Piercing the Veil 5: Can the Owner Be Liable for Debt to Suppliers?

Here we have another Texas law case on piercing the corporate veil. This time, two trade suppliers and their distributor sued a corporation and the individual who was the sole shareholder, director and president of that corporation, to collect a rather large debt on an open account. To get to the owner, these creditors claimed the owner used the corporation as a corporate sham to defraud creditors. I’ll give you the good news first–they lost. The bad news? The decision was a 2-1 split with a strongly worded dissenting opinion.

Rimade, Ltd., and Giait, Ltd., are two Swiss-based tire manufacturers. Their distributor is Pneus Acqui S.P.A., an Italian company. How did these foreigners, with names so strange you can’t even pronounce them, end up on Texas soil? Rimade and Giait, via Pneus Acqui, sold tires to Hubbard Enterprises, Inc., a Fort Worth-based tire company. Alas, Cowtown proved to be a money drain for them, or rather Hubbard Enterprises did.

From 1998 to August of 2000, things went quite well. Hubbard Enterprises purchased, and paid for, more than $4.3 million of tires from these guys. Then something happened. The court doesn’t say what, but the corporation began to fail to make payments. Amazingly, Hubbard induced the tire companies to continue to supply tires on credit, promising to use the profits from future sales to pay past invoices. That must have been some sales job. Strangely, perhaps, it actually worked from January to June of 2001, when further delivery of tires to Hubbard Enterprises ceased.

In August of 2001, a representative of the distributor came to Texas and met with Hubbard to discuss the outstanding balance owed, which totaled $452,570.19. The resolution was that Hubbard would confirm in writing the amount owed, and give the representative six post-dated checks, each in the amount of $105,000, to begin a payment plan. This Hubbard did. However, only two of those checks cleared, because Hubbard put a stop-payment order on the other four checks. This brought the balance down to $359,052, exclusive of interest, and there the balance stayed until these three trade creditors filed this lawsuit.

The Three Creditors basically hung their “we get to pierce the veil” argument on two sets of facts. Keep these facts in mind as we go through this because the 2 majority judges and 1 dissenting judge made very different conclusions from what were basically undisputed facts. And also keep in mind this case took one day to try, before a judge–no jury was requested by either party.

Here’s the first set of facts. The Three Creditors had at one point required Hubbard’s corporation to establish a letter of credit at its bank, which secured the open account. If you are unfamiliar with letters of credit, don’t worry, just consider it like a partially-funded insurance policy insuring payment. If no payment is made when due, the letter is cashed out and the money goes to pay the debt. In this case the money was to go to the Three Creditors’ bank.

Unbeknownst to the Three Creditors, in January of 2001, their bank told Hubbard Enterprises’ bank that the letter of credit was no longer needed, and so it was canceled. One day after Hubbard Enterprises’ bank confirmed to Hubbard (in writing) that it had canceled the letter, one of the Three Creditors requested Hubbard to increase Hubbard Enterprises’ letter of credit to cover a growing deficit balance in the trade account. Although Hubbard knew the letter of credit had been canceled, and had to surmise that the Three Creditors didn’t know that fact, Hubbard responded by stating he could not increase the letter of credit. Was that a misleading statement? Was it fraudulent?

Hubbard also continued to accept tire shipments from the Three Creditors which were accompanied by invoices stating they were covered by the letter of credit. Again, he knew there was no letter of credit, but did nothing affirmative with that information. Was that misleading? Was it fraudulent? These shipments continued from January through June of 2001, when the Three Creditors finally learned, from their own bank, that the letter of credit had been canceled in January. One can only imagine the possible liability of the Three Creditors’ bank for mistakenly advising Hubbard Enterprises’ bank to cancel the letter of credit.

Now to the second set of facts. It seems Mr. Hubbard and his family were quite the entrepreneurs in tires. While Mr. Hubbard owned Hubbard Enterprises, his sons owned and operated Tire Dealers Warehouse. From between October of 2000 and June of 2001, when the Three Creditors stopped delivering tires to Hubbard Enterprises due to non-payment, Hubbard Enterprises transferred over $1 million in assets, including the tires from the Three Creditors, to Tire Dealers Warehouse. From April of 2001 to August of 2001, this trend greatly accelerated to over $1.4 million in tires and assets.

From January of 2001 to September of that same year, Tire Dealers Warehouse paid Hubbard Enterprises several hundreds of thousands of dollars, but then stopped, unable to pay any more. As of March, 2003, Tire Dealers Warehouse ceased doing business and sold all of its assets–some to yet other Hubbard entities. As of the trial date in this case, Tire Dealers Warehouse still owed Hubbard Enterprises over $1.9 million and was making payments to Hubbard Enterprises’ secured creditors.

Hubbard Enterprises, not surprisingly, never sent a demand letter to Tire Dealers Warehouse, it never took any effort to collect that debt. Hubbard never told the Three Creditors about any of these other businesses, and never told them he was selling tires to related Hubbard family entities on credit. And at trial, the Three Creditors had evidence that Hubbard Enterprises was always insolvent during its entire life, and that, notwithstanding all this financial trouble, Hubbard Enterprises paid Hubbard a salary of $88,000 in 2000 and $64,000 in 2001. Hubbard also received some rental income from Tire Dealers Warehouse in each of these two years as well.

So basically, what you have here is one entrepreneurial family with multiple corporations, seeming to play a shell game with assets, which included (1) making loans to each other that were never collected, (2) renting property to each other without collecting the full rents, and (3) overextending credit to each other. Was this fraudulent? If so, could the creditor use the fraud as a basis to successfully pierce the corporation’s veil and get a judgment against Hubbard individually?

Let’s first look at the applicable law laid down by the court, with which all three judges seemed to agree. Said the Fifth Circuit, Texas law recognizes three broad categories in which a court may pierce a corporate veil:

(1) the corporation is the alter ego of its owners and/or shareholders;

(2) the corporation is used for illegal purposes; and

(3) the corporation is used as a sham to perpetuate a fraud.

If the case is a breach of contract case, Texas statutes require additional elements. The veil can only be pierced “where the defendant shareholder ‘caused the corporation to be used for the purpose of perpetrating and did perpetrate an actual fraud on the obligee primarily for the direct personal benefit of the holder.’‘ The Fifth Circuit seemed to say that, in breach of contract cases, alter ego and illegal purposes are not available to would-be plaintiffs. They only have the “sham to perpetuate a fraud” theory.

Fraud is defined under Texas law as follows: the misrepresentation of a material fact with intention to induce action or inaction, reliance on the misrepresentation by a person who, as a result of such reliance, suffers injury. But then you get in to the whole area of “when do you have a duty to disclose certain facts” issue, too. This is a much less obvious analysis, but the Court helped us out a bit by identifying these three situations which require affirmative disclosures:

1. if the defendant has some legal duty to disclose facts, such as in some sort of special relationship, particularly a fiduciary or confidential relationship;

2. there is always a duty to correct one’s own prior false or misleading statements;

3. a speaker making a partial disclosure assumes a duty to tell the whole truth even when partial disclosure was not legally required, so that he does not convey a false impression.

Now here’s how two of the three judges applied this law to the facts.

First, the court addressed the issue of the canceled letter of credit. The Three Creditors argued, obviously, that Hubbard misled them by not advising them of its cancellation and affirmatively acting as though it had not been canceled. And they protested, loudly, that they would never have continued to deliver tires to Hubbard if they had known the truth.

The majority of the three-judge panel of the Fifth Circuit disposed of this rather easily, finding that Hubbard had no legal duty to advise them of the cancellation. Also, Hubbard took the stand at trial and testified he never intended to mislead them about that point. So, once the judge chose to “believe” Hubbard’s admittedly self-serving testimony instead of the circumstantial facts, this part of the case was over.

And there was a final nail in the coffin of the death of this theory for the majority. From January through June of 2001, the crucial time period, Hubbard paid for all new tires delivered during that time, in full, plus $300,000 on past due, old invoices. As a result, if the Three Creditors had ceased doing business with Hubbard in January of 2001, they wouldn’t have made up that $300,000, so they were actually better off, not worse off, by continuing to trade with Hubbard. “No damages” said the Court.

But here’s the danger. There was one judge on this panel that believed Hubbard had a duty to affirmatively disclose to the Three Creditors that the letter of credit had been canceled, and saw damages. He looked at the same facts, and the same law, both of which were not in dispute, and came to a very different conclusion. How? Is this explainable? Neither opinion cited to a definitive prior court decision. They each stated the conclusion as their own opinions. I think his general judicial philosophy differed from the 2 other judges, and maybe even his view of life even differed, to produce this opposite result. More on this later.

Now to the second set of facts, the inter-affiliated company dealings and such. The Three Creditors argued that by transferring their tires to a related company which paid salaries and rents to family members and such, Hubbard was literally “giving away the store” while knowing that Hubbard Enterprises would never be repaid and that any judgment against it would be worthless.

But said the majority, “selling on credit cannot be considered fraudulent, as this is the way the Three Creditors themselves transacted business with Hubbard Enterprises.” Plus, Hubbard did not own any of Tire Dealers Warehouse. And Tire Dealers Warehouse paid Hubbard Enterprises over $500,000 during the first three quarters of 2001–pre 9-11, noted the Court. Finally, Tire Dealers Warehouse collections are (still) paying Hubbard Enterprises’ secured debts. No fraud found. Since the Three Creditors knew nothing of these facts, the facts were, by definition, not misrepresented to them by Hubbard. And there was no duty to disclose them.

And again the majority found no personal benefit by Hubbard, no damages to the Three Creditors. This part of the opinion was probably the weakest. Suffice it to say that the majority rejected the theory that Mr. Hubbard benefited as long as the Hubbard family generally benefited. And there were other facts, brought to light in the dissenting opinion, that the majority just ignored. It seems to me that the majority took the view of “that’s just business.”

Now read these quotes from the dissenting opinion and note the different overview of this case (emphasis as in the opinion:

the panel majority errs by viewing each discrete fact as a snapshot–“in a vacuum”–rather than as a series of links in a continuous and evolving chain of ongoing business transactions between the parties..

Knowing full well that these plaintiffs were unaware that the security for these transactions had ceased to exist and that they would not sell merchandise to him in its absence, Hubbard not only continued to make unsecured purchases of tires, but proceeded to orchestrate duplicitous non-arms-length transfers of that merchandise from his wholly owned and operated corporation to entities owned and controlled by none other than his own sons. He deliberately put this merchandise and its sales proceeds beyond the reach of his uninformed, arms-length creditors and simultaneously made them available instead to his corporation’s lending bank, a secured creditor to which–not so coincidentally–Hubbard was personally liable as a guarantor.

This judge viewed all facts together, tied with multiple “ands”, and saw a forest, while the majority took the facts as separate, and only saw one tree at a time. If you knew which type of judge you’d get, it’d be easier to plan your life. But you don’t.

And here’s the deal-closer from the dissent:

Except for Hubbard’s wide-eyed, self-serving testimony that he intended no fraud, all objective evidence demonstrates, to my satisfaction at least, that this is the very kind of case that cries out for the piercing of the corporate veil to hold its sole shareholder personally liable to those he duped by interposing his corporate alter ego and remaining silent in the face of his duty to inform.

Then this one last zinger:

If nothing else, we today re-affirm the age-old adage that “debtors either die or move to Texas.

So what’s the bottom line? This case reminds me of a trip to the grocery store, where the clerk gives you back too much change. It’s not identical, but similar. The store has all the facts necessary to understand the situation and act however they choose, but they cannot get the information discovered and transmitted quickly enough. The “morally right” choice is to affirmatively disclose the mistake and help correct it. Give others the facts and the freedom to make their choice.

This case basically says there’s no affirmative duty to bring such facts to the actual knowledge of the other party. This means that conduct which violates some morality codes does not violate the law. I think this is the “rub” of the case. The law is not always moral.

I personally think the single most crucial fact in this case, given the way it was mentioned by the majority, is that Mr. Hubbard actually did what he said he’d do if the Three Creditors would keep delivering him tires, which is pay for them in full, plus use the profits to repay on the old invoices. Because he did this successfully to the tune of $300,000, the majority kinda let him off the hook for the rest. If he had not done that, I think the court’s opinion may well have been the opposite, piercing the veil and imposing this liability on him personally. The facts were there to do that.

This case illustrates a dangerous state of affairs. Often, a judge can get a gut sense of what the “equities” of the case require as a result, and write an opinion that achieves that result. Cases alleging “fraud” often fall into this category. The problem is, “gut sense” is a very personal matter, you rarely know a judge’s predisposition ahead of time, you can’t pick the judge anyway, and it is difficult to really challenge on appeal. OK, so there is more than one problem with gut sense.

What that means for you, the business owner, is that anytime you know someone you do business with is acting on incorrect information about you, you must at least determine whether you have a legal duty to correct that false information. You should also consider the practical implications of disclosing, or not disclosing, the truth, in terms of risk. From a business perspective (and not a moral perspective), the lower the risk that the truth will hurt you, the more likely it is you should disclose. Do not think that disclosure is a deal-killer. Often, it just changes the deal a little bit.

And you should consult with a lawyer on it as well, who can explain the pro’s and con’s of disclosure vs. non-disclosure with you. This decision is not the lawyer’s to make, but merely to advise. In other words, finding loopholes is our business, exploiting loopholes is your business, and making loopholes is the business of legislatures and courts.

Rimade, Ltd., et al. v. Hubbard Enterprises, Inc., et al., Case No. 03-11294, 5th Circuit U.S. Court of Appeals, decided October 7, 2004

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Piercing the Veil 4: Texas Law Means What it Says

The fact pattern of this case is complicated, but can be boiled down to these basics. In 1985, the City of Edinburg signed a franchise agreement with Rio Grande Valley Gas Co. (“RGVG”), to supply natural gas to customers within its city limits. In exchange for the franchise, RGVG paid Edinburg 4% of the gross income derived from all gas sales within the city.

Natural gas prices for consumers are regulated and set by the Texas Railroad Commission. As things developed, the market price dropped significantly below the regulated price. Large industrial customers began clamoring for cheaper gas than was available at regulated rates. What to do? Well, the owners of RGVG formed another company, Reata Industrial Gas Co. (this is called a brother-sister relationship between the corporations) and used it to sell deregulated “spot market” gas to industrial customers in Edinburg. The price for this spot market gas fluctuated in price according to the market price, and put a lot of extra money in the pockets of RGVG’s and Reata’s owners.

At some point in time Edinburg realized that it wasn’t getting 4% of the gross revenues of those spot sales, and it sued RGVC, Reata, its successors, and affiliated entities (basically every company in sight), under the “single business enterprise” theory. The time period at issue was from October 1, 1985, through September 30, 1993, and by this time the amount in controversy was up to $774,445.33. As is common, the liability for attorneys fees dwarfed the amount in controversy: $3,518,000. Now that’s a number that needs the additional assets of more than one business entity in order to ensure collection.

Here’s how the 13th District Texas Court of Appeals described the “single business enterprise” theory to impose one business’s liability on another business entity:

The ‘single business enterprise’ theory is described as analogous to partnership principles: that when corporations are not operated as separate entities, but rather integrate their resources to achieve a common business purpose, each constituent corporation may be held liable for the debts incurred by the other component entities in pursuit of that business purpose.

Factors that are relevant to determine whether a “single business enterprise” is present include:

common employees
common offices
centralized accounting
payment of wages by one corporation to another corporation’s employees
common business name
services rendered by the employees of one corporation on behalf of another corporation
undocumented transfers of funds between corporations
unclear allocation of profits and losses between corporations

Now, this sort of test means that a court looks at these factors, and any others the plaintiffs want to raise (note the “including” term at the beginning). In other words, every “single business enterprise” case is different. Every test in every case is a little bit different. As long as a plaintiff lists multiple affiliated entities and shows a few of these factors, or any other “connection”, then the case becomes a “fact case” and a jury gets called in to decide it. No motion for summary judgment, no easy way out for the defendants. It’s full bore “dog and pony show” time for the defense, and all the legal fees that entails.

Just for good measure, the City also pleaded the theory of “joint enterprise liability”, which requires proof of the following:

an agreement among the members of the group;
a common purpose;
a community of pecuniary interest; and
an equal right to control the enterprise.

This one smacks of “plain old” conspiracy, other than that last element. And it was only appropriate, I suppose, in a sarcastic sort of way, that the trial court referred to the corporate defendants as the “Valero family.” The jury found a single business enterprise, but no joint enterprise liability.

Well, the Court of Appeals went way back to the horrible 1987 decision of Castleberry v. Branscum, and decided this case as though Casteberry was still good law. I was stunned when I read the opinion, as to how thoroughly the Court of Appeals used the old Castleberry logic.

The Court of Appeals just totally ignored Article 2.21 of the Texas Business Corporation Act, a law passed after, and in response to, the Castleberry decision in a valiant attempt to restore some sanity to Texas law. That law overturned the Castleberry decision. It made the decision irrelevant by “superceding” it.

Now, to bring you up to speed, Article 2.21 provides that a plaintiff can pierce a corporation’s veil on any of the theories of alter ego, actual fraud, constructive fraud, sham to perpetuate a fraud, and any other similar theory, ONLY if the plaintiff shows the person or entity upon whom liability is alleged:

1- caused the corporation to be used for the purpose of perpetuating, and did perpetrate, an actual fraud on the plaintiff primarily for the direct personal benefit of such person or entity; or
2- expressly agreed to assume liability, such as signing a guaranty of corporate debts, or
3- is otherwise liable to the plaintiff under the Texas Business Corporation Act or another applicable statute.

There is no “factor” test. There is no “includes.” The single business enterprise theory, as well as the joint enterprise liability theory, are covered by Article 2.21, Texas Business Corporation Act. As such, the Texas Supreme Court rightly said:

Since 1993, article 2.21 has provided that…..section A of article 2.21 is the exclusive means for imposing liability on a corporation for the obligations of another corporation in which it owns shares…..The City argues that the Valero entities had common directors, shared employees, and had central accounting and payroll systems. We have held that such facts do not justify disregarding the corporate structures of affiliated companies. But more importantly, proof of such facts would not establish liability under article 2.21….We…render judgment that the City take nothing.

Bingo. Turn out the lights, the party’s over. Or maybe we should let it begin. Peace on earth to you folks brave enough to own your own businesses.

S. Union Co., et al. v. City of Edinburg, 129 S.W.3d 74 (Tex. 2003)

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Piercing the Veil 3: Sole Shareholder Liable in Bizarre Slip and Fall Case

Here’s a simple case that could happen to any business with any responsibility. Mike Schlueter formed a Texas corporation, Entertainment Properties, Inc., with himself as the sole shareholder, sole director, sole everything. Entertainment Properties, Inc., leased some space in a retail strip center on Lancaster Boulevard in Fort Worth, just across from a local police headquarters. Entertainment Properties, Inc., then subleased this space by the night to different charities, who would actually run the bingo games.

Billie Jean Carey, a woman in her 50s, tried her luck at this bingo parlor one evening. And no matter how bruising the game may have been, it couldn’t compare to the bruises and breaks she sustained from the speed bump she tripped over as she meandered out to her car. Could this have possibly been her fault? Could anyone reasonably expect a parking lot to have speed bumps? Perhaps she just didn’t see them on the way in. Well, in any event some of the light fixtures on the building were not working, and so there was “fault” which produced injury Turns out, the responsibility for maintaining the lights fell on Entertainment Properties, Inc., per the terms of its lease.

We must assume liability here, for the trial court imposed it. On a short digression, this is, in and of itself, a great reason why businesses should be incorporated. I frequently am asked “should I form a business entity for my business?” And I nearly always answer “yes” because, in part, there are so many unexpected, hidden liabilities just waiting to happen, particularly in this “somebody owes me” lawsuit lottery society we have created. This case is a great example of unforeseen liabilities. Few lawyers could ever have seen this one coming.

And fewer still could have predicted what else happened in this case. I was able to speak with Carl Wilkerson, the attorney for Mike Schlueter (Bush & Motes, PC, Arlington, Texas), trying to make some sense out of the court’s opinion. But I ended up shaking my head in disbelief that much more. Keep reading as we head for the Twilight Zone.

Ms. Carey hired a lawyer who didn’t do much on it, other than filing a lawsuit against Mike Schlueter individually. This lawyer eventually sent the case to another plaintiff’s lawyer. This second plaintiff’s lawyer totally dropped the ball in terms of getting the case ready for trial. The case was even dismissed for failure to prosecute. It just laid there pretty much dead.

But then the original plaintiff’s lawyer took it back, and began to get it ready for trial. It was reinstated and came back to life like Lazarus, only with much worse effect. The plaintiff’s lawyer finally figured out that the bingo charity didn’t lease the space from Mike Schlueter, but rather from Entertainment Properties, Inc. Now, this was not a secret, nor did anyone try to cover it up. But a very difficult dilemma arose for Ms. Carey and her lawyer, because by now the statute of limitations had run, preventing her from adding Entertainment Properties, Inc., to the lawsuit.

And so she did the next best thing. She sued “Mike Schlueter d/b/a Lancaster Bingo, a/k/a Lancaster Bingo, Inc.” She sued “Mike Schlueter, individually, and d/b/a Entertainment Properties, Inc. a/k/a Entertainment Properties, Inc.” And if that wasn’t enough overkill, she added “Mike Schlueter, individually, and d/b/a Lancaster Bingo a/k/a Lancaster Bingo, Inc.” Got all that? Do you even know who the defendant is anymore? When you can’t do anything else, confuse the enemy and, in this case, the court, and take your chances.

Surprisingly, it worked. And yet the story only gets stranger. When the parties showed up for trial in April of 2001, which was to the court and not to a jury (another fact that makes no sense to me–another ball dropped by the plaintiff?), the issue of the lease, and Entertainment Properties’ insurance coverage, came up right off the bat. The judge stopped the trial, and suggested to the plaintiff’s lawyer that he should try to pierce the corporate veil! I rarely write with exclamation points but that last fact is a doozie and there’s just no other way to say it. Then, the judge recessed the trial, giving the plaintiff’s lawyer time to conduct more discovery, and decide whether or not to add a claim to pierce the corporate veil. Wanna guess what they did?

The court reconvened the case on August 6 of 2001, and that very same day the plaintiff filed an amended petition alleging Mr. Schlueter used the corporation as a “sham to perpetuate a fraud.” Ms. Carey’s lawyer did not claim that the corporation was the “alter ego” of Mr. Schlueter. Yet the trial court found that the corporation was the “alter ego” of Mr. Schlueter, did not find any sham to perpetuate a fraud, and pierced the veil. As best I can tell, the court apparently felt sorry for Ms. Carey and wanted to see that she was taken care of.

There are only two facts the court mentioned in its opinion to support its “alter ego” conclusion, allowing it to pierce the corporate veil. First, Mike Schlueter filed an assumed name certificate showing that he, individually, was doing business as “Lancaster Bingo.” And second, while testifying at trial, Schlueter often referred to himself and Entertainment Properties, Inc., interchangeably. In my opinion, this is much ado about nothing, obviously a predetermined answer in search of the question. Witnesses cannot be held to a standard of perfection, of dealing in specifics as easily as lawyers. The court even acknowledged that Entertainment Properties, Inc., was the entity that collected rent from the bingo operators, that Schlueter didn’t commingle any personal assets with business assets. It specifically did not find that Entertainment Properties, Inc. was undercapitalized.

And here’s the kernel of truth that makes this whole case bizarre. If Ms. Carey had EVER sued the corporation Entertainment Properties, Inc., in time before the statute of limitations expired, there would have been insurance coverage for her injuries. The fact that her lawyer dropped the ball and just didn’t get things done in time–and they had two years’ worth of time here–put everyone in a bad position.

In any event, the trial court pierced the corporate veil, and imposed personal liability on Mr. Schlueter for Ms. Carey’s injuries. The tab was around $20,000. Mr. Schlueter does not have the ability to turn this in to his insurer. A case like this, which is so bizarre it could not have been foreseen by any reasonable attorney, is “Exhibit A” for business owners who are thinking about personal asset protection planning in addition to using a business entity to conduct business operations.

Well, having lost in the trial court, Mr. Schlueter appealed the case to the Fort Worth Court of Appeals, and that opinion is “tortured” to say the least, meaning its logic isn’t very obvious, and it relies on some very technical rules in order to sustain the trial judge’s decision.

The corporate veil is, by definition, the corporation’s. We don’t call it a “shareholder’s veil”. It comes into existence when a corporate charter is issued by the Secretary of State, upon the filing of articles of incorporation. A shareholder doesn’t “own” the veil. It was pierced without the corporation even being at trial to defend it. Entertainment Properties, Inc., was basically tried in the court, even though it wasn’t a party.

The court simply stated “Schlueter was Entertainment Properties’ alter ego; therefore, Schlueter was liable to Carey for any breach of the legal duty that Entertainment Properties owed her.” How do you establish or defend that duty if Entertainment Properties isn’t even a party to the lawsuit?

From bad facts comes bad law, and this case is no exception to that rule. And the parties must have settled this case before it was appealed to the Texas Supreme Court, so we are stuck with bad law.

This case is a lesson for business owners about the unforseen risks we face any given day. No one can list every reason you may need some asset protection planning in addition to putting your separate business operations in separate business entities. Crazy things can happen that’ll make you wish you had some. If you don’t do it before you need it, it’ll be too late.

Schlueter v. Carey, 112 S.W.3d 164 (Tex. App.–Fort Worth 2003)

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Piercing the Veil 2; Texas Provides Extra Protection

In 1987, the Texas Supremes supremely confused the law allowing plaintiffs to impose business liabilities on individual owners by “piercing the veil.” Fortunately, a pro-business state legislature stepped in to undo the problem and give owners of Texas businesses extra protection from this risk.

The 1987 decision by the Texas Supremes, Castleberry vs. Branscum, proves the maxim that bad facts make bad law. In this case, three men (Castleberry, Branscum and Byboth) each owned one-third of a Texas corporation named Texan Transfer, Inc. (TTI). This moving business proceeded nicely for a few years, but then Branscum and Castleberry got crossways with each other. Apparently, Branscum wasn’t fully satisfied, so he formed a competing moving business named Elite Moving.

Either Branscum or his lawyer dropped the ball, because neither of them protected the name “Elite Moving.” My guess from reading the case is that Branscum didn’t have a lawyer until it was far too late. In any event, Castleberry saw the error of Branscum’s ways and decided to teach him a lesson. So, Castleberry filed an assumed name certificate for the name “Elite Moving” to prevent Branscum from competing with TTI under that name. Branscum and Castleberry then exchanged verbal pleasantries until Byboth, the third partner who turned out to be the devil in disguise, proposed the ultimate solution: Castleberry would sell his stock in TTI back to the company for a total of $42,000, paid in $1,000 monthly installments, and transfer the name “Elite Moving” to Branscum and Byboth. The business divorce concluded on these terms, and in 1981 TTI made the first $1,000 installment.

After the buyout, Elite Moving gradually took over TTI’s business, assets and equipment. TTI’s net income went from $65,479 for the 18 months prior to the buyout, to $2,814 in 1981 after the buyout, and then to a loss of $16,000 for 1982. In contrast, Elite Moving reported income of $195,765 in 1982. Not surprisingly, after making the first payment, TTI defaulted on the remaining $41,000 owed to Castleberry.

Castleberry wasn’t willing to walk away from this debt, especially not with such bad blood between the players. He did have one problem: collectability. It’s not enough to get a judgment. You have to collect the judgment to improve your position. TTI had no way to pay a judgment, so a lawsuit against only TTI was out of the question. Castleberry needed to go where the assets were: the B Boys and their other companies.

In hindsight, Castleberry could have saved himself this whole headache if he had retained a competent lawyer way back in 1981. Selling stock in a business to the business, or other individuals, with seller financing, is a fairly standard transaction. And all sellers have the same issue: insuring collection as much as possible. In this case, Castleberry could have included language in the buy-out documents which:

1.  prevented TTI from transferring any assets or substantially changing its business; and
2.  had the B Boys each personally guarantee the note, jointly and severally.

Either of these would have contractually kept the B Boys from successfully doing what they did. But since he didn’t, in order to get Castleberry from where he was to where he needed to be, yet another lawsuit was filed. Castleberry sued every party in sight, under just about every theory of piercing the veil, to try to push this liability onto someone with assets sufficient to pay the judgment.

Whereas I would have preferred to hang Castleberry with the deal he voluntarily struck, the Texas Supremes felt ultimate compassion and rewrote Texas law to accommodate his (pick one): (1) oversight; (2) ignorance; or (3) stupidity. Unfortunately, in the process, they made all “pierce the veil” theories equitable, and dependent on the individual facts of each case. This meant that in nearly every case a jury would decide whether to pierce the veil, and one factor they could consider would be whether it would be “fair” to allow the plaintiff to pierce the veil. As you can see, any time a business did not have assets sufficient to pay a judgment, a jury would be inclined to impose the liability on the owners.

In order to restore some confidence in the sanctity of the liability shields of business organizations, the Texas legislature quickly amended the Texas Business Corporation Act. The statute restricted a plaintiff’s use of the theories of alter ego, actual fraud, constructive fraud, sham to perpetuate a fraud, and any other similar theory, to pierce a corporation’s veil. The statute provided that a plaintiff could succeed on any of these theories ONLY if the plaintiff shows the person or entity upon whom liability is alleged:

(1) caused the corporation to be used for the purpose of perpetuating and did perpetrate an actual fraud on the obligee (plaintiff) primarily for the direct personal benefit of such person or entity; or

(2) expressly agreed to assume liability, such as in the case of signing a guaranty of corporate debts, or

(3) is otherwise liable to the obligee under the Texas Business Corporation Act or another applicable statute.

For limited partnerships, general partners are liable by law for 100% of the debts of the limited partnership. For this reason, a limited liability entity of some sort is almost always used as the general partner of a limited partnership. A limited partner is generally not individually liable for partnership debts unless the limited partner participates in control of the business.

What does this mean for the business owner? On the positive side, it means that Texas has favorable laws designed to keep business debts from passing through the business veil if you do your part. On the other hand, though, owners must still be careful to not actively cause a third party to rely on their personal financial strength when making a deal. Here’s a classic no-no: “don’t worry about how strong my corporation is, you know that when you deal with my company it’s the same as dealing with me.” And make sure the business is correctly named in each contract, and that the signature block includes the title of each individual signing for the business.

And finally, business records should be kept up to date to identify officers, directors/managers, and owners (as well as who are NOT in these positions).

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CREDITS

Enviropinions are original writings of Mark McPherson.
© 2014, Mark McPherson. All rights reserved.
15950 Dallas Parkway, Suite 400
Dallas, TX 75248
214-722-7096 Office
214-540-9866 Facsimile
mark@texasenvironmentallaw.com
www.TexasEnvironmentalLaw.com

Piercing the Veil 1: It’s Hard Now Because It Used to be Easy

In 1977 Wyoming became the first US state to establish limited liability companies. It is the “mother state.” And so it was “big doings” on May 15, 2002, when the Wyoming Supremes ruled that the remedy of piercing the veil was available even in the absence of fraud, under Wyoming statutes.. A similar result recently came out of Louisiana. The question is, would this result be the same in Texas?

Roger Flahive was the managing member of Flahive Oil & Gas, LLC, a Wyoming limited liability company which owned no assets. FO&G, LLC entered into a contract with Kaycee Land & Livestock to use the surface of some real estate it owned. Unfortunately, in the process of this use, FO&G, LLC, caused environmental contamination to Kaycee’s land. Given our federal environmental laws, cleanup costs, fines and other damages were quite substantial, and while Kaycee probably wanted blood, it was willing to settle for money. Lots of money. But this posed some problem, however, because FO&G, LLC, had no assets. So, Kaycee and its lawyers, in their quest for money, targeted Roger and his assets. It was every business owner’s nightmare: Kaycee wanted to pierce the company’s veil, to impose a debt of the LLC on its owner.

Basically, Kaycee argued that an LLC should be no different than a corporation when it comes to piercing the corporate veil. Wyoming had no statute that stated when a corporate veil could, or could not, be pierced. When and whether to pierce a corporate veil and impose a corporate debt on an individual owner was, in Wyoming, established by a line of cases (basically, judges wrote additional provisions into the Wyoming corporate statutes).

The Wyoming Supreme Court agreed with Kaycee that the same rules apply to corporations and LLCs when it comes to piercing the entity’s veil. Here is the rule in Wyoming:

The corporation must not only be influenced and governed by that person, but there must be such unity of interest and ownership that the individuality, or separateness, of such person and corporation has caused, and the facts of the case are such that adherence to the fiction of the separate existence of the corporation would, under the particular circumstances, sanction a fraud or promote injustice.

Promote injustice? Now, that’s a very broad, subjective rule, and it is applied on a case by case basis. Worse yet, since it is so subjective, it is almost impossible for a defendant business owner to win short of a full blown trial. If the trial happens to be a jury trial, a jury will decide whether it is “equitable” to enforce a company debt on an owner. If the company has done something that has caused damages, and it does not have the assets to pay the damages, the plaintiff has sympathy on its side as well. All of these factors, along with general uncertainty, which is never good, increases the pressure on the individual defendant business owner to settle the case, irrespective of the merits.

Kaycee Land and Livestock v. Flahive, Case No. 00-328 (Wyoming, 2002)

In Louisiana, the Orleans Regional Hospital, a Louisiana limited liability company, suffered financial setbacks due to medicaid policy changes. It ultimately closed. The employees brought a lawsuit against Orleans Regional Hospital under the federal Worker Adjustment and Retraining Notification Act (appropriately anacronymed “WARN”). WARN requires at least 60 days prior notice to employees of a plant closing or mass layoff. Orleans did not provide the 60 day notice. Most employees got about 14 days notice instead. Since Orleans Regional Hospital obviously didn’t have enough assets to pay any judgment, the plaintiffs sued everyone in sight using every “pierce the veil” theory Louisiana law allowed.

Before the case was over, not only was Orleans Regional Hospital, LLC, on the hook, but so was North Louisiana Regional Hospital, Inc., Precision, Inc. (both were members of Orleans Regional Hospital), John C. Turner, William Windham, and Richard W. Williams, (the major individuals behind all these entities), North Louisiana Regional Hospital Partnership, Magnolia Health Systems, LLC, Spectrum Community Counseling, LLC, Success Counseling Services, LLC (also owned by Turner, Windham and Williams directly or indirectly), and Brentwood Behavioral Healthcare, LLC (a successor entity to North Louisiana Regional Hospital Partnership). Total damage was $334,046.28, plus pre-judgment interest, PLUS $305,992.61 in attorneys fees to the winner.

So the plaintiffs and their lawyers could then pick and choose among the assets of all of these people and entities to satisfy that judgment.

Hollowell v. Orleans Regional Hospital, 217 F.3d 379 (5th Cir. 2002).

As an aside, in determining where to incorporate or organize a business entity, wise clients will consult with their attorneys to look at cases like these, and avoid organizing in states that so liberally allow the veil to be pierced.

Would either of these cases be the same under Texas law? Probably not. In 1987 the Texas Supreme Court issued a very poorly rationalized decision known as the infamous “Castleberry case.” It so confused the law concerning piercing the corporate veil, and arguably made it so easy, that the Texas Legislature stepped in and passed a law in 1989 to basically overturn that decision. They wanted Texas to be known as “business friendly,” and not risk having entities incorporated here move to another state.

This statute, what was then Article 2.21 of the Texas Business Corporation Act and is now in the Texas Business Organizations Code, substantially restricts a plaintiff’s ability to pierce a corporation’s veil. More on these details in later posts.

REFERRAL NETWORKS

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CREDITS

Enviropinions are original writings of Mark McPherson.
© 2014, Mark McPherson. All rights reserved.
15950 Dallas Parkway, Suite 400
Dallas, TX 75248
214-722-7096 Office
214-540-9866 Facsimile
mark@texasenvironmentallaw.com
www.TexasEnvironmentalLaw.com

 

Suing Everyone In Sight: Asset Protection in Action

Frank Johnson invented a new type of dump truck, one that could dump its load both (1) out the back by raising up its trailer; or (2) through its doors in the belly of the hopper. It was called the “Shape Shifter.” Martin Kirbie, an employee of Hoss Equipment Co., heard about it and introduced his boss, Gregg Hoss, to the idea. Hoss bought into it hook, line and sinker, and seems to have called his lawyer for the next step.

Hoss, already the sole shareholder of Hoss Equipment Co., formed a limited partnership, JHC Ventures, LP, and a new corporation, JHC Holding Co., as its general partner. JHC Ventures was to obtain the patent for the Shape Shifter dual dump truck, manufacture it, and sell it. The limited partnership structure eliminated all franchise taxes on the earnings of JHC Ventures, and provided asset protection by keeping the income stream–and any associated liabilities–of JHC Ventures separate from his other operations.

Hoss appeared on the cusp of success as JHC began marketing the Shape Shifter. Sam Vale, sole shareholder of Fast Trucking, Inc., saw an ad and was so impressed he began negotiations to buy several Shape Shifters. Unfortunately, Hoss’s mouth nearly destroyed his asset protection planning. Hoss expressly assured Vale about the superior durability of the Shape Shifters, their ability to haul various, and very different, types of materials, and their dual-dumping capabilities. Hoss told Vale these trucks could haul grain, sand, and sludge with the purchase of certain additional accessories. These representations became an express warranty, meaning if the trucks didn’t live up to their billing as blabbed by Hoss, somebody would be liable for something.

The hot air must have worked, because on December 13, 1994, Fast Trucking, Inc., Vale’s corporation, signed a commercial invoice with JHC Ventures to buy five new Shape Shifters for $175,000 plus $21,000 in federal excise tax. Under separate invoice with JHC Ventures, Fast Trucking also bought accessories for $9,750. This one act would later become a critical fact.

Sure enough, the trucks did not live up to their spectacular billing. The sludge seeped out. Hydraulic lines and structural welds broke. The belly dump doors failed to function properly. The back dump feature worked only part of the time. Within a few short months, the Shape Shifters were returned for repairs, and returned over and over for a total of about 10 times. Apparently the repairs were completed by Hoss Equipment Co., and not the seller, JHC Ventures.

Finally, on October 30, 1998, Fast Trucking gave up and sued JHC Ventures over the Shape Shifter trucks. Fast Trucking included Hoss Equipment Co. in the lawsuit. Later, Fast Trucking added Hoss individually as a defendant, because he allegedly told Fast Trucking that the seller was Hoss Equipment, as opposed to JHC Ventures. Plus, he’s the one who was spouting all the wonderful qualities of these trucks. The asset protection planning wasn’t looking too good right about then.

In November of 1998, Fast Trucking sold the Shape Shifter trucks plus the accessories for the abysmally low price of $43,000, and that was probably a good deal for Fast Trucking.

At trial, the jury decided that damages were $104,500, plus $5,000 for transportation and freight charges, and they assessed $50,000 in punitive damages against both JHC Ventures and Hoss Equipment. On top of that, the jury awarded Fast Trucking its trial attorneys fees of $150,000. The attorneys fees were larger than the amount of actual damages!

Here’s where it begins to get interesting. Because Fast Trucking leveled different claims against Hoss and his various business entities, it ended up with a trial court judgment of different amounts against different parties, as follows:

Hoss Equipment, JHC Ventures JHC Holding: $109,500 actual damages
Hoss, Hoss Equipment, JHC Ventures, JHC Holding: $50,000 punitive damages
Hoss Equipment: $50,000 punitive damages
Hoss, Hoss Equipment, JHC Ventures, JHC Holding: $150,000 attorneys fees

And somebody was liable for everything and then some.

On appeal, the various defendants whittled away at this judgment. First, the Court of Appeals agreed that Fast Trucking could not, by law, get a judgment for its attorneys fees on its breach of warranty claims. Then, it held that Fast Trucking didn’t put on the right evidence to get its “transportation costs” and so the $109,500 was reduced to $104,500.

And here is where the case got really interesting. The defendants argued that Hoss individually should not have any judgment against him. The jury had been asked by what date Fast Trucking should have known the false, misleading or deceptive trade practices it alleged Hoss committed in the case. The jury answered “December 13, 1994.” This is the date on which Fast Trucking signed the invoice for the trucks on JHC Ventures letterhead. The invoice clearly indicated that the seller was “JHC Ventures, L.P.” Fast Trucking had 4 years after that date, December 13, 1994, to sue Hoss personally, or it would lose its right to sue him by law (these sorts of laws are referred to as “statutes of limitation). Sure enough, they waited until over 5 years after that date before they added him to the lawsuit.

But Fast Trucking wasn’t ready to just let Hoss walk. It argued that the judgment really meant Hoss was the alter ego of his businesses. The Court of Appeals noted that the jury found that “Hoss was responsible for the conduct of JHC Holding,” a non-party to the case. It was not asked whether Hoss was the alter ego of JHC Ventures. Without an express jury finding of alter ego, Hoss could not be included in the judgment on the basis of alter ego. The corporate/limited partnership veil could not be pierced, and so Hoss was spared individual liability in this case. Things were lookin’ up.

Finally, the defendants pointed out that JHC Holding was never even a party to the lawsuit, so it couldn’t have any judgment entered against it. Fast Trucking countered “but it’s the general partner of JHC Ventures, and it’s liable for all its debts as a matter of law, and we sued JHC Ventures by serving JHC Holding as its general partner.” Said the Court of Appeals, “you should have served ‘JHC Holding Co., by and through its registered agent Gregg Hoss’ and you didn’t.” And so, all of the judgment against JHC Holding Co. was out, as well. The asset protection was looking better and better.

Next issue. This is just beautiful. Texas has a “proportionate responsibility” statute which says, for tort claims (but not for breach of contract claims), where there is more than one party involved the jury decides how much responsibility for the injury should be allocated to each party. In this case, on the fraud claim, the jury had allocated responsibility like this:

Fast Trucking: 40%
Hoss: 30%
Hoss Equipment:; 20%
JHC Ventures: 10%

Since the Court of Appeals threw out the judgment against Hoss, what was to happen to its 30%? Fast Trucking wanted to re-allocate that to Hoss Equipment and JHC Ventures. The Court of Appeals said “no can do, we have to send this case back to the jury and see what they have to say.”

And so, after all this wrangling, the final result was modified like this:

Hoss Equipment, JHC Ventures JHC Holding: $109,500 actual damages $104,500
Hoss, Hoss Equipment, JHC Ventures, JHC Holding: $50,000 punitive damages $0
Hoss Equipment: $50,000 punitive damages $0
Hoss, Hoss Equipment, JHC Ventures, JHC Holding: $150,000 attorneys fees $0

My suspicion is the only reason Hoss Equipment had the judgment against it is because it performed all the repairs to the Shape Shifter trucks. The bottom line is that this case is a good example of why us professionals like for our clients to use a separate business entity for each separate business activity. As a result of that, the ensuing $104,500 judgment (down from $359,500) was only against two entities, and not against the owner individually in any way.

This case also shows very clearly the importance of written documents, because the only thing that saved Hoss individually were the 2 written invoices signed by JHC Ventures and Fast Trucking. Those written invoices clearly indicated that JHC Ventures was the seller, notwithstanding Hoss’s oral platitudes, which made the case for the jury and preserved Hoss’s asset protection planning. They basically saved him from himself. Can your documents do that?

JHC Ventures, LP, et al, v. Fast Trucking, Inc., Case No. 04-01-00251-CV, Texas Court of Appeals, 4th District, Nov. 27, 2002.

REFERRAL NETWORKS

Your new client referrals are a big part of our continued success, and the same is true about this blog. Please take a moment to think about friends and colleagues you know who might enjoy receiving notice of new Enviropinions blog posts and forward this to them. Individual subscription information is below.

SUBSCRIPTIONS

To subscribe to the free Enviropinions Blog, please enter your preferred Email address in the right column under “FOLLOW BLOG VIA EMAIL”. There is no set schedule for postings. I write them as important or interesting developments occur.

CREDITS

Enviropinions are original writings of Mark McPherson.
© 2014, Mark McPherson. All rights reserved.
15950 Dallas Parkway, Suite 400
Dallas, TX 75248
214-722-7096 Office
214-540-9866 Facsimile
mark@texasenvironmentallaw.com
www.TexasEnvironmentalLaw.com