Veil Piercing

When On February 2, 2012, the Colorado Court of Appeals issued its opinion in the case of Martin vs. Freeman, a case that is important for all limited liability company owners who want to avoid becoming liable for the debts of their LLC.

The Facts

Dean C.B. Freeman was the sole member and manager of Tradewinds Group, LLC, a Colorado limited liability company.  Tradewinds only asset was an airplane that it owed free and clear with a value of approximately $300,000.  Tradewinds hired Robert L. Martin to build an airplane hangar for its airplane. Tradewinds sued Martin in 2006 for breach of the construction  contract. In 2007 Tradewinds sold the airplane for $300,000.  After making sure that all creditors were paid Freeman caused the LLC to pay him all funds that remained in the LLC’s bank account.  Thereafter Freeman paid all of Tradewinds’ litigation expenses from his funds.

In 2008, the trial court entered a judgment in favor of Tradewinds. Martin appealed and won the appeal. The Colorado Court of Appeals found that Tradewinds’ damages were speculative and sent the case back to the trial court with directions to enter judgment in favor of Martin. The trial court ruled in 2010 that Martin was the prevailing party and awarded him $36,645.40 in costs.

 When Martin won the $36,645 judgment against Tradewinds Group, LLC, it did not have any because it had sold its only asset and paid all of the company’s funds to its sole member, Dean Freeman. Martin then sued to pierce the LLC veil and collect Tradewinds’ debt from Freeman, the sole member of the LLC.

The primary issue before the Colorado Court of Appeals was should the court allow Martin to pierce the LLC’s veil and hold its sole member liable for Martin’s judgment against Tradewinds Group, LLC? The appellate court stated:

“To pierce the LLC veil, the court must conclude

1. the corporate entity is an alter ego or mere instrumentality;
2. the corporate form was used to perpetrate a fraud or defeat a rightful claim; and
3. an equitable result would be achieved by disregarding the corporate form.”

The Colorado Court of Appeals in a two to one decision ruled that all three criteria existed and that Dean C.B. Freeman was personally obligated to pay the judgment owed to Robert L. Martin.

1st Factor:  Alter Ego

The majority’s opinion says that courts consider a variety of factors in determining alter ego status, including whether:

1. “the entity is operated as a distinct business entity;
2. funds and assets are commingled;
3. adequate corporate records are maintained;
4. the nature and form of the entity’s ownership and control facilitate insider misuse;
5. the business is thinly capitalized;
6. the entity is used as a mere shell;
7. legal formalities are disregarded; and
8. entity funds or assets are used for non-entity purposes.”

The Court does not, however, tell us if alter ego status exists if a majority of the factors exist or if all all of the factors must exist or it is is merely a gut feeling determined by the court that sufficient factors exist to justify a finding that the company was the alter ego of the member.  The Court found the following facts that justified its conclusion Tradewinds was Freeman’s alter ego:

• “Tradewinds’ assets were commingled with Freeman’s personal assets and the assets of one of his other entities, Aircraft Storage LLC;

•  Tradewinds maintained negligible corporate records;

•  the records concerning Tradewinds’ substantive transactions were inadequate;

•  the fact that a single individual served as the entity’s sole member and manager facilitated misuse;

•  the entity was thinly capitalized;

•  undocumented infusions of cash were required to pay all of Tradewinds’ operating expenses, including its litigation expenses;

•  Tradewinds was never operated as an active business; legal formalities were disregarded;

•  Freeman paid Tradewinds’ debts without characterizing the transactions;

•  Tradewinds’ assets, including the airplane, were used for non­entity purposes in that the plane was used by Aircraft Storage LLC, without agreement or compensation;

•  Tradewinds was operated as a mere assetless shell, and the proceeds of the sale of its only significant asset, the airplane, were diverted from the entity to Freeman’s personal account.”

2nd Factor:  Defeat of a Rightful Claim

The Court stated:

“The second prong of the veil-piercing test is whether justice requires recognizing the substance of the relationship between the corporation and the person or entity sought to be held liable over the form because the corporate fiction was ‘used to perpetrate a fraud or defeat a rightful claim.”

The Court went on to make the unfortunate statement that there is no Colorado case that ruled “that a party seeking to pierce the corporate veil must show wrongful intent.”  The Court found:

“We conclude that defeating a potential creditor’s claim is sufficient to support the second prong. We further conclude, as a matter of first impression, that wrongful intent or bad faith need not be shown to pierce the LLC veil.”

The Court’s ruling effectively throws out the second prong of the three prong alter ego test and ignores 100+ years of corporate law.  If a company has assets sufficient to pay its debt, the creditor does not need to sue the owner and try to pierce the corporate/company veil.  It is only when the company cannot pay its debt that a creditor will sue the owner in an attempt to collect the company’s debt from the owner.

The corporate and LLC law of most if not all states provides that a fundamental asset protection concept is that the owners of the entity are not liable for the entity’s debts or obligations.  It may be appropriate in some cases to find that a rightful claim of a creditor should be paid by an owner of the company after a court finding that the company was the owner’s alter ego and used to perpetrate a fraud, but the mere fact that the creditor was not paid should never be considered and used to find the owner liable.  If people will be held liable for the debts of a company simply because the company has unpaid debts it will have a chilling affect on business and prevent many people from investing in businesses that would hire employees.

3rd Factor: Equitable Result

The Court did not discuss the facts that support a finding that an equitable result would be achieved by disregarding the corporate form, nor did it rule on the issue.  Apparently Colorado now has a two prong test to determine if the when a Colorado court will pierce the company veil and hold the owner of an LLC liable for its debts.

Let’s hope this case is appealed because it is bad law for the owners of LLCs, corporations, limited partnerships, limited liability partnerships and limited liability limited partnerships.

What Martin v. Freeman Means for LLC Members

Some commentators have written that this case is another reason people should shy away from the single member limited liability company.  I disagree.  The court did not discuss that the fact the LLC had only one member was significant.  What was significant to the court was the historical facts as to how the LLC operated and conducted its affairs.  The case stands for the proposition that LLC owners, both single and multiple members) must follow the formalities of operating the company or risk having the veil pierced and the owners becoming liable for the LLC’s debts.

Consider the facts that the Court found that cased it to conclude that the company was Freeman’s alter ego:

1.  Tradewinds’ assets were commingled with Freeman’s personal assets and the assets of one of his other entities, Aircraft Storage LLC:  This is a fundamental no no.  Never allow assets of a member to be commingled with the company’s assets.

 2.  Tradewinds maintained negligible corporate records:  Again this is a no brainer.

Your LLC must maintain a good set of financial books.  Use Quickbooks.  Have an experienced Quickbooks expert set it up.  It’s not too expensive.  Make sure all income and expenses are entered and properly annotated.

If you loan money to your LLC, the books must show the date and amount of the loan and the loan should be documented by a promissory note signed by the LLC and a resolution signed by all of the members that authorizes the loan.

If you transfer assets to the company, prepare a Bill of Sale signed by the transferor that lists the assets transferred as of the stated date.  If you are an employee of the company, sign an employment agreement with the company and have the members sign a resolution authorizing the LLC to enter into the employment agreement.

If the company enters into a contract with a third party have the members sign a resolution authorizing the LLC to enter into the contract.

 3.  The records concerning Tradewinds’ substantive transactions were inadequate:  The tasks listed in the prior paragraph apply here too.  In addition, one of the best things every LLC should do is routinely document all significant major actions taken by the company with minutes or resolutions signed by the members.  Here is a partial list of company actions that EVERY LLC should document with minutes or resolutions:

Contributions of money or property by a member to the LLC.

Loans of money by a member to the LLC.

Adding or removing a member.

Changing the percentage ownership of a member.

Employing a member or key employee.

Hiring an independent contractor.

Buying, selling or leasing real property or personal property with significant value.

Entering into contracts with third parties.

Purchasing insurance.

Applying for licenses such as a real estate broker’s license or a contractor’s license.

Doing business in another state.

Entering into an Operating Agreement with the members.

Entering into a Buy Sell Agreement with the members.

An annual meeting of members and managers (if manager managed).

It is imperative that the members of the company document all significant actions taken by the company with minutes or resolutions.  I know from being a business lawyer since 1980 that very few companies have the self discipline to document their actions.  Routinely documenting transactions is one of the most important things the members of an LLC should do to prevent a court from finding that the company was the alter ego of the members.

3.  Solution to the Lack of Records Problem: Prepare minutes and resolutions and have them signed by the members and managers.

 4.  The fact that a single individual served as the entity’s sole member and manager facilitated misuse:  Note the Court said that having a single member “facilitated” misuse.  It did not say that having a single member LLC is always a negative factor.  The Court recognized that doting the eyes and crossing the tees is less likely to occur with a single member LLC because it takes more self discipline to have meetings with yourself and document those meetings.  This fact of life is another reason why it is particularly important for single member LLCs to follow all of the formalities of operating the LLC and using a minutes service like Just a Minute.

 5.  The entity was thinly capitalized:  The law requires that every LLC to be adequately capitalized, but it does not give LLC owners a clue as to what that term means.  Adequate capitalization for an LLC means the company must always have sufficient assets for its needs, but the law doesn’t tell LLC owners exactly what constitutes adequate capitalization.  LLC owners only know if their company is adequately capitalized years later if they are sued and a judge or jury rules one way or the other on the issue.  Another problem is that adequate capitalization is a moving target because the number changes as the LLCs business facts and circumstances change.  If the LLC does not have sufficient assets to meet its capital needs then it is not adequately capitalized.  However, if the LLC does have sufficient assets to meet its capital needs a court could still find the company was not adequately capitalized.  Remedy:  Make sure the company has sufficient capital to pay its expenses plus a reserve of as much as you can afford and hope that if your LLC is ever challenged the judge or the jury will rule in your favor.

6.  Undocumented infusions of cash were required to pay all of Tradewinds’ operating expenses, including its litigation expenses:  This is a common problem that is easily avoided.  If your LLC needs money there are two ways to get the money: (a) one or more members make a capital contribution to the company, or (b) the company borrows money from one or more members or a third party lender.

Capital  Contributions:  A capital contribution is a gift of money or property by a member of an LLC to the company.  The company is not obligated to repay the contribution at any time except on liquidation if the contribution was not previously repaid.  The company should document all capital contributions by: (a) making a proper entry in the company’s books that the member made a contribution of $x on a specified date, and (b) having the members sign minutes or a resolution that authorizes and approves the contribution.

 Loans:  Regardless of who loans money to the LLC, the loan must always properly documented by: (a) having the LLC sign a promissory note that states the loan amount, interest rate and repayment terms, and (b) having the members sign minutes or a resolution that authorizes and approves the loan.  For more on this topic see my article called “How Do I Loan Money to My LLC?“

Undocumented infusions of cash are a routine event in most LLCs, but that does not make it right.  Protect yourself by always documenting cash infusions.  It’s easy to do and could make the difference between whether a court will one day allow or refuse to allow a creditor of the company to get a judgment against you.  Undocumented cash infusions should never happen if you use a minutes service like Just a Minute, LLC, to automate the preparation of minutes on a monthly basis.

7.  Tradewinds was never operated as an active business:  Tradewinds only purpose was to own and operate Freeman’s airplane.  It did not have any customers or generate any revenue.  This factor is what other courts call the business purpose doctrine.  A concept in asset protection law is that a court may disregard the formation of an entity like an LLC or a corporation if it has  no business purpose.  For example there is no business purpose to transfer title to your home to your solely owned LLC while you continue to live in the home.  If the only reason you put property into an LLC is to protect it from the claims of your creditors, then the plan probably will not work.  Imagine what would happen if you take the witness stand and the plaintiff’s attorney asks why did you put your home in the LLC and you answer to prevent my creditors from getting it.  You lose.  Because Tradewinds did not have a business, customers or revenue, it failed the business purpose test.

 8.  Legal formalities were disregarded:  Yes the are legal formalities that apply to operating LLCs and your LLC must comply with all of them.  One of the reasons I wrote my 170 page book called the Arizona LLC Operations Manual is so I could notify my LLC clients and purchasers of the book about the legal formalities applicable to Arizona LLCs.  Every LLC must comply with the legal formalities of its formation state.

9.  Freeman paid Tradewinds’ debts without characterizing the transactions:  This is a no brainer.  Members should never pay the LLCs debt.  The LLC should never pay a member’s debt.  DO NOT DO THIS.  If your LLC needs money, write a check payable to the LLC and deposit the funds in the LLC’s bank account then pay the debt with the LLC’s money.  Don’t forget to properly document the transaction as a capital contribution or a loan.  If you need LLC money to pay your debt, have the LLC write a check to you so you can deposit the funds in your account and pay from your account.  Don’t forget to properly document the distribution of money as a loan, compensation or a return of capital (if you have a positive capital account balance).  Document the distribution with a promissory note (if a loan) and minutes or resolutions signed by the members.

 10.  Tradewinds’ assets, including the airplane, were used for non­entity purposes in that the plane was used by Aircraft Storage LLC, without agreement or compensation:  The LLC allowed another entity to use its $300,000 airplane without paying any compensation and without a written agreement.  Why?  This type of transaction is a red flag asking for trouble in more ways than one.  No person or entity should ever use LLC assets for non-LLC purposes unless the LLC enters into a written agreement with the user and the user compensates the LLC for the reasonable value of the use.

 11.  Tradewinds was operated as a mere assetless shell, and the proceeds of the sale of its only significant asset, the airplane, were diverted from the entity to Freeman’s personal account:  The Court is wrong on this factor.  The LLC was not assetless.  It owned a $300,000 asset free and clear.  It sold its assets and distributed the proceeds to its only member.  The Court calls this “diversion” of assets, but this is the common and accepted method of liquidating an LLC or a corporation.  The law does not require companies to retain cash in the company in perpetuity after the company liquidates its assets.  It is not right that the Court found this fact to be a negative factor.

Conclusion

This case is a wake up call to all LLCs that do not dot the eyes and cross the tees.  If your LLC is not religiously following the legal formalities of your state’s LLC law and properly documenting LLC transactions, especially transactions with members, then the company is setting the groundwork for a court ruling that the company veil should be pierced and the member(s) should be liable for the debts of the company.

Does your LLC properly document all significant transactions?  If not, then I have two statements for you:

• If your LLC has not been documenting LLC transactions with minutes and resolutions, you won’t be doing it in the future.

Here are some other articles on this important topic:

• Martin: The Inherent Dangers Of The Single Member LLC And Alter Ego Veil Piercing

• Colorado Court of Appeals Erodes Liability Protection of Corporations and LLCs that says:

“With the stripping of the requirement to prove wrongful conduct and expansion of liability for contingent claims, the ruling diminishes the limited liability protection afforded to all corporations and LLCs operating in Colorado. Incorporation in a jurisdiction with more robust liability protections seemingly provides no remedy – the Martin Court applied Colorado LLC statutes and case law without discussion of why Colorado law should apply to Tradewinds, a Delaware LLC. The ruling also highlights the renewed importance of maintaining adequate corporate records and practices as a means of avoiding ensnarement under the first prong of the veil-piercing test.”

• Piercing the Corporate Veil – Breakdowns in Limited Liability Protection in PA

• Asset Protection Strategies for Your Business that says:

“Update Corporate Records and Follow Required Formalities. Many closely held businesses do not keep their corporate record books up to date. In the event of a lawsuit against the company, a plaintiff’s attorney can attempt to “pierce to corporate veil”. This means the corporation will essentially be ignored and the owners (shareholders) will be personally liable for the corporate debts.  Following basic corporate formalities, including

• Holding an annual shareholders meeting;
• Holding regular meetings of the Board of Directors;
• Avoiding any mixing of personal and corporate assets; and
• Keeping corporate records up to date.

will all help to insure that the assets of the owner(s) of the business are insulated from any judgment against the business.”

• Noack: The Single Member LLC, Alter Ego, and Undercapitalization

For People Who Want to Form an LLC Themselves

If you think you might want to create a do-it-yourself Arizona LLC you must read Arizona LLC attorney Richard Keyt’s article called “Step by Step Guide: How to Form Arizona LLC 2019 in (6 Easy Steps).”