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.

On Charging Orders, Bankruptcy, and the Scope of the Automatic Stay

On Charging Orders, Bankruptcy, and the Scope of the Automatic Stay

      In a recent decision out of Louisiana, the Federal District Court, sitting as the appellate court from a Bankruptcy Court, pointed out some important issues to be considered in connection with the bankruptcy of an individual member of an LLC and the scope of the automatic stay. In this instance, certain of those important matters had not been fully considered by the Bankruptcy Court. For that reason, remand was ordered. In the Matter of: Thomas Mack and Mary Susan Mack, Civ. Act. No. 17-3587, 2018 WL 1532979 (E.D. LA. March 29, 2018).

 

Consequent to some financial setbacks, Thomas Mack, along with certain others, was held liable to First Bank for some $400,000 plus attorneys’ fees and additional collection costs. Mack, in turn, was a member in two LLCs, but the only one relevant to the opinion was Matrix Hospitality Group, L.L.C. Therein, he held a 60% membership interest, and apparently it was only through Matrix that Mack had any income, specifically:

Mack is paid by Matrix in three ways: (1) a monthly salary as a 1099 employee; (2) a periodic disbursement of profits as a part-owner; and (3) a performance bonus paid in April by particular clients if Matrix is able to meet client-set goals.

Seeking to collect on the judgment debt of approximately $400,000, First Bank sought a charging order against Mack’s interest in Matrix. The charging order was awarded and served on the company, but it failed to respond in accordance with Louisiana procedure. In addition, Matrix made distributions to Mack after the charging order was served. When legal action was then initiated against Matrix, Mack (both Thomas and Mary Susan) filed for Chapter 11 bankruptcy. At that point, the value of First Bank’s judgment had increased to $789,212.85.

From there the chronology of what happened gets somewhat confusing. What is known is that, on January 31, 2017, First Bank moved for relief from the automatic stay. Ultimately that relief was denied.

The reason this is confusing is that when a member files for bankruptcy, and the LLC is not itself in bankruptcy, and activities of the LLC are not automatically subject to the automatic stay there is an exception to this rule when, in the presence of “unusual circumstances,” “there is such identity between the debtor and the third-party defendant at the debtor may be said to be the real party defendant and that a judgment against the third-party defendant will in effect be a judgment or finding against the debtor.” 2018 WL 1532979, *3. In those circumstances, the automatic stay may extend to a non-debtor, in this instance Matrix. In this instance, however,:

The Court is unable to evaluate the Bankruptcy Court’s decision in denying the modification of the scope [of the automatic stay] because the Bankruptcy Court never made a finding on whether the scope of the stay included Matrix. Although it is arguably implied that the Bankruptcy Court determined that it did because it denied First Bank’s motion for relief, neither party raised the issue and the Bankruptcy Court did not state on the record whether the automatic stay applies to Matrix. Further, the Bankruptcy Court held that First Bank had the burden to modify the automatic stay, but the appellees [i.e., Mack], the parties seeking to maintain the stay, actually had the burden. The Bankruptcy Court failed to apply the appropriate standard to determine if modifying the stay was appropriate. Because the Bankruptcy Court did not require the appellees to meet their burden, the factual record is not sufficiently developed for this Court to determine whether the circumstances justify the rare finding that the stay applies to non-debtors [i.e. Matrix].

Id. (bracketed language added).

So the matter will go back to the Bankruptcy Court to determine whether Matrix and Mack are of such unitary interests that First Bank cannot, outside of the bankruptcy proceedings, seek to enforce its judgment by means of a charging order.

Fiduciary Duties Not Limited to Members In An LLC

Fiduciary Duties Not Limited to Members In An LLC

In a recent decision from Illinois, there applying Delaware law, the court considered and rejected the suggestion that not being a member in an LLC precludes fiduciary duties. Rather, the court found that the defendant, who had been an employee of the plaintiff LLC, may have violated fiduciary obligations arising consequent to the employment relationship. Act II Jewelry, LLC v. Elizabeth Ann Wooten, Case No. 15 C 6950, 2018 WL 1316715 (N.D. Ill. March 14, 2018).

The defendant Wooten was the Vice President of Product Development for Act II Jewelry, LLC, a company that marketed and sold jewelry through a sales representative network who held parties in customer homes. At the end of 2014, Act II determined that it was going to wind down its business model. Before that announcement, however, Wooten had organized a new LLC with the intention that it engage in the jewelry business through the direct sale model.

After addressing and resolving the question as to whether Illinois, where Wooten was located, or Delaware, where Act II was organized, law should apply, ultimately determining that it should be Delaware, the question became whether Wooten’s conduct, in setting up a new venture while still an employee of Act II violated her fiduciary obligations. Wooten defended on the basis that “only controlling members and managers of an LLC who are named as such in the LLC’s operating agreement owe fiduciary duties to the company.” 2018 WL 1316715,*7. Having never been a member or manager in Act II, she continued, no fiduciary duties could arise. The Court rejected this argument, holding rather that the allocation of fiduciary obligations among the members and the managers of an LLC pursuant to the Delaware LLC Act “does not govern the duties owed by employees who are not parties to the LLC’s operating agreement (or even those addressed within it).” Id. Rather:

Employees are not governed by an LLC’s operating agreement, but rather by employment contracts and traditional rules of agency. Many employees never read the operating agreement of the LLC and certainly have nothing to do with ownership decisions, even if the role they play in the business is vital. The LLC’s operating agreement may modify fiduciary duties imposed by the parties to that agreement, but to widen its control beyond what is specifically contemplated - especially to completely eradicate the entire doctrine of agency - goes too far.

Id. The court reviewed a variety of decisions which stand for the proposition that employees may owe fiduciary obligations to the employer, those obligations arising out of the law of agency. On that basis, rejecting Wooten’s motion for summary judgment seeking the dismissal of the fiduciary duty claims, the court wrote:

Thus, Wooten, may owe fiduciary duties to Act II if the plaintiff established that she was a key managerial employee and/or an agent of Act II. Whether those duties were breached we leave for another day.

Id., *8

Stoll Keenon Ogden at the Spring Meeting of the ABA Section of Business Law

Stoll Keenon Ogden at the Spring Meeting of the ABA Section of Business Law

Next week, the Section of Business Law of the American Bar Association will be meeting in Orlando. At the meeting, Lea Goff will be part of a panel discussing bankruptcy remote structures. A.J. Singleton will be on a panel discussing legal ethics and who is the client when an attorney is representing an LLC. I will be involved in several programs of the LLCs/Partnership Committee and the Corporate Laws Committee.

Kentucky Tax Reform

Kentucky Tax Reform

Tim Eifler and others in the State & Federal Tax Practice Group of Stoll Keenon Ogden have prepared a comprehensive review of H.B. 366, the 2018 Tax Reform. This new law occasions numerous significant changes to the tax law including the imposition of sales tax on a variety of services, changes in corporate and individual tax rates, a change in the apportionment formula and the elimination of the angel investor program.

HERE IS A LINK to this review.

The Obligation of Good Faith and Fair Dealing Versus Hanaway

The Obligation of Good Faith and Fair Dealing Versus Hanaway

Last year, the Pennsylvania Supreme Court, in considering challenges to actions taken by the general partner of a limited partnership, held that the contractual obligation of good faith and fair dealing is not applicable in limited partnership agreements formed under what are now the prior statutes. Characterizing limited partnership agreements as being different than typical contracts, the court found that they do not include the implied contractual covenant of good faith and fair dealing because the controlling Limited Partnership Act did not impose that obligation in limited partnership agreement. This is in contrast with the most modern of those statutes, which expressly incorporates the implied covenant of good faith and fair dealing.

My personal view is that this decision is simply wrong, and that every limited partnership agreement, as a contract, incorporates the obligation of good faith and fair dealing. The Journal of Passthrough Entities last week released my review of the Hanaway decision; HERE IS A LINK to that article.

Kentucky Tax Reform

Kentucky Tax Reform

            The General Assembly has approved and sent to the Governor significant changes in Kentucky’s tax code.  HERE IS A LINK to the review prepared by Dean Dorton Allen Ford.