Piercing the corporate veil (PCV) is a remedy often pursued by a creditor of an insolvent entity against the entity’s parent or principal. While the corporate veil generally shields a shareholder from the general obligations of his or her corporation, PCV allows a creditor to look beyond the corporate shield and, in certain instances, hold a shareholder liable for the corporation’s debts.
Common factors that warrant piercing the corporate veil include the lack of adherence to corporate formalities, the level of shareholder control, and the commingling of assets and business among the shareholder and corporation. When such factors are present, a creditor is able to argue that a corporation is a mere sham or instrumentality of its parent or principal. These factors, however, may be less indicative of a sham when applied to an entity that is not a corporation and is not governed by regimented corporate laws. For example, a limited liability company (LLC) is by design a more flexible entity, which is allowed, among other things, to maintain less formalities and to be managed by its members (owners). These distinctions and others may necessitate a different analysis when attempting to pierce the veil of an LLC.
In Steve Baldwin, et al. v. Atlantis Water Solutions, LLC, et al. (In re Atlantis Water Solutions, LLC), Adv. No. 18-00016-BPH (D. Mont. Nov. 5, 2018), the United States Bankruptcy Court for the District of Montana discussed the different analysis required to pierce the veil of a limited liability company. The Court ultimately found that a creditor could not pierce the veil of a Montana LLC, using traditional PCV factors applicable to corporations.
Iofina Resources, Inc. (Iofina) is a corporation engaged in the exploration and production of iodine. Sometime in 2011, it formed Atlantis Water Solutions, LLC (Atlantis), as a single-member, member-managed LLC, to pursue the development of a fresh water depot in eastern Montana to serve the oil and gas industry in that area. Atlantis’ business plan was to take water from the Missouri River and distribute it from a depot that would accommodate tanker trucks. This water depot project was clearly outside of Iofina’s core business.
While Atlantis maintained good standing in Montana as a separate entity (LLC), in reality, there was not much separateness between Iofina and Atlantis. Among other things, Atlantis (a) shared its President with Iofina’s Chief Operating Officer; (b) never had its own bank accounts; (c) never generated revenue; (d) was provided all its operating funds by Iofina; (e) had no employees; (f) had no hard assets and only had contract rights and studies/surveys; (g) did not file its own tax returns; (h) had no credit; and (i) had no corporate minutes or resolutions.
After it was formed, Atlantis entered into a surface lease with a Montana landowner, pursuant to which the landowner agreed to lease the surface area on its property to Atlantis for the purpose of building a pump station, obtaining easements and running a water processing operation. The surface lease had a 10-year term. In connection with the surface lease, Atlantis also entered into an option agreement, which granted Atlantis the option of obtaining a lease and access to the Missouri River from the sub-surface of the landowner’s property.
The Atlantis water project was always dependent upon Atlantis receiving a water permit from the Montana Department of Natural Resources (DNRC). The landowner understood that at the time it entered into the surface lease.
Unfortunately, the permitting process took much longer than expected. Due to pressures from the landowner, Atlantis was forced to exercise the sub-surface option and pay the landowner an access fee of $175,000.00, before ever obtaining the requisite permit.
Shortly thereafter, Atlantis was informed that the DNRC denied its request for a water permit. Although Atlantis appealed the DNRC’s decision, by that time, due to the delays, Atlantis was operating at losses in excess of $400,000.00. Approximately a year later, Atlantis lost the appeal.
Following the loss, Iofina’s COO (also Atlantis’ President) informed the landowner that Atlantis was abandoning the water project and would no longer be making lease payments to the landowner. Although Atlantis had already paid almost $460,000 in option money, fees and rent, over $700,000 was still due under the various agreements with the landowner.
The landowner subsequently filed suit in state court against Atlantis for breach of contract and further sought to hold Iofina liable on the theory that Atlantis was its alter ego. This action was eventually removed to bankruptcy court when Atlantis filed for chapter 7 relief.
The Bankruptcy Court first noted that, while Montana’s LLC laws generally shield members of an LLC from personal liability for obligations of the company, common law principles of PCV still apply to LLCs. Pursuant to traditional PCV principles—historically applied to corporations—the corporate shield can be pierced using the following two-prong test:
- the defendant must be shown to be an alter ego, instrumentality, or agent of the corporation; and
- substantial evidence must exist that the corporation was used as a subterfuge to defeat public convenience, justify wrong or perpetrate fraud.
Peschel Family Trust v. Colonna, 75 P.3d 793, 796-97, 799 (Mont. 2003). Montana courts also use 14 factors to determine whether the first prong is met. These factors generally gauge the shareholder’s control and use of corporate assets and the corporation’s adherence to corporate formalities, separateness from its shareholder, representations to third parties, and capitalization. Id. at 133-34.
The Court was persuaded that the traditional first prong was generally inapplicable to LLCs, because such entities are starkly different from corporations. For example, unlike corporations, LLCs are not required under state law to observe a variety of formalities in their governance and operations. LLCs are also permitted to have single members and are permitted to be managed by its members. MCA §§ 35-8-201(1), 35-8-202(e)(ii). LLCs are not required to have operating agreements, which generally dictate governance. MCA § 35-8-109(1). Moreover, Montana’s LLC statute expressly provides that an LLC’s failure to observe corporate formalities or requirements relating to the exercise of company powers and management is not a ground for imposing personal liability on its members or managers. MCA § 35-8-304(2). The Court found these distinctions compelling.
The Court also found that the second prong of the PCV test was not met because the landowner admitted that he did not believe that Iofina was using Atlantis as a subterfuge or to commit a crime or perpetuate fraud.
The landowner’s sole argument was that Atlantis was always undercapitalized, which was indicative of such bad faith as to warrant piercing the corporate veil. However, the Court found that undercapitalization was insufficient to prove bad faith, where, unlike past cases, (a) there was no evidence of self-dealing between Atlantis, Iofina and their COO/President; (b) the landowner was paid a substantial amount of money before Atlantis ceased its business; (c) Iofina and Atlantis both suffered a loss; not a gain; and (d) from the beginning, the landowner was aware that Atlantis was a start-up, whose future depended on the DNRC’s decision.
Accordingly, the Court did not allow the landowner to hold Iofina liable for Atlantis’ debt.
PCV is an equitable remedy that is not warranted in all situations where an entity is insolvent or undercapitalized. Recognizing the equitable nature of this remedy, courts often are not bound by formulaic tests in determining whether piercing the veil is warranted. Indeed, as the Court noted in the Atlantis case, traditional PCV factors do not necessarily apply in cases where the insolvent entity is not a corporation and state law expressly permits the non-corporate entity to operate in a less formal manner.