The Fourth Circuit, “Suem” and Reverse Veil Piercing in Delaware
In Sky Cable v. DIRECTV, Inc., the United States Court of Appeals for the Fourth Circuit answered two narrow questions of first impression regarding the equitable remedy of reverse veil piercing in Delaware. Sky Cable provides an affirmative answer to a question of whether Delaware would recognize reverse veil piercing and a negative answer to a question of whether Delaware’s charging statute for limited liability companies precludes reverse veil piercing for a judgment creditor of an LLC member. In this Article, we suggest that Delaware courts might answer reverse veil piercing questions differently, based on equitable maxims and language in Delaware’s charging statute not considered in Sky Cable v. DIRECTV, Inc.
In 2000, Randy Coley contracted with Plaintiff DIRECTV, Inc. to provide DIRECTV “programming to 168 rooms at the Massanutten Resort in Virginia.” For the next twelve years, Coley received payments for DIRECTV’s programing from more than 2,300 units while paying DIRECTV a monthly fee based on only 168 rooms and “fraudulently” retaining the excess revenue. In 2014, the District Court for the Western District of Virginia found Coley liable for 2,393 violations of the Communications Act and entered judgment against Coley for statutory damages of $2,393,000.
As a part of its post-judgment discovery, DIRECTV learned that in 2008 Coley formed several Delaware limited liability companies, including Thundertime, LLC. Thundertime was referred to by the Fourth Circuit as “ITT”. Coley is ITT’s sole member. In a deposition, Coley described ITT as a “real estate holding company.” ITT exists to hold title to North Carolina real property purchased by Coley valued at more than $5,000,000.
To collect its judgment against Coley from these assets of ITT, DIRECTV filed a motion in the district court to “reverse pierce” the “corporate” veil of ITT. The district court granted that motion. The Fourth Circuit affirmed.
Sky Cable distinguishes between “traditional veil piercing” and “reverse veil piercing.” Traditional veil piercing is an equitable remedy that enables a creditor of a business entity to recover a debt owed only by that business entity from an owner of that business entity. A scholar has traced the first judicial use of the label veil piercing to an 1809 United States Supreme Court decision.
Law professors are divided as to the merits of traditional veil piercing. Nonetheless, all of the states have reported cases that recognize traditional veil piercing. There have been thousands of cases specifically dealing with this legal issue. Legal opinions usually begin with “Courts are reluctant to pierce the corporate veil and destroy the important fiction under which so much of the business of the country is conducted, and will do so only under such compelling circumstances as required such action to avoid protecting fraud, or defeating public or private rights.”
Reverse veil piercing is an equitable remedy that enables a creditor of a business owner to recover a debt owed only by that business owner from the business entity. Courts and commentators trace the concept of reverse piercing to Kingston Dry Dock Co. v. Lake Champlain Transportation Co., an opinion by Judge Learned Hand.
In Kingston Dry Dock, the plaintiff, Kingston, contracted with the parent corporation to repair the steamer Charleston, owned by a subsidiary corporation. While the parent and subsidiary corporations shared nearly identical boards, the “business of each was separate.” Following default by the parent, Kingston seized two other canal boats (not the steamer Charleston) owned by the subsidiary to satisfy the debt incurred and owed only by the parent.
The trial court permitted Kingston’s attachment of the subsidiary corporation’s property to satisfy the judgment against the parent corporation, in essence using the reverse veil piercing concept (without using the term “reverse veil piercing.”). The parent was a shareholder of the subsidiary. Kingston, a creditor of the parent, was permitted to pierce the veil between the parent and the subsidiary to take property of the subsidiary to satisfy a debt of the parent.
The Second Circuit reversed. In doing so, Judge Hand, by dictum, acknowledged the possibility of reverse veil piercing where a judgment creditor of the parent company is trying to collect that debt from property of a subsidiary company (without using the term “reverse veil piercing”): “[It may] be too much to say that a subsidiary can never be liable for a transaction done in the name of a parent, . . . . [S]uch instances, if possible at all, must be extremely rare.”
While the Kingston Dry Dock opinion acknowledges the possibility of reverse veil piercing, the opinion nowhere uses the label “reverse veil piercing.” Indeed, the first reported case that we have been able to find that uses the phrase “reverse pierce” is a 1981 Minnesota Supreme Court decision, Roepke v. Western National Mutual Insurance Co.
In Roepke, Beverly Roepke, the widow of the sole shareholder and president of Rice County 66 Oil Company, was seeking reverse veil piercing. Beverly’s husband, Lawrence, died in a car crash involving one of the six motor vehicles owned by the corporation. At the time of the accident, the corporation maintained insurance policies on the six vehicles owned by the corporation, and Rice County 66 Oil Company was the named insured.
Under a somewhat convoluted Minnesota insurance statute, Beverly could recover $60,000 from the insurance company if the court reverse pierced the corporate veil and treated sole shareholder Lawrence Roepke as the same legal person as Rice County 66 Oil Company. Otherwise, Beverly could only recover $10,000 from the insurance company.
The court ruled in favor of Beverly. The full benefits of the insurance policy—an asset of the corporation—were thus made available to a person whose claim was based on a relationship to the shareholder and the rights of the shareholder to property owned by the corporation. The Minnesota Supreme Court expressly limited:
[T]his holding to the facts peculiar to this case, the most significant of which are that decedent was the president and sole shareholder of the named insured corporation; the vehicles insured by defendant were used as family vehicles; and neither decedent nor members of his household owned any other vehicles.
The Roepke opinion also noted that Rice County 66 Oil Company had no creditors so that no other shareholder or creditor would be “adversely affected” by the reverse veil piercing. With respect to the adverse effects of reverse veil piercing on the insurance company, the Roepke opinion did not expressly consider that the insurance company would be “adversely affected” by the reverse veil piercing.
Minnesota is not the only state in which courts have ordered reverse veil piercing. For example, in United States v. Dimeglio, a United States District Court held that Texas law recognized reverse veil piercing and that under the Texas law of reverse veil piercing, creditors of John Joseph Dimeglio could collect from assets belonging to a limited liability company, Oak Creek II, LLC.
Dimeglio had convinced wealthy investors to purchase “units” in Oak Creek II, LLC, promising high yield returns; however, the investment was nothing more than a Ponzi scheme. The court found that “Oak Creek II was Dimeglio’s alter ego based on [a] consideration of the total dealings [between] Oak Creek II, Dimeglio, and Oak Creek Management.” The trial record showed that:
(1) Oak Creek II was run exclusively by its “Managing Member,” Oak Creek Management; (2) Oak Creek Management was . . . owned and operated [solely] by Dimeglio, meaning Dimeglio was, in effect, the “Managing Member” with exclusive control over Oak Creek II; (3) Dimeglio used Oak Creek II as a . . . business conduit to perpetrate fraud on investors; (4) Dimeglio and Oak Creek II were one and the same; (5) Oak Creek II’s property and Dimeglio’s property were commingled and Dimeglio used Oak Creek II for personal purposes; and (6) Dimeglio had significant financial interest, ownership, and control over Oak Creek II.
After establishing that Oak Creek II was Dimeglio’s alter ego, the court noted that to pierce the veil of a limited liability company there must be proof the defendant used the entity to “perpetrate actual fraud for the defendant’s direct personal benefit.” The court found that Dimeglio perpetrated actual fraud when he used Oak Creek II “to raise money from wealthy investors . . . [promising] guaranteed high yield returns, [and] [i]nstead of investing the [money] as he represented[,] . . . paid large management fees while initially returning about 10% of investors’ capital[,] . . . behavior . . . typical to a traditional Ponzi scheme.” Dimeglio’s use of Oak Creek II as a Ponzi scheme allowed the government to reverse-pierce Oak Creek II’s veil.
Less than half of the states have reported cases ordering reverse veil piercing. Still fewer states have expressly rejected the possibility of ordering reverse veil piercing under appropriate facts. The strongest statements of rejection of reverse veil piercing come from Georgia courts.
In Acree v. McMahan, the Georgia Supreme Court said:
We reject reverse piercing, at least to the extent that it would allow an “outsider,” such as a third-party creditor, to pierce the veil in order to reach a corporation’s assets to satisfy claims against an individual corporate insider. . . . Allowing outsider reverse piercing claims would constitute a radical change to the concept of piercing the corporate veil in this state and, thus, should be created by the General Assembly and not by this Court.
Other states have only opinions that simply find reverse veil piercing is not applicable to the facts before the court, without indicating whether reverse veil piercing will ever be available. For example, in Commissioner of Environmental Protection v. State Five Industrial Park, Inc., the Connecticut Supreme Court ruled that the “trial court should not have applied reverse veil piercing, regardless of whether it is a viable theory in Connecticut.”
The court provided three reasons for its ruling. First, there were other shareholders of the corporation who would be adversely affected if the corporate veil were pierced so that a creditor of a shareholder could collect its judgment. Second, there were other creditors of the corporation that would be similarly adversely affected. Third, “there must be some wrong, beyond the creditor’s inability to collect, . . . .”
Finally, there are states in which there are no reported cases that have expressly ruled one way or the other on the availability of reverse veil piercing. Delaware is one such state.
At first blush, that might seem surprising. Businesses specifically incorporate in Delaware because Delaware corporate law is more certain and complete than the corporate law of any other state. Naturally, it would seem that if any state would have a well-developed law of reverse veil piercing, it would be Delaware.
Upon further reflection, however, the absence of settled Delaware law on reverse veil piercing is not surprising. Primarily public corporations—or those corporations that aspire to be large public corporations—incorporate in Delaware instead of the state in which they predominantly operate. There is not a single reported case—in any state throughout the country—which involves piercing the corporate veil of a publicly held corporation. Veil piercing issues arise in cases involving relatively small businesses that are close corporations or limited liability companies.
And, as the facts of Sky Cable illustrate with Coley’s creation of a single member Delaware limited liability company to hold North Carolina real property, Delaware has become a mecca for not only incorporation but also for the organization of limited liability companies. The combination of Delaware LLC’s increasing popularity for closely held businesses—and the practical reality that courts will only pierce the veil of closely held businesses—makes Sky Cable’s answers to questions about reverse veil piercing under Delaware law important.
Judicial opinions on choice of law commonly use the phrase “significant contacts.” The Sky Cable litigation had significant contacts with Virginia and North Carolina. The contract between DIRECTV and Coley was limited to Virginia—providing access to DIRECTV programming to residents at the Massanutten Resort located in Virginia. There are reported Virginia state court decisions expressly recognizing reverse veil piercing.
In Sky Cable, there were also significant contacts with North Carolina. The real property that ITT owned was located in North Carolina. There are reported North Carolina state court decisions expressly recognizing reverse veil piercing.
In Sky Cable, the only contact with Delaware was the fact that ITT was a Delaware limited liability company. There were no Delaware state court decisions expressly recognizing reverse veil piercing.
Not surprisingly, Coley argued that the court should look to the law of the state that had not recognized reverse veil piercing: “[T]he law of the state of incorporation in determining whether to disregard the corporate form and find the assets held by Coley’s limited liability companies are subject to the execution of the judgment against Coley in this case.” Both the district court and the Fourth Circuit decided to apply Delaware law.
The Fourth Circuit provided the following reasoning for its decision to apply Delaware law: “The law of the state in which an entity is incorporated generally governs the question whether a court may pierce an entity’s veil. Accordingly, we apply Delaware law to this question.” In a somewhat more extended discussion of the choice of law issue, the district court in Sky Cable refers to the internal affairs doctrine and to Restatement (Second) of Conflict of Laws section 307. Most decisions to apply the law of the state of incorporation in resolving veil piercing problems are based on the internal affairs doctrine or Restatement (Second) of Conflict of Laws section 307.
The United States Supreme Court explains the internal affairs doctrine as “a conflict of laws principle which recognizes that only one State, i.e., [the state of incorporation] should have the authority to regulate a corporation’s internal affairs—matters peculiar to the relationship among or between the corporation and its current officers, directors and shareholders.” The relationship between a corporation and its officers and directors—or the relationship between a corporation and its shareholders—is an “internal” relationship.
Veil piercing, however, does not involve a matter “peculiar to the relationship among or between the corporation and its current officers, directors and shareholders.” Veil piercing involves the rights of a third-party creditor. The relationship between a corporation and its creditors is an “external” relationship. As such, should the internal affairs doctrine apply to piercing?
Professor Franklin Gevurtz provides a couple of reasons for the lack of judicial opinions that expressly consider the question of whether the internal affairs doctrine should govern choice of law in piercing cases. First, piercing opinions often cite to—and rely on—reported decisions from other states. Second, piercing opinions generally involve small corporations that do business and incur debts only in their state of incorporation.
Recently, in Pertuis v Front Roe Restaurants, Inc., the South Carolina Supreme Court considered whether the internal affairs doctrine applied to veil piercing. Finding that the internal affairs doctrine applied to the “inner-workings” of a corporation and veil piercing involved “governmental policies”—and not the inner workings of a corporation—Pertuis rejected the internal affairs doctrine and applied South Carolina law in deciding whether to pierce the veil of a North Carolina corporation.
The internal affairs doctrine seems even less relevant to choice of law considerations for reverse veil piercing. In reverse veil piercing, neither the creditor nor the underlying transaction has any relationship—internal or external—to the corporation.
Similarly, Restatement (Second) of Conflict of Laws section 307 does not seem to address choice of law for traditional veil piercing, much less reverse piercing. Section 307 is set out below.
The local law of the state of incorporation will be applied to determine the existence and extent of a shareholder’s liability to the corporation for assessments or contributions and to its creditors for corporate debts.
Note both the italicized phrase “corporate debts” and the title of section 307. There are two different kinds of “corporate debts.” There are the debts owed by the corporation and the debts owed to the corporation. And, there can be shareholder liability for each of the two different kinds of corporate debts.
Traditional veil piercing becomes important when there is an unpaid debt owed by the corporation. Traditional veil piercing results in shareholder liability for the debts owed by the corporation.
There are also debts owed to the corporation by shareholders. A shareholder can have liability for a debt they owe to the corporation. The first sentence of the Comment to Restatement (Second) of Conflict of Laws section 307 gives an example of a corporate debt that is a debt owed to the corporation by a shareholder: “Under the local law of most states, a shareholder is liable for any balance that remains unpaid upon a subscription made by him to the shares of a corporation.”
And the last sentence of that Comment suggests that section 307 deals with choice of law to determine a shareholder’s liability for their own debt that they owe to the corporation, not choice of law to determine shareholder liability under piercing the veil for a debt owed by the corporation: “Thus, only shareholders who have not fully paid for their shares or who have paid otherwise than in cash may be made liable to creditors of the corporation for its debts.”
It is not necessary to look to the Comment to Restatement (Second) of Conflict of Laws section 307 to see that section 307 does not address choice of law for reverse veil piercing. Again, the title to the section is “Shareholders’ Liability,” and it refers to “liability on the shareholder” for corporate debts. Reverse veil piercing does not involve a shareholder’s liability for corporate debts; reverse veil piercing involves “corporate liability” for “shareholders’ debts.”
In Sky Cable, the Fourth Circuit’s choice of Delaware law was not outcome determinative. All of the other states with relevant contacts—North Carolina and Virginia—also recognize reverse veil piercing.
There are, however, veil piercing situations in which a court’s choice of law will matter. Several professors who have conducted more ambitious empirical research regarding veil piercing have concluded that “veil piercing rates vary substantially based on which state’s law is applied.” For example, Professor Peter Oh reports a sixty percent rate of veil piercing in cases in which the court applied South Carolina law and only a 25.81% rate of veil piercing in cases in which the court applied Maryland law.
Certification is the process by which a federal court, faced with a question of first impression of state law, asks that state’s Supreme Court to decide that state law question. Coley filed a motion for certification of issues of Delaware law as to reverse veil piercing to the Delaware Supreme Court. Initially, the Fourth Circuit granted the motion but later withdrew its certification order.
The certification of state law questions is discretionary within the federal court. Obviously, the federal court is in the best position to determine whether it is confident in its determination of the state law answer to the question. In this case, Judge Keenan, who wrote the opinion in Sky Cable, was uniquely qualified to make such a determination. In 2002, the Fourth Circuit, in C. F. Trust, Inc. v. First Flight Ltd. Partnership, certified the question of whether reverse veil piercing was a part of Virginia law to the Virginia Supreme Court. At the time, Judge Keenan was a part of the Virginia Supreme Court, which provided an affirmative answer to that question.
And, so, we are not criticizing or even questioning the Fourth Circuit’s decision not to certify the question. We are just “wondering” whether the Fourth Circuit’s decision not to certify the question of reverse veil piercing to the Delaware Supreme Court in this case can (or even needs to be) reconciled with the Fourth Circuit’s decision to certify questions of reverse veil piercing to the Virginia Supreme Court in C. F. Trust.
Prior to Sky Cable, no case applying Delaware law had granted reverse veil piercing, and no prior case applying Delaware law had even expressly stated that reverse veil piercing was an available remedy—albeit not available under the facts before the court. There is, however, language in Delaware Court of Chancery decisions from 2015 and 2016 that the Fourth Circuit looked to for guidance as what the Delaware position on reverse veil piercing might be.
In 2015, in Cancan Development v. Manno, the Delaware Court of Chancery stated:
Despite seeking to hold Manno Enterprises liable for Manno’s conduct, CanCan’s arguments rely entirely on instances when courts have done the opposite and held an individual liable for the debts of an entity. ‘Reverse pierce claims implicate different policies and require a different analytical framework from the more routine corporate creditor veil-piercing attempts.’ No one grappled with the different implications. Had the claim been properly presented and supported, [the claim for reverse veil piercing] might have prevailed. Under the circumstances, it fails for lack of support.
While dictum, this statement seems to predict that Delaware law would recognize reverse veil piercing under the facts of this case if the claim for reverse veil piercing had been properly presented and supported.
The 2016 Delaware Court of Chancery opinion that Sky Cable quotes from is less helpful. In Spring Real Estate v. Echo/RT Holdings, LLC, the court of Chancery noted:
One exception exists to the general rule that a parent has no property interest in the assets of a subsidiary. This general rule is based on the premise that a corporation’s assets are owned by the corporation, which is considered by state law to be a legal entity distinct from its shareholders. Thus, where the subsidiary is a mere alter ego of the parent to the extent that the Court may engage in “reverse veil-piercing,” the Court may treat the assets of the subsidiary as those of the parent for purposes of a trustee’s standing to void allegedly fraudulent transfers of such assets.
Note the italicized phrase “to the extent that the Court may.” This statement is not a prediction that under these facts a court would—or even might—recognize reverse veil piercing. The statement is obiter dictum as that term is defined in White’s Law Dictionary: “Latin, saying ‘by the way.’”
In 2017, in PNC Bank v. Udell, a creditor with a judgment against a member of a Delaware limited company argued a federal district court in Illinois should use outsider reverse veil piercing so that it could collect that judgment from the assets of the Delaware limited liability company. The court summarily rejected that argument, stating, “Delaware law has not recognized reverse veil piercing as a cause of action. . . . [I]t is not the role of this Court in a diversity case like this one to expand the state law of another jurisdiction.”
In holding that Delaware would recognize reverse veil piercing, Sky Cable describes Cancan Development and Spring Real Estate as “signal[ing] some willingness to apply a reverse theory of veil piercing.” Sky Cable also justified its reverse veil piercing holding on Delaware’s strong interest in preventing its business entities from being used as “vehicles for fraud,” explaining that without reverse veil piercing, fraudulent business owners could defraud their creditors by hiding assets in Delaware business entities.
The Fourth Circuit expressly limits its holding to “outsider” reverse veil piercing: “The district court . . . correctly held that under Delaware law, outsider reverse veil piercing of an LLC is warranted . . . .” Courts and commentators generally distinguish between outsider reverse veil piercing and insider reverse veil piercing.
Outsider reverse veil piercing permits a creditor of one of the owners of a business entity to recover that owner’s debt from the assets of the business entity. That creditor has no relationship with the business entity. The equitable remedy is referred to as outside reverse veil piercing because the party seeking to disregard the business entity’s separateness operates from outside the business entity.
Kingston Dry Dock Co. v. Lake Champlain Transportation Co. is an example of outsider reverse veil piercing. The parent corporation that was the judgment debtor was a shareholder of the subsidiary. The creditor of the parent corporation seeking to disregard the separateness of the parent and the subsidiary had no relationship with the subsidiary.
On the other hand, insider reverse veil piercing permits one of the owners of a business entity to treat the entity’s assets as their own. This type of veil piercing is named so due to the fact that the party seeking to disregard entity separateness is an owner of the entity—in a sense, inside the entity.
Roepke v. Western National Mutual Insurance Co. is an insider reverse piercing case. Cargill, Inc. v. Hedge is an easier-to-understand example of insider reverse veil piecing. In that case, Sam and Annette Hedge purchased a farm, created a Minnesota family corporation (Hedge Farm, Inc.) and transferred title to their farm to Hedge Farm, Inc. Sam bought supplies on credit for Hedge Farm, Inc. from Cargill. When Hedge Farm, Inc. defaulted, Cargill obtained a judgment against Hedge Farm, Inc., executed the judgment on the farm, and bought the farm at a judicial sale. Annette, the sole shareholder of Hedge Farm, Inc., intervened, asserting a homestead exemption.
Individuals are only entitled to such a homestead exemption in family homes that they themselves own. The farm that Annette was claiming as her homestead belonged to a separate legal entity. Hedge Farm, Inc. owned the farm; all that Annette owned was the stock of Hedge Farm, Inc. In order for Annette to have the farm as her homestead, she needed the court to treat what belonged to Hedge Farm, Inc. as belonging to her by ordering insider reverse veil piercing.
In ruling for Annette, the Minnesota Supreme Court looked to its earlier decision in Roepke:
The farmhouse was their family home . . . . The corporation was as much an alter ego for the Hedges as Mr. Roepke’s corporation was for him. Appellant argues that its creditor rights are adversely affected if the corporate entity is disregarded, but Cargill is no more adversely affected by the reverse pierce than the insurance company in Roepke.
As the Cargill case illustrates, the end results of insider reverse veil piercing are very different from the results of traditional veil piercing. In traditional veil piercing, the creditor is the “winner” able to pierce the veil and satisfy debts from assets not otherwise available to it, and the shareholder is the “loser”—held liable for debts incurred by the business entity. Insider reverse veil piercing can be truly the reverse. Reconsider the end result in both Roepke and Hedge. The owner who wrongly treated the business entity as their alter ego was the “winner.”
While Sky Cable notes that “many courts strongly oppose allowing a company’s veil to be pierced for the benefit of the individuals who themselves have created the company,” it does not decide whether the Delaware Supreme Court would use the equitable remedy of insider reverse veil piercing. Rather, the Fourth Circuit merely limits its holding regarding Delaware law of reverse veil piercing to outsider reverse veil piercing.
The dynamics and effects of the outsider reverse piercing in cases like Dimeglio and Sky Cable are also very different from the dynamics and effects of traditional veil piercing cases. In the typical traditional veil piercing case, liability for the debts of a business entity is imposed on an owner of that business because of actions of the owner—actions such as undercapitalizing the business, disregarding corporate formalities, or treating the business as their alter ego. In essence, the “bad actor” is the loser when there is traditional veil piercing.
In Dimeglio and Sky Cable, liability for the debt of an owner of a business entity is imposed on that business entity because the owner treated that business entity as an alter ego. Consequently, Dimeglio and Sky Cable are like traditional veil piercing cases in that the owner of the business is the bad actor. The difference between Dimeglio and Sky Cable and traditional veil piercing is that in Dimeglio and Sky Cable, the debts of the bad actor are paid from the assets of another legal entity, and in traditional veil piercing, the debts of the business entity are paid from the assets of the bad actor. The bad actor is, in essence, the winner in Dimeglio and Sky Cable because of the outsider reverse veil piercing.
The outsider reverse veil piercing in Dimeglio and Sky Cable is not only inconsistent with traditional veil piercing, but it is also inconsistent with Kingston Dry Dock Co. v. Lake Champlain Transportation Co., the first case to recognize the possibility of outsider reverse veil piercing. In Kingston, Judge Learned Hand refused to reverse pierce the veil of a subsidiary so as to permit a creditor of its parent/shareholder because the subsidiary was not the bad actor—the subsidiary did not in any way “interpose in the conduct of [the parent/shareholder’s] affairs.” And, as Judge Hand noted, a situation in which the business entity is interposing in the conduct of its owner’s affairs is “extremely rare.”
The Fourth Circuit further limits its holding in Sky Cable to cases where the limited liability company is the alter ego of the judgment debtor. There are Delaware law cases and commentaries on Delaware law that treat the terms “alter ego” and “piercing the veil” interchangeably.
Still other cases and commentaries do not use the terms “alter ego” and “piercing the veil” interchangeably. Instead they treat the alter ego theory as one of several possible grounds for veil piercing. There is language in the Sky Cable opinion that suggested the Fourth Circuit took this one of several possible grounds approach when it said: “Reverse veil piercing under the alter ego theory . . . .”
The question of whether a business entity is the alter ego of its owner is a question of fact. Reported cases set out various lists of factors to be considered.
In holding that the United States District Court’s determination that Coley is the alter ego of ITT was not clearly erroneous, the Fourth Circuit recited the following facts: “[U]tter lack of proper accounting records;” “abundant evidence . . . that Mr. Coley and his LLCs comingled their funds,” including, inter alia (1) checks made out to the LLCs were deposited in Coley’s bank account; (2) unexplained transfers of funds from ITT to the other LLCs; (3) other LLCs payments on ITT’s mortgages; and (4) Coley’s use of ITT’s mortgage interest deductions on his individual tax returns.
These facts are similar to the Dimeglio facts. Dimeglio, however, had one additional and crucially important fact that cannot be overlooked. The alter ego had been created for a fraudulent purpose; the owner created the limited liability company to implement his Ponzi scheme.
Coley contended that Delaware law also required a fact finding that the alter ego was created for a fraudulent purpose. Coley did not use ITT in the unlawful transmission of DIRECTV programming. Coley alleged that ITT was created for the lawful purpose of “insulating the Coleys from liability related to their rental properties.”
The Fourth Circuit rejected Coley’s contention of a fraudulent purpose requirement, reading Delaware alter ego law as requiring only “an overall element of injustice or unfairness.” The court then concluded the element of “injustice or unfairness” in this case was “DIRECTV has not received any payment on its judgment against Mr. Coley although the district court found Mr. Coley liable over four years ago.”
That element of “injustice of unfairness”—DIRECTV had not received any payment on its judgment—would seem to be present in every case in which outsider reverse piercing is invoked. Why else would the question of reverse veil piercing ever arise? By definition, the party invoking outsider reverse veil piercing is always an unpaid creditor that has a judgment against an owner of the business entity. That is why the Connecticut Supreme Court in Commissioner of Environmental Protection v. State Five Industrial Park, Inc., required “some wrong beyond the creditor’s inability to collect.”
Wallace ex rel. Cencom Cable Income Partners II, L.P. v. Wood is the Delaware Chancery Court case that seems most supportive of Coley’s contention. In that case, a creditor with a judgment for breach of fiduciary duty against the corporate general partner of a limited partnership asked the court to pierce the corporate veil so that it could collect the judgment from the corporate general partner’s shareholders. In holding that the plaintiff creditor failed to state a claim for piercing the corporate veil, the Delaware Chancery Court stated:
Piercing the corporate veil under the alter ego theory “requires that the corporate structure cause fraud or similar injustice.” Effectively, the corporation must be a sham and exist for no other purpose than as a vehicle for fraud. Plaintiffs merely state that the purpose of the General Partner is to manage and operate the Partnership. Plaintiffs have not stated sufficient facts that if true would justify disregarding the corporate form of the General Partner.
In Wallace, the only stated purpose for the creation of the corporate general partner entity was to insulate the owners of the corporate general partner from liability for the business activities of the corporate general partner. And, so the court in Wallace refused to pierce the veil.
Similarly, the only stated purpose for the creation of ITT was to insulate Coley from liability of the business activities of ITT. Nonetheless, the court in Sky Cable affirmed the district court’s decision to reverse veil pierce.
The Sky Cable opinion cited Wallace for various other general legal concepts but did not compare the facts of Wallace with the facts in the instant case. Coley’s appellate briefs did not even mention Wallace.
The Fourth Circuit further limited its holding as to the availability of the equitable remedy of reverse veil piercing to business entities that have a single owner. That is a significant limitation.
Reverse veil piercing, unlike traditional veil piercing, adversely impacts any owner of the business. For example, if David and Jake are owners of B business entity, then traditional veil piercing by C—a creditor with a judgment against B business entity—to collect that judgment from owner David has no negative economic impact on other owner, Jake. In fact, such an outcome would have a positive economic impact on Jake. His equity interest in B business entity should have a greater value because B business entity’s debts are reduced by traditional veil piercing.
On the other hand, if David and Jake are owners of B business entity, then reverse veil piercing by C—a creditor with a judgment against David—to collect that judgment from B business entity has a negative economic impact on Jake. Even though Jake has no connection to the debt David owes C, the economic value of Jake’s interest in business entity B has been reduced because B business entity has less assets. Such a result occurs because the assets of a business entity that Jake owns will have been used to pay a debt that Jake does not owe.
In Sky Cable, there is no mention of whether ITT has any other creditors; however, is that not something that should be discussed? Such a fact was extremely important to the Connecticut Supreme Court in Commissioner of Environmental Protection v State Five Industrial Park, Inc., because reverse veil piercing impacts other creditors differently from traditional veil piercing.
Traditional veil piercing, based on the doings and misdoings of an owner, adversely affects the other creditors of that owner. Returning to the prior hypothetical example, if David and Jake are owners of B business entity and creditor L has made a loan to David, and creditor S has provided services to David for which it has not been paid, then traditional veil piercing by C—a creditor with a judgment against B business entity—to collect that judgment from owner David has a negative economic impact on L and S. If C is successful, it will be paid from David’s assets that would otherwise be available to pay L and S. Such a result seems appropriate—creditors bear the risk of the doings and misdoings of their debtor.
Outside reverse veil piercing, like traditional veil piercing, is based on the doings and misdoings of an owner. The negative impact of reverse veil piercing, however, is on the creditors of the business entity rather than on creditors of that bad actor owner.
Again, assume that David and Jake are the owners of business entity B. B has two creditors: L, which has made a loan to B, and S, which has performed services for B and has not yet been paid. If C, a creditor with a judgment against David, is able to invoke the equitable remedy of reverse veil piercing to collect its judgment against David from the assets of business entity B, then there will be fewer assets available for B to pay L and S. Why should those creditors of B bear the risk of the doings and misdoings of David, someone who is not their debtor?
Coley’s principal argument was that Delaware § 18-703 (referred to by both Coley and the Fourth Circuit as “the charging statute”) precludes the use of reverse veil piercing of a Delaware limited liability company. The statute provides in pertinent part:
(a) On application by a judgment creditor of a member or of a member’s assignee, a court having jurisdiction may charge the limited liability company interest of the judgment debtor to satisfy the judgment. To the extent so charged, the judgment creditor has only the right to receive any distribution or distributions to which the judgment debtor would otherwise have been entitled in respect of such limited liability company interest.
(b) A charging order constitutes a lien on the judgment debtor’s limited liability company interest.
. . . .
(d) The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or a member’s assignee may satisfy a judgment out of the judgment debtor’s limited liability company interest and attachment, garnishment, foreclosure or other legal or equitable remedies are not available to the judgment creditor, whether the limited liability company has 1 member or more than 1 member.
(e) No creditor of a member or of a member’s assignee shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the limited liability company.
In order to understand § 18-703, it is necessary to remember the difference between owning an interest in a corporation and owning an interest in a limited liability company. Ownership interest in a corporation is commonly referred to as stock, and the owner of stock is generally able to sell all of their ownership interest—their voting and other management rights as well as their dividend and other economic rights. Similarly, a judgment creditor of an owner of stock can seize that stock. The buyer of that stock—in a sale by the stockholder or its judgment creditor—has whatever rights were held by the previous stockholder.
An owner of a Delaware limited liability company can sell—or otherwise assign—only their “limited liability company interest,” which is statutorily limited to economic rights, such as the right to share in distributed profits, but excludes voting and other business management rights.
Just as Delaware statutorily limits what ownership interest an owner of a limited liability company can voluntarily transfer, Delaware also statutorily limits what ownership interest a judgment creditor of an owner of a limited liability company can reach to satisfy its judgment: the same “limited liability company interest,” i.e., economic rights only. That is the essence of § 18-703(a), (b) and (d), read together.
Coley focuses on the words “exclusive remedy” in § 18-703(d)—and on legislative history—to argue that “Delaware’s Legislature has plainly instructed courts that if a judgment creditor wants to use an LLC’s assets to satisfy the debt of one of its members, the exclusive remedy is a charging order.” The Fourth Circuit focuses on the words “attachment, garnishment, foreclosure”(and the Latin phrase “ejusdem generis”) to conclude that the remedy of reverse veil piercing is not excluded by the Delaware charging statute because it is different from the remedies that are specifically excluded by the Delaware charging statute. Those remedies enable a creditor to satisfy its judgment from its debtor’s property. Reverse veil piercing enables a creditor to satisfy its judgment from a separate entity’s property by disregarding the separateness.
The phrase “out of the judgment debtor’s limited liability company interest” in Delaware § 18-703(d) also supports the Fourth Circuit’s position. A judgment creditor of a limited liability company member does not seek reverse veil piercing to collect its judgment “out of the judgment debtor’s limited liability company interest.” A judgment creditor of a limited liability company seeks reverse veil piercing to collect its judgment from the property of the limited liability company.
A California case, Curci Investments, LLC v. Baldwin, provides further support for the Sky Cable holding that “Delaware’s LLC charging statute does not prevent a court from reverse piercing the veil of an LLC.” Delaware § 18-703(d) is markedly similar to California’s charging statute § 17705.03(f): “This section provides the exclusive remedy by which a person seeking to enforce a judgment against a member or transferee may, in the capacity of judgment creditor, satisfy the judgment from the judgment debtor’s transferable interest.”
In Curci Investments, the LLC member judgment debtor made the same argument as Coley—that the phrase “exclusive remedy” in the California charging statute prevents a court from reverse piercing the veil of a California LLC. Curci Investments, like Sky Cable, rejected that argument, stating that “Reverse veil piercing is a means of reaching the LLC’s assets, not the debtor’s transferable interest in the LLC.”
In their discussion of the Curci case, Professors Carter Bishop and Daniel Kleinberger predict that the outcome of Curci “would likely have been different under Delaware law.” Their prediction is based on § 18-703(e): “No creditor of a member or of a member’s assignee shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the limited liability company.”
Note the italicized phrase in Delaware § 18-703(e). Like reverse veil piercing, Delaware § 18-703(e) looks to the “property of the limited liability company.” And, unlike Delaware § 18-703(d), Delaware § 18-703(e) expressly excludes equitable remedies that enable a judgment creditor of a member to look to “the property of the limited liability” company to satisfy its judgment against the member.
There are other states that have limited liability company acts with a charging order provision similar to Delaware § 18-703(e). As of this Article’s publication, we have not found a reported case in any state that expressly considers the possible effect of such a provision on the availability of reverse veil piercing by a creditor with a judgment against a member of a limited liability company to collect that judgment from the property of the limited liability company. None of the appellate court briefs in Sky Cable address the possible relevance of Delaware § 18-703(e). The Sky Cable opinion does not expressly address Delaware § 18-703(e).
There is, however, language in Sky Cable’s dismissal of Coley’s Delaware § 18-703(d) argument that might also be relevant to consideration of a contention that Delaware § 18-703(e) excludes reverse veil piercing. The Fourth Circuit concluded its analysis of the Delaware charging statutes with the statement “piercing the veil of an LLC effectively eliminates the legal status of the LLC.” If the status of the LLC is eliminated, then, arguably, there is no limited liability company and no “property of the limited liability company”—and as a result, reverse veil piercing is not barred by § 18-703(e), which protects “property of the limited liability company.”
Piercing the veil does not end the actual existence of the business entity. In DeWitt Truck Brokers, Inc. v. W. Ray Flemming Fruit Co., a case cited by the Fourth Circuit in Sky Cable, the court’s piercing of the corporate veil of W. Ray Flemming Fruit Co. (WRF Fruit Co.) simply meant that DeWitt Truck Brokers could collect its judgment against WRF Fruit Co. from the principal shareholder of WRF Fruit Co. (whose name, not surprisingly turned out to be W. Ray Flemming). This result did not result in WRF Fruit Co. ceasing to exist as a corporation.
And so, in Sky Cable, ITT still exists. Recall that ITT held North Carolina real estate worth more than $5,000,000. DIRECTV’s judgment was less than $3,000,000. ITT is still a Delaware limited liability company, holding the balance of the North Carolina real estate not needed to satisfy DIRECTV’s judgment against Coley. It is just that ITT has no separate legal status for purposes of the DIRECTV transactions.
The Fourth Circuit limited its holding to “reverse piercing of an LLC.” There is no mention in Sky Cable of whether Delaware law would permit reverse piercing of a corporation—even a corporation that is the alter ego of its sole member.
California courts have concluded that reverse veil piercing is available when the business entity is a limited liability company but not available when the business entity is a corporation. In Curci Investments, LLC v. Baldwin, a California intermediate appellate court recognized reverse veil piercing of a limited liability company even though an earlier decision of that same court, Postal Instant Press v. Kaswa Corp., a case involving a corporation, had broadly stated that there was no reverse veil piercing in California. The court in Curci emphasized that a creditor with a judgment against a shareholder of a corporation has a legal remedy that is not available to a creditor with a judgment against a member of a limited liability company. In that situation, the creditor of the shareholder has the legal remedy of seizing and selling its debtor’s shares.
Veil piercing is an equitable remedy. Generally, an equitable remedy is not available where there is an adequate remedy at law. One of the oldest equitable maxims is that equity follows the law, i.e., a creditor must first exhaust its available legal remedies before obtaining an equitable remedy.
One of the remedies at law available to creditors in Delaware and other states is to recover property that its debtor has fraudulently transferred. If a shareholder of a corporation has fraudulently transferred property to the corporation—or a member of a limited liability company has transferred property to the limited liability company—then a judgment creditor of that business owner could use state fraudulent transfer law to recover the property fraudulently transferred.
The Delaware fraudulent transfer statute provides in pertinent part:
§ 1304. Transfers Fraudulent as to Present and Future Creditors
(a) A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation:
(1) With actual intent to hinder, delay or defraud any creditor of the debtor; or
(2) Without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor:
(a) Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or
(b) Intended to incur, or believed or reasonably should have believed that the debtor would incur, debts beyond the debtor’s ability to pay as they became due.
(b) In determining actual intent under paragraph (a)(1) of this section, consideration may be given, among other factors, to whether:
(1) The transfer or obligation was to an insider;
(2) The debtor retained possession or control of the property transferred after the transfer;
(3) The transfer or obligation was disclosed or concealed;
(4) Before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit;
(5) The transfer was of substantially all the debtor’s assets.
Had the facts suggested that Coley transferred all his real property for no consideration after engaging in a course of conduct that incurred significant liability for criminal fines, it would seem that Coley’s transfers could be attacked as fraudulent under either Delaware § 1304(a)(1) or (a)(2). Although Coley raises this argument in his brief, neither the district court nor the Fourth Circuit in their opinions raised the possibility of fraudulent conveyance law as an adequate legal remedy. The fact that Coley’s transfers to ITT occurred in 2008 raises the possibility that DIRECTV’s fraudulent conveyance claim was barred by Delaware’s four-year statute of limitations.
Professor Robert Clark’s general discussion of veil piercing provides yet another possible explanation for the absence of any consideration of Delaware § 1304. He notes that many piercing the corporate veil cases involve “behavior that would invoke fraudulent conveyance law” but “piercing cases suppress mention of fraudulent conveyance law.” He then provides two reasons that piercing cases do not consider a possible fraudulent conveyance alternative: (1) plaintiffs’ attorneys believe that it is easier to prove a piercing case than a fraudulent conveyance case and (2) judges believe that piercing the corporate veil law gives them greater discretion than fraudulent conveyance law. Professor Clark then concludes his coverage of piercing with the admonition that in developing the law of veil-piercing, courts should “do so with explicit awareness of the extent to which plaintiffs resort to these doctrines as a way of avoiding the requirements of fraudulent conveyance law.”
Moreover, by recovering under reverse veil piercing instead of fraudulent conveyance law, a creditor can avoid one of the limits of fraudulent conveyance law. Reverse veil piercing makes all of the assets of a business entity available to a creditor of an owner. Fraudulent conveyance law permits a creditor of an owner to recover from the business entity only those assets that the owner fraudulently transferred to the business entity.
And then there is the newest equitable maxim—the “ultimate equitable maxim.” According to a recent South Carolina Law Review article by Judge Roger Young and Professor Stephen Spitz, the ultimate equitable maxim, which they refer to as “Spitz’s ultimate equitable maxim” (SUEM) is that “in equity, good guys should win, and bad guys should lose.”
In Sky Cable, there is no problem of identifying the “bad guy” and the “good guy” as those terms are used in the SUEM maxim. The district court and the Fourth Circuit clearly viewed Randy Coley as the bad guy and the long-suffering DIRECTV as the good guy. And, so it is clear that because of the court’s use of outsider reverse veil piercing, the good guy wins. DIRECTV is able to collect its judgment against Coley from the assets of ITT.
What is less clear is whether a bad guy like Coley is the only loser when a court orders outsider reverse veil piercing and holds a business entity liable for the debts of one of its owners. What about other owners of the business? Creditors of the business? Employees and customers of the business?
It is not surprising that we have questions about the application of SUEM to reverse veil piercing and questions about Sky Cable’s application of reverse veil piercing. Judge Cardozo, while sitting on the New York Court of Appeals, used the phrase “enveloped in the mists of metaphor” to describe veil piercing. More recently, Judge Easterbrook—while still a law professor—and Professor Daniel Fischel described veil piercing as “happen[ing] freakishly. Like lightning, it is rare, severe and unprincipled.” The law of reverse veil piercing is even less clear.
In Sky Cable, the Fourth Circuit provided clear answers to two very specific questions of first impression: (1) under Delaware law, outsider reverse piercing of a limited liability company’s veil is available when the LLC is the alter ego of its sole member, and (2) subsection (d) of Delaware’s LLC charging statute did not prevent the court from reverse piercing the veil of an LLC. We do not disagree with Sky Cable’s answers to these narrow questions. Rather, we suggest that when a Delaware court—or a court in any other state—addresses reverse piercing issues it also consider the questions we have raised in this Article.