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Archive for September, 2014

A Massachusetts appellate court recently pierced the liability veil of a single-member limited liability company because of its failure to keep “corporate records.” According to the LLC Law Monitor, in Kosanovich v. 80 Worcester Street Associates, LLC, No. 201201 CV 001748, 2014 WL 2565959 (Mass. App. Div. May 28, 2014) the Massachusetts Appellate Division, pierced the limited liability veil of a single-member LLC based on only one factor: the LLC’s failure to maintain business records.

Background – Piercing the Corporate Veil

Shareholders and other equity owners of corporations, as a general rule, will not be personally liable for the debts and other liabilities of the corporation. If a corporation owes a creditor money, the creditor cannot seek payment from the shareholders’ personal assets, even when the corporation is owned by only one or two people, because corporations have “limited liability.” This is commonly called the “corporate veil,” or the “liability veil.” Limited liability extends by law to other statutory entities, such as limited liability companies (LLCs), and limited partnerships.

However, under certain circumstance the courts may “pierce the corporate veil” to hold one or more shareholders (corporation), members (LLC) or limited partners personally liable for the debts of the company or partnership. The court may take this action when justice requires, but in doing so, normally considers a number of factors to determine if the company has maintained its separate identity. In Colorado, the factors are:

• whether a corporation is operated as a separate entity;

• commingling of funds and other assets between the company and its owners;

• failure to maintain adequate corporate records or minutes;

• the nature of the corporation’s ownership and control;

• absence of corporate assets and undercapitalization;

• use of a corporation as a mere shell, instrumentality, or conduit of an individual or another corporation;

• disregard of legal formalities and the failure to maintain an arms-length relationship among related entities; and

• diversion of the corporation’s funds or assets to non-corporate uses.[1]

The Massachusetts Case

In the Kosanovich case Milan Kosanovich purchased a condominium from 80 Worcester Street Associates, LLC (WSA), which was owned by Jeffrey Feuerman. WSA agreed to repair any defects in the condominium for up to one year after closing.

During the following year Kosanovich complained of defects, and Feuerman repaired some but not all of the problems. Kosanovich sued WSA and Feuerman for breach of contract, breach of an implied warranty of habitability, and violations of the Massachusetts Consumer Protection Act. At trial the judge ruled in favor of Kosanovich and awarded him $9,000 in damages. The judge also pierced WSA’s veil and found Feuerman personally liable for the damages award.

On appeal the appellate court examined the factors applicable to “piercing the corporate veil” (Massachusetts applies 12-factors, which are similar to the 8-factor test under Colorado law).

Feuerman ran WSA out of his house and his car and he had no bookkeeping records, tax records or returns, checkbook, or records of payments to subcontractors. The Massachusetts appellate court held that was enough to pierce the veil, saying that “Feuerman’s failure to maintain or produce records hindered the court’s ability to establish the twelve factors, including intermingling of assets, thin capitalization, and insolvency…. Feuerman’s failure to maintain business records coupled with his sole ownership and pervasive control of WSA supported the [trial] judge’s decision to pierce the corporate veil.”

Lawyers have an old saying that “bad facts make bad law,” and veil piercing cases often provide facts that cause courts to stretch the law to find liability when justice requires. The Kosanovich case likely fits that model, since undoubtedly Feuerman took all the money out of his company, and didn’t do the promised work, leaving no funds to pay the judgment.

However, the Colorado Limited Liability Company Act contains one key provision that may lead to a different outcome were the Kosanovich case brought in Colorado:

§ 7-80-107. Application of corporation case law to set aside limited liability
(1) In any case in which a party seeks to hold the members of a limited liability company personally responsible for the alleged improper actions of the limited liability company, the court shall apply the case law which interprets the conditions and circumstances under which the corporate veil of a corporation may be pierced under Colorado law.

(2) For purposes of this section, the failure of a limited liability company to observe the formalities or requirements relating to the management of its business and affairs is not in itself a ground for imposing personal liability on the members for liabilities of the limited liability company.

There is no similar language in the Massachusetts Limited Liability Company Act, and so a Colorado court could not hold that the failure to maintain business records by itself was a reason to pierce the corporate veil. Nevertheless, even in Colorado, the failure to maintain company records remains a factor that, when combined with one or more other factors showing the company is a mere alter-ego for the owner, will support imposing liability on the owner(s) if justice requires it. In fact, in a 2009 Colorado case, McCallum Family L.L.C. v Winger, 221 P.3d 69 (Colo. App. 2009), the court pierced the liability veil to impose personal liability on a person who was not an owner, director, or officer, but who was a mere employee. In that case, even though Marc Winger was not an owner, director, or officer of the company, the court found that he “managed the entire business” and routinely used company funds to pay his personal bills, and his wife was a director, a 50% shareholder, and president, and his mother was a director, a 50% shareholder, vice president, and secretary. Thus, the court held that the company was his alter ego and that he would be liable for the debts of the company.

Colorado appellate courts have resolved claims under the alter ego doctrine 21 times. In those cases, the corporate veil has been pierced nine times and maintained 12 times; Federal courts applying Colorado law have pierced the veil in seven of 22 cases.[2]

While the Kosanovich case may have not been decided on the same grounds by a Colorado court, a Colorado court could well reach the same result on other grounds; these cases serve as a valuable reminder that the relatively simple requirement of keeping separate company books and records, have annual meetings (at least on paper), and observing basic corporate and governance formalities, remains important to preserving the limited liability that business owners expect when they chose the corporate or LLC form to do business.

[1] Cherry Creek Card & Party Shop, Inc. v. Hallmark Marketing Corp., 176 F.Supp.2d 1091 (D.Colo.,2001); See 1 Colo. Prac., Methods Of Practice § 1:58 (7th ed.), Kathy Stricklan Krendl.

[2] 1 Colo. Prac., Methods Of Practice § 1:58 (7th ed.), Cathy Stricklan Krendl

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