DAVID J. WILLIS ATTORNEY
Copyright © 2013. All rights reserved worldwide.
PIERCING THE VEIL OF A TEXAS LLC OR CORPORATION
By David J. Willis, J.D., LL.M.
This article addresses "piercing the corporate veil," a term which refers to the limited circumstances under which the liability shield of a registered legal entity may be "pierced" and the individuals behind that entity held personally accountable. Knowing when this might or not occur is an important factor in asset protection planning since a piercing event defeats a central purpose of forming a corporation or limited liability company in the first place.
Piercing the veil is an equitable remedy the applicability of which depends on the specific facts at hand. However, the liability barrier of a registered entity may be pierced only in exceptional circumstances. See Wilson v. Davis, 305 S.W.3d 57, 59, 69 (Tex.App. – Houston [1st Dist.] 2009, no pet).
Evolution of the Law
Traditional Texas law in this area is summarized by Rimade Ltd. v. Hubbard Enters (388 Fed 138, 143, 5th Cir.2004), which drew upon case law and statutes beginning with the foundational Texas Supreme Court case of Castleberry v. Branscum, 721 S.W.2d 270 (Tex. 1986). The Rimade court stated "Under Texas law, there are three broad categories in which a court may pierce the 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 a sham to perpetrate a fraud."
Apparently Rimade went too far for the Texas legislature. Two years after the Rimade case, and partially in reaction to it, the legislature enacted Sec. 101.114 of the Texas Business Organizations Code (the "BOC") which sought to limit veil piercing by codifying the law in this area:
§ 101.114. LIABILITY FOR OBLIGATIONS. Except as and to the extent the company agreement specifically provides otherwise, a member or manager is not liable for a debt, obligation, or liability of a limited liability company, including a debt, obligation, or liability under a judgment, decree, or order of a court.
Sec. 21.223 further defines and limits the exposure of shareholders and members (underlining added):
§ 21.223. LIMITATION OF LIABILITY FOR OBLIGATIONS.
(a) A holder of shares, an owner of any beneficial interest in shares, or a subscriber for shares whose subscription has been accepted, or any affiliate of such a holder, owner, or subscriber of the corporation, may not be held liable to the corporation or its obligees with respect to:
(1) the shares, other than the obligation to pay to the corporation the full amount of consideration, fixed in compliance with Sections 21.157-21.162, for which the shares were or are to be issued;
(2) any contractual obligation of the corporation or any matter relating to or arising from the obligation on the basis that the holder, beneficial owner, subscriber, or affiliate is or was the alter ego of the corporation or on the basis of actual or constructive fraud, a sham to perpetrate a fraud, or other similar theory; or
(3) any obligation of the corporation on the basis of the failure of the corporation to observe any corporate formality, including the failure to:
(A) comply with this code or the articles of incorporation or bylaws of the corporation; or
(b) Subsection (a)(2) does not prevent or limit the liability of a holder, beneficial owner, subscriber, or affiliate if the obligee demonstrates that the holder, beneficial owner, subscriber, or affiliate 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, beneficial owner, subscriber, or affiliate.
(B) observe any requirement prescribed by this code or the articles of incorporation or bylaws of the corporation for acts to be taken by the corporation or its directors or shareholders.
Thus "actual fraud" committed by the entity primarily for the "direct personal benefit" of the shareholder or member is now required, at least for contract-type claims. Merely alleging "alter ego" is by itself insufficient. This is Texas´ actual fraud rule. Texas courts have since recognized the "strict restrictions on a contract claimant´s ability to pierce the corporate veil" (Ocram, Inc. v. Bartosh, 2012 WL 4740859 *2-3 (Texas.App. – Houston [1st Dist.] 2012, no pet.).
Corporate Rules Applied to Limited liability Companies
The reader may note that the foregoing statute refers specifically to corporations. What about LLC's? Sec. 101.002 provides the answer. It imports "piercing the veil" provisions set forth in Sec. 21.223 (above) even though this section derives from a part of the BOC that is applicable to corporations. In other words, the same standards apply to both corporations and LLC's even though applicable provisions of the statute may refer to a "corporation" rather than an LLC and to "shareholders" rather than "members." LLC members can expect to receive the same treatment as shareholders of a corporation – no more, no less. See Penhollow Custom Homes, LLC v. Kim,320 S.W.3d 366 (Tex.App.– El Paso 2010, no pet.).
In SSP Partners v. Gladstrong Inv. (USA) Corp., 275 S.W.3d 444, 451–52 (Tex.2008) the Texas Supreme Court stated that the limitation on corporate (or LLC) liability may be ignored only when the corporate form has been used as part of a basically unfair device to achieve an inequitable result. Continuing this line of thought, also in 2008, the Houston Court of Appeals (1St District) in Tryco Enterprises, Inc. et al vs. James A. Robinson stated that in order "to pierce the corporate veil and impose liability under an alter ego theory of liability pursuant to SSP Partners, a plaintiff must show: (1) that the persons or entities on whom he seeks to impose liability are alter egos of the debtor, and (2) that the corporate fiction was used for an illegitimate purpose, in satisfaction of . . . Business Organizations Code section 21.223(a) and (b)." What factors are important? The Court of Appeals in Tryco listed the following:
Any and all of the above should be considered "red flags" in a piercing-the-veil case. From an asset protection perspective, all can be avoided by sound planning and documentation.
- whether the entities shared a common business name, common offices, common employees, or centralized accounting;
- whether one entity paid the wages of the other entity´s employees;
- whether one entity´s employees rendered services on behalf of the other entity;
- whether one entity made undocumented transfers of funds to the other entity; and
- whether the allocation of profits and losses between the entities is unclear.
Liability of Company Officers and Managers
The signature by a corporate officer or LLC manager does not, by itself, make that individual personally liable, even if the signature line fails to specify that the signer is acting solely in his or her capacity as an officer or authorized representative. Neel v. Tenet HealthSystem Hospitals Dallas, Inc., 378 S.W.3d 597, 604-604 (Tex.App. – Dallas 2012, pet. filed). This rule tracks agency law: an agent is not liable on contracts made on behalf of a principal whose identity has been disclosed. Nonetheless, it is always the better practice to make sure that the signer on a contract fully discloses his capacity and authority to act on behalf of an entity.
Directors and officers face full personal exposure, however, if the entity fails to pay its taxes (see Tex. Tax Code Sec. 171.255 set out below). If a registered entity´s status is forfeited for non-payment of taxes, then each director, officer, or manager may be held liable for debts of the entity from the date on which the tax was due up to the time the entity is reinstated. In re Trammel, 246 S.W.3d 821 (Tex.App. – Dallas 2008, no pet.).
Litigation and Discovery
During the discovery phase of a lawsuit involving a corporation or LLC, a plaintiff´s attorney will request production of the company book and all relevant documentation. Purpose? If the company has no company book or documentation other than its Certificate of Formation, the plaintiff´s attorney may then amend his pleadings to include an allegation that the LLC is merely the "alter ego" of the individual(s) behind it, and therefore the liability shield should be pierced to hold members personally accountable for company wrongdoing. But what does "alter ego" mean? "Under the alter ego theory, courts disregard the corporate entity when there exists such unity between the corporation and individual that the corporation ceases to be separate and when holding only the corporation liable would promote injustice." Mancorp, Inc. v. Culpepper, 802 S.W.2d 226, 228 (Tex. 1990). In other words, the company failed in its mission to become and maintain itself as a legal entity independent of its owner. While Sec. 21.223(a)(2) eliminates the alter-ego theory as a basis for veil piercing, it cannot be eliminated as a factor in a case where actual fraud is present – particularly since piercing the veil in Texas has always been linked to values of fairness and justice.
Clients often worry whether or not the LLC liability shield will hold up if there is only one member. This is not a concern in Texas. Since BOC Sec. 101.002 makes it clear that rules in this area relating to corporations also apply to LLC´s, then (subject to the piercing rules outlined above) an LLC´s liability shield remains intact even though there is only one member. Most small business LLC´s consist of a single member, a couple of partners, or a husband and wife team. These persons should have no fear that, if properly documented, their LLC will protect them.
Implications for Series LLC´s
A Texas Series LLC (as opposed to a traditional LLC) allows for different compartments or series that are insulated from the assets and liabilities of other series within the company. While not technically separate legal entities, these individual series are nonetheless permitted to behave as sub-companies – doing business independently of the company at large, entering into contracts, and holding title to property. The Series LLC has become an increasingly popular vehicle, particularly for real estate investors. Although there is not yet Texas statutory or case law on this subject of which we are aware, it is likely that if a particular series is pierced the other series within the company will remain intact – but, as is always true in litigation, it depends on the circumstances.
Many business persons utilize online services or otherwise engage in no-frill LLC filings involving a one-page Certificate of Formation and the payment of a filing fee – and then believe they are safe from lawsuits. This may not be so if the company fails to follow up with a company agreement, issuance of membership certificates, minutes of meetings, and the like. While Sec. 21.223(a)(3) expressly eliminates the failure to observe corporate formalities as a basis for veil piercing, such failure may well be subtly considered by a real-world court in determining whether or not an actual fraud was perpetrated. Add an "inflamed jury," one that is outraged at a perceived injustice, and the risk that a court will pierce the veil grows more likely. The law is not a machine. One cannot underestimate the human factor.
This firm would prefer to be safe rather than sorry when it comes to company documentation and other "formalities." We therefore include asset protection provisions from the outset, in the Certificate of Formation ("COF"), since it is our view that a one-page filing, standing alone, may not be adequate to fully maintain an LLC's liability shield and protect the company's members. For instance, our COF publicly announces that the company will have two classes of membership interest – Class A with full rights for regular members and Class B with limited rights. Class B consists of creditors who have obtained their membership interest by means of a judgment or other legal process. Why include such provisions in the COF? Deterrence. A creditor will know in advance that any interest it may obtain in the company will be essentially worthless – so why incur the expense and effort of going after it?
In addition to a comprehensive COF, a properly documented LLC includes organizational minutes (a record of the first meeting of members), a company agreement that outlines the fundamental structure and operating rules of the company, signed and issued membership certificates, annual meeting minutes, a banking resolution, minutes of special meetings, company resolutions, and any other documents, memoranda, or contracts that apply to significant company operations, circumstances, obligations, and liabilities. In other words, it may not be enough merely to establish an LLC with a minimal filing and then view the job as done – in spite of BOC Sec. 21.223(a)(3). Maintaining a thorough record of the company's activities is a matter of ongoing prudence in a litigation-prone world.
Obtaining an official company book from a business printing company is useful for keeping LLC documents together and professionally in order. Warning to real estate investors: expect that a plaintiff´s attorney´s first request for production will be to see your company book.
What if documentation for your LLC or other entity has not been attended to for years? Fortunately, it is perfectly legal to go back in time and document a company´s activities, so long as this is not linked to actual fraud. Such documents are signed by the members as of a retroactive "effective date," regardless of the date of actual signature.
For more detail on the content of principal LLC documents, see our companion web article entitled LLC´s in Texas – Governing Documents.
Paying Franchise Taxes
Failing to pay Texas franchise tax and subsequent loss of the company´s charter can be disastrous for asset protection. Note the following from the Texas Tax Code:
Sec. 171.255. Liability of Directors and Officers
(a) If the corporate privileges of a corporation are forfeited for the failure to file a report or pay a tax or penalty, each director or officer of the corporation is liable for each debt of the corporation that is created or incurred in this state after the date on which the report, tax, or penalty is due and before the corporate privileges are revived. The liability includes liability for any tax or penalty imposed by this chapter on the corporation that becomes due and payable after the date of the forfeiture.
(b) The liability of a director or officer is in the same manner and to the same extent as if the director or officer were a partner and the corporation were a partnership.
(c) A director or officer is not liable for a debt of the corporation if the director or officer shows that the debt was created or incurred:
(1) over the director´s objection; or
(d) If a corporation´s charter or certificate of authority and its corporate privileges are forfeited and revived under this chapter, the liability under this section of a director or officer of the corporation is not affected by the revival of the charter or certificate and the corporate privileges.
(2) without the director´s knowledge and that the exercise of reasonable diligence to become acquainted with the affairs of the corporation would not have revealed the intention to create the debt.
A Note on Trusts
Trusts – whether created for the purpose of anonymity, facilitating land transactions, or for probate avoidance – can be an important element in an overall asset protection structure. However, a trust is not a "legal entity" in the same sense as a corporation or LLC. Trust agreements are not filed anywhere and have no state registration or approval. Accordingly, there is no liability barrier and piercing rules do not apply. The participants in a trust – the trustor/grantor, the trustee, and the beneficiaries – are automatically exposed to lawsuits in their personal and individual capacities. For this reason, it is our view that investment trusts are most effectively used in conjunction with an LLC. The exception is a stand-alone living trust for the homestead since the homestead and related assets are already protected by Art. XVI, Sec. 50 of the Texas Constitution and Property Code Chapters 41 and 42. See our companion articles Living Trusts in Texas and Homestead Protections in Texas.
The law applicable to LLC´s in this area continues to evolve at the level of the courts. In particular, the Tryco< case, which is currently on appeal to the Texas Supreme Court, may be influential.
The safest practice is to establish and maintain an LLC with thorough and ongoing documentation. Company documents – starting with the Certificate of Formation and continuing with the company agreement, organizational meeting, appropriate resolutions, and the like – should all be drafted with the expectation that an adversary may attempt to pierce the liability shield and hold members individually liable.
If you have an LLC that needs documentation (or re-documentation), consult a lawyer who actively practices in this area.
Information in this article is proved for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is expressly retained in writing to do so.
Copyright ©2013 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his web site http://www.LoneStarLandLaw.com.