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Piercing the “Veil” of a Company’s “Limited Liability”or Looking Through the Entity to Hold Owners Liable for a Company’s Debts | e-LawLines Paste your Google Webmaster Tools verification code here

A recent Missouri Court of Appeals case out of the Eastern District of Missouri now gives us an indication of how the Missouri courts will approach the issue of piercing the “corporate veil” of a limited liability company. The case is Mobius Management Systems, Inc. v. West Physician Search, L.L.C. While the court’s holding is couched in the cloak of a limited liability company, the lesson is equally applicable to corporations and any other business entity.

In Mobius, the basis for the litigation was a commercial real estate sublease between Mobius Management Systems, Inc. (“Mobius”) and West Physician Search, L.L.C. (“West”). The sublease was signed by David West, West’s managing member, and obligated West to pay Mobius monthly rent. West defaulted under the sublease when it failed to pay rent for September 2002 through December 2002. In December 2002, Mobius filed its Petition for Rent and Possession and in July 2003, a Consent Judgment was entered against West, awarding $175,000.00 to Mobius. The Consent Judgment was signed by David West. Mobius was unsuccessful in its attempts to collect on the judgment from West and subsequently filed a Motion to Pierce the Corporate Veil, seeking to recover from David West personally. In its motion, Mobius alleged that David West co-mingled personal funds with those of West, failed to maintain corporate books and records for West, that West was undercapitalized and that West failed to follow corporate formalities. West filed a Motion to Dismiss which was sustained and an appeal followed.

On appeal, Mobius argued that the lower court erred when it dismissed Mobius’ Motion to Pierce the Corporate Veil and failed to hold David West personally liable on the judgment because David West operated West while it was undercapitalized, West violated its statutory duties, manipulated corporate assets, stripped itself of its corporate assets and co-mingled its funds with David West’s personal funds. The Court agreed with Mobius and reversed and remanded the case for trial.

In so holding, the Court stated that “in some circumstances, a court may disregard a corporate entity and hold its owners personally liable for corporate debts.” There are three elements required to be proven by a plaintiff to pierce the corporate veil. A plaintiff must first show control, which is not merely majority or stock control, but complete domination, not only of the finances, but of policy and business practices with respect to the questioned transaction. The Court held that “when a corporation is so dominated by a person as to be a mere instrument of that person, and indistinct from the person controlling it, the court will disregard the corporate form if its retention would result in an injustice.” The facts of the case showed that David West owned 80% of West, that David West often paid the West employees with his own personal funds, and that there was no corporate resolution authorizing the Consent Judgment. All of these facts indicated that West and David West operated with one mind and that the control requirement for piercing the corporate veil was satisfied in the court’s opinion.

The second requirement which a plaintiff must show is a breach of duty. That is that the control was used to commit a fraud or a wrong, to perpetrate the violation of a statutory or other positive legal duty, or to commit a dishonest or unjust act in contravention of the plaintiff’s legal rights. It is not necessary to show actual fraud. The undercapitalization of a company or the stripping of a company’s assets can be used as circumstantial evidence of improper purpose or reckless disregard for the rights of others. The evidence in Mobius showed that West did not maintain accounts receivable or accounts payable ledgers, that there was no corporate bank account for almost one year prior to the entering of the Consent Judgment, and that when David West agreed to and signed the Consent Judgment, he knew West was unable to pay it. The Court found that David West created West, never acquired sufficient capital to operate West, entered into a sublease without sufficient capital to fulfill West’s obligations under the sublease, and signed a Consent Judgment one year after West had been abandoned. Moreover, David West circumvented West’s legal obligations by operating an undercapitalized shell corporation, and that therefore, the second requirement for piercing the corporate veil was satisfied.

The final element a plaintiff must show is that the control and the breach of duty proximately caused the injury or unjust loss. The Court found that Mobius had clearly sustained an injury, the unpaid judgment of $175,000.00. Moreover, the injury was proximately caused by West’s and David West’s conduct because West lacked the necessary capital to satisfy the Consent Judgment. Thus, the Court found that Mobius had met its burden and that the dismissal of its Motion to Pierce the Corporate Veil was improper.

The Court in Mobius applied the exact same test that courts have used when faced with the piercing the veil of corporations. Basically those elements are control, breach of duty and proximate cause. In so holding, the Mobius Court relied heavily upon the Missouri Supreme Court case, 66, Inc. vs. Crestwood Commons Redevelopment Corporation. This case is the preeminent case upon which most courts rely upon to determine whether to pierce a company’s veil and hold the individual shareholders or owners liable for the company’s debt.

In 66, Inc., an owner of commercial property brought an action for damages against Crestwood Commons Redevelopment Corporation (“Redeveloper”) and its joint venture owners after the Redeveloper abandoned its condemnation action to acquire the owner’s property by eminent domain. In holding for the owner, the Missouri Supreme Court stated that Missouri law recognizes the narrow circumstances in which the “corporate veil” can be “pierced” in order to hold the corporation’s owners liable for its debts. A court can disregard the corporate entity and hold the corporate owners liable if the following can be shown: control, use of the control to commit fraud or a wrong or a violation of statutory or other positive legal duty, or a dishonest and unjust act in contravention of the legal rights of a plaintiff, and the control and breach of duty must proximately cause the injury or unjust loss.

The Redeveloper’s joint venturers did not dispute the exercise of complete control. Instead, they argued that a court may only disregard the separate corporate entity if the separateness is used to defraud and further, that the use of unfunded redevelopment corporations was a common practice and, as such, could not be a fraudulent means of shielding the principals. In response, the Court stated that proof of actual fraud is not required, that “making a corporation a supplemental part of an economic unit and operating it without sufficient funds to meet obligations to those who must deal with it would be circumstantial evidence tending to show either an improper purpose or reckless disregard of the rights of others” was all that is required. As for the third prong, causation, the Court found that “when the dominant corporation renders the subservient corporation insolvent, then the requisite injury and causal connection are established.” The Court held that the partners in the joint venture were jointly and severally liable for the joint venture’s (the Redeveloper’s) debts.

As Mobius shows, the limited liability company “corporate veil” will shield the individual(s) associated with the company from liability arising from the acts of the company and the liability arising from the actions of individuals associated with the company as long as those actions are generally not wrongful. However, limited liability is not absolute. When an individual intertwines personal and company dealings so as to make the company an agent of the individual, the courts will pierce the veil of limited liability and hold the individual(s) liable along with the company. Prior to Mobius, it was thought by most legal scholars that the courts would not rely heavily on an entity’s failure to follow formalities as a factor in holding investors liable. However, a big factor in Mobius considered by the Court, was that the managing member did not follow corporate formalities such as seeking the company’s consent to enter into the judgment, the keeping of corporate books and records and the co-mingling of personal funds and company funds, all in contravention of corporate law and the Missouri Limited Liability Company Act.

In order to avoid the outcome in Mobius, the first thing members of a limited liability company should do is to review the company’s operating agreement to make sure the company is operating in conformance with said agreement. If not, the operating agreement should be amended or the members should change the way the company is being operated. Second, the members should review the company’s capital structure. A key theme throughout the reported cases is that the companies whose owners were found liable entered into contracts without the necessary capital to comply with the terms of the contracts. The primary focus on “undercapitalization” is intent. Did the company enter into a contract knowing that it could not perform? If the answer is yes, then the courts will pierce the veil of limited liability. Finally, members should never co-mingle company funds with personal funds or use the company bank account as their own personal bank account. This type of behavior in and of itself will give a plaintiff all the evidence they need to prove the “control” and “breach of duty” element required to pierce the corporate veil.

Ordinarily a limited liability company is regarded as a separate legal entity, whether there are many members or just one. However, the Missouri Court’s will pierce the “veil” when it is necessary to prevent injustice or the limited liability company was used for an improper purpose or with reckless disregard for the legal rights of others.