By Rick Landers, Axilon Law

As many business litigation attorneys know, the law on piercing the veil of a corporation or LLC is continuously evolving, and the concept of limited liability is frequently under attack.  Most states have developed a test involving multiple factors that are considered in determining whether principles of equity warrant piercing the veil.  With no two cases being exactly alike, the law that has developed can be arcane and inconsistent.  In some cases, the courts focus on the circumstances that led to the underlying debt or liability at issue, while in other cases the focus is on what occurred after the fact and whether the principles or parent company of the debtor entity siphoned off assets or took other actions in a scheme to defeat a creditor’s recovery. 

In trying to determine whether fraud or bad faith was involved, courts often look at whether the debtor entity was undercapitalized in a manner that left it unable to pay its debts.  The inquiry into capitalization is most relevant for the inference it provides into whether the entity was established to defraud its creditors or for another improper purpose such as avoiding risks known to be attendant to a type of business.^[1] 

In one recent case defended by Axilon Law attorneys, the Ninth Circuit Bankruptcy Appellate Panel expounded upon the undercapitalization theory and rejected the plaintiffs’ attempt to pierce the veil of a failed start-up company.  Baldwin v. Atlantis Water Solutions, LLC (In re Atlantis Water Solutions LLC), 2019 WL 4874764 (B.A.P. 9th Cir. 2019), involved a start-up subsidiary LLC, Atlantis, that was formed by its corporate parent, Iofina, to pursue a water depot business venture in eastern Montana to serve the nearby oil and gas industry.    

Atlantis applied to the state of Montana for a permit to appropriate water from the Missouri River, while simultaneously acquiring real property rights for its planned facilities.  It entered into a 10-year lease with the Baldwins for surface rights for a water pipeline, agreeing to pay the Baldwins $8,000.00 per month.  After a multi-year contested case proceeding, Atlantis’ water permit application was finally denied, and the project was abandoned.  Atlantis never had its own employees, bank account, or operating funds.  Rather, it relied upon Iofina to pay its bills and supply the personnel needed for its initial operations.  Because the water depot venture was entirely dependent upon a water permit that it never received, Atlantis never progressed beyond the start-up phase.

When Atlantis stopped making lease payments, the Baldwins sued Atlantis, as well as Iofina, seeking to pierce the LLC veil and hold Iofina liable under an alter ego theory. The Baldwins argued that, under Montana law, Iofina’s failure to provide Atlantis with sufficient operating capital was evidence of bad faith and justification for piercing the veil. 

The 9^th Circuit Bankruptcy Appellate Panel rejected the Baldwins’ argument and affirmed the Bankruptcy Court’s decision holding that the Baldwins could not pierce the LLC veil of Atlantis.  The BAP first distinguished the prior Montana cases^[2] cited by the Baldwins for the proposition that the “creation of an undercapitalized shell subsidiary that was not capable of satisfying its liability for breach of contract” was sufficient to show fraud or bad faith for purposes of piercing the corporate veil.  The BAP noted that, in contrast to Atlantis and Iofina, those cases involved corporate veil piercing in which the parent corporation or sole shareholder engaged in bad faith conduct (i.e., siphoning off assets, self-dealing and other suspect transactions) following the breach of contract.

The BAP then reasoned that, although the Montana Supreme Court has not addressed the issue of whether undercapitalization alone is sufficient to pierce the LLC veil, it likely would not take such a position for several reasons.  First, like most states, Montana’s statutory framework for LLCs does not require an LLC to observe traditional corporate formalities in order to protect its members from liability.  Thus, “to impose member liability based solely upon undercapitalization of the LLC, without some evidence that the member was acting to perpetuate a fraud, appears to be contrary to the intent of the liability limitations of the statute.”  Second, the BAP noted that in courts in other jurisdictions that have considered the issue, undercapitalization alone will not suffice to pierce the veil.^[3]  Third, the BAP noted that start-ups are often undercapitalized and that undercapitalization, without more, does not necessarily infer improper motives. 

Ultimately, the BAP’s affirmance of the decision not to pierce the LLC veil and hold Iofina liable turned upon the fact that Atlantis complied with Montana law governing LLCs; the fact that Atlantis’ business model and source of income was dependent upon receiving a water permit that was never approved; and the fact that Iofina infused adequate capital into Atlantis for approximately three years, during which the Baldwins were paid a total of $459,000 while Iofina received nothing in return. 

Jilted creditors and counterparties in failed business transactions may continue to seek new ways to pierce the veil of a corporation nor LLC.  The takeaway from Baldwin v. Atlantis Water Solutions, LLC, is that when a start-up LLC was not undercapitalized in bad faith but instead fails due to circumstances largely beyond its control, its members will continue to have limited liability.    

[1] Trustees of Nat. Elevator Industry Pension Health Benefit and Ed. Funds v. Lutyk, 332 F.3d 188, 196 (3d Cir. 2003). 

[2] Peschel Family Trust v. Colonna, 75 P.3d 793 (Mont. 2003), and E.C.A. Environmental Management Services, Inc. v. Toenyes, 679 P.2d 213.

[3] The BAP cited Gasstop Two, LLC v. Seawo, LLC, 225 P.3d 1072, 1078 (Wyo. 2010); Frazier v. Sikeston Bd. Of Mun. Utils. (In re Liberty Coal, Co., LLC), 2010 WL 1415998 (S.D.Ill. Mar. 31, 2010)(applying Colorado law); and Milk v. Total Pay & HR Sols., Inc., 634 S.E.2d 208 (Ga. 2006).