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What is reverse veil piercing, and when is it appropriate?

A business owner typically forms a limited liability entity, e.g., a corporation or a limited liability company, to insulate the owner from liabilities arising from the entity’s activities. Likewise, the entity also insulates the entity’s assets from the owner’s liabilities. Reverse veil piercing allows the owner’s personal creditors to seize an entity’s assets to satisfy an owner’s debts. A modification of the familiar alter ego doctrine, reverse veil piercing has been recognized by many courts and it appears to be gaining favor. While controversial (see, e.g., Stephen M. Bainbridge, Corporate Law and Economics 166 (2002)), a recent California appellate decision illustrates how reverse veil piercing can be appropriate for limited liability companies.

The alter ego doctrine applies – whether “veil piercing” or “reverse veil piercing” – when an entity’s owner dominates the entity to the point that the entity and its owner are indistinguishable. Where the owner uses an entity to commit a fraud or other harm, the court will lift the entity’s “veil of protection” and allow its owner to be sued personally. Courts rigorously scrutinize such claims, evaluating the entity’s capitalization and solvency and its owner’s adherence to formalities and use of corporate funds. Even the most plaintiff-friendly courts are hesitant to use the remedy.

Reverse veil piercing is the reverse of traditional veil piercing – permitting a creditor to access an entity’s assets in satisfaction of an owner’s liability. Reverse veil piercing requires “such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist” and “circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.” Most courts analyzing veil piercing apply factors similar to those under a traditional veil piercing analysis, but “reverse” the application. For instance, under a straight veil piercing analysis, a court may take into consideration an individual’s use of an entity’s assets. A reverse veil piercing analysis would consider an individual’s questionable transfers of assets into an entity.

Reverse veil piercing was most famously recognized in California’s Fourth District Court of Appeals, in Curci Investments v. Baldwin, where the court applied the doctrine to a Delaware LLC. The plaintiff obtained a multimillion dollar judgment against the owner and sought to add the LLC as a judgment debtor. The court’s decision achieved notoriety because the Fourth District had previously held that California did not recognize reverse veil piercing. Curci noted that the earlier decision held that the reasoning of the cases adopting “reverse piercing of the corporate veil is flawed.” Curci recognized that “reverse piercing is not a logical extension of the standard alter ego doctrine but instead addresses significantly different concerns.”

The facts of Curci illustrate the court’s concerns and highlight the appropriateness of reverse veil piercing. Baldwin and his wife, the defendants in Curci, owned 100% of the LLC , which they formed to manage their cash balances. Two years after establishing the LLC of which Baldwin was the chief manager and controlling member, Baldwin borrowed $5.5 million from Curci’s predecessor in interest. Thereafter, Baldwin formed family trusts and family general partnerships, loaned the family partnerships a total of $42.6 million, and caused the LLC to distribute $178 million to them in the six years prior to entry of the judgment on the note. However, when Curci’s note came due, Baldwin defaulted and litigation ensued. Curci took a judgment against Baldwin, but was limited to a charging order against the LLC and 35 other entities that Baldwin owned. After the judgment, Baldwin elected not to make any distributions to himself and his wife. With three years of Curci’s collection efforts frustrated by Baldwin’s tactics, Curci moved to add the LLC as a judgment debtor on the theory of reverse veil piercing.

The appellate court held that reverse veil piercing may be available if the entity is an LLC, as long as no innocent parties are harmed and an inequitable result would occur if reverse veil piercing was not available. The court distinguished reverse veil piercing against a corporation in part because a creditor of a shareholder of a corporation can “step into the shoes of a shareholder” by foreclosing on the debtor’s interests in the shares of a corporation, and have whatever rights the shareholder had in the corporation.  By contrast, the creditor of an LLC member is limited to the charging order against the LLC. “The debtor remains a member of the LLC with all the same rights to manage and control the LLC … including the right to determine when, if ever, distributions are made.”

Give credit to the Fourth District for its well-reasoned opinion and limiting the reverse veil piercing remedy to unique circumstances.

Category: Compliance & Ethics, Corporate Law