Commercial Division Finds Allegations of Complete Control Insufficient to Support a Veil-Piercing Theory

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A familiar fact pattern: ParentCo is the owner and controlling shareholder of SubCo.  ParentCo completely controls SubCo.  The two companies have the same officers, issue consolidated financial returns, and the profits and losses of SubCo are passed through to ParentCo.  ParentCo deliberately keeps SubCo in a cash-starved and undercapitalized state, so SubCo is entirely dependent on advances and direct payments from ParentCo to meet its obligations.  ParentCo’s leash on SubCo is so tight that SubCo is destined for liquidity problems and, eventually, failure.  Meanwhile, ParentCo itself transfers most of the cash it receives from SubCo to another affiliate, RelatedCo.

When SubCo fails, creditors of SubCo obtain judgments against SubCo, then seek to unwind transfers made from ParentCo to RelatedCo that frustrated their ability to collect on their judgments.  The creditors reason that because ParentCo dominated and controlled SubCo, because the two were essentially the same entity, and because ParentCo deliberately kept SubCo undercapitalized, equity requires that Court pierce the corporate veil and unwind the fraudulent transfers made by ParentCo.  Otherwise, the creditors argue, ParentCo and RelatedCo will have gotten away with their shell game.

Justice Jennifer G. Schecter of the New York County Commercial Division recently considered this issue in South College Street, LLC v. Ares Capital Corp., No. 655045/2019 (N.Y. County June 15, 2020).  The case continues a recent trend toward greater scrutiny of veil-piercing allegations at the motion to dismiss stage and provides welcome guidance for all litigators facing veil-piercing claims.

Generally

“A basic tenet of American corporate law is that the corporation and its shareholders are distinct entities.”  Dole Food Co. v. Patrickson, 538 U.S. 468 (2003).  However, “[i]n the interests of justice, in an ‘appropriate case,’ a party wronged by actions taken by an owner shielded by the veil of a corporate shell may exercise its equitable right to pierce that screen and ‘skewer’ the corporate owner.”  David v. Mast, 1999 WL 135244 (Del. Ch. Mar. 2, 1999).

A plaintiff seeking to pierce defendant’s corporate veil must show: (1) the defendant exercised complete domination of the corporation in respect to the transaction attacked and (2) defendant used that domination to commit a fraud or wrong against the plaintiff which resulted in plaintiff’s injury.  Morris v. Dept. of Taxation and Finance, 623 N.E.2d 1157, 1160–61 (1993).

Although the standard is articulated with disarming ease, its application to a pre-answer motion to dismiss is, for several reasons, difficult and has at times been inconsistent.  First, Courts are understandably reluctant to wade into likely disputed issues of control, abuse of corporate formalities, and inadequate capitalization on a motion to dismiss.  See E. Hampton Union Free Sch. Dist. v. Sandpebble Builders, Inc., 884 N.Y.S.2d 94 (2d Dept 2009) (Dillon, J. concurring in part and dissenting in part); Cornwall Mgt. Ltd v. Kambolin, 2015 WL 2090371, at *7 (N.Y. Sup. Ct. Apr. 29, 2015) (“[A]s veil piercing claims are inherently fact driven, they are not typically susceptible to attack on a pre-answer motion to dismiss. . . . In fact, New York courts are even typically reluctant to dispose of veil piercing claims on summary judgment.”).  Second, veil-piercing allegations are subject only to the pleading requirements of CPLR § 3013, which is satisfied so long as the pleading provides notice to an adversary of the transactions or occurrences giving rise to a claim.  Third, in many veil-piercing cases, the equities weigh strongly in favor of resolution on the merits, irrespective of whether the complaint adequately alleges both the control and fraud elements of a veil-piercing theory.  Elements aside, Courts dislike shell games.

As a consequence, it is not at all rare to see relatively boilerplate allegations of domination and control survive a motion to dismiss.  This is true even where the allegations of the second element—that the domination or control was used to perpetrate a wrong against plaintiff—are thin.  See, e.g., 9 E. 38th St. Assocs., L.P. v. George Feher Assocs., Inc., 640 N.Y.S.2d 520, 521 (1st Dept 1996); Trans Int’l Corp. v. Clear View Techs., 278 A.D.2d 1, 1-2 (1st Dept 2000) (plaintiff adequately alleged alter ego liability by alleging “that the individual defendants are [the corporation]’s equitable owners, that [the corporation] was their alter ego, that they exercised complete dominion and control over [the corporation] and that equity requires that they be held liable for [the corporation]’s obligations to plaintiff”) Toledo v. Sabharwal, No. 653234/2017, 2019 WL 495801, at *1 (N.Y. Sup. Ct. Feb. 04, 2019).

First Department Encourages Closer Examination of Alter Ego Claims on Motion to Dismiss

Last year, as covered on this blog, the First Department reversed a trial court order denying defendants’ motion to dismiss an ill-pled veil piercing claim and, by so doing, encouraged courts to take a closer look at veil-piercing allegations at the motion to dismiss stage.

The facts of that case are recounted in our previous post.  Aspire Music Group signed the popular musician Drake to an exclusive recording artist agreement.  After Drake’s rise to stardom, Aspire furnished Drake’s services to a joint venture that included Cash Money Records, in exchange for one-third of the net profits from Drake’s albums.  When Cash Money Records failed to properly account to Aspire, Aspire sued not only Cash Money Records, but also its controller, Universal Music Group.

Aspire alleged that Universal took over control of Cash Money Records and paid itself higher distribution fees, which in turn left less for Aspire.  Aspire further alleged that Cash Money Records is a corporate instrument of Universal; Universal shares offices with Cash Money Records; Universal operates Cash Money Records’ website; and Cash Money Records remains undercapitalized and entirely dependent on advances and payments from Universal.

The First Department directed dismissal of Aspire’s claims against Universal, holding, “even assuming Universal was an “equitable owner” of Cash Money . . . the complaint fails to allege that Universal’s domination of Cash Money was used to commit a wrong against plaintiff.”  Aspire Music Grp., LLC v. Cash Money Records, Inc., 94 N.Y.S.3d 24 (1st Dept 2019) (emphasis added).  The Court held that Universal’s increasing its own fees, leaving less for Aspire, was “legitimate business conduct.”  Even assuming control, therefore, Aspire failed to plead abuse of that control to perpetrate a wrong against it.

South College Street, LLC v. Ares Capital Corp.

In accordance with the First Department’s ruling in Aspire, Justice Schecter closely scrutinized the veil-piercing allegations in South College Street

South College Street concerns a creditor’s attempt to unwind allegedly fraudulent transfers made by an alleged alter ego of the debtor.  Charlotte School of Law, LLC (“CSL”) was a for-profit law school in North Carolina.  CSL was a wholly-owned subsidiary of InfiLaw Corporation (“InfiLaw”), which itself was a wholly owned subsidiary of InifiLaw Holding, LLC (“HoldCo”).  InfiLaw was a guarantor on CSL’s lease.  When the CSL defaulted on the lease, the landlord—plaintiff here—obtained a $24.55mm judgment against CSL and InfiLaw.  But CSL and InfiLaw were insolvent.  As a result of a recapitalization and investment from Ares Corporation (“Ares”)—defendant here—InfiLaw and HoldCo had transferred more than $32 million to Ares over 14 months.

Generally, the New York Debtor and Creditor Law allows a creditor to commence an action against the transferee of a fraudulent conveyance made by the debtor.  Accordingly, Plaintiff sued Ares seeking to unwind the allegedly fraudulent transfers that InfiLaw (the debtor) made to Ares.

Plaintiff also sought to unwind transfers that HoldCo made to Ares.  But these claims were more difficult; HoldCo was not subject to Plaintiff’s $24mm judgment, and HoldCo had no obligations to Plaintiff.  In other words, Plaintiff was not a creditor of HoldCo with standing to unwind a transfer between HoldCo and Ares.

To overcome this hurdle, Plaintiff argued that Holdco and InfiLaw were alter egos.  They had consistently overlapping officers; they prepared consolidated financial returns; they had the same office; HoldCo engaged in no other business activities, and profits of InfiLaw were consistently passed through to HoldCo.  HoldCo’s control over InfiLaw was so complete, Plaintiff alleged, that it caused CSL’s failure and InfiLaw’s insolvency.  HoldCo’s practice of keeping InfiLaw in an undercapitalized state (with huge payments going through HoldCo to Ares) resulted in liquidity problems at CSL.  This caused CSL to lower its admission standards, which resulted in lower bar passage rates and employment placement.  Nonetheless, to continue meeting HoldCo’s obligations to Ares, CSL lowered its admissions standards even further, sending CSL into a death spiral.  Ultimately, the North Carolina Board of Governors terminated CSL’s license.  By kicking off this spiral, Plaintiff alleged, HoldCo caused InfiLaw to default on its obligations to Plaintiffs.

Ares moved to dismiss the claims, arguing, with respect to the transfers from Holdco, that Holdco was not a debtor and, consequently, Plaintiff could not state a DCL claim with respect to transfers from HoldCo to Ares.

Justice Schecter granted Ares’ motion to dismiss.  The Court held that although a veil-piercing theory would be sufficient to implicate the transfers between HoldCo and Ares, Plaintiff failed to sufficiently allege facts warranting veil piercing here.  Specifically, the Court found that the complaint—while not lacking in allegations of complete control—failed to allege that the purpose of the corporate distinction between InfiLaw and HoldCo was to defraud or injure Plaintiff.  The Court explained:

While plaintiff alleges that Holdco dominates and controls the Debtor, that is not enough.  Rather, plaintiff must plead, for instance, that the capital structure of Holdco and the Debtor was designed to ensure the Debtor’s creditors would be left seeking to collect from an empty shell. Nothing of the sort is alleged.

As to Plaintiff’s allegation that the transfers left CSL destined to fail, the Court found that those facts went to Plaintiff’s fraudulent transfer claim and, consequently, they could not also be used to pierce the corporate veil; something more was required.

Practical Considerations

Whether equity requires a Court to disregard corporate separateness and pierce the corporate veil remains a fact-intensive inquiry.  Nonetheless, litigants can expect that allegations in support of a veil-piercing theory will be closely scrutinized at the motion to dismiss stage.  And, as set forth in South College Street, complete control is not enough.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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