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Professor Conaway on Veil-Piercing in LLCs

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On My Mind
Professor Ann E. Conaway
Widener University School of Law
Wilmington, DE

In recent months, I have had the opportunity to re-examine a longstanding Delaware corporate equitable principle – that of piercing the corporate veil on the basis of alter ego. My opportunity was sparked by an expert case in South Carolina that arose in the context of several Delaware LLCs organized as parent-subsidiaries in a real estate condominium conversion. In my research, I found three Delaware Chancery Court opinions that each assumed, without any explanation or supportive reasoning, that Delaware corporate alter ego principles should apply in toto to Delaware LLCs. After extensive research and thought on the matter, I respectfully disagree with the Delaware Courts and advocate instead the abolition of the veil piercing doctrine in favor of a test of fraud or illegality in the case where a Delaware LLC franchise is being sought to be pierced.

First, the Delaware corporate cases are in a somewhat confused state. The Delaware Courts appear to apply the alter ego test to corporations in two circumstances: (1) when trying to impose liability on a natural person who is the sole or dominant shareholder of a corporation; and (2) in a parent-subsidiary context. In most jurisdictions, alter ego is properly applied in the first scenario since the corporate shield is being used as an “alter ego” for the natural person’s individual, non-business activities. In the second scenario, traditional corporate dogma does not apply an alter ego test since: (1) control is always present; (2) transferring funds from the sub to the parent is legal; (3) corporate formalities are more likely to be present between separate legal entities; and (4) capitalization alone is never dispositive for piercing. Instead, as between two independent legal entities, the test is generally proof of fraud or illegality. Indeed the Delaware Courts, after paying lip service to the terms alter ego, avoid application of the factual tests of that theory and move directly to a determination of fraud, illegality or injustice in the use of the corporate franchise.

In an unusual Chancery Court opinion, VC Parsons pierced the veil of a Delaware corporation to reach a natural, individual shareholder in Midlands Interiors, Inc. v. Burleigh, 2006 Del.Ch. LEXIS 20 (Dec. 19, 2006). Without citing the equitable theory of alter ego, the Court found that there was clear evidence of fraud where an administratively dissolved corporation continued to conduct the exact same business with creditors notwithstanding its known dissolution. The case, when it first was published, caused some concern among the Delaware Bar. However, some comfort could be gained from the fact that the elements of alter ego did not sustain the Court’s holding. Rather, an egregious set of fraudulent facts led the Court to its finding – a standard higher than “alter ego.”

So, what’s on my mind? In light of the recent Delaware Supreme Court opinion in CML V v. Bax, the Supreme Court made clear that investors have a “choice” between a corporation and an unincorporated entity. That choice, according to the Supreme Court, affects the law that applies to the entity. As the Supreme Court made obvious in CML V, corporate law has no place in Delaware LLCs. Specifically, as regards to the “alter ego” test: (1) LLCs have no “corporate formalities” and to the extent an operating agreement imposes “formalities,” those formalities are meant solely for the parties to the agreement and do not affect limited liability; (2) the “dominant shareholder” factor is irrelevant in LLC law where a “dominant” member may be a non-economic member; and (3) “undercapitalization” by shareholders is also a non-relevant concept in LLC law, since members in an LLC are not required to make contributions to become members. In sum, the alter ego theory of corporate law is premised on pro rata ownership of stock and other mandatory corporate organizational and operational rules. Virtually no “mandatory” rules exist in LLC law.

Further, an “alter ego” test for piercing should never be used to ignore the internal shields of a Delaware “series” LLC. Unlike a regular LLC, a “series” LLC permits an allocation of property, obligations or assets of the LLC into “cells” or “units” if the certificate of formation gives notice of the series and its internal limitation on liability. A Delaware series may then grant any rights, duties, profits, losses or management rights to be associated with any particular series. Separate books must be kept for each series. Each series may have an independent business or investment purpose. According to the 2007 amendments to the series, a series may sue, be sued, or contract in is own name and may grant security interests or liens. A series under Delaware law is not an entity. A series is, however, a person under the statute. If a creditor gets a judgment against a series and the assets are insufficient to pay the judgment, it is suggested in some commentary that veil piercing is available. The notion is that the veil is pierced to reach the “assets” of the series. Yet, this argument is misleading. The judgment reaches the assets. A veil piercing action ostensibly seeks to pierce the internal wall of liability limitation and impose personal liability on those persons associated with the series whether they are members, managers or other persons named under the operating agreement. If veil piercing is available in this context, it makes even less sense to use “alter ego.” The only fair test must be clear evidence of fraud or illegality – with an attempt to avoid liability not constituting fraud or illegality. In any event, veil piercing in the circumstance of a series should never permit a judgment to leap from one series to another – that concept is consolidation and is best left to the bankruptcy courts.

So what is the answer to this conundrum? Because Delaware has consistently required proof of fraud and illegality in addition to the “true” alter ego cases, it only makes sense to eliminate the corporate paradigm from LLC law and instead to replace it with the consistent Delaware standard of factual proof of fraud or illegality in the use of the LLC franchise (or series thereof) to perpetuate social injustice.

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