Liability exposure is one consideration owners have when debating about which type of business they should form (LLC, Partnership, etc.).
There is a distinction between inside and outside liability exposure:
- Inside: owner exposure on business obligations.
- Outside: business exposure on owner obligations.
Inside Liability Exposure
Inside liability exposure refers to the potential liability owners of a business may personally have. Essentially, this is why businesses often form as Corporations, LLCs, or LLPs, so there is an existing liability shield. Most often, those who want internal liability protection choose Corporations or LLCs because they provide even more protection than LLPs.
However, even this protection can be shattered. There are two ways this occurs. First, by direct liability. If an owner engages in a tort (even while going about normal business activities), that owner will still be personally liable to the victim and will not be shielded. Second, by a process called veil piercing. This is when the courts determine that the shield should not apply in that specific instance. The only problem is, the factors applied when determining whether the veil pierce are inconsistent.
GreenHunter Energy, Inc. v. Western Ecosystems Technology, Inc.
337 P.2d 454 (Wyo. 2014).
GreenHunter lost and appealed.
Should the liability shield be pierced?
The liability shield can be pierced if:
- The LLC is not really separate from the owners due to misuse of the LLC and
- The facts would lead to injustice, unfairness, or inequality.
To determine if these elements are met the court will consider:
- Fraud (usually required to pierce, and can be a sole reason for the piercing)
- Inadequate capitalization
- The degree of intermingled finances
The veil should be pierced, affirmed.
GreenHunter LLC entered into a contract with Western. Western upheld their side of the deal but the LLC failed to pay up. When Western obtained a judgment against the LLC and was unable to collect, they sued GreenHunter, Inc., the sole owner of the LLC. They argued that because the owner mimicked the LLC almost exactly, the liability shield should be pierced and the owner should cover the judgment of the LLC.
Piercing has had a long and complicated history. Ultimately, the purpose of the pierce was to prevent corporations from abusing the liability shield. As such, the following factors could be evaluated to determine whether a piercing should occur:
First, fraud. Obviously, you do not want a business to simply be using the liability shield to create fraudulent transactions.
Second, inadequate capitalization. This is an indicator that the liability shield was established simply to provide liability. This is usually an indicator that there is not enough capital to keep the business running. Thus, the only purpose is for the liability protection. This can be determined by evaluating how much effort the business put in to obtaining capital and what the acquired capital is being used for.
Finally, the degree of intermingled finances. This goes to tax returns and other accounts. If the owner and the LLC basically share the same documents, it is clear that they are really one in the same. Although not sufficient on its own to establish a pierce, combined with the inadequate capitalization (or fraud), this factor may be influential.
Although there is nothing wrong with a holding company (a company owning a subsidiary company), the subsidiary should have all of their own features. That is, own employees, own accounts, own finances, etc.
Ultimately, there are two takeaways if: 1) separateness ceases to exist and 2) it results in unfairness, then there are grounds for piercing.
Outside Liability Exposure
This refers to the owners assets within the company to be protected from outside creditors. For instance, if an owner gets into a lawsuit and has a controlling interest in the company, LLCs would protect the owners interest from being seized if there is a judgment.
There is an exception to this rule. That is, the party could obtain a foreclosure against the owner. Even in this case though, often times the company assets are still protected. There is another exception to this rule. A creditor could go to the courts and request that the LLC is dissolved. At this point, the creditor could then liquidate assets to satisfy any judgment.
In re Albright
291 B.R. 538 (Bank. C. Dolo. 2003).
Albright was in bankruptcy court and a creditor was trying to reach the assets of his business. He was the sole-member of an LLC
Because Albright was a sole member of a LLC, there is no need to protect the assets of other owners. As such, the business assets can be reached to justify the debt of the sole member.
Reverse Veil Piercing
C.F. Trust, Inc. v. First Flight Limited Partnership
C.F. Trust, and Atlantic Funding had promissory notes totaling about $8,000,000 which were signed by Peterson. Peterson owned First Flight and Birchwood Holding. From the facts presented, it appears that Peterson deliberately defaulted on the notes, a judgment was obtained against him and he refused to ay. C.F. Trust then sought this remedy of reverse veil piercing seeking to obtain the assets of First Flight. The reason for this is because First Flight was owned by Peterson and his son. Although he was not receiving direct payments, he had given instructions that the businesses should pay for his personal expenses, under the guise that they were “repaying their loan.”
The court adopts the theory of reverse veil piercing. Ultimately, reverse veil piercing works the same way as a traditional veil piercing. The difference between the two are whose assets are going to be reached.
Reaching corporate assets.
The content contained in this article may contain inaccuracies and is not intended to reflect the opinions, views, beliefs, or practices of any academic professor or publication. Instead, this content is a reflection on the author’s understanding of the law and legal practices.