Friday, November 14, 2014
The Supreme Court of Wyoming recently decided to pierce the limited liability veil of a single-member LLC. Green Hunter Wind Energy, LLC (LLC), had a single member: Green Hunter Energy, Inc. (Corp). LLC entered into a services contract with Western Ecosystems Technology, Inc. (Western). The court determined that veil piercing – thus allowing Western to recover LLC’s debts from Corp – was appropriate for several reasons. I think the court got this wrong. The case can be accessed here (pdf).
The court provides the following rule for piercing the veil of a limited liability company, providing three basic factors 1) fraud; 2) undercapitalization; and 3) “intermingling the business and finances of the company and the member to such an extent that there is no distinction between them.” The court noted that the failure to following company formalities was recently dropped as a factor by changes to the state LLC statute.
Here’s where the court goes wrong:
(1) As to undercapitalization, the court completely ignores the fact that Western freely contracted with the LLC with little to no cash. If Western wanted the parent Corp to be a guarantor, it could have required that. If Western thought LLC was acting as an agent for Corp, Western should have claimed that. It seems to me this is directly analogous to an actual parent-child relationship. Western contracted with adult (but penniless) child. Child didn't have money when the contract was signed or when the bill was submitted. Western then calls parent and says, "Pay up." Western is free to call, but parent can say, “No. You dealt with my kid, not me, and I didn't agree to this debt.”
(2) There is a better argument this should be different if this were a tort suit where Western did not choose to engage with the LLC, but that's not the case here. I don't see how Western can claim undercapitalization now when they had the opportunity to ask before the contract was formed. Western is the least cost avoider here and assumed the risk of dealing with a lightly capitalized company. It seems to me that should be part of the assessment. Undercapitalization is, as the court notes, “a relative concept.” The court cites potential abuse of LLC laws if they were to adopt such a rule that motivates companies to ask for guarantees. instead adopting a rule that could incentivize companies like Western actively avoid ask ingfor guarantees. Why? Because if you ask for a guarantee and are refused, it could be used against you later. But if you don’t ask, you may get to piece the veil and seek a windfall recovery by getting a post hoc guarantee that was not available via negotiation.
The court’s rationale is as follows:
It makes good business sense for a contract creditor to try to obtain a guarantee from the member or retainer from the limited liability company itself. But we are mindful of the reality of the marketplace that many businesses are not in a position—competitively or economically—to insist on guarantees. For that reason, we decline Appellant’s invitation to find piercing inappropriate in this case because Western did not protect itself from Appellant’s misuse of the LLC by attempting to obtain a guarantee or other form of security. To do so would invite abuse of entities, as is the case here.
No way. If you can’t “competitively or economically” secure a guarantee, then too bad. If the legislature wants to create guarantees or minimum capitalization requirements for all entities, fine. Otherwise, this is absurd.
(3) Further, Court state that "the district court correctly concluded that the LLC 'failed to adequately capitalize the LLC, that LLC was undercapitalized at all times relevant to this suit and the LLC lacks corporate assets." Wrong. Again, if Western knew the finances of LLC at the time of contracting (as it could and should have), then it wasn’t undercapitalized. LLC simply existed and Western did not seek to avoid the risk of dealing with such an entity.
More important, though LLCs cannot have “corporate assets.” It’s a limited liability company, not a corporation. Sheesh. I’ll add this one to my list of courts getting LLC distinctions wrong. (See, e.g., here, here, here, and here.) I would have loved to see the Supreme Court correct the district court on that, at least.
(4) The court incorrectly suggests that the tax filings of the parent corporation and a subsidiary LLC can be a factor in the veil piercing analysis. Sorry, but no. For a single-member LLC, for federal tax purposes, the LLC will probably be a disregarded entity. As such, the LLC will usually (if not always) look like part of the parent corporation. To even consider the tax filing necessarily makes one factor weigh toward piercing. That’s wrong.
Early in the opinion, the court notes, “Piercing seems to happen freakishly. Like lightning, it is rare, severe, and unprincipled.” (quoting Frank H. Easterbrook & Daniel R. Fischel, Limited Liability and the Corporation, 52 U. Chi. L. Rev. 89 (1985) (internal quotation marks omitted)). In this case the court seems to be trying to make veil-piercing law in LLCs more predictable. I’m concerned they are – they are making is more likely the veil piecing will occur, at least in the single-member LLC context. To the extent we’re going to allow single-member LLCs, that’s unfortunate.