If you read enough of my posts about LLCs, you’ll soon realize that your protection is only as good as its operating agreement — and the laws of the state in which you’ve organized it. They’re NOT all the same…as some of my clients have found out the hard way. For instance…
- Imagine you create an LLC in a given state, and then find out that state’s law permits a creditor to seize your membership interest in a lawsuit.
- Or you’re in another state, where creditors can force an LLC’s members to repay all distributions they’ve received in the previous two YEARS!
The first instance is a failure of outside creditor protection; the second is an inside protection failure. You ignore these possibilities (and many more like them) at your peril, but all too often, that’s exactly what an investor will do: assume an LLC provides the same level of protection, regardless of where it’s created.
And if that isn’t bad enough, I’ve also encountered local professionals who are unable to advise their clients on all the various nuances of these vehicles, because they’ve never completely researched the issues themselves.
What’s An Investor to Do?
When it comes to LLCs and investor protection, there’s only one “assumption” you’re safe making: that for LLCs, it depends on whether you’re talking about liability or internal workings. In liability concerns, your LLC is governed by the laws of the state in which you’re doing business.
If you didn’t see it, I discuss this in more detail in this post, in which we review the case of American Institutional Partners, LLC (“AIP”) v. Fairstar Resources LTD (“Fairstar”). This case illustrated how Delaware charging order protections did not apply when the LLC was conducting business in Utah.
However, when the issue has to do with the internal workings of an LLC, then the state law of formation will apply. This choice of law principle was applied in a recent Kentucky Court of Appeals decision, wherein the court was faced with a claim against the sole member of an Ohio LLC registered to conduct business in Kentucky. Howell Contractors, Inc. v. Berling, No. 2010-CA-001755-MR, 2012 WL 5371838 (Ky. Ct. App. Nov. 2, 2012).
In this case, the defendant, Charles Berling, was the sole member of Westview Development, LLC, an Ohio LLC; Howell provided services and materials to Westview’s real estate development in Ohio. When a payment dispute arose, Howell sued Westview and Berling (plus two companies he owned) in Kentucky for the unpaid amount. Howell asked the court to “pierce the veil” by disregarding Westview’s status as an LLC, and to hold Berling and his companies liable for Westview’s debt to Howell.
The court looked at the issue and determined the law of the state of formation — Ohio — applied to the claim, rather than that of Kentucky, and denied the veil-piercing attempt.
“Piercing the Veil” in More Detail
What, exactly, is “piercing the veil”? It comes about from the complete failure of the LLC, allowing a creditor to ignore its existence. How successfully this type of liability can be pursued depends greatly on state law doctrine…which — you guessed it — varies widely from state to state.
Consider the Colorado case Martin v. Freeman, 272 P.3d 1182 (Colo. App. 2012), wherein the court allowed a creditor to pierce the veil of an LLC and hold the member personally liable. The court in Martin described several factors to be considered in determining alter ego status: commingling of funds and assets, inadequacy of corporate records, thin capitalization, disregard of legal formalities, and using entity funds for non-entity purposes. Unfortunately (in typical Colorado fashion), the court ignored settled law to reach its conclusion.
This varied sharply from what the Kentucky Court of Appeals did when faced with the Howell claim against the sole member of an Ohio LLC. Although the LLC was registered to conduct business in Kentucky, the court first analyzed the choice-of-law question. Did Ohio’s veil-piercing law apply, or did Kentucky’s? The court decided that Ohio law, not Kentucky’s, was binding.
A Peek at the Court’s Analysis
The Court of Appeals first considered which law to apply. The parties apparently had briefed only Kentucky law, because the court noted that “[o]ne aspect of this case which has received scant attention by the parties is that Westview was formed under the laws of Ohio and the real estate development which gave rise to the debt in question is located in Lockland, Ohio.” Id. at *2. The court then quoted the Restatement (Second) of Conflict of Laws for the proposition that the law of a corporation’s state of incorporation applies to determine the extent of a shareholder’s liability to the corporation’s creditors, and applied that rule to LLCs by analogy.
The court also cited several federal cases in support of the rule that the law of the state of formation applies to issues of piercing an entity’s veil. (Choice of law for veil-piercing claims was apparently a question of first impression in Kentucky, although the court did not so characterize it. None of the cases cited by the court involved Kentucky law.)
The court then applied Ohio’s veil-piercing rule. This rule requires that for the veil to be pierced, there must be evidence of fraud or an illegal act against the claimant. In this instance, the differentiation was clear: the court determined that Westview’s conduct did not rise to the level of fraud or illegality, and that Westview had “merely failed to pay an entity debt.” Id. at *3.
The court also considered Kentucky’s standards for veil piercing, reached the same conclusion, and affirmed the trial court’s dismissal of the veil-piercing claims against Berling and his companies. (For a more detailed review of the court’s analysis of Kentucky’s veil-piercing law, I recommend Thomas Rutledge’s post on his Kentucky Business Entity Law blog, here.)
Safety (Sort of) in Numbers
Incidentally, this court’s holding on the choice of law is consistent with the majority rule. “[T]he vast majority of jurisdictions addressing this question have applied the law of the state of incorporation to veil-piercing claims.” Tomlinson v. Combined Underwriters Life Ins. Co., 684 F. Supp. 2d 1296, 1298 (N.D. Okla. 2010).
…But Not All the Time.
Such was NOT the case in the Colorado instance (Martin v. Freeman) I cited earlier. In that instance, the Colorado Court of Appeals applied Colorado’s veil-piercing law to a Delaware LLC, without articulating (or seeming to bother with) any consideration of whether Delaware law should apply. The court pierced the LLC’s veil and liberalized the Colorado standard for piercing the veil of a single-member LLC. The result almost certainly would have been different if Delaware’s veil-piercing law had been applied. (For an analysis of the Martin case, see my blog post here.)
Indeed, instead of playing “fast and loose” with laws of one state and not considering the laws of another, the Kentucky Court of Appeals bent over backwards to be thorough. Consider: it first applied Ohio law and concluded that the veil-piercing claim failed. It then, additionally, examined Kentucky law and concluded that the claim also failed under those statutes. Since choice-of-law was not outcome-determinative, the court could have avoided deciding that issue at all. To its credit, it didn’t.
Navigating Shark-Filled Waters
If this brief examination of the choice-of-law principles show anything, it’s that trying to fly by the seat of your figurative investor’s pants can cost you…sometimes a lot more than you bargained for. Find professionals who are well-versed enough in these issues to give you solid advice that is backed up by appropriate state law and precedent. Better to “bend over backwards” on your side of the street than to hope an appeals court will be willing to do it on your behalf!