Brad Hamilton will be speaking on the Careers in International Law Panel at Colorado University Wolf Law Building Room 207 on March 3, 2015 at 6:00 pm. Sponsored by the CU Law Careers Office, CBA Young Lawyers Division, and CBA International Law Section.


In Quadrant Structured Products v. Vertin et al, the Delaware Court of Chancery held in an opinion issued October 1, 2014, and again confirmed in relevant part on October 28, 2014, that lenders do not have direct claims against directors of a company for breach of fiduciary duty, and the directors do not owe fiduciary duties to the company’s lenders, but if a company is in the zone of insolvency, lenders do have the right to bring a derivative claim, just as a shareholder would under normal circumstances.


When a company is in financial difficulty, its shareholders and lenders often find themselves at odds. This is particularly true when the company has been through several rounds of financing, because holders of preferred stock have first right to the company’s assets in a liquidation, and even though they are shareholders, they are also pseudo-creditors. During the last recession, lender’s lawyers creatively asserted claims against company directors, first claiming that when a company was broke or nearly broke (in the “zone of insolvency”), the directors owed fiduciary duties to the lenders. When that didn’t work, they claimed that directors breached their fiduciary duties to the company by making risky business decisions that put a troubled company deeper in debt. These came to be known as the “zone of insolvency” claims.

Because a large percentage of U.S. companies are incorporated in Delaware, and many other states follow Delaware law on matters of corporate governance and fiduciary duties, Delaware courts addressed these arguments frequently from 2004 through 2010.

Company Directors or Mangers do NOT Owe Fiduciary Duties to Lenders

First, Delaware courts made it clear that directors (corporations), managers (LLCs), and general partners (partnerships) owe fiduciary duties to the entity, not to its owners, and not to its creditors. Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 792 (Del. Ch. 2004); North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007). It has long been law that shareholders cannot sue directors for breach of fiduciary duty, because fiduciary duties are owed to the company, not to individual shareholders. Instead, they must bring a “derivative” action – a law suit against the company, to cause the company to sue its directors. When lenders tried to sue directors for breach of fiduciary duty, Delaware courts turned them away also – in Gheewalla the court held: “The directors of Delaware corporations have the legal responsibility to manage the business of a corporation for the benefit of its shareholder owners,” and denied creditors the right to sue directors for breach of fiduciary duty. However, the court also held that once a company is broke, its creditors also have the right to bring a derivative suit for breach of fiduciary duty – like shareholders, lenders can sue the company to cause the company to sue its directors for breach of fiduciary duties.

Insolvency Does Not Expand the Usual Fiduciary Duties

Based on the decisions in Production Resources and Gheewalla, lenders next brought derivative claims asserting that if a company is in financial trouble (in the zone of insolvency), the directors have a duty to manage the company for the benefit of its creditors, and not make risky decisions that could lead to the company going broke, or “deepening its insolvency.” The argument goes like this: When a company is in trouble, the directors often take big risks, entering into questionable deals that, if successful will save the company, but have a high risk of failure. A risky deal that destroys the company leaves little for the creditors, but if the directors instead act to preserve the remaining assets for the creditors, they will at least get some if not all of their money back. If a company has significant debt, shareholders of troubled companies support taking bet-the-company risk – they have already lost their investment to the lenders, who get first pick. Thus, they have nothing to lose.

Delaware courts do not support the lenders argument that fiduciary duties shift to benefit the lenders: “…if a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.” Gheewalla, 930 A.2d at 101, See also Trenwick American Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 202-203 (Del. Ch. 2006) affd., 931 A.2d 438 (Del. Supr. 14 Aug 2007). The business judgment rule, as developed and refined over the years, particularly in Delaware, encourages risk and protects directors from risky decisions that do not work out, so long as they are taken properly and fairly.

Quandrant Structured Products v. Vertin

The Delaware Court of Chancery addressed this issue again recently. In Quadrant Structured Products v. Vertin et al, Athilon Capital, a company that sells credit protection to large financial institutions, guaranteed credit default swaps on collateralized debt obligations sold by its wholly-owned subsidiary. During the 2008 financial crisis, Athilon was deep into the zone of insolvency. Another company, EBF, bought all of the Athilon’s Junior Subordinated Notes and all of its equity, gaining control over Athilon. Thereafter, Quadrant Structured Product bought Athilon’s Senior Subordinated Notes.

EBF, now in control of Athilon, but in a junior security position, decided (1) not to exercise its right to defer interest payments to itself on the junior notes, (2) to pay above-market service and licensing fees to its own affiliate, and (3) to adopt a new, riskier business strategy instead of dissolving Athilon, which would have benefited other creditors like Quadrant. Since EBF’s notes were junior to Quadrant’s notes, EBF would get nothing in a liquidation, but could benefit if the risky strategy worked – they already had nothing, so all of the risk of EBF’s strategy fell on Quadrant. In short, a junior lender was able to improve its position over a senior lender by taking over the company and making decisions to its benefit. Quadrant, the senior creditor, sued the new directors, claiming that since the company was in the zone of insolvency, the directors breached their fiduciary duties by not making business decisions to benefit the senior lenders.

The Delaware court held that the directors’ decision to try to increase the value of the insolvent corporation by adopting a highly risky investment strategy was allowed under the “business judgment rule,” even though Quadrant and other senior creditors bore the full risk if the strategy failed. Vice Chancellor Laster held: “In the case of an insolvent corporation, board decisions that appear rationally designed to increase the value of the firm as a whole will be reviewed under the business judgment rule, without speculation as to whether those decisions might benefit some residual claimants more than others.”

The ruling makes it clear that, at least in Delaware, even though creditors gain the rights of shareholders to bring a derivative action when a company is in the zone of insolvency, that right does not include a shift of fiduciary duty from the company to the creditors. The directors’ duty remains to the company, and decisions normally protected by the business judgment rule do not lose that protection just because a company is going broke.

It should also be noted that the Delaware court remained consistent by holding that the directors’ decisions not to defer interest on the notes held by the junior creditor, and to pay above-market fees to an affiliate of the junior creditor, were conflicting interest transactions subject to entire fairness review, and not purely protected by the business judgment rule. That portion of the decision would have been the same without a “zone of insolvency” situation, and those claims were not dismissed

The U.S. Securities and Exchange Commission has allowed a marijuana company to register its shares. Terra Tech Corp of Irvine, California is a Nevada corporation that primarily manufactures and sells hydroponic agriculture equipment and supplies. According to The Cannabist, hydroponics is booming: “Supplying the lighting, nutrient and water needs of … plants has resulted in huge growth in hydroponics stores and grow operation supply retailers. According to a market research report published by IBISWorld, the hydroponic equipment retail industry has grown by 7.2 percent per year nationwide since 2009, with California and Colorado growing at a whopping 32 percent.”

Terra Tech stock trades on the OTCBB under the symbol TRTC.

According to Terra Tech’s Prospectus and recently allowed Form S-1 Registration Statement,

“[Terra Tech] recently formed three majority-owned subsidiaries for the purposes of cultivation or production of medical marijuana and/or operation of dispensary facilities in various locations in Nevada upon obtaining the necessary government approvals and permits, as to which there can be no assurance. Each subsidiary was formed with different investors, thus necessitating the need for multiple entities with different strategic partners and advisory board members.  In addition, we anticipate each subsidiary will service a different geographical market in Nevada.  Effectuation of the proposed business of each of (i) MediFarm, LLC (a Nevada limited liability company (“MediFarm”), (ii) MediFarm I, LLC, a Nevada limited liability company (“MediFarm I”), and (iii) MediFarm II, LLC, a Nevada limited liability company (“MediFarm II”) is dependent upon the continued legislative authorization of medical marijuana at the state level. We expect to allocate future business opportunities among MediFarm, MediFarm I and MediFarm II based on the locations of such opportunities.”

Thus, Terra Tech is not yet in the marijuana cultivation and sales business, but will commence that business if and when it receives the necessary licenses in Nevada. This appears to be the first SEC allowance of registration of shares of a cannabis grower and seller, albeit one not yet in production.

In November 2014 Terra Tech filed a registration statement for the resale of stock owned by one of its investors. The Wall Street Journal LawBlog reports that the SEC recently allowed the registration statement to go effective without action, which means it becomes effective 20-days after the SEC approves the disclosures in the registration statement. Typically, an issuer will request, and the SEC will grant, acceleration of the effective date to allow the issuer to immediately sell its shares. The SEC refused to grant Terra Tech’s request for acceleration. The article at the WSJLawBlog includes a good discussion of the significance to issuers of not receiving accelerated effectiveness – it makes it difficult if not impossible to do an underwritten public offering. However, that was not an issue in this case because Terra Tech was registering for resale stock acquired earlier by an institutional investor, Dominion Capital LLC, who purchased convertible notes and warrants from Terra Tech. Under the terms of the notes and warrant, Dominion had a right to require that stock be registered for resale in the future (registration rights). Therefore, Terra Tech was not registering its own stock for sale, and will not directly receive any of the proceeds from the sale of the registered stock for use in the marijuana business. It will be interesting to see whether the SEC allows a registration statement for direct sale to the public by a marijuana company.

What About Colorado?

Terra Tech is a Nevada corporation that plans to conduct its marijuana business in Nevada through Nevada subsidiaries. Currently, Colorado law prohibits ownership or beneficial financial interest in a Colorado licensed cannabis business, by any person who is not a Colorado resident as defined under Colorado marijuana regulations. To qualify, the owners must submit exhaustive and detailed identification information, including fingerprints, to the Colorado Marijuana Enforcement Division, and be approved for ownership by the MED. Under current Colorado law, there would be no reason for a Colorado licensed marijuana company to register its shares with SEC, unless it can also control the sale of those shares solely to persons who qualify to own a financial interest in a licensed company. Failure to do so would cause the loss of its license. Colorado’s regulatory scheme precludes registration and public trading of shares in a marijuana company on any exchange or bulletin board, since it is not possible to limit ownership to qualified Colorado residents. Only time will tell if allowance and registration by the SEC of stock in marijuana companies will provide some incentive for Colorado regulators to loosen the ownership restrictions on licensed Colorado marijuana companies, long term.

In a December 19, 2014 ruling the Delaware Supreme Court confirmed that the “market-check” requirement from the original Revlon decision, and the subsequent QVC decision, do not require a board to run a mandatory auction as part of every change of control transaction. There are other options the board may use to satisfy its Revlon duties in a change of control of transaction, such as a  post-signing market check, so long as there are no material barriers against the emergence of a superior proposal and the company’s stockholders are provided with a non-coercive, fully informed shareholder vote. In the ruling, C&J Energy Services, Inc. et al v. City of Miami General Employees’ and Sanitation Employees’ Retirement Trust, the court held “Revlon does not require a board to set aside its own view of what is best for the corporation’s stockholders and run an auction whenever the board approves a change of control transaction.”  The ruling is discussed in detail on The Harvard Law School Forum on Corporate Governance and Financial Regulation: Delaware Court Reverses Preliminary Injunction Requiring Go-Shop.

In Cigna Health and Life Insurance Company v. Audax Health Solutions, Inc., the Delaware Court of Chancery invalidated (1) the buyer’s post-closing requirement of releases from the selling stockholders, that were not specifically set out in the merger agreement, and (2) indemnifications or “clawbacks” from the merger target’s stockholders that were not limited by time or amount.

The ruling in Cigna v. Audax effectively eliminates, at least in Delaware, a “work-around” often used by some lawyers to implement an acquisition of a private company by merger, but with terms typically found in a stock purchase.

Company Combinations Generally

There are three primary ways to combine companies:

1. an asset purchase;
2. an acquisition (where the buyer buys the equity of the target); and
3. a merger.

Of those three methods, only a merger is governed by state laws with specific, detailed requirements (often called a “statutory merger”). Mergers can take many forms, including a direct merger of two entities (forward or reverse), and triangular mergers (forward or reverse). The structure of a merger is normally chosen to minimize taxes payable as a result of the merger, and to be effective, the merger must be conducted in compliance with the merger law of the applicable state or states.

Generally, the ruling in Cigna v. Audax does not impact public company mergers, because the process of merging public companies is governed by SEC and stock exchange rules, and indemnifications and releases of the type addressed in Cigna v. Audax are uncommon in that context. Not so for combinations of private companies. For simplicity, I will use the corporation example; however, the same issues may arise in a combination between LLC’s or between a corporation and an LLC, depending on the law of the state or states involved.

Representations, Warranties, and Indemnification

In business combination agreements, representations, warranties, and indemnity obligations combine to protect the buyer and help maximize the purchase price to the sellers. Typically, the agreement will include representations and warranties respecting a broad array of matters reflecting the business, operations, and legal status of the company. The buyer relies on these representations and warranties, in part, in setting the price it is willing to pay for the company. If the representations or warranties turn out to be untrue in any material respect, the value of the company would be diminished and the buyer will have paid too much. As a remedy, the seller agrees to indemnify the buyer for damages or loss of value if any of the representations or warranties turns out to be untrue. For example, the seller will represent to the buyer that the company owns all of its assets free and clear. If it turns out that one of the target company’s assets was encumbered by a $100,000 lien in violation of the representation that all of the assets were free and clear, the buyer would reduce the purchase price by $100,000, and, if already paid, “clawback” the $100,000 from the sellers. With these protections, the buyer will theoretically be willing to pay a higher price, because its risk of overpayment is reduced.

Indemnification agreements in business combinations have become very complex, and can vary as widely as the creativity of the lawyers and negotiators involved. Often, some of the purchase price will be placed in escrow for a period of time after closing to fund the indemnification. In addition, the parties may employ a “basket” whereby all indemnified amounts are aggregated and the stockholders don’t have to pay until the amount exceeds a minimum threshold, and a “cap” placing an upper limit on the amount that must be indemnified. Each of these has a number of variations. Indemnification obligations are also typically time-limited, either by their own terms, such as an escrow that only lasts for one year, or by a limit on the length of time the representations and warranties will “survive” after closing the deal.

When the combination is an asset purchase, the representations, warranties and indemnity are provided by the target company. In an acquisition, the buyer purchases all of the stock of the target directly from the stockholders. The stock purchase agreement between the buyer and the stockholders will include representations and warranties from all of the stockholders, or from a group comprising the largest or controlling stockholders. If the combination is a merger, the representations and warranties are provided by the target company, and sometimes by its controlling stockholders. However, a statutory merger is legally and procedurally different than an acquisition by stock purchase agreement. A merger is authorized and governed by state merger law; a stock purchase is not. This is because an acquisition by stock purchase is a private contract, and must be entered into by each stockholder. A merger does not require the consent of each stockholder, and can be forced on dissenting shareholders by law.

It is not uncommon for a successful private company to have scores or even hundreds of shareholders. It may have gone through multiple rounds of equity financing, issued stock and stock options to employees who have long since departed the company, and some of those stockholders may be hard to locate or generally disagreeable to anything the company proposes. In that situation it may be very difficult or impossible to enter a stock purchase agreement with each stockholder, and since a statutory merger requires only the affirmative vote from a specified number of stockholders, it is the better alternative. Minority shareholders who do not approve the merger have the choice to either accept the deal or exercise their statutory “dissenter’s right” and get a valuation of their shares. Either way, they are required by law to give up their stock in the company in the merger, and the merger may conclude without their approval.

Problems may arise, as reflected in Cigna v. Audax, when buyers (or their lawyers, at least) try to impose stock purchase terms like indemnification on the merged company’s stockholders as though they had entered into a private stock purchase agreement, even though some of those stockholders did not approve the merger, and would not have signed a contract containing those terms – they want their cake (private contract indemnification) and to eat it too (force dissenting shareholders to sell). To be fair to buyers and their lawyers, such terms can benefit the target company’s stockholders in the form of a higher purchase price; the buyer is typically willing to pay a higher purchase price when its risk is lower, and will reduce the purchase price if it must accept a greater risk of reduction in value from promises the stockholders won’t stand behind.

Cigna v. Audax

This brings us to the case of Cigna v. Audax. Cigna was a substantial shareholder in Optum Services, a medical services provider. Audax, a Cigna competitor, acquired Optum through a merger. Cigna voted against the merger, but the merger was approved by the required stockholder vote. Audax then sent the stockholders a “Transmittal Letter” and required each stockholder to sign and return it before receiving its money from the merger. The Transmittal Letter included the stockholder’s agreement to be bound by the indemnification provisions in the merger agreement, the appointment of a shareholder representative to deal with any indemnification claims in the future, and a release by each stockholder of any claims against Audax and Optum. Cigna refused to sign the Transmittal Letter and demanded its money, and when Audax refused to pay unless Cigna signed, Cigna sued.

Invalidation of Unlimited Indemnification

The Optum merger agreement included the typically extensive representations and warranties discussed above, and extensive indemnification obligations from the stockholders. Some of the representations and warranties survived for 18-months, and some for 36-months, but a substantial portion had no time limit, surviving forever. Moreover, there was no “cap” or limit on the amount the stockholders would have to pay if any of the surviving representations or warranties turned out someday to be untrue.

Cigna argued, and the court ruled, that the unlimited indemnification violated Delaware merger law, which requires that shareholders be able to determine the value of the merger consideration before approving the merger. Specifically, DGCL § 251(b)(5) requires the merger agreement to state “the cash, property, rights or securities of any other corporation or entity which the holders of such shares are to receive.” The court held that a shareholder indemnification that continues indefinitely, and has no limit on the amount, leaves the stockholders unable to determine what they are receiving as merger consideration, as required by Delaware law. The court stated: “…this case raises the novel problem that, … the value of the merger consideration itself is not, in fact, ascertainable, either precisely or within a reasonable range of values,” and, since the indemnity obligation is indefinite, “There is no point in time at which the merger consideration in this case ever becomes firm or determinable.”

As a result, the court invalidated the indemnification. However, the court took care to clarify that its ruling applies only to indemnification obligations in statutory mergers that (1) have no monetary limit, and (2) continue indefinitely. The ruling does not invalidate escrow agreements. The ruling does not invalidate post-closing adjustment provisions, but it does call them into question. The court said:

• “Post-closing price adjustments that could require individual stockholders to repay part of their merger consideration occupy an uncertain status under Delaware law;” and
• “This Opinion does not … rule on the general validity of post-closing price adjustments requiring direct repayment from the stockholders. This Opinion does not address whether such a price adjustment that covers all of the merger consideration may be permissible if time-limited, or whether an indefinite adjustment period as to some portion of the merger consideration would be valid.”

Accordingly, to be enforceable in Delaware, merger agreement post-closing price adjustment mechanisms, escrow provisions, indemnifications, and “claw-backs,” should be time limited, and also limited as to a reasonable and foreseeable portion of the purchase price. Failure to provide such limits in the merger agreement will leave buyers at risk for challenges based on uncertainty of purchase price.

Invalidation of Stockholder Releases

The merger agreement between Audax and Optum did not mention stockholder releases. Instead, it required a Transmittal Letter “in form and substance reasonably acceptable to Buyer,” including, “among other things,” indemnification. Merger agreements typically provide that when all of the merger conditions are satisfied, the companies are merged and the stockholder’s shares in the company are converted into the right to receive the merger consideration “without any further action by any party.” Cigna argued, and the court agreed, that the merger had already occurred when Audax sent the Transmittal Letter, Cigna had the right to receive its money, and there was no consideration for requiring releases not included in the merger agreement.

While this holding may seem significant, it is not. It is common drafting practice to provide that a related document must be signed and delivered in the future “in form and substance reasonably acceptable to” the parties. Such a provision does not allow one party to add new terms or obligations that go beyond the original agreement. The stockholder releases would have been enforceable if they had been detailed in the merger agreement, or the form of Transmittal Letter, including releases, had been attached to the merger agreement in final form. It is black letter law that one party cannot dictate new terms after a deal has closed.

What Does it mean in Colorado?

Could Colorado courts follow the decision in Cigna v. Audax? The decision to invalidate the releases is not unique to Delaware law; it is based on the common law of contracts applicable across the land. No consideration equals no contract, and that is as true in Colorado as it is in Delaware.

Invalidation of the unlimited indemnification is less certain, since it is based on interpretation of the language in the Delaware merger law. Delaware and Colorado merger laws are compared below. Delaware’s requirements are more detailed than Colorado, which on its face provides more flexibility:

Delaware Section 251(b)(5): The [merger] agreement shall state . . . The manner, if any, of converting the shares of each of the constituent corporations into shares or other securities of the corporation surviving or resulting from the merger or consolidation, or of cancelling some or all of such shares, and, if any shares of any of the constituent corporations are not to remain outstanding, to be converted solely into shares or other securities of the surviving or resulting corporation or to be cancelled, the cash, property, rights or securities of any other corporation or entity which the holders of such shares are to receive in exchange for, or upon conversion of such shares and the surrender of any certificates evidencing them…

Colorado Section 7-90-203.3: A plan of merger shall state . . . (c) the terms and conditions of the merger, including the manner and basis of changing the owners’ interest of each merging entity into owners’ interests or obligations of the surviving entity or into money or other property in whole or in part.

Delaware law requires a statement of the cash, property, rights or securities the stockholders will receive. Colorado law requires only “the terms and conditions of the merger” and the manner of exchanging the stock into money or property. However, despite the difference in statutory language, the concept behind the decision in Cigna v. Audax is sound and could be persuasive to a Colorado court – that is, stockholders cannot be expected to approve and accept a merger agreement, or have one imposed on them, if they cannot tell by its terms what consideration they will receive for their stock. If the terms of the merger could reduce their consideration to zero over time because of clawbacks for unknown liabilities, then one could argue that the “terms and conditions of the merger” are not sufficiently certain to allow approval of the merger, and therefore an unlimited indemnification should be invalid.

Practice Pointers

The way forward in Delaware is clear for now – indemnifications from stockholders in mergers should be limited in time and amount, such that the stockholders can determine the consideration they will receive in the merger, at least within a reasonable range. Colorado law appears to provide more flexibility, and it is difficult to predict how a Colorado court might decide the same question.

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

I warned against so-called “shareholder activists” who represent short-term shareholders to the detriment of businesses and their broad population of additional stakeholders here, here and here. To combat “shareholder activists” who pay or otherwise compensate people to run for boards of directors in activist-initiated proxy fights, Provident Financial Holdings, Inc. adopted a by-law that prohibited its directors from being paid by anyone other than Provident for being a director or running for the board. As a result, for Provident’s next shareholder meeting Institutional Shareholder Services (ISS) recommended that shareholders withhold votes for the directors who supported the amendment. The board survived the challenge, but an unusually high number of shareholders withheld votes. Details are reported on the Harvard Law School Corporate Governance blog in an article by Berl Nadler of Davies, Ward, Phillips & Vineberg LLP

ISS may not oppose these measures in all circumstances, but corporations considering adopting similar provisions should review the Nadler article and ISS’s objections before adopting similar provisions.