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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