Piercing the Veil in Texas

Introduction

This article addresses piercing the veil, a legal term of art referring to the limited circumstances in which the liability shield of a registered legal entity (an LLC or corporation) may be pierced and the individuals behind that entity held personally accountable. Knowing when this might or might not occur is an important factor in asset protection since a piercing event defeats the purpose of forming an entity in the first place.

Piercing the veil (the liability shield of an LLC or corporation) is an equitable remedy that is available only in exceptional circumstances. Wilson v. Davis, 305 S.W.3d 57, 59, 69 (Tex.App.—Houston [1st Dist.] 2009, no pet.). The Business Organizations Code (updated on this subject in 2006) states:

BOC Sec.101.114. 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.

Most states allow some sort of veil piercing under certain conditions. Texas adds an additional hurdle with its actual fraud rule.

Historical Practice

Historically, Texas law permitted piercing the corporate veil when “(1) the corporation is the alter ego of its owners and/or shareholders; (2) the corporation is used for illegal purposes; [or] (3) the corporation is used as a sham to perpetrate a fraud.” Rimade Ltd. v. Hubbard Enterprises, 388 F.3d 138 (5th Cir. 2004); Castleberry v. Branscum, 721 S.W.2d 270 (Tex. 1987).

“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).

These traditional piercing standards were largely cast aside in 2006 when the legislature enacted BOC Section 101.114 (quoted above) which significantly narrowed legitimate avenues for piercing.

The problem in Texas courts is that many lawyers want to continue using the old piercing rules. One routinely sees alter ego and sham-entity allegations in pleadings against LLCs and corporations. In spite of this, the actual fraud rule is now firmly in place in Texas. Mere allegations of alter ego or sham-entity are insufficient. Metroplex Mailing Servs. v. RR Donnelley & Sons Co., 410 S.W.3d 889 (Tex.App.—Dallas 2013, no pet.).

A plaintiff must establish that the defendant caused an LLC or corporation to be used for the purpose of perpetrating an actual fraud primarily for the direct personal benefit of the defendant. Fisher v. Blue Cross & Blue Shield, No. 3: 10-CV-2652-L, 2015 WL 5603711 (N.D.Tex. 2015).

The Actual Fraud Rule

A member of an LLC or a shareholder in a corporation may not be held personally liable for “any contractual obligation of the [entity] or any matter relating to or arising from the obligation on the basis that the [member or shareholder] is or was the alter ego of the [entity] or on the basis of actual or constructive fraud, a sham to perpetrate a fraud, or other similar theory.” (BOC Sec. 21.223(a)(2)). However, this does not protect a member or shareholder if that person’s actions “caused the corporation to be used for the purpose of perpetrating and did perpetrate an actual fraud . . . primarily for the direct personal benefit of” such a person. (BOC Sec. 21.223(b)).

Actual fraud committed primarily for the direct personal benefit of the LLC member or corporate shareholder is thus required, at least for contract-type claims. Courts should look to the circumstances to determine whether or not the defendant in a piercing case caused the LLC or corporation “to be used for the purpose of perpetrating and did perpetrate an actual fraud on [the plaintiff] primarily for the direct personal benefit of the . . . defendant.” In re JNC Aviation, LLC, 376 B.R. 500, 527 (Bankr. N.D. Tex. 2007), aff’d, 418 B.R. 898 (Bankr. N.D. Tex. 2009).

“[The] veil of an LLC may be pierced with respect to the entity’s contractual liability only upon proof that [a member or manager] used the LLC to perpetrate actual fraud for the defendant’s direct personal benefit.” Shook v. Walden, 368 S.W.3d 604, 607 (Tex.App.—Austin 2012, pet. denied).

Allegations by the plaintiff that the defendant company is a sham without substance or is operated as the alter ego of its owners—both of which appear regularly in Texas pleadings—are an attempt to achieve piercing under the old rules. Such allegations are now insufficient as a matter of law to achieve a piercing. Actual fraud is required.

Procedural Barriers to Piercing Claims

There are also a procedural barriers to traditional veil piercing. BOC Section 101.113 prohibits suing an LLC and a member in the same suit, which is problematic for a plaintiff since this is the typical way past piercing cases were pursued.

Also, veil piercing is not itself a cause of action but only a means of imposing liability on an individual in the event a true cause of action (such as fraud) is proven. Accordingly, piercing allegations cannot stand alone. Standing alone, they are subject to being dismissed on procedural grounds for failure to state a proper cause of action.

How permissive is the actual fraud rule?

As an example of what the actual fraud rule allows one to get away with, see AvenueOne Props. v. KP5 Ltd. P’ship., 540 S.W.3d 643 (Tex.App.—Amarillo 2018, no pet.). The real estate broker defendant created a new company and openly moved substantial assets into it and out of the old company that was the object of the suit, effectively depleting the old company and rendering it judgment-proof. The court denied the plaintiff’s attempt to pierce the veil of the new company, finding insufficient evidence of actual fraud.

In a case reminiscent of Texas’ cattle baron days, the alter-ego doctrine was found relevant to a judgment for reverse piercing (meaning accessing the LLC’s assets as a result of an individual member’s fraudulent actions) where a member used the LLC as a mere “shadow of his personality.” The existence of actual fraud remained, however, an essential element of the ruling. Clement v. Blackwood, No. 11-16-00087-CV, 2018 WL 826856 (Tex.App.—Eastland 2018, pet. denied).

Alter-Ego and Sham-Entity Allegations Today

While BOC Section 21.223(a)(2) eliminates alter-ego and sham-entity allegations as a basis for veil piercing, these cannot be eliminated as a factors in a case where actual fraud is present, particularly since piercing in Texas has always been linked to values of fairness and justice.

During the discovery phase of a lawsuit involving an LLC or corporate defendant, the plaintiff’s attorney will likely request production of the company book and all relevant entity documentation. Purpose? If the company has no documentation other than a certificate of formation and its approval by the secretary of state, the plaintiff’s attorney may then be tempted to amend his pleadings to include alter-ego and sham-entity allegations. In such instances, the defending attorney will always prefer that his client has a well-kept company book that can be produced in discovery.

The Tryco Case

In SSP Partners v. Gladstrong Investment (USA) Corp., 275 S.W.3d 444, 451-52 (Tex. 2008), the Texas Supreme Court stated that the limitation on entity liability may be ignored only when the corporate form has been used as part of an unfair device to achieve an inequitable result.

Continuing this line of thought, the Houston Court of Appeals in Tryco Enterprises, Inc. v. Robinson, 390 S.W.3d 497 (Tex.App.—Houston [1st Dist.] 2012, pet. dism’d) 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,” meaning “actual or constructive fraud, a sham to perpetrate a fraud, or other similar theory.”

What factors are important in assessing whether or not such a fraud has occurred? The Court of Appeals in Tryco listed the following factors:

(1) whether the entities shared a common business name, common offices, common employees, or centralized accounting;

(2) whether one entity paid the wages of the other entity’s employees;

(3) whether one entity’s employees rendered services on behalf of the other entity;

(4) whether one entity made undocumented transfers of funds to the other entity; and

(5) whether the allocation of profits and losses between the entities is unclear.

Any and all of the above factors should be considered red flags in a piercing case.

Keeping Good Company Records

From an asset protection perspective, much grief can be avoided by maintaining sound documentation. Keeping good records remains a prudent thing to do in spite of BOC Section 21.223(a)(3) which denies veil piercing merely on the basis of failure by an LLC to observe traditional formalities.

Why get into a potentially disastrous court fight about whether a certain measure is a mere formality or something more substantive, particularly given the inherent powers of a Texas court to enforce equity? Is failing to have an annual or special meeting approving borrowing money to acquire property for the company a mere formality or a serious lapse? If you do not think lawyers could engage in a serious battle on this point then you do not know lawyers.

Piercing lawsuits remain common even though (as noted above0 the alter-ego and sham-entities theories standing alone have been dead in Texas for quite some time. As a result, business lawyers defending LLCs and corporations are regularly called upon to expend resources responding to such cases.

It is far better to take simple steps to document and regularly maintain one’s company (having annual meetings and so forth) so that these sorts of allegations have no basis for arising in the first place.

Corporate Rules Applied to LLCs

When it comes to the actual fraud rule, the same standards apply to both corporations and LLCs even though provisions of the statute may refer to a corporation rather than an LLC. BOC Section 101.002 imports the corporate piercing provisions of Section 21.223 into the realm of LLCs. LLC members can expect to receive the same treatment as shareholders of a corporation, no more and no less. Penhollow Custom Homes, LLC v. Kim, 320 S.W.3d 366 (Tex.App.—El Paso 2010, no pet.).

Signatures of Officers and Managers

The signature by a corporate officer or LLC manager does not by itself make that individual personally liable for company obligations 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 HealthSys. Hosps. Dallas, Inc., 378 S.W.3d 597, 604-04 (Tex.App.—Dallas 2012, pet. denied). This rule tracks a central tenet of 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 the capacity and authority to act on behalf of the entity for which he or she signs.

Are single-member LLCs vulnerable in asset protection?

No, not per se. Single-member LLCs have the same solid liability barrier as LLCs with multiple members. This distinction is meaningful only when it relates to federal taxes. For federal tax purposes, the IRS considers a single-member LLC a disregarded entity (i.e., the IRS taxes the business just like it would tax a sole proprietorship). The profits or losses of the business are reported on the single member’s personal tax return on schedule C. That’s the extent of the difference in Texas.

The reason clients ask their attorney if a multi-member LLC is better for asset protection than a single-member LLC is because some states allow the holder of a judgment against an individual that owns 100% of an LLC to seize the judgment debtor’s LLC interest. This is not true in Texas, where a charging order is the exclusive remedy—at least in the absence of actual fraud, which is always the standard exception in Texas contract, business, and real estate law.

Since Business Organizations Code Section 101.002 makes it clear that rules in this area relating to corporations also apply to LLCs, then (subject to the piercing rules outlined above) an LLC’s liability shield remains intact even though there is only one member.

Implications for Series LLCs

A 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 nonetheless behave as subcompanies capable of doing business independently of the company at large. They enter into contracts and hold title to property. There is not yet published Texas case law on this subject, although extensive precedent exists from other jurisdictions to which a Texas court may look for guidance in the series context. It is our view that even if a particular series is pierced, the other series within the company should remain intact.

The Value of Company Documentation

Some business persons utilize online services or otherwise engage in no-frill LLC filings involving a brief certificate of formation and 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 Section 21.223(a)(3) expressly eliminates the failure to observe corporate formalities as a basis for piercing, such failure may well be subtly considered as a factor 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 yet ruled by artificial intelligence. One cannot underestimate the human factor. It is more prudent to be safe than sorry when it comes to company documentation and other formalities.

What if documentation for an LLC or other entity has not been attended to for years? It is legal to go back in time and document (or re-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.

Paying Franchise Taxes

Failing to pay Texas franchise tax and subsequent loss of the company’s charter can be disastrous for asset protection. The Tax Code reads:

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 (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.

(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.

If a registered entity’s active status is forfeited for non-payment of taxes then each director, officer, or manager may be held liable personally 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.).

Trusts and Piercing Rules

Trusts—whether created for the purpose of anonymity, facilitating land transactions, or for probate avoidance—can be an important element in an asset protection structure. However, trusts are not legal entities in the same sense as an LLC or corporation although they often act like it in the real world. Trusts are not entities but contractual relationships. Trust agreements are not officially filed anywhere and have no state registration or approval requirements. Accordingly, there is no liability barrier to pierce. 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, which can be a dangerous position in which to find oneself. For this reason, investment trusts are often used in conjunction with an LLC.

Conclusion

The law applicable to entity piercing continues to evolve. The safest practice in the real world is to establish and maintain an LLC or corporation with thorough and ongoing documentation that is contained in a proper company book. Certificates for membership interests should also be issued. It is a good idea to periodically document significant activities and events affecting one’s company using resolutions, special meetings, and the like. Documentary maintenance like this (while not always strictly required under the BOC) can go a long way toward pre-empting piercing allegations before they arise.