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Single-Member LLC's Veil Pierced In Greenhunter

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Western Echosystems Technology, Inc. (Western) provided consulting services to GreenHunter Wind Energy ("the LLC") for the latter's wind turbine farm in Wyoming. The LLC, however, failed to pay Western anything.

Western sued the LLC for breach of contract, and was awarded a judgment of $43,646 plus another $2,161 in attorney's fees. But when Western tried to collect, it found out that the LLC had no assets available to satisfy the judgment.

Not one to be stiffed on a judgment, Western brought an action against the LLC's sole member, Greenhunter Energy, Inc. ("Greenhunter"), a Texas corporation, to pierce the LLC's veil and make Greenhunter liable on the judgment.

At trial, Greenhunter was proven to be the sole member and manager of the LLC, which was Greenhunter's wholly-owned subsidiary. The LLC itself never carried a capital balance that was sufficient to cover its debts, and many times had a capital balance of zero. Instead, Greenhunter simply advanced as much money to the LLC as necessary to cover accounts payable. Greenhunter did not, however, provide any funds to pay Western's judgment.

The LLC did not have any employees of its own, but Greenhunter's employees did everything for the LLC including negotiate leases on the wind farm. The LLC's chairman was Greenhunter's chairman, and the LLC's general counsel was likewise Greenhunter's general counsel. Not surprisingly, the LLC and Greenhunter had the same business address, and Greenhunter's employees kept the LLCs books and financial records.

Moreover, between Greenhunter and the LLC, the LLC was treated as a "disregarded entity" for tax purposes, as permitted by U.S. tax law, and indeed Greenhunter had deducted $884,092 in expenses and a loss of $61,047 from a result of the LLC's operations on its tax return.

For its part, Greenhunter's case seemed to consist of putting the LLC's general counsel (also, of course, Greenhunter's general counsel) to testify that he "could not recall much". Greenhunter also introduced the LLC's filings with the Wyoming Secretary of State and some other records to show that the two entities were "detached" and maintained separate accounts.

Probably not to anybody's surprise except Greenhunter, the trial court found in favor of Western and entered judgment against Greenhunter for $45,808. Greenhunter appealed to the Supreme Court of Wyoming, which issued the Opinion that I am about to relate.

The Court first noted that corporations and LLCs are entities which are legally distinct from their owners, so long as that protection does not result in an injustice. In exceptional circumstances, courts will "pierce the veil" of limited liability. But:

Piercing seems to happen freakishly. Like lightning, it is rare, severe, and unprincipled.

quoting Frank H. Easterbrook & Daniel R. Fischel, Limited Liability and the Corporation, 52 U. Chi. L.Rev. 89 (1985).

But there are general guidelines for a court to follow in making the determination whether or not to pierce. Ultimately, there must be a "unity of interest and ownership" between the entity and whoever piercing is sought against, and that unity must be so severe that for the court to respect the separate existence of the entity would be to sanction injustice.

LLCs are basically subject to the same rules of veil piercing as are corporations, though of course it is easier for LLCs to prove the compliance with formalities, since they have few or no formalities (technically, not even an Operating Agreement is required).

Prior to 2010, the case law in Wyoming has developed such that a court evaluating a veil piercing claim would focus on four factors:

1) Fraud

2) Inadequate capitalization

3) Failure to observe company formalities

4) Intermingling of the business and finances of the company with the party against whom the veil is sought to be pierced.

In 2010, however, Wyoming updated its LLC law to provide that an LLC's limited liability shield could be pierced in these circumstances:

(a) The debts, obligations or other liabilities of a limited liability company, whether arising in contract, tort or otherwise:

(i) Are solely the debts, obligations or other liabilities of the company; and

(ii) Do not become the debts, obligations or other liabilities of a member or manager solely by reason of the member acting as a member or manager acting as a manager.

(b) The failure of a limited liability company to observe any particular formalities relating to the exercise of its powers or management of its activities is not a ground for imposing liability on the members or managers for the debts, obligations or other liabilities of the company.

See Wyo. Stat. Ann. sec. 17–29–304.

The 2010 Act made clear that the failure of the LLC to follow formalities was not a ground for veil piercing, not that it was much of a ground in the first place.

Based on the 2010 changes to Wyoming law, the Wyoming Supreme Court decided that it was time to update its test for veil piercing. Thus, according to the Court, the veil of a Wyoming LLC can be pierced "under exceptional circumstances" if a two-pronged test is met:

(1) The separateness of the LLC and its owner(s) has ceased to exist because of misuse of the LLC; and

(2) Under the facts, to respect the separate existence of the LLC would lead to an injustice.

Such a vague test requires further guidelines, which the Wyoming Supreme Court then set out

First, fraud would favor veil piercing. Here, "fraud" doesn't mean just an affirmative misrepresentation, but its broader concept of some act or omission that causes another to be injured.

Second, inadequate capitalization of the LLC would favor veil piercing. This factor looks to the business that the LLC is conducting and determines whether the LLC was capitalized so as to be financially responsible for its ordinary debts.

Third, intermingling of the assets and operations of the LLC and the assets of its owner(s) would favor veil piercing. This test looks to whether the LLC and its owner(s) conducted business on an arm's length basis, or whether assets were commingled.

With the factors in mind, the Court turned to the case before it. The trial court had pierced the LLC's veil based on four factors:

(1) the LLC's undercapitalization and absence of assets,

(2) the LLC's and Appellant's intermingling of finances and business, including commingling of funds and concentration of benefits in the member and liabilities in the LLC,

(3) the lack of any separateness between the two, and

(4) Appellant's course of conduct in engaging and contracting with Western in the name of the LLC for services when it knew that it could not or would not provide funds to pay Western's bills, which it found to be fraudulent and not protected by the veil of limited liability.

The Wyoming Supreme Court held that the trial court had correctly applied the law in piercing the LLC's veil, though noting that the case was a "close call".

The Court first examined whether the LLC was adequately capitalized for its purposes, finding that it was not. To the contrary, the LLC's operating account frequently showed $0.00 balances, and it was up to Greenhunter to transfer money into the account so that the LLC could pay its bills. In fact, the LLC would frequently get a bill but have no funds to pay it, and then Greenhunter would transfer into the account only the exact amount necessary to pay that particular bill. In other words, the LLC wasn't just undercapitalized -- effectively, it wasn't capitalized at all.

Next, the Court looked at whether the LLC's financial and business operations were commingled with those of Greenhunter, and of course they were. For its part, Greenhunter tried to argue that keeping separate books was enough to avoid this factor. Not so fast, my friend, the Court retorted, and instead noted that:

In actions seeking to pierce the veil of a limited liability company, each case must be governed by its own facts. [] There is no rigid formula to which a court's analysis must conform; instead, each case requires a fact-intensive inquiry that must address the particular circumstances.

If by this time, the cynic in you has determined that the Wyoming Supreme Court has simply adopted a "totality of the facts and circumstances" test (which is probably what it should be anyhow), well then, there you go.

The circumstances favoring veil piercing included:

+ There was a considerable overlap of the LLC's and Greenhunter's ownership, membership (which is really the same thing), and management. Plus, they used the same mailing address for invoices, and their accounting departments were the same folks.

+ The LLC didn't have any employees of its own, but instead relied upon Greenhunter's employees to actually do things, including to pay creditors.

+ The LLC really didn't have any revenue separate from Greenhunter, since the LLC simply passed through all the revenue to Greenhunter, and Greenhunter only kicked back enough money to the LLC to pay particular bills.

+ Although the LLC contracted with Western to procure services for the benefit of the wind farm, it was Greenhunter that claimed a $884,092 deduction for that project on its tax return.

+ Greenhunter manipulated the assets and liabilities of the LLC so that Greenhunter got all the rewards and benefits (including tax breaks), but the LLC was stuck with the losses and liabilities.

Based on all these factors, it was of course a foregoing conclusion that the intermingling of the LLCs and Greenhunter's business operations and finances favored veil piercing.

Well, hold on, protested Greenhunter. Federal tax law clearly permits (and it does) a single-member LLC, such as the LLC, to be taxed as a "disregarded entity". In English, this means that the LLC doesn't file its own tax return, but the LLC's taxable activities and operations simply "flow up" and are shown on the tax return of its parent, here, Greenhunter.

Granted, conceded the Wyoming Supreme Court, that everything you just said is true. Thus, we will not consider the "disregarded entity" tax status to be dispositive, but simply another piece of evidence of that favors veil piercing. Thus:

For that reason, while consideration of Appellant's consolidated tax return and the losses of the LLC reported therein may have been relevant to the district court's piercing analysis, the amount of weight given to this evidence must be balanced by the fact that this practice is permitted under our nation's tax laws. Stated differently, courts should not create a scenario in which a single-member limited liability company would be confronted with a catch 22: either follow federal tax law and risk losing limited liability, or forego advantages available under federal tax law to assure limited liability. The district court's ruling does not create that dilemma. Instead, it considered Appellant's tax filings as only one of many relevant pieces of evidence demonstrating that Appellant directed benefits from the LLC to itself, while at the same time it concentrated wind farm project debts it decided would not to be paid in the LLC. The district court did not err in doing so.

Next, Greenhunter argued a point that was pure chutzpah: Greenhunter should be able to cheat Western out of the value of its services because Western did not require Greenhunter to either guarantee the LLC's payment of its debtors, or request that the LLC post a retainer to cover Western's services. The Court did not find that to be any defense to veil piercing.

Finally, the Wyoming Supreme Court got to the issue of fraud: Whether Greenhunter used the LLC to perpetrate a wrong on Western. The Court agreed with Greenhunter that there was no evidence that Greenhunter had made any material misrepresentation to Western, which is the classic test of fraud. But that did not end the inquiry:

However, we believe the district court instinctively applied the test we have set forth above, although it used the term "fraud." It found that Appellant misused the LLC in order to improperly manipulate the situation to avoid paying for services which benefitted it, that it failed to maintain adequate separation, and that to allow it to do so would be unjust and inequitable. Thus, even though there was no fraud in the classic and technical sense, the district court's decision to pierce the LLC's veil to hold Appellant responsible for a debt for services which benefitted it was legally correct and not clearly erroneous.

And with that, the Wyoming Supreme Court ruled against Greenhunter, and affirmed the trial court.

ANALYSIS

There are lots of meaty issues highlighted by this Opinion, but the most important issue wasn't directly addressed by the Court. Instead, the Court chews around it by telling us that a critical element in determining whether to pierce the veil of an LLC is whether there is a unity of identity between the LLC and its owner -- this often expressed by the phrase "unity of ownership".

The problem with a single-member LLC, of course, is that there is an undeniable "unity of ownership" between the single-member LLC and its sole owner. This is little different than the situation of the sole-shareholder corporation, but those haven't stood up very well to veil piercing challenges, either, and for this same reason.

If one looks a veil piercing law as fundamentally comprising two elements: (1) unity of ownership, and (2) the entity was used as a vehicle to commit some wrong, then the single-member LLC (and the sole shareholder corporation) starts out with one foot in the veil piercing grave.

This is exactly why single-member LLCs are fundamentally lousy asset protection vehicles, despite the gazillion ads appearing in sports pages and classifieds advertising "Form an LLC for Asset Protection!"

This doesn't mean that single-member LLCs should never be used; to the contrary, they are frequently and properly used in a number of situations for reasons other than liability protection.

This brings us to corporate formalities. Within corporation law generally there has been a tremendous erosion in past years of the "lack of corporate formalities" being a grounds for veil piercing.

The courts no longer spend much time looking at whether all the "i"s were dotted and "t"s crossed in minutes and resolution. Instead, these days it takes almost a wholesale failure of corporate formalities (such as stock shares never being issued) for the "lack of corporate formalities" to by itself trigger veil piercing.

Instead, the courts are now looking at the "lack of corporate formalities" more in the light of just additional evidence of "lack of separateness" -- that the identity of the entity and its owner so overlap that they really should be treated as one and the same. In English, it is as if the courts are telling owners of entities, "If you are going to treat the entity like it is you, we're going to treat the entity like it is you too."

If there really are anything like required elements to modern veil piercing law, the "lack of separateness" is one of those (only two) elements. The question then becomes, "What tends to prove the lack of separateness?" Here, we have several things the courts will primarily look at, though keeping in mind that these days the courts (including the Wyoming Supreme Court here) are taking a "totality of the facts and circumstances" stance in measuring veil piercing.

As mentioned, the "lack of corporate formalities" can prove the "lack of separateness", but the errors in the corporate formalities these days must be shockingly bad (again, think in terms of a corporation which doesn't even issue shares). The problem in the LLC context, as the Greenhunter court quite correctly points out, is that LLCs by their very design have few corporate formalities -- an LLC isn't even required in most states to have an Operating Agreement!

Still, there will be minimum lines that even an LLC should not cross. For instance, if the LLC's records are not clear on who the members are, or what interests they hold in the entity, that will favor veil piercing (ironically, this is easier to comply with in the single-member LLC context because it only has one member). Other circumstances will be where the company's records are not clear what assets the LLC owns, or its financial records are a mess.

But these will be extreme cases, and because of that, a creditor should not waste much time in trying to prove the "lack of formalities" unless they are really, really bad.

Much more important for creditors will be those instances where the financing and operations of the entity and its owners are blurred, which was the case in Greenhunter. While the LLC was contracting for services, it was really Greenhunter's employees that were doing everything for the LLC. Again, this sort of analysis makes life difficult for the single-member LLC, since the sole owner will often be doing everything for the LLC.

Which is to say that an LLC where the sole owner is taking all actions on behalf of the company, is much less likely to stand up to scrutiny than an LLC which has employed others to act on behalf of the LLC. For example, take the typical case of a retiree who owns a rental home, and puts the rental home into a single-member LLC. If the retiree goes out to the rental home and does everything herself, then the limited liability veil of the LLC is probably unlikely to stand up. By contrast, if the retiree causes the LLC to hire a management company to take care of the rental home, and herself otherwise takes a "hands off" role, then veil piercing is that much more unlikely to happen.

[As an aside, if retiree is managing the property herself, then she can be held directly liable for her own negligence in regard to the property. For instance, if the retiree is told that the water heater is acting up, but she decides to defer maintenance, and it later explodes and injures somebody, then retiree can be held directly liable for her own negligence whether an LLC owns the rental home or not. This is something that the "LLCs for Asset Protection!" promoters are likely to tell you.]

In these case, the courts are looking at the question, "Are you really treating the LLC as a separate company, or is the LLC really just you and you're trying to wrap liability protection around your asset through the fiction of the LLC?"

Another factor that can favor, or help defeat, veil piercing is whether the entity has adequate capital. The concept of "adequate capitalization" is not particularly difficult to state: For the limited liability shield of an entity to stand up, the entity needs to have sufficient capital to sustain its normal business operations and liabilities.

Where this gets confusing to some folks is that entities don't need much, if any, capital to be formed. One can form an LLC, for instance, with no capital at all, and usually the Secretary of State's office doesn't even inquire as to how an LLC will be capitalized.

But whether the entity is adequately capitalized upon formation is not when the adequacy of capitalization is tested. Instead, the salient inquiry is how well capitalized the entity was when it incurred the liability to the creditor who now seeks to pierce the corporate veil.

Consider the case of Pete who forms an LLC on Day 1 but doesn't put any capital into the entity, and then on Day 2 (still without capital) causes the entity to enter into a guarantee for his business partner, George. In that case, the LLC doesn't have sufficient capital to make the guarantee, and the liability shield of the LLC will be pierced as to Pete. That is an easy example.

Here, the LLC wasn't capitalized at all by Greenhunter, which routinely left the LLC running zero balances in its checking account, and only sent enough money to it so that the LLC could pay particular bills. This was the easy case.

Where this gets much more complicated is where the LLC has numerous obligations, but is thinly capitalized. The mere fact that the LLC fails, or even files for bankruptcy, is not dispositive on the issue of whether the LLC was adequately capitalized. Instead, somebody (probably a forensic accountant) is going to have to make a determination whether the LLC had enough capital to cover its ordinary operational costs and liabilities. The more capital that has been injected into the entity, the greater the odds that the veil piercing challenge will be defeated; the less capital, the lower the odds.

Which is all to say that "things change", and that when an LLC goes into financial stress, somebody ought to be making a capitalization analysis to make sure that the company is adequately capitalized, with the penalty being the potential loss of the limited liability shield if it is not. Yes, it is a moving target, but oftentimes in business and the law one has to shoot at moving targets. What one cannot do is to blissfully presume that because $100 or whatever was put into the LLC initially, that such will suffice as adequate capitalization, because it just doesn't work that way.

Probably no part of the Greenhunter opinion caused such consternation, if not mild outrage, among some law professors and LLC practitioners, as to the Court's holding that the LLC's tax treatment as a "disregarded entity" as to Greenhunter, was a factor (albeit a very mild one) in the decision to pierce the LLC's limited liability veil. Their argument is that because the federal tax laws specifically allow a single-member LLC to be treated as a "disregarded entity", that such should not be a factor at all in considering veil piercing.

A single-member LLC by default is taxed as a partnership, but if there is only one member, then partnership taxation is unavailable and instead the LLC is taxed as a "disregarded entity", i.e., a great big tax nothing, and all of its taxable activity flows through to the tax return of its owner.

However, a single-member LLC can always "check the box" to be taxed as a corporation, and thereby report its own taxable activities on its own tax return, just like any other company. A single-member LLC that has elected to be taxed as a corporation, can further make the S-election if it chooses and thereafter be treated as an S-corporation.

In other words, for the LLC to be treated as a "disregarded entity" is not something that is mandated by tax law, but rather is an option (albeit the default option) that the LLC and its owner choose to follow, as opposed to the LLC being taxed as a corporation.

The Wyoming Supreme Court latched on to this treatment as tending to show the "lack of separateness", i.e., that the LLC's taxable activity was treated as Greenhunter's taxable activity was just another factor in considering whether the two entities were really one and the same in reality. However, the Greenhunter Court went on to state that while disregarded entity status is a factor, it is not much of a factor -- in fact, hardly a factor worth considering. So, it is all really the difference between "no factor" and "not much of a factor", so the whole controversy is practically little more than grousing about yesterday's weather.

Notably, one court has held to the contrary of Greenhunter, being Alkanani v. Aegis Def. Servs., LLC, 976 F. Supp. 2d 1, 9-10 (D.D.C. 2013), where the Court on radically different facts held that the tax treatment of a single-member LLC was irrelevant. Again, either way this shakes out, it is much ado about nothing, or at least greatly overshadowed by the other much meatier issues in the case.

One can argue that veil piercing law has evolved (or devolved, some might argue) to where it really has two elements:

First, the "lack of separateness" just discussed, and,

Second, the entity was misused by its owner as a vehicle to commit some wrong.

This latter element is what differentiates the real veil piercing case from those cases where the entity simply went bust for whatever reason, leaving jilted creditors. It is not enough that the entity failed and cannot pay its debts; the entity's owner must have affirmatively misused the entity either for some wrongful purpose or as a wrongful means.

While the definition of what constitutes a sufficient "wrong" to support veil piercing is quite liberally interpreted, it is clear that it means something more than just that creditors are not being paid. As with everything else in modern veil piercing law, the courts measure this element by looking at the totality of the facts and circumstances, meaning that they are looking to see "what was really going on".

Here, Greenhunter was using the LLC to pick-and-choose the creditors that it wanted to pay, and those that it wanted to jilt. That is a misuse of the LLC, and it sufficed as a "wrong". Certainly, the element of a wrong (broadly defined) is an amorphous test, but often the cases where it is applied involve facts where the LLC's owner was committing an overt fraud on somebody and then trying to stand behind the LLC's liability shield. The Greenhunter case was not one where an LLC was inadvertently left with unsecured creditors who went unpaid; to the contrast, all the evidence indicated that Greenhunter was quite intentionally using the LLC to cheat those creditors.

The rest of Greenhunter's arguments, i.e., that Western should have required a retainer or other collateral, fail to rise to the level of respectable nonsense. Unsecured creditors, including those working without a retainer, have a legitimate expectation of being paid, and if somebody is misusing the vehicle of an LLC to intentionally thwart that expectation, then they should be responsible for the LLC's debts. That very fundamentally is the bottom-line ruling in the Greenhunter case.

Finally, this article would not be complete without some mention of the fact that this case arose under Wyoming law, which supposedly has some of the "best" LLC law on the planet. Heck, one can't read a financial newspaper or magazine without seeing at least one ad touting the benefits of "Wyoming LLCs" or "Nevada LLCs" or "Delaware LLCs" or wherever.

The real truth is that as to creditor issues all LLC laws are about the same, and work about the same in real life. Sure, various states can come up with neat-sounding provisions, but in the crucible of the courtroom, they all work about alike. The "better mousetrap" of Wyoming, Nevada, Delaware, etc., usually doesn't work any better than anybody else's mousetrap at the end of the day. What you had better consider is that if there is some internal dispute among members, do you want to have the local court and your local lawyer handle the issue, or do you want to be dragged off into some distant state where you'll have to hire local counsel that is unfamiliar to you?

Not just a few legal scholars posit something to the effect that, "The best jurisdiction to form an LLC in is the one you are in," and point out that the supposedly superior laws of some states never seem to make an actual difference in court cases. Indeed, they add, all you might be doing is unnecessarily layering another batch of fees if you have to register the out-of-state LLC in your state anyway. The Greenhunter case, they would note, came about pretty much exactly like it would in about every other state.

There is not just a little truth in that.

CITE AS

Greenhunter Energy, Inc. v. Western Ecosystems Tech., Inc., 2014 WY 144, 2014 WL 5794332 (Wyo., Nov. 7, 2014). http://goo.gl/nbte3u

This article at http://onforb.es/12fMvlF and http://goo.gl/TMVAkg