Tuesday, October 23, 2012

Texas Court Limits Alter Ego Doctrine for Member of Limited Liability Company

Legislatures encourage entrepreneurial risk taking by allowing individuals to form artificial entities to limit their personal exposure for corporate debts.    Plaintiffs’ lawyers attempt to tear down those walls by piercing the corporate veil.   In recent years, the Texas legislature has moved away from a formulaic approach to veil piercing (i.e., did the entity keep regular minutes) toward one focusing on whether the corporate vehicle had been used by the owner to perpetuate a fraud.   A Texas court of appeals has now confirmed that this principle applies to limited liability companies even prior to the enactment of corrective legislation.    Shook v. Walden, 368 S.W.3d 604 (Tex. App.—Austin, 2012, pet. filed).   

The case involved a father who wanted to set up his new son-in-law in business.   Shook, the father, and Jahne, the son-in-law, formed S & J Endeavors, LLC.   S & J was supposed to build a home for the Waldens.    Problems ensued and the Waldens sued.   After a fourteen day trial, the jury rendered a verdict against S & J and Jahne for fraud but did not award damages.   The jury also found that S & J had breached its contract with the Waldens and awarded $80,000 in actual damages and $315,000 in attorney’s fees.   The jury imposed personal liability on both Shook and Jahne by finding that S & J was the alter ego of the individuals, that they constituted a “single-business entity” and that the LLC was a “sham.”   

On appeal, the Waldens conceded that “single-business entity” was no longer a viable theory for piercing the corporate veil under Texas law.  See SSP Partners v. Gladstrong Invs. (USA) Corp., 275 S.W.3d 444 (Tex. 2008).    This left the alter ego and sham findings.

The Court noted that the Texas legislature had restricted the alter ego doctrine in cases involving business corporations to cases where the defendant used the corporation to commit an “actual fraud” for his “direct personal benefit.”   This eliminated veil piercing based on failure to keep minutes and other technical violations.  

While this legislation was evolving over the period from 1989 to 1997, the legislature created the limited liability company as a new form of entity in 1991.   While the legislation contained general provisions that the members of an LLC were not liable for the entity’s debts, it did not address veil piercing principles until 2011.  See Business Organizations Code Sec. 21.223 and 21.224.    Unfortunately, this legislative change did not apply to Shook's case.

Nevertheless, after an extensive discussion, the Austin Court of Appeals concluded that the “actual fraud” for “direct personal benefit” standard should apply to a limited liability company even prior to the recent legislative amendments.    While this seems like a sensible conclusion, one Justice dissented and a petition for review is now pending before the Texas Supreme Court.  

For cases arising after September 1, 2011, the new legislation dictates the higher standard for veil piercing.   I would suggest that the facts of the Shook case illustrate why the legislature was right to make this change. 
Mr. Shook invested approximately $200,000 in the home-building business.    He was one of two members and managers.    The company used the Shook residence as its mailing address and he signed a few checks.    Shook contributed some nominal services to the company such as helping to install door hinges, door knobs and towel bars.   Mr. Shook would have been quite justified in asking, "Does this make me a bad guy?"

The issue submitted to the jury allowed them to find that “a corporation is the alter ego of a shareholder when there is such a unity between the corporation and the shareholder that the separateness of the corporation has ceased, or when a corporation operates as a mere tool or business conduit of its shareholder” as “shown from the total dealings” of the shareholder and the corporation.    The jury was also instructed to consider eight other factors including “the amount of financial interest, ownership and control the shareholder maintains over the corporation.”  Unfortunately, the instructions submitted to the jury gave them virtual carte blanche to impose liability based upon their subjective whims. 

In my personal view, if the legislature is going to allow persons to use artificial entities to do business, the Courts should respect that judgment by setting a high bar to impose personal liability.    While it is reassuring that the much-maligned Texas legislature has set standards to rein in the courts, it is also comforting that in this particular case, the appellate court (or at least 2/3 of its members) did the sensible thing.   

Note:  While the reader may discern that I have some personal opinions about the issue in this case, I did not have any involvement.

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