“Piercing The LLC Veil” by John M. Carnahan, III
Historically in the corporate law arena, there has been a doctrine known as “Piercing the Corporate Veil.” This is the belief that you can go through or pierce the corporation, and look to the shareholders or related entities for liability for claims or damages. The doctrine is used to go after a sister-corporation in a brother/sister arrangement, or go to a parent entity in a parent/subsidiary arrangement, and even against individual shareholders. Basically, it involves the theory that you cannot take advantage of the limited liability provided by a corporation if you fail to follow the basic rules involving organizing and acting like a corporation.
With the advent of limited liability companies, this is the new hot area of the law. When deals go bad, loans or accounts are not paid, or when there is a liability claim in excess of insurance, the plaintiff is always seeking ways to get to the deeper pocket. Therefore, plaintiffs are now filing lawsuits against limited liability companies and their owners or affiliates, seeking to “Pierce the LLC Veil.” While the majority of decisions hold in favor of the defendant and do not allow application of the doctrine in either the LLC or the corporate arena, a recent
Connecticut decision serves as an excellent example of how not to own and operate an LLC.
The basic facts of Tzvolos v. Wiseman* are as follows:
In August of 2003, Mr. and Mrs. Tzvolos sold kitchen equipment to Seawind, LLC for a new restaurant opening in Woodbridge, Connecticut. The price of the equipment was $35,000, $10,000 down and the balance to be paid via promissory note and security agreement. The initial $10,000 check from the LLC was really an endorsed check for
$10,000 from Mr. Hartmann. The note was executed by Mr. Wiseman who was also the Manager of the LLC, individually and not in the name of the LLC. Therefore, the Bill of Sale for the restaurant equipment and the UCC filed were in the individual name of the Manager, Mr. Wiseman. Mr. Wiseman, on behalf of the LLC, entered into a lease for the restaurant location. The Hartmann family put the majority of capital into the LLC for purposes of funding its purchases commenced renovations of the restaurant facilities, and building permits were obtained identifying Mr. Hartmann’s corporation as the owner. There was no contract between the LLC and Mr. Hartmann’s corporation with regard to the construction work. The final bill presented was in excess of $100,000.
The trial court concluded that the records documenting the services and work depict a confusing and contradictory collection of invoices, some marked “paid,” some duplicate and some with conflicting dates. By late 2003, the restaurant was not making any money and, in fact, had defaulted on rent and the payments on the note. In January of 2004, Mr. Hartmann, concerned about the construction cost payments, obtained a note and security agreement from the LLC. Unfortunately, the note was to an LLC owned by Mr. Hartmann and not his construction corporation.
The Plaintiffs, the Tzvolos, ended up suing the LLC, Mr. Hartmann and Mr. Hartmann’s corporation and LLC, in an
attempt to collect on the original purchase price note and looking to Mr. Hartmann and his entities under the “Piercing the LLC Veil” doctrine.
The Court found in favor of the Plaintiffs, Mr. and Mrs. Tzvolos, and against the Defendants, including Mr. Hartmann and his business entities. The Court noted that Connecticut law recognizes two theories under which it will permit the corporate veil to be pierced and the protection of the corporate structure to be set aside. Those theories are:
a.“Instrumentality Rule” wherein it is shown that one entity had control and complete domination of the finances, policies and business practices of the entity and that the control was used to commit fraud and to perpetrate the violation of a statutory or other legal duty, and that the aforesaid control and breach of duty must approximately cause the injury to the plaintiff.
b. The second theory is the “Identity Rule” wherein there is such a unity of interest and ownership that the independence of the corporation’s “business entities” had, in effect, ceased or never begun and the business entities are, in reality, controlled as one enterprise because of the existence of common ownership, officers, directors or share-holders because of the lack of observance of corporate formalities between the various entities.
The Court concluded that the Plaintiff had satisfied both theories and held the Hartmanns and their entities responsible. The moral of this story is that so many times we set up LLCs and there are what are known as related-party transactions. These transactions must be properly documented. In the corporate world, we maintain corporate
minute books containing actions ratifying and affirming related-party transactions, whether they be loans, security agreements, leases, construction contracts, etc. and that there be actual contracts between related parties. The same reasons we do this in the corporate arena, should also be followed in the LLC world.
*Tzvolos v. Wiseman – 2007 WL 1532760