June 16, 2015 Articles

Alter Ego Liability in a Post-Tort World

What is an "inequitable result"?

By Wendi J. Berkowitz and Patrick Lai

Imagine this not-so-farfetched scenario: A conglomerate—let’s call it Company Zeus—determines, after careful study and investigation, that it must diversify its holdings to survive. Rather than starting afresh on unfamiliar terrain, Zeus’s chief executive officer and board conclude they should locate and purchase a profitable business in the identified industry. Zeus ultimately winnows the field of potential acquisition targets to a specific enterprise, Company Athena. Unfortunately, though, Athena is a subsidiary of Poseidon Corporation, and it is most definitely not for sale. The only way for Zeus to have Athena is to buy Poseidon. Poseidon, meanwhile, a conglomerate itself, has dozens of other subsidiaries operating in a variety of industries and businesses, none of which Zeus is interested in maintaining for the long term. Instead, Zeus will sell all of Poseidon’s businesses other than Athena in order to finance the Poseidon acquisition. The proceeds from the sale of Athena’s affiliates will pay for Athena’s purchase.

So far, so good. But now imagine that one of the non-Athena Poseidon affiliates (Artemis Inc.) had manufactured products that injured people over a long period of time. Or that Artemis had polluted the groundwater, creating an environmental hazard and leading to a cancer cluster in the immediately surrounding area. Further assume that by the time Zeus purchased Poseidon and its affiliates, Artemis was no longer in the hazardous business but that the effects of the hazard would be felt for years, even decades, to come. Finally, suppose that at some point after Zeus purchased the Poseidon corporate family, Artemis became insolvent and unable to respond to the many personal injury, death, and environmental claims now arising. Will injured people, or the government, or adjoining landowners, be permitted to pierce the corporate veil to hold Zeus liable in alter ego for the injuries caused by Artemis’s torts? In assessing the applicability of the alter ego remedy, which is of course an equitable doctrine, does it matter (and should it) that Zeus did not have any corporate relationship with Artemis or Artemis’s injurious activities until after those activities ceased? And is it decisive, in considering whether Zeus should be deemed the alter ego of Artemis, that Zeus (as Artemis’s ultimate shareholder) sold Artemis’s businesses and used the proceeds for its own purposes—that is, to pay off acquisition debt—rather than to fund victim recoveries?

Whom do the equities favor when there has been wrongdoing and injury but the actual culprit cannot be held accountable and the only solvent, related entity played no role whatsoever in the underlying “bad acts”? Can it be that courts will disregard the corporate form to fashion a remedy solely because a latecomer shareholder takes value from its subsidiary? Although there is scant authority on the precise scenario discussed here, case law suggests that courts may and will decide, assuming the typical “unity of interest” tests are satisfied, to pass liability through the corporate veil to a shareholder, even one completely foreign to the wrongdoer at the time of the wrongdoing, where the shareholder knowingly diverts the wrongdoer’s assets to its own use. This is especially so when the asset stripping renders the underlying tortfeasor incapable of compensating its victims. In other words, advice to acquiring companies might be framed as “caveat emptor”—buy carefully and dispose of subsidiary operations, particularly those with long-term liabilities, with an eye less toward maximizing shareholder value and more toward fairly and adequately compensating victims.

Defining the Alter Ego Remedy As a general rule, a properly formed and operated corporation shields its shareholders from liability for the acts of the corporation. However, the corporate “veil” extends only so far, and in appropriate circumstances where equity requires, a court may disregard the corporate fiction, pierce the corporate veil, and pass liability through to a corporation’s shareholder. One form of veil piercing is commonly referred to as alter ego liability.

Each state’s formulation on the requisites for an alter ego finding is slightly different, and the analysis is typically fact-intensive. Some states, such as Florida and Texas, which require a showing akin to actual fraud before alter ego liability will attach, are openly hostile to these kinds of claims. See, e.g.Dania Jai-Alai Palace, Inc. v. Sykes, 450 So. 2d 1114, 1121 (Fla. 1984); Steinhardt v. Banks, 511 So. 2d 336 (Fla. Dist. Ct. App. 1987); Tex. Bus. Orgs. Code Ann. § 21.223(a)(2). California, in contrast, is more hospitable to pass-through alter ego liability, though even California recognizes that “the corporate form will be disregarded only in narrowly defined circumstances and only when the ends of justice so require.” Mesler v. Bragg Mgmt. Co., 39 Cal. 3d 290, 301 (1985). While disclaiming a “litmus test” for liability, the California Supreme Court identifies “two general requirements: ‘(1) that there be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist and (2) that, if the acts are treated as those of the corporation alone, an inequitable result will follow.’” Id. at 300 (internal citations omitted). Other jurisdictions are in accord that alter ego liability, though available, should be used sparingly. See, e.g.Dewitt Truck Brokers, Inc. v. W. Ray Flemming Fruit Co., 540 F.2d 681, 683 (4th Cir. 1976) (power to pierce veil to be wielded “reluctantly” and “cautiously”); Winner Acceptance Corp. v. Return on Capital Corp., 2008 WL 5352063, at *5 (Del. Ch. 2008) (courts will disregard the corporate form only in the “exceptional case”); Tower Inv., LLC v. 111 E. Chestnut Consultants, Inc., 864 N.E.2d 927, 941 (Ill. Ct. App. 2007) (courts will “reluctantly” pierce the corporate veil).

The factors that courts will examine to determine whether the nexus between entities is sufficient to transfer liability from the “wrongdoer” to the putative alter ego (that is, the first prong identified above) also differ from jurisdiction to jurisdiction. They can include such elements as commingling of funds or other assets, use of funds for something other than the corporation’s purposes, failure to maintain appropriate corporate records, overlapping boards of directors or officers, use of common facilities, lack of adequate capitalization, use of the corporation as a shell for another entity, failure to maintain arm’s length in transactions between the entities, and the use of one entity to procure goods or services for another entity. See In re Silicone Gel Breast Implants Prods. Liab. Litig., 887 F. Supp. 1447, 1452 (N.D. Ala. 1995) (stating that “some variation on [alter ego] liability is recognized in all jurisdictions” and discussing additional factors including consolidated financial statements and tax returns, payment by one corporation for the salaries and expenses of another, common business departments, whether the parent caused the incorporation of the subsidiary, and the use by one company of another company’s property); Associated Vendors, Inc. v. Oakland Meat Co. Inc., 210 Cal. App. 2d 825, 838–40 (1962) (listing 21 factors to consider). Although no single factor will dictate a finding of alter ego, unsurprisingly, it is the balancing of the number of factors met against the strength of each that will drive the ultimate result. See Van Maanen v. Youth With A Mission-Bishop, 852 F. Supp. 2d 1232, 1252 (E.D. Cal. 2012); Monteau v. Reis Trucking & Constr., Inc., 553 S.E.2d 709, 712–13 (N.C. Ct. App. 2001).

The range of reported fact patterns presented in support of the “unity of interest” prong is virtually unlimited. Thus, a detailed discussion of this component of the alter ego analysis is beyond the scope of this article. Instead, attention will be shifted to the “injustice” or “inequitable result” prong of the alter ego test.

What Is an “Inequitable Result”? Because alter ego is an equitable remedy, it makes sense that if a court is to impose liability on this ground, the balance of equities should weigh in favor of piercing the veil. See Trs. of Nat’l Elevator Indus. Pension, Health, Benefit & Educ. Funds v. Lutyk, 332 F.3d 188, 192 (3d Cir. 2003) (identifying veil piercing as an equitable remedy). Stated differently, if it would be inequitable or unjust to permit the corporate fiction to stand, thereby preventing recovery by a deserving plaintiff (and assuming the unity of interest factors are sufficiently demonstrated), application of the alter ego doctrine is appropriate. But this begs the question of what is “unjust” or “inequitable.” Cf. United States v. Bestfoods, 524 U.S. 51, 62 (1998) (recognizing that, in performing alter ego analysis in connection with environmental contamination, “the corporate veil may be pierced and the shareholder held liable for the corporation’s conduct when, inter alia, the corporate form would otherwise be misused to accomplish certain wrongful purposes, most notably fraud, on the shareholder’s behalf”). And how is a court to decide?

In the example raised earlier, the tortfeasing company, Artemis, is no longer a going concern. Its ultimate parent company, Zeus, did not own Artemis at the time Artemis was manufacturing and selling dangerous products (or in the alternative example, poisoning the local environment). In fact, at the time the “bad acts” were occurring, Zeus and Artemis were strangers. But when Zeus bought Artemis and its affiliated companies, Zeus sold off Artemis’s profitable businesses and took the proceeds for its own uses. Now, as a result, Artemis has no money to pay settlements or judgments to those it injured. Assuming the presentation of the requisite evidence on “unity of interest,” what is the equitable result? The key to answering this question may lie in the post-tort “asset stripping” element of the hypothetical.

Courts often consider post-tort activity in assessing alter ego allegations, with varying results. Indeed, the relevance of post-tort activity to the alter ego assessment is a well-recognized rule of law. See, e.g.Seiko Epson Corp. v. Print-Rite Holdings, Ltd., 2002 WL 32513403, at *19 (D. Or. 2002); Hale Propeller, LLC v. Ryan Marine Prods., Pty., Ltd., 98 F. Supp. 2d 260, 265 (D. Conn. 2000); General Textile Printing & Processing Corp. v. Expromtorg Int’l Corp., 891 F. Supp. 946, 950 (S.D.N.Y. 1995); Weinreich v. Sandhaus, 850 F. Supp. 1169, 1179 n.17 (S.D.N.Y. 1994); Star Creations Inv. Co., Ltd. v. Alan Amron Dev., Inc., 1995 WL 495126, at *11 (E.D. Pa. 1995); Winchel v. Craig, 934 S.W.2d 946, 950–51 (Ark. Ct. App. 1996).

In Minnesota Mining & Manufacturing Co. v. Eco-Chem, for example, the U.S. Court of Appeals for the Federal Circuit ruled that “[p]osttort activity, when conducted to strip the corporation of its assets in anticipation of impending legal liability, may be considered in making the determination whether to disregard the corporate entity.” 757 F.2d 1256, 1264 (Fed. Cir. 1985) (quoting 1 W. Fletcher, Cyclopedia of the Law of Private Corporations § 45 (rev. ed. 1983)). In that case, Minnesota Mining (3M) sued a competing company (ECI) for patent infringement. While the action was pending, the individual principals of ECI ceased ECI’s operations and transferred all of its assets to a new company that they formed and controlled, ECL. ECI then defaulted in the lawsuit. In affirming the default judgment against the individuals, as alter egos of ECI, the court concluded that they “purposely manipulated ECI so as to thwart 3M’s recovery of its judgment. This is precisely the situation in which courts feel most comfortable in using their equitable powers to sweep away the strict legal separation between corporation and stockholders.” Id. at 1265.

In the 3M case, the new company to which assets had been transferred ECL did not even exist at the time of the patent infringement—that is, the underlying wrongdoing. The opinion did not discuss this fact as an element of the analysis, although it seems significant that the 3M court was not deterred in imposing liability on ECL by the facially appealing lack of a relationship between ECL and the underlying tort. It is possible, if not likely, this is because the principals clearly were directly involved in the wrongdoing and they also entirely controlled the new entity ECL as well as the stripped corporate husk, ECI.

In Morgan v. Burks, 611 P.2d 751 (Wash. 1980), the Washington Supreme Court reached the opposite conclusion from the 3M court on alter ego liability, though it agreed that post-tort activity is appropriately considered in analyzing the issue. There, the defendant corporation’s president shot the plaintiff, rendering him a paraplegic. After the shooting but before the trial, the defendant transferred various assets of the corporation to other parties. The question in the case was whether the trial court properly considered the asset transfers in assessing an alter ego relationship between the president and the corporation. Concluding that it had, the supreme court ruled it determinative that the corporation retained some assets to meet the judgment—that “no ‘gutting’ of corporate assets” had occurred—and that, therefore, no “inequitable” result would follow if alter ego liability did not attach. Id.at 756. In Morgan, the relationship (or lack thereof) between the players at the time of the tort was a non-issue.

A Delaware case perhaps comes closest to answering our question of the significance to the alter ego analysis of the timing of the corporate relationship vis-à-vis the underlying tort. In Mobil Oil Corp. v. Linear Films, Inc., 718 F. Supp. 260 (D. Del. 1989), the court discussed this temporal issue. In declining to find an alter ego relationship, the court based its reasoning, in part, on the fact that the alleged patent infringement began five years before the purported alter ego parent was even incorporated. But this was far from the end of the alter ego analysis. The court noted that the “necessary element,” that a corporate fiction be used to “execute a fraud or injustice,” was missing. Id. at 270. Most important, all assets were held by the subsidiary; therefore, the plaintiff would be fully compensated without resort to derivative liability for the parent.

Conclusion In short, a more critical element of the “unfairness”/“injustice” prong of alter ego analysis appears to be capitalization and, in particular, whether the putative alter ego has siphoned off the assets of the culpable entity to evade the grasp of creditors. A corporate relationship at the time of the tort would appear to be a much less compelling concern. In our hypothetical, then, if the evidence shows that Zeus funneled Artemis’s assets to its own pockets and thereby deprived Artemis’s creditors of their rightful remedy, these facts will go much further toward an “unfairness” finding than the countervailing “lack of relationship” argument in rebuttal.

Keywords: litigation, business torts, alter ego, piercing the corporate veil, business torts, post-tort activity, asset stripping, unfairness, injustice

Wendi J. Berkowitz and Patrick Lai – June 16, 2015