Iowa Court of Appeals Says LLC Corporate Veil Properly Pierced

Background

The defendants included a husband and wife who owned a number of poultry-related companies. They each owned a 50 percent share of an LLC they established in August of 2010. The purpose of the LLC was to purchase eggs for hatching, coordinate delivery of hatched chicks to contracted growers, and coordinate the delivery of the grown birds to a family-owned poultry processing company.

The plaintiff was a supplier of eggs for hatching. In early 2010 (before the LLC was formed), the defendants’ daughter contacted a sales manager employed by the plaintiff to see if the plaintiff could supply eggs to the LLC. When the plaintiff inquired about credit information, a bookkeeper employed by another of the defendants’ family entities supplied the plaintiff with credit references for all entities related to the defendants.

In July of 2010, the husband entered into a hatching egg purchase agreement with the plaintiff on behalf of the yet-to-be-formed LLC. The agreement provided that the plaintiff would supply eggs on a weekly basis and that invoices were due within 21 days of receiving the eggs. Over the course of five months, the plaintiffs shipped the LLC hundreds of thousands of eggs under the terms of the agreement. The LLC paid the plaintiff $495,234 for the eggs, but the LLC owed an additional $248,000 to the plaintiff. The LLC ceased its operations in January of 2011, and the family-owned processing company went into involuntary bankruptcy.

Trial Court

The plaintiff filed a breach of contract action against the defendants, asserting that the LLC was a shell corporation and merely the alter ego of the defendants. Named as defendants were not just the husband and wife, but also six family-related companies. The lawsuit alleged that all defendants were jointly and severally liable for the debt. The trial court ruled that it was appropriate to pierce the corporate veil and hold the husband and wife individually responsible for the debt. The trial court based its decision on the fact that the LLC did not have adequate capitalization. It also ruled that recognizing the corporate structure in this case would promote injustice. The trial court, however, rejected the alter-ego theory with respect to the other defendants. The husband and wife appealed the order piercing the corporate veil. The creditor appealed the trial court’s refusal to enter judgment against the other defendants.

Iowa Court of Appeals

The Iowa Court of Appeals affirmed both holdings.

After analyzing the evidence, the court held that the plaintiff had shown the exceptional circumstances required to pierce the corporate veil. The court began by reviewing the general law applicable to Iowa LLCs. An LLC, the court stated, is an entity distinct from its members.”[i] The separate LLC entity enables LLC members to limit their personal liability.[ii] “The separate corporate personality ordinarily enables corporate stockholders to limit their personal liability to the extent of their investment.” The court, however, continued, “A court may disregard a corporate structure by piercing the corporate veil” “where the corporation is a mere shell, serving no legitimate business purpose, and used primarily as an intermediary to perpetuate fraud or promote injustice.”

The court reviewed a non-exclusive list of factors (called Briggs[iii] factors) that courts can consider when determining whether the corporate entity should be disregarded. These included (1) the corporation is undercapitalized; (2) it lacks separate books; (3) its finances are not kept separate from individual finances, or individual obligations are paid by the corporation; (4) the corporation is used to promote fraud or illegality; (5) corporate formalities are not followed; and (6) the corporation is a mere sham.

An expert for the plaintiff had testified that adequate capitalization for the LLC would have been at least $1 million. He testified that the defendants had not supplied nearly that amount of capital to the entity. Instead, he argued that “the infusion of payments from related-party entities was ‘ad hoc,’ made on an ‘emergency basis,’ and was not adequate as capital for the startup company.” An expert for the defendants had testified that the LLC had a separate set of books, filed separate tax returns, and had separate general ledgers. He testified that the LLC was established for a legitimate purpose and that the LCC had not abused the corporate privilege.

The court found that the trial court’s finding of inadequate capitalization was supported by substantial evidence. In so finding, the court noted the defendants’ history of moving funds between related entities, the lack of LLC assets and employees, and its failure to reduce losses to the plaintiff, despite knowing its funding was inadequate. The court also pointed out that the husband and wife had not read the LLC’s operating agreement and had not provided any consideration for their ownership of the LLC.

It was significant, the court found, that the financial wellbeing of the LLC was entirely dependent upon the goodwill of the related entities. Furthermore, the fact that the daughter had submitted to the plaintiff the credit references of the related entities was “strong evidence that equity should intervene to pierce the corporate veil.” The court noted that best practice would have been for the plaintiff to have obtained a personal guarantee from the husband and wife. Nonetheless, the court concluded that the trial court’s finding that adherence to the corporate structure would promote an injustice to the plaintiff was supported by substantial evidence.

The court also summarily affirmed the trial court’s ruling that the remaining defendants were not the alter egos of the LLC. Although family members were involved as owners of those entities, their ownership structures differed. The court ruled that the plaintiff had not met his burden to prove the alter-ego theory.

Dissent

One justice dissented from the veil-piercing ruling. The dissenting justice did not believe that the plaintiff had carried its heavy burden of establishing that “this is one of the exceptional cases in which the statute providing for limited liability should be disregarded and personal liability imposed on the member of the LLC.” The justice did not agree that the Briggs factors detailed by the majority supported the imposition of personal liability on the husband and wife. Specifically, the justice pointed to several key factors supporting his conclusion: (1) The LLC maintained separate finances and separate financial records, (2) there was no evidence that the LLC was used to promote fraud or illegality or that the entity was a mere sham, and (3) because the entity was an LLC, is was largely immaterial whether the LLC followed formalities.

The justice argued that the LLC was created to execute a specific business plan. The “mere failure” to perform under a contract, the justice urged, was not a sufficient reason to impose personal liability. The justice also pointed out that courts are more likely to impose personal liability in tort rather than contract cases and that the parties in this case negotiated their contract at arms’ length.

Conclusion

Given the strong dissent, it is likely this case will be end up before the Iowa Supreme Court. Given the large number of LLCs now established in Iowa, more case law on the crucial topic of veil piercing would be welcome.

The case is Keith Smith Company, Inc. v. Bushman, No. 15-0347 (Iowa Ct. App. Dec. 9, 2015).