Piercing the Veil in Texas

Topics Covered

Law Applicable to Piercing
Historical Practice of Sham Entity and Alter Ego
The Actual Fraud Rule
The Tryco Case
Implications for Series LLCs and Trusts
Liability of LLC Managers
The Value of Good Company Documentation
Paying Taxes and Avoiding Forfeiture

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.

LAW APPLICABLE TO PIERCIING

An Equitable Remedy

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.

Piercing the veil 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 states:

BOC Sec.101.114. Liability for [LLC] Obligations

[Unless] 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.

Historical Practice of Sham Entity and Alter Ego

Traditionally, 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.

Old-fashioned allegations of sham entity and alter-ego are now insufficient as a matter of law to achieve a piercing. Actual fraud is required.

Relevance of Sham and Alter-Ego Today

The problem is that many Texas lawyers want to continue using the old standards. 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. Metroplex Mailing Servs. v. RR Donnelley & Sons Co., 410 S.W.3d 889 (Tex.App.—Dallas 2013, no pet.).

Caveat: while BOC and case law eliminate sham-entity and alter-ego allegations as a basis for veil piercing, these cannot be eliminated as factors in a case where actual fraud is present (1) particularly since piercing in Texas has always been linked to values of fairness and justice, and (2) particularly when a jury will be deciding damages.

THE ACTUAL FRAUD RULE

Strict Texas Rule

Most states allow some sort of veil piercing under certain limited conditions. Texas has a strict version that includes the actual fraud rule. Fisher v. Blue Cross & Blue Shield, No. 3: 10-CV-2652-L, 2015 WL 5603711 (N.D.Tex. 2015) states:

[In order to pierce the veil 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.

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 look to the specific circumstances to determine whether or not the defendant 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).

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).

“[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).

Permissiveness of 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).

Actual Fraud Rule Applies 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.).

THE TRYCO CASE

Assessing Fraud

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 commission of an] actual or constructive fraud, a sham to perpetrate a fraud, or other similar theory.

Indicators of Actual Fraud

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.

IMPLICATIONS FOR SERIES LLCs AND TRUSTS

Piercing and 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.

Piercing and Trusts

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.

LIABILITY OF LLC MANAGERS

The Effect of a Signature

The signature by a manager or officer 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.

THE VALUE OF GOOD COMPANY
DOCUMENTATION

Corporate Formalities

While BOC 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 (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.

Document Discovery

During the discovery phase of a lawsuit, the plaintiff’s attorney will likely request production of the LLC 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 sham-entity and alter-ego 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.

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.

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.

PAYING TAXES AND AVOIDING FORFEITURE

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.).

Tax Code Sec. 171.255. Liability of Directors and Officers

(a) If the [registration of an entity is] forfeited for the failure to file a report or pay a tax or penalty, each director or officer [or manager of the entity becomes] liable for each debt of the [entity] that is created or incurred. . . . The liability includes liability for any tax or penalty imposed . . . after the date of the forfeiture.

(c) A director or officer [or manager] is not liable for [entity debts] if the director or officer [or manager] shows that the debt was created or incurred: (1) over the director’s objection; or (2) without [the person’s] knowledge and that the exercise of reasonable diligence to become acquainted with the affairs of the [entity] would not have revealed the intention to create the debt.

(d) If [an entity’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 [entity] is not affected. . . .

Conclusion

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 actually 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 be effective in pre-empting piercing allegations before they arise. This is an area where doing just a bit more than the minimum can have long-term beneficial consequences.