The "Shell Company" Controversy: Energy Version

Earlier this week, I was quoted in a Reuters story about a large energy company's use of smaller a "shell company" in making leases for a potential shale play in Northern Michigan.  (MSNBC picked it up here, with the title: "Oil giant's shell game nets elderly farmers: Promises made, but not kept, and it's all legal." 

The article explains:

Legal scholars say the operation serves as an intriguing test case of the use of shell companies.

The tactics "raise moral and ethical questions about how entities can be used," says Joshua Fershee, a contract law professor at the University of North Dakota.

Others, including Chesapeake, defend the need to use shell companies and front companies - contractors with local ties who do business on behalf of a larger corporation. John Lowe, a professor of energy law at Southern Methodist University, calls it "business as usual."

(Side note: I'm really a business and energy law professor, not a contracts professor.) From the quote, it may appear that John Lowe and I disagree, but I don't suspect we do.  I stand by my quotes -- I do think the apparent use of a smaller shell company in this case raises some moral and ethical questions, as well as legal ones.  But I, too, believe that larger corporations can and should be able to use smaller companies for a variety of ends, including creating local ties and managing the larger entity's risk.  Still, there are boundaries. 

The MSNBC article title notes that promises weren't kept, but "it's all legal."  I'm not sure that's true in this case, but it's true it is legal to use smaller entities to manage risk.  That shouldn't be a problem. That doesn't mean it's legal to commit fraud.  So, for example, if the large entity created a small entity to take out leases and speculate on the land, it's probably legal. The entity can create a company to try new ventures like any of the rest of us.  If, on the other hand (and as an example), the entity created a small LLC, instructed the LLC to draft leases with specific flaws or otherwise use deceptive practices so that the entity would only need to pay if the shale play was viable, that could certainly be a problem.  

Furthermore, if the smaller entity was created to act as agent for the large entity, there may be liability for the larger entity as principal.  And if the smaller entity were an alter ego of the larger entity, there may be a veil piercing opportunity if the smaller entity doesn't have the funding necessary to cover its debts. (Whether veil piercing is proper here is different than whether it's possible.)

One of the complaints here is that the large entity used a small "local" company to entice landowners to do business with the local entity over other companies.  Of course, if it were so important that the landowner work with a local person solely, the landowner could contract for that protection by limiting transferability or adding some other change in control provision.  That would reduce the value of the lease, but if it matters that much, ask for it. If you take the local person at his or her word, then you have signed up for the risk that your ability to judge character wasn't that good. 

Ultimately, I can't tell whether this is a case of lessors wanting more than they bargained for or if it's a case of a large entity using a subsidiary lessee to speculate without taking on any concomitant risk. Frankly, it sounds like a little of both, but the facts available are limited.  

Last July, when Reuters published another of story in a series on the use of shell companies, I said this:

[Another] thing worth mentioning is that corporations and LLCs are not inherently evil.  Sure they can be used to help facilitate some bad things, but it doesn't take a corporation or an LLC to do evil. Individuals, sole proprietorships, and partnerships can all be pretty scummy, too. It has to do with the people running them, not an entity form.

I'm all for a little monitoring of bad behavior, but a some self policing can help, too.  Among the reasons people claim to want to form a company is to make it look like their operation is bigger or more established. Before doing business with anyone, we all need to do our due diligence. Check financials and get personal guarantees if that's necessary.  And if we don't care to check, then caveat emptor is still usually an appropriate rule.  And if we do check, and it's a well-played scam, well, it's not the entity that is the problem. It's criminal behavior, that happened because of the criminal, not the corporate code.

I'd add to that that even if it's not criminal behavior, it may be traditional civil fraud, and that creates liability for the perpetrator, too. I am not naive -- I have noticed that corporations and LLCs can do bad things, and because they are often larger and have more resources than individuals, the harm can be broader.  But people are not incapable of gathering information. At least some of the complaints about the "evil entity" are really complaints that we can't always get what we want.  Unfortunately that's true, but if we get what we bargained for, we don't have a lot of room to complain about the legality of entities, even if we did deal with a scummy person.  

--JPF