Normally, limited liability business entities, which include corporations and limited liability companies (LLCs), prevent the entity's creditors from going after an owner's personal assets to satisfy their claims. But in rare circumstances, courts allow piercing of the corporate veil. When this occurs, creditors who win a legal judgment against the corporation or LLC may target the personal assets of a shareholder or LLC member to satisfy the debt.
Reverse veil piercing also allows an exception to the legal separateness between corporate or LLC entities and their owners, but in the opposite direction. When the corporate veil is pierced—in reverse—business assets can be used to pay for obligations incurred by the owner.
Courts are hesitant to allow veil piercing or reverse veil piercing except in cases where there has been serious wrongdoing, such as fraud. Whether a court will permit reverse veil piercing is based on the specific facts of the case, as well as the law of the state where the LLC is formed or the corporation is incorporated. Reverse veil piercing has been permitted by courts in Delaware, California, North Carolina, and Virginia.
When Reverse Veil Piercing May Be Permitted
In general, courts analyze similar factors when deciding on the appropriateness of veil piercing or reverse veil piercing. Corporations and LLCs or their shareholders and members must usually engage in relatively egregious conduct for the corporate veil to be pierced in either direction.
According to an article published in the Cornell Law Review, veil piercing may be allowed under the following circumstances:
- The corporation is the alter ego of its shareholders. The identities of the owner and the corporate entity are separate only on paper, not in reality.
- The corporation is undercapitalized. Undercapitalization means a company does not have enough capital to perform normal business operations and pay creditors. If your company enters contracts that it is unable to fulfill due to a lack of funds at the time the contract is signed, this could be evidence of undercapitalization.
- Corporate formalities are not observed. Corporations and LLCs are expected to follow certain procedures, as established by state corporate and LLC law. For example, corporations are usually required to hold meetings and record meeting minutes. LLCs require fewer formalities.
- The corporation or LLC is used to promote fraudulent, unjust, or illegal actions. Courts are unlikely to look favorably on the doctrine of entity separateness if the corporation or LLC appears to have been formed as a cover to allow shareholders or members to escape personal liability for misconduct.
Another factor that courts might look at is the commingling or diversion of corporate finances and owner finances. Although owners are permitted to take legitimate distributions from the company and accept expense reimbursements as outlined by the operating agreement, these finances should generally be kept separate, and any transactions should be documented.
Examples of Reverse Veil Piercing
Here are some recent examples in which courts have authorized reverse veil piercing:
- Manichean Capital, LLC v. Exela Technologies, Inc. This case was the first instance of reverse veil piercing recognized under Delaware law. It arose from a merger between SourceHOV Holdings, Inc., and Exela Technologies, Inc. The plaintiffs were former SourceHOV stockholders who dissented from the merger and won an appraisal judgment. They won a claim for reverse veil piercing against Exela, arguing that it was the only way they could collect the judgment. You can read the full decision here.
- Curci Investments v. Baldwin. In this California case, a $7.2 million judgment was entered against a real estate developer (Baldwin) when he defaulted on a loan. The creditor was unable to collect from Baldwin because he used an LLC in which he had a 99 percent member interest to divert money to other accounts. The creditor filed a motion seeking to pierce the veil of Baldwin's LLC and won the case on appeal.
Avoiding Reverse Veil Piercing
The best way to keep the legal barrier up between yourself and your company is to avoid using your company to evade a personal obligation, carry out fraud or crime, or obtain an unfair advantage. Courts in several states have found that when the personalities of the corporation and the individual are no longer separate and maintaining that separateness would result in an injustice, it is appropriate to pierce—and in some cases, reverse pierce—the corporate veil.
Do you have questions? Contact a New York City business attorney at The Browne Firm. Give us a call at 914-530-3070.