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Corporate Veil Pierced Due To Fraud On Creditor

  • Posted on: Jul 20 2017

Although courts will pierce the corporate veil “to prevent fraud or achieve equity,” Morris v. N.Y. State Department of Taxation & Finance, 82 N.Y.2d 135, 140 (1993) (quoting Int’l Aircraft Trading Co. v. Mfrs. Trust Co., 297 N.Y. 285, 292 (1948)), they are, nevertheless, reluctant to disregard the corporate form. TNS Holdings Inc. v. MKI Sec. Corp., 92 N.Y.2d 335, 339 (1998). After all, the purpose of incorporating is to allow individuals to avoid personal liability. See Gartner v. Snyder, 607 F.2d 582, 586 (2d Cir. 1979) (citing Bartle v. Home Owners Cooperative, 309 N.Y. 103 (1955)). Thus, New York courts will pierce the corporate veil and hold shareholders/owners liable for the corporation’s debts only when “(1) the owners exercised complete domination of the corporation in respect to the transaction attacked; and (2) that such domination was used to commit a fraud or wrong against the plaintiff which resulted in plaintiff’s injury.” Morris, 82 N.Y.2d at 141. (This Blog previously addressed veil piercing here and, more recently, here.)

The determination whether to pierce the corporate veil is a fact-intensive one. And, because it is fact-intensive, the courts have held that it is not appropriate to make the determination “on a pre-answer, pre-discovery motion to dismiss.”  BT Ams. Inc. v. ProntoCom Mktg. Inc., 859 N.Y.S.2d 893 (Sup. Ct. N.Y. County 2008) (holding that veil piercing “is not well suited for resolution on a pre-answer, pre-discovery motion to dismiss”).

Significantly, because the analysis is so fact dependent, it “eschews mechanical interpretation.” LiquidX v. Brooklawn Capital, LLC, 1:16-cv-05528-WHP (S.D.N.Y. May 23, 2017) (quoting Morris, 82 N.Y.2d at 141). Accordingly, the courts consider the totality of the facts and evidence, as well as the public policy of “protect[ing] those who deal with the corporation.” Wm. Passalacqua Builders Inc. v. Resnick Developers South, Inc., 933 F.2d 131, 139 (2d Cir. 1991).

Exercise of Control

The first inquiry – whether the alleged alter-ego “exercised complete domination” – is case-specific and must be considered in view of “the totality of the facts.” United States v. Funds Held in the Name or for the Benefit of Wetterer, 210 F.3d 96, 106 (2d Cir. 2000). New York courts consider a number of factors in aid of this determination. These factors include:

(1) the absence of the formalities and paraphernalia that are part and parcel of the corporate existence, i.e., issuance of stock, election of directors, keeping of corporate records and the like, (2) inadequate capitalization, (3) whether funds are put in and taken out of the corporation for personal rather than corporate purposes, (4) overlap in ownership, officers, directors, and personnel, (5) common office space, address and telephone numbers of corporate entities, (6) the amount of business discretion displayed by the allegedly dominated corporation, (7) whether the related corporations deal with the dominated corporation at arms length, (8) whether the corporations are treated as independent profit centers, (9) the payment or guarantee of debts of the dominated corporation by other corporations in the group, and (10) whether the corporation in question had property that was used by other of the corporations as if it were its own.

Wm. Passalacqua, 933 F.2d at 139; Shisgal v. Brown, 21 A.D.3d 845, 848-49 (1st Dep’t 2005).

Because the decision whether to pierce the corporate veil depends “on the attendant facts and equities,” Morris, 82 N.Y.2d at 141, and said facts can apply to an “infinite variety of situations,” William Wrigley Jr. Co. v. Waters, 890 F.2d 594, 601 (2d Cir.1989), no one factor controls the consideration. Thus, for example, in applying the factors, “courts recognize that with respect to small, privately-held corporations, ‘the trappings of sophisticated corporate life are rarely present,’” and, therefore, they “must avoid an over-rigid ‘preoccupation with questions of structure, financial and accounting sophistication or dividend policy or history.’” Bridgestone/Firestone, Inc. v. Recovery Credit Servs., Inc., 98 F.3d 13, 18 (2d Cir. 1996) (quoting Wrigley, 890 F.2d at 601); see also Capricorn Investors III, L.P. v. Coolbrands Int’l, Inc., 897 N.Y.S.2d 668, 24 Misc. 3d 1224(A), at *5 (Sup. Ct. N.Y. Co. 2009) (“LLCs generally have operating agreements, which may include meeting requirements, or other such formalities. Plaintiff’s assertion that the LLCs have no officers or directors, and did not hold board or executive committee meetings are not persuasive veil piercing factors for an LLC, where plaintiff does not argue that management was required to be centralized in a board.”).

In applying these and other factors, the cases “reveal[] common characteristics” that necessitated piercing the corporate veil. Wrigley, 890 F.2d at 601. “In each case, the evidence demonstrated an abuse of that form either through on-going fraudulent activities of a principal, or a pronounced and intimate commingling of identities of the corporation and its principal or principals, which prompted the reviewing courts, driven by equity, to disregard the corporate form.” Id.

The Use of The Corporate Form to Commit a Fraud or Wrong

The second factor allows courts to pierce the corporate veil where the shareholder/owner uses the corporation “to commit fraud [or other wrong], or violate other legal duty, or has been used to do an act tainted by dishonesty or unjust conduct violating plaintiff’s rights or … where such fraud or wrong results in unjust loss and injury to plaintiff ….” Lowendahl v. Baltimore & Ohio R.R. Co., 247 A.D. 144, 157 (1st Dep’t 1936), aff’d, 272 N.Y. 360 (1936); Morris, 82 N.Y.2d at 141. It is not necessary, however, for there to be an alleged fraud. Gorrill v. Icelandair/Flugleidir, 761 F.2d 847, 853 (2d Cir. 1985). Rather, it is sufficient that the alter ego “through their domination of the corporation, ‘abused the privilege of doing business in the corporate form to perpetrate a wrong or injustice against [the aggrieved party] such that a court in equity will intervene.’” JSC Foreign Econ. Assoc. Technostroyexport v. Int’l Dev. And Trade Servs., Inc., 386 F. Supp. 2d 461, 465 (S.D.N.Y. 2005) (quoting Morris, 81 N.Y.2d at 142).

In fact, in Wm. Passalacqua, the court held that it would be error to instruct a jury “that plaintiffs were required to prove fraud” to pierce the corporate veil, stressing that the “critical question is whether the corporation is [a] ‘shell’ being used by the [shareholders/LLC members] to advance their own purely personal rather than corporate ends.” 933 F.2d at 138.

Piercing the Veil Between Corporations

The alter ego doctrine has also been applied to pierce the veil between corporations when affiliate or subsidiary corporations are used by a dominating parent corporation to engage in fraudulent or wrongful conduct. Under New York law, a corporation is considered to be a “mere alter ego when it ‘has been so dominated by . . . another corporation . . . and its separate identity so disregarded, that it primarily transacted the dominator’s business rather than its own.’” Trabucco v. Intesa Sanpaolo, S.p.A, 695 F. Supp. 2d 98, 107 (S.D.N.Y. 2010). When that occurs, “the dominating corporation will be held liable for the actions of its subsidiary . . ..” Id.

As with veil piercing, control is an important factor. The factors considered for veil piercing are also used to determine alter ego liability.  Trabucco, 695 F. Supp. 2d at 107. Again, no one factor is dispositive and “all need not be present to support a finding of alter ego status.” N.Y. Dist. Council of Carpenters Pension Fund v. Perimeter Interiors, Inc., 657 F. Supp. 2d 410, 421 (S.D.N.Y. 2009).

LiquidX v. Brooklawn Capital, LLC

Recently, Judge William H. Pauley, III of the Sothern District of New York had the opportunity to consider these principles in LiquidX v. Brooklawn Capital, LLC, 1:16-cv-05528-WHP (S.D.N.Y. May 23, 2017).

Background

The Receivables Exchange and the Final Funding Round

The dispute arose out of the demise of The Receivables Exchange (“TRE”), a financial technology company that operated an online exchange for accounts receivable – i.e., debts held on a company’s books, such as scheduled payments for goods shipped on credit. The platform allowed companies to access short-term liquidity by selling these accounts at a discount to buyers on the exchange, who would then become the creditors on these accounts and would profit if and when the debtor paid the account in full.

By the fall of 2013, though raising nearly $60 million from a variety of venture capital entities over five rounds of funding, TRE found itself in dire financial straits. To staunch the bleeding, TRE’s board implemented a number of measures to slow the company’s “burn rate”, and secured a $3.25 million loan from Comerica Bank while it sought additional funding.

In the summer of 2015, after the TRE board failed to secure a sixth round of funding, Gary Mueller (“Mueller”), an investor and entrepreneur, who was a business acquaintance of John Connolly (“Connolly”), a managing director of TRE, agreed to invest money into TRE and lead a renewed financing campaign. Mueller began his diligence in earnest and set a closing date of September 28, 2015.

In late September, Solaia Capital, an aggrieved customer of TRE, won an arbitration against TRE in which the arbitrator awarded Solaia $186,000 in damages. Although the award was relatively small, the Solaia arbitration involved claims substantially similar to those asserted by Brooklawn Capital Fund LLC, and Brooklawn Capital Fund II, LP (collectively, “Brooklawn”) in a separate arbitration against TRE. Brooklawn was seeking more than $8 million in its arbitration. Mueller reviewed the award and, after discussing it with TRE’s management, understood that TRE was exposed to greater liability, and canceled the funding round on the very day it was set to close.

The “NewCo” Plan

By October 1, two days after he canceled the funding round, Mueller began working with James Toffey (Toffey”), president and CEO of TRE, on an alternative plan – Mueller would form a “NewCo” to purchase TRE’s loan from Comerica and foreclose on TRE’s assets as the first-priority secured creditor. Comerica, aware of the failed funding round, sent a letter on October 15 outlining several different options for TRE to avoid default, including a “going-concern” sale or an outright sale of TRE’s assets. Toffey declined to consider those alternatives and instead pursued Mueller’s proposal. Three TRE insiders – Toffey, Connolly, and finance chief James Kovacs (“Kovacs”) – planned to invest in “NewCo” and join Mueller in running “NewCo” after the foreclosure.

An integral part of the plan was keeping it from the other members of TRE’s board, whom Connolly and Mueller did not intend to include in “NewCo.” Starting in October 2015, the three TRE insiders stopped using their TRE email accounts to communicate with Mueller and switched to their personal Gmail accounts.

On October 15, 2015, Comerica consented to the Mueller/Toffey plan, but only if the sale was to a “disinterested buyer” who would offer the loan’s entire principal and interest. Because TRE was not yet in default, Comerica would only agree to a sale at par – i.e., at a price that “pays the bank back in full.”

On November 6, 2015, “NewCo” came into being as LiquidX, Inc., with Mueller as president and Kovacs as Treasurer. Toffey, Connolly, Kovacs, and Mueller capitalized the new company with $1,000, receiving approximately 80% of the shares at incorporation. By the end of November, the four investors had purchased additional LiquidX stock and loaned the company $4.05 million. LiquidX was ready to purchase the Comerica loan.

The Loan Purchase and Foreclosure

On November 20, 2015, Mueller sent a term sheet to the TRE board outlining his plan to purchase the loan and effect a strict partial foreclosure on TRE’s assets. Those assets, which Mueller believed were worth “$2 to $3 million,” would constitute partial satisfaction of the $3.25 million loan – thus, LiquidX would remain TRE’s senior secured creditor. In effect, TRE would cease to be an existing company and LiquidX would acquire its remaining cash and assets, including the exchange platform.

In order to implement the foreclosure, TRE needed to obtain an independent appraisal of its assets. Mueller needed the valuation to be low – i.e., below the $3.25 million loan amount – for the transaction to work. If TRE’s assets were appraised above $3.25 million, TRE’s junior creditors (like Brooklawn) would still have claims on those assets after LiquidX foreclosed. Therefore, Mueller needed a valuation between $2 and $3 million in order to “leave unsecured creditors behind.”

On December 4, 2015, Toffey learned that the appraisal expert had valued TRE at $2.05 million With the appraisal in place, LiquidX could acquire TRE for $4.05 million (the cost of the loan plus interest), notwithstanding the fact that Mueller had valued TRE’s assets at $18.2 million, with considerable upside potential.

TRE becomes LiquidX

Over the following two months, TRE’s management worked on the “rebranding” into LiquidX. Toffey and other executives moved vendor contracts, bank accounts, and customer agreements to LiquidX. Although TRE had informed its vendors and customers of the “rebranding,” TRE’s common stockholders and contingent creditors (including Brooklawn) were left in the dark. LiquidX commenced operations on January 1, 2016, using, inter alia, the same offices, employees, vendors, and finance department that had served TRE the day before.

The Lawsuit and Decision

As noted, Brooklawn brought an arbitration proceeding against TRE. After the foregoing events occurred, Brooklawn sought to join LiquidX in that proceeding. When Brooklawn did so, LiquidX filed the action seeking a declaration that joinder would be improper on the grounds that it is not TRE’s alter ego. Following a four-day bench trial, the Court found that LiquidX “is the alter ego of TRE.”

On the issue of control, Judge Pauley found that TRE and LiquidX “are virtually indistinguishable” and that “LiquidX is a new company in name only.”

Beginning on January 1, 2016, LiquidX continued to operate TRE’s business in a seamless transition. TRE’s offices and employees became LiquidX’s offices and employees, the exchange was simply rebranded, and LiquidX took over responsibility for financing and defending TRE’s outstanding legal disputes (including the Brooklawn arbitration.) ….

Citation omitted.

In concluding that there is “no meaningful distinction between the company that TRE was and the company that LiquidX is today,” the Court rejected LiquidX’s argument that there is no “overlap in ownership because Toffey, Connolly, Kovacs, and Mueller never owned shares of both TRE and LiquidX.” Judge Pauley found that the argument was not compelling, “as it rests on an overly formalistic conception of ‘domination and control.’”

Ownership, in the corporate context, is a proxy for control. It is certainly possible, however, to exercise control over corporate functions without owning the corporation itself ….

The Court found Mueller, Toffey, Connolly, and Kovacs did, in fact, control LiquidX. In this regard, the Court found that

The TRE insiders ensured that Mueller’s transaction would be successful by declining to consider other options after the funding round fell apart. Connolly and Toffey, both former TRE board members, became directors of LiquidX on the company’s first day in business. Kovacs worked for both companies simultaneously in November 2015 as he endeavored to ensure a smooth transition after the foreclosure. Mueller was never a part of TRE but nonetheless exercised considerable influence on the board, as he was the only viable source of funding at the end of 2015. Taken together, these facts reveal a substantial overlap in directors, officers, and control between TRE and LiquidX.

“The most significant factor” said the Court, is the fact “that the corporations did not deal with one another ‘at arm’s length.’”

The substantial involvement of TRE’s management team, and Toffey in particular, in engineering the foreclosure from both sides suggests that this was anything but a disinterested negotiation between sophisticated parties. Toffey’s influence over the independent appraisal is particularly glaring.… Indeed, there would be no reason for Toffey to push for a low valuation if he were a disinterested TRE executive.

On the issue of using control of TRE to commit a wrong, the Court found that there was “ample evidence … that LiquidX, through the actions of TRE’s management, structured and executed this transaction to perpetrate a wrong—namely, a foreclosure that would allow LiquidX to acquire TRE’s business free and clear of its creditors, leaving Brooklawn with nothing but a shell company to litigate against.” According to Judge Pauley, “[t]he sequence of events leading to the foreclosure renders this conclusion inescapable.”

TRE’s final funding round cratered immediately upon Mueller learning of the Solaia arbitration award—not because the award was large, but because it amplified the litigation risk of Brooklawn’s more substantial claim. Instead of walking away from the transaction, Mueller and Connolly came up with an approach that would allow them to acquire TRE’s functioning platform while ‘leav[ing] unsecured creditors behind.’ Brooklawn would find itself arbitrating against a ‘ShellCo,” and LiquidX, with TRE’s contingent creditors safely in the rearview mirror, would be a functioning business worthy of a multi-million dollar investment in a matter of months. To achieve this outcome Mueller relied on insiders like Toffey to stack the deck in LiquidX’s favor—for example, by agreeing on behalf of TRE (without disclosing his interest in LiquidX to the board) to amend the loan agreement and allow LiquidX to conduct a private foreclosure. Ultimately, the foreclosure turned Brooklawn’s otherwise-viable arbitration into an exercise in futility. This result would not have been possible without the high degree of control that Mueller, Toffey, Connolly, and Kovacs exercised over TRE’s operations.

Citations omitted.

Takeaway

Although courts are reluctant to impose alter ego liability or pierce the corporate veil, they will do so when the facts and circumstances indicate that the corporate form was used to commit a fraud or other wrong. LiquidX illustrates the type of circumstances in which the factors considered by the courts support the imposition of liability on the corporate owners or affiliates.

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