets of the LLC may be applied to the sole member’s judgment-debt. In doing so the court also addressed an always vexing question, namely personal jurisdiction over the party being held liable on the debt. Sky Cable, LLC v. DIRECTV, Inc., __ F.3d __, 2018 WL 1514413 (4^th Cir. March 28, 2018).

In 2013, Brandy Coley was found liable in the connection with a fraudulent scheme pursuant to which he provided content from DIRECTV to more than 2300 individual customers even while remitting payment for only 168 units. That judgment exceeded $2.3 million. Seeking to collect on that judgment, DIRECTV sought to pierce a trio of LLCs in which Coley was the sole member in order to “obtain access to the LLCs’ assets.” 2018 WL 1514413, *2. None of those LLCs had been party to the case against Coley and had not been served with process in connection therewith. The trial court, applying Delaware law found that an LLC could be reverse pierced and that:

(1) under Delaware law, the three LLCs were alter egos of Mr. Coley, and

(2) that Delaware would recognize reverse veil piercing under such circumstances.

Id. (footnote omitted).

In addition, it was held by the District Court that DirecTV’s failure to serve process on the LLCs did not prevent the court from exercising jurisdiction over them. Id. On appeal, each of these determinations would be affirmed.

Before continuing with the merits, there was as well a side discussion going on based upon an after-the-fact assertion by Coley’s spouse that she was a member in the LLCs. Reading between the lines, as she was not liable on the judgment in favor of First Bank, she wanted to assert an interest in the LLCs in order to defeat a reverse pierce on the basis that it would be detrimental to a person not liable on the judgment itself. However, earlier in the action, based on affidavits submitted to the effect she was not a member, she had been dismissed from the action. Applying principles of collateral estoppel, her efforts to reverse that position were rejected.

The challenges to the reverse pierce effected by the District Court were challenged on a pair of bases, namely that Delaware does not recognize reverse piercing and that the charging order provision of the Delaware LLC Act should set forth the exclusive remedy of a judgment creditor, thereby precluding a reverse pierce. Both of these arguments were rejected.

Reverse Piercing of a Delaware LLC

The Fourth Circuit began by reviewing on a number of veil piercing cases arising under Delaware law and discussing the nature of reverse piercing in both the insider and outsider realms, noting almost in passing that Delaware, being the jurisdiction of organization of the LLC, set the controlling law. From there reviewing a variety of Delaware cases as to the requirements for satisfying it’s alter ego test, it wrote:

Just as traditional veil piercing permits a court to hold a member liable for a company’s actions, reverse veil piercing permits a court to hold a company liable for the member’s actions if recognizing the corporate form would cause fraud or similar injustice.

Reverse veil piercing is particularly appropriate when an LLC has a single member, because the circumstances alleviate any concern regarding the effective veil piercing on other members who may have an interest in the assets of an LLC. Therefore, when an entity and its sole member are alter egos, the rationale supporting reverse veil piercing is especially strong.

Id., *5.

The court noted as well that Delaware has an interest in precluding the use of the business entities it allows to come into existence to be used for improper purposes. Therefore, the Fourth Circuit held that reverse feel piercing of the single-member LLC organized in Delaware is permissible.

Charging Order Exclusivity

Turning to the question of the charging order, the court found that reverse piercing is not in the nature of a remedy that is intended to be excluded by the “exclusivity” provision of the LLC Act’s charging order provision.

Finding Cooley to be the Alter Ego of the LLCs

Which then brought the opinion to the question of whether the District Court had properly determined that the LLCs at issue were Coley’s alter egos and therefore subject to piercing.

First, the court considered what is Delaware’s law on piercing. While acknowledging that it is not formulaic, in reliance upon NetJets Aviation, Inc. v. LHC Commc’ns, LLC, 537 F.3d 168 (2d Cir. 2008), the Fourth Circuit wrote:

In Delaware, to prevail under an alter ego theory, a plaintiff is not required to show “actual fraud that must show a mingling of the operations of the entity and its owner plus an ‘overall element of injustice or unfairness.’”

In this instance, it had been and was again found that Coley operated all three of the companies and himself as a “single economic entity in which money flows freely between them at [Mr.] Coley’s whim.” Id at *8. For example, it found:

The evidence that Mr. Coley and his LLCs are alter egos is substantial. Mr. Coley clearly controls ITT and, on multiple occasions, testified pre-judgment that he is ITT’s sole member. Mrs. Coley separately testified that she had no ownership interest in any of Mr. Coley’s business entities and was not a member of ITT.  Mr. Coley also produced an operating agreement during pre-judgment discovery listing himself as ITT’s only member, and testified that he is the only one who “get[s] a check” from his LLCs.

There is also abundant evidence in the record that Mr. Coley and his LLCs commingled their funds. Mr. Coley failed to keep complete records of how and why funds were deposited from one LLC’s account into another LLC’s account, or into his personal accounts. Checks made out to “East Coast Sales” were sometimes deposited into Mr. Coley’s personal account. However, Mr. Coley also received income directly from East Coast. Mr. Coley even reported East Coast’s profit and loss on his individual tax return. Yet, in his deposition testimony, Mr. Coley could not explain the amounts that he received from his LLCs as salary and other income.  ….

Funds also were transferred freely among the LLCs. For example, South Raleigh and East Coast collected the rental revenue on properties owned by ITT, but South Raleigh and East Coast then transferred that revenue, less their expenses, to ITT as profit. Mr. Coley failed to explain why the revenue did not go directly to ITT, the owner of the properties. And when asked why certain transfers of funds also were made from ITT to one of the other LLCs, Mr. Coley had no explanation.

Mr. Coley also testified that payments for ITT’s “major expenses” frequently were transferred from another LLC to ITT. He stated that these expenses included “major thing[s] like taxes, insurance, taxes, we make sure it’s all paid out of [ITT].” Other expenses, however, were paid by another LLC, without passing through ITT. For example, Mr. Coley speculated that certain checks written from the South Raleigh account might have been used to pay “HOA fees” on the properties owned by ITT. Yet, he stated confusingly that those checks “are paid to South Raleigh Air. [But t]hey are [ITT’s] money.” Still other funds from Mr. Coley’s LLCs were used to pay loans on two vehicles for which Mr. Coley personally was the borrower.

Finally, the LLCs also made payments on mortgages for properties owned by ITT. Mr. Coley testified that on one such property, East Coast made payments on the mortgage loan, but that he and his wife were the borrowers. South Raleigh also made mortgage payments on a separate property owned by ITT, for which Mr. and Mrs. Coley were the borrowers. Moreover, even the mortgage on Mr. Coley’s personal residence was paid by one of his LLCs. Nevertheless, Mr. Coley took the mortgage interest deduction on such properties on his personal tax return. This cumulative evidence strongly indicates that Mr. Coley and his LLCs were in fact a single economic entity utterly dominated and controlled by Mr. Coley. We also conclude that an “overall element of injustice or unfairness” is present in this case, because DIRECTV has not received any payment on its judgment against Mr. Coley although the district court found Mr. Coley liable over four years ago. We therefore hold that the district court’s finding that ITT and Mr. Coley are alter egos was not clearly erroneous.

Id. at *8-9 (citations and footnote omitted)

Jurisdiction Over the Pierced LLCs

Coley asserted that as the LLCs who are subject to being pierced were not parties to the action, the judgment cannot be enforced against them. The court quickly dispatched this argument, holding, inter alia, that if there was jurisdiction over the judgment-debtor, with respect to each business organization who is the judgment-debtor’s alter ego, there exist jurisdiction over the alter ego. Therefore, while “service of process is a precondition to the court’s exercise of personal jurisdiction over a defendant.”, “When a court has engaged in traditional veil piercing, the court may exercise personal jurisdiction vicariously over an individual, if the court has jurisdiction over the individual’s alter ego company.” Id. at *9.

All in all a quite satisfying decision.