One of the factors for determining when the owners of an LLC (or a corporation) may be held liable for the obligations of the business is whether the required corporate formalites have been observed. A while back, we posted an article about the required corporate formalities for Indiana limited liability companies. One of them is that each Indiana LLC must maintain certain records and must make them available to members for inspection and copying. Notably, that requirement is not a default provision that can be reduced or eliminated by the operating agreement.
Last week the LLC Law Monitor blog by Doug Batey of Stoel Rives commented on a Massacusetts case, Kosanovich v. 80 Worcester Street Associates, LLC, No. 201201 CV 001748, 2014 WL 2565959 (Mass. App. Div. May 28, 2014), that imposed liability on the sole member of a Massachusetts limited liability company primarily because of the LLC’s failure to maintain records. Doug described the case (correctly, in my view) as “an outlier decision on veil-piercing” for piercing the veil based on so little.
First, a quick summary of Massachusetts veil-piercing law as described in the decison by the Appellate Division of the Boston District Court. A corporate veil may be pierced only in rare circumstances and only to defeat or remedy fraud, wrong, or injustice. Massachusetts courts weigh twelve factors, but the analysis is not merely an exercise in counting factors. The twelve factors are (1) common ownership (presumably relevant when multiple entities are involved); (2) pervasive control (which is not enough, by itself, to pierce the veil); (3) confused intermingling of business assets; (4) thin capitalization; (5) nonobservance of corporate formalities; (6) absence of corporate records; (7) no payment of dividends; (8) insolvency at the time of the litigated transaction; (9) siphoning away of corporation’s funds by dominant shareholder; (10) nonfunctioning of officers and directors; (11) use of the corporation for transactions of the dominant shareholders; and (12) use of the corporation in promoting fraud.
In this case, the LLC was owned and entirely controlled by one person, a construction contractor who set up a separate LLC for each of his projects. The only record the LLC produced was a copy of the articles of organization. The owner testified that some of the records might have existed at one time but that they might have been lost when his former partner left the business. There were no tax records, no checkbook, no statements from subcontractors — none of the records that one would ordinarily expect to be created in the ordinary course of a construction contracting business. The court upheld the trial judge’s decision to hold the owner liable based on only two of the twelve factors: pervasive control (which, taken alone, would be insufficient) and the absence of corporate records.
One gets the sense that the court (and almost certainly the plaintiff’s lawyer) was frustrated by the absence of records because they are also the records that, if they existed, might have served as evidence of the other veil-piercing factors and of the independent prerequisites of fraud, wrong, or injustice. Nonetheless, there was no evidence of any of the ten other factors nor evidence of fraud, wrong, or injustice. Had there been proof that the owner had destroyed records, it might have justified an inference that the records destroyed would have proven enough to pierce the veil, but there was no evidence of that, either. The evidence proved was that the owner completely neglected business records, but not that he destroyed them. As Doug stated in his blog, “The court’s reliance on [the owner’s] inadequate record-keeping effectively placed on his shoulders the burden to prove that he was innocent of violating any of the other 12 factors.”
Would the result have been the same under Indiana law? I do not believe so, or at least I do not believe that it should, based in part on a provision of the Indiana Business Flexibility Act, the statute that governs Indiana LLCs. As mentioned in the first paragraph, the statute requires Indiana LLCs to maintain certain records and to make them available to members for inspection and copying. However, Ind. Code section 23-18-4-8(e) specifies that failure to maintain those records does not constitute grounds for holding the owners personally liable for the obligations of the LLC. Even without that provision, I do not believe Indiana courts would pierce the veil of an Indiana LLC under similar circumstances, but I think that provision forecloses any possibility of the owner of an Indiana LLC (sole owner or otherwise) being held liable just because the LLC does not maintain the required records.
As Doug also pointed out, lawyers (including this one) advise their business clients to observe formalities of running a business and to maintain good records, including those required by the Indiana Business Flexibility Act, and this case, even if it is an outlier, and even if an Indiana court would not reach the same result, is an example of a business owner who paid a price for not doing so.
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