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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