Wilmington North Carolina Business Law and Litigation Attorney Blog

Piercing the Corporate Veil in NC After the Judgment

Over at my North Carolina Judgment Enforcement blog, there is a post about a recent NC Court of Appeals decision regarding an attempt to pierce the corporate veil to levy on shareholder property after judgment against only the corporation.  The short answer is that it cannot be done.  The full post is here.

The Business Judgment Rule and North Carolina LLCs

In North Carolina, the business judgment rule applies to LLC managers. In Mooring Capital Fund, LLC v Comstock North Carolina, LLC (07 CVS 20852, Wake Co., Business Ct.), 2006 WL 46447078, 2009 NCBC 26, Judge Jolly was ruling on motions to stay, dismiss, and appoint a receiver.

In the course of issuing his ruling, the Judge opined, for what appears to be the first time in North Carolina, that, just as directors of a corporation are, the managers of an LLC are protected by the business judgment rule. “The managers of an LLC may also be entitled to the protections of the 'business judgment rule...'" Taking note of similar language found in the NC Business Corporation Act, § 55-8-30, the judge noted the corresponding portions of the North Carolina Limited Liability Company Act:

"See, e.g., G.S. 57C-3-22(d) (“A manager is not liable for any action taken as a manager, or any failure to take any action, if the manager performs the duty of his office in compliance with this section.”) and G.S. 57C-3-22(b) (“A manager shall discharge his duties as manager in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in the manner the manager reasonably believes to be in the best interests of the limited liability company. . . .”). Such language suggests application of the business judgment rule, a matter of common law in North Carolina, to limited liability companies." (emphasis added).

He then went on to state:

"The rule applies in addition to the North Carolina Business Corporation Act (the “NCBCA”), G.S. 55-1-01 to -17-05, and creates an evidentiary presumption that directors acted reasonably and fairly in discharging their corporate duties. State ex rel. Long v. ILA Corp., 132 N.C. App. 587, 601 (1999). The Long court described the business judgment rule as follows:

[It] creates, first, an initial evidentiary presumption that in making a decision the directors acted with due care (i.e., on an informed basis) and in good faith in the honest belief that their action was in the best interest of the corporation, and second, absent rebuttal of the initial presumption, a powerful substantive presumption that a decision by a loyal and informed board will not be overturned by a court unless it cannot be attributed to any rational business purpose.

Id. at 602 (quoting Russell M. Robinson, II, Robinson on North Carolina Corporation Law § 14.6 at 281 (5th ed. 1995)). "

So while it may have seemed a fairly straightforward matter to put the two together and conclude that the Business Judgment Rule should also apply to LLC managers, we now have at least one written opinion stating as much -- though bear in mind that under the local rules of certain districts, you may not be able to cite to this opinion. Hopefully however, any case in which you would need to cite to this would be taking place in the Business Court.

Choosing Your North Carolina Business Entity: LLC or Corporation?

Then starting a new business in North Carolina, one of the most common questions people have is what form of business entity to use.  In this post I will compare corporations to LLCs (under North Carolina law only).  To put it mildly, when it comes to dealing with liability issues, there is little question that the LLC is the best choice.

A lot of clients initially prefer corporations.  This may be because they are more traditional, or more familiar.  But for most businesses, it makes much more sense to set up as an LLC.  For one, the LLC has stronger liability protection.  As has been discussed previously on this blog in older posts, North Carolina has a well developed "piercing the veil" doctrine -- a rule which allows courts to "look past" a corporation in order to find its shareholders liable in lawsuits.

In contrast, there is no such doctrine in North Carolina for LLCs.  For most practical purposes, this fact alone makes the LLC the clear-cut choice for most businesses.  But there's another aspect to LLCs that bears mentioning, where LLCs offer an even greater benefit:  if you end up having a judgment against you, individually, North Carolina law allows the other party to seize the shares of stock you hold in a North Carolina corporation, and liquidate them to satisfy the debt.  Whereas the law does not allow a judgment creditor to do the same with a person's membership interest in an LLC.  The most the creditor can do there is obtain a "charging order" to have the LLC pay over any distribution you might be owed - but not any salary.  Obviously then, if you own an LLC, and a court enters a judgment against you, you'll simply consult your accountant to figure out the best way to minimize "distributions" in such situations, in order to remain insulated from the effects of the judgment.  In theory, you could have any number of judgments against you and continue to receive salary from that LLC indefinitely, with creditors virtually powerless to reach that money, owing to the extraordinarily debtor-friendly nature of North Carolina law.  Accordingly, if someone recommends that you form a corporation or a partnership instead of an LLC, you should not hesitate to ask some pointed questions as to exactly why they would recommend such a choice.  The answer had better be quite compelling, because from a liability standpoint, forming any other type of entity besides an LLC is simply giving away a great deal of protection, often for little or no benefit. 

Port City Java Sues Founder

Wilmington-based coffee-house chain Port City Java has filed suit against its founder and former COO Don Reynolds.  The suit, filed in New Hanover County Superior Court, alleges that Reynolds, his wife, and an LLC held by Reynolds, diverted funds from the company for personal use, including the purchase of real estate in Highland, NC. 

According to the Star-News, the suit was filed on December 23, and in keeping with the Rules of Civil Procedure, does not specify the dollar amount sought, but instead recites the claim for damages as "in excess of $10,000."

Converting a North Carolina Corporation to An LLC

Many clients have sought to convert their closely held corporations to LLC's lately, and with good reason.  Very few small business owners actually do anything with their corporations that couldn't also be done under an LLC.  And let's face it:  very few closely held corporations do an adequate job of keeping up with corporate formalities.  In the event of a lawsuit, this can result in "veil piercing" which, as we have discussed here previously, is much harder to do to an LLC. 

So for this reason alone -- simpler management, fewer formalities, and less risk of a court overlooking the corporate entity to reach the assets of business owners -- many clients are choosing wisely to convert to an LLC.

While this seems like just a simple bit of paperwork (you can download Articles of Conversion from the secretary of state's website, after all) there can be a few catches.  There are also other methods for accomplishing the same result, without using the state conversion form.  A careful review of the tax implications involved should be undertaken prior to making a final decision on conversion.  For one, the conversion could trigger a taxable gain.  For another, there could be an effect on employment tax wage bases.  These effects could, of course, be quite sizable, and result in the need for additional planning, or foregoing conversion altogether. 

Forming a New Business in North Carolina: Additional Resources

In my last post, I listed some resources for starting a new business in Wilmington, North Carolina.  Each of those were local to the area.  The additional resources below can help you start a business statewide.

Business ServiCenter.  Sponsored by the North Carolina Department of Commerce.  The ServiCenter provides assistance with business plans, hiring, expansion, development, marketing, operations, and logistics for most types of businesses.  Additionally, the ServiCenter offers specific advice for companies involved in manufacturing, workforce training, exporting, and government contracts.

Contact:    North Carolina Department of Commerce
                    Business ServiCenter
                    4310 Mail Service Center
                    Raleigh, NC 27699-4310
                    919-715-2864
                    Toll-Free:  1-800-228-8443
                    Fax:  919-715-2855
                    http://www.nccommerce.com/servicenter

SBA - United States Small Business Administration

Contact:        SBA
                        North Carolina District Office
                        6302 Fairview Road
                        Charlotte, NC 28210-2227
                        704-344-6563

The SBA’s Small Business Guide for North Carolina can be found at:

http://www.reni.net/guides/pdf/english/northcarolina.pdf

Starting a Business in Wilmington, NC: Some Resources

If you are starting a business in North Carolina, particularly in the Wilmington area, here are some resources to help you get started.  Note that even if you are not around Wilmington, many of these services have offices in your area.  If you have any questions or would like a list of similar services in your area, please contact us. 

Small Business Technology Development Center.  Assists new businesses with planning, operation, human resources, marketing, government contracts, and other aspects of business.

Contact:    SBTDC
                5051 New Center Drive
                Wilmington, NC 28403-3297
                910-962-3744
                http://www.sbtdc.org

Wilmington SCORE.  Provides free business counseling and mentoring.  Holds seminars on topics such as accounting, business planning, and marketing.

Contact:  Wilmington SCORE
                    4010 Oleander Drive, Suite 6
                    Wilmington, NC 28403
                    910-452-5395
                    http://www.wilmingtonscore.org

Cape Fear Community College - Small Business Center.  Provides classes and counseling for small businesses.  Also offers a library of resources for new and small businesses, including books, pamphlets, videos and software.

Contact:        CFCC Small Business Center
                    419 North Third Street
                    Wilmington, NC 28401
                    E-mail:  sbc@cfcc.edu
                    910-362-7216

 

Foreign Corporations and the Certificate of Authority in North Carolina

If you are a foreign / out-of-state corporation and need to file suit in North Carolina, you will first need to file a Certificate of Authority with the Secretary of State, and as of the date of this post, that will cost you $250.00.   

This is a prerequisite; if you do not have a Certificate of Authority on file in North Carolina prior to filing suit, your case will be thrown out of court.  You can click the following link to get a Certificate of Authority form.  You will have to scroll down to Form B-09.  Instructions are included on page three of that form. 

Piercing the "Corporate" Veil of LLCs in North Carolina - Part 4

In the previous post, I promised a discussion of motions for sanctions pursuant to Rule 11 of the North Carolina Rules of Civil Procedure, in cases where LLC members are named as individual defendants in contract, fraud and Chapter 75 cases.

In North Carolina, the rule is straightforward:  an individual LLC member cannot be sued, except "by reason of his own acts or conduct."  See N.C.G.S. s 57C-3-30(a).  This section does not, however, establish an alter ego or veil piercing creteria.  It is intended to allow plaintiffs to recover for torts committed by LLC members, not, as some might have it, to establish member liability in actions against the LLC.

Clarifying this purpose, subsection (b) provides:  "A member of a limited liability company is not a proper party to proceedings by or against a limited liability company, except where the object of the proceeding is to enforce a member's right against or liability to the limited liability company."

This subsection should clarify any doubt a litigant might have about what subsection (a) allows. 

In Page v. Roscoe LLC, 128 N.C. App. 678, 497 S.E.2d 422 (1998) the plaintiff learned this lesson the hard way.  Plaintiffs sought to enjoin the defendant LLC from constructing a gas storage facility they deemed a nuisance.  LLC member Dale Bone was also named as a defendant.  No actions by Bone were alleged that were not also alleged to have been undertaken by the LLC.   Accordingly, the court held that naming Bone was a violation of Rule 11, on the theory that the complaint, in naming him, was not well grounded in law.

In so holding, the Court of Appeals agreed with the trial court, that "no acts by Bone, individually, were properly alleged. Therefore, under the above statute [N.C.G.S. s57C-3-30(b)], it was improper to name an individual member of a limited liability company as a party defendant without any evidence to support it.  As such, the naming of Bone as an individual defendant was not well-grounded in law and therefore a violation of Rule 11." 

The decision provides little guidance to a plaintiff hoping to pierce the corporate veil of an LLC.  There is no explanation about what would need to be alleged to state a complaint If anything, it provides broad grounds to support Rule 11 motions whenever an individual LLC member is named in the same complaint as the LLC.

Piercing the LLC Veil in North Carolina - Part 3

As I touched on in previous posts, in North Carolina, the factors to consider in determining whether to pierce the corporate veil include: (1) inadequate capitalization; (2) non-compliance with corporate formalities; (3) complete domination and control of the corporation so that it has no independent identity; and (4) excessive fragmentation of a single enterprise into separate corporations. See Ridgway, 329 S.E.2d at 330-31 (citing generally, Robinson, North Carolina Corporation Law §§ 2-12, 9-7 to -10 (3d ed. 1983)).

Yesterday in Part 2 of this series, I looked at the second factor - non-compliance with formalities.  Today I will look at the first factor above, inadequate capitalization.

One common misconception surrounding this factor is the timing of its applicability.  Litigants frequently assume that when a bill is unpaid, that this fact, standing alone, establishes inadequate capitalization, regardless of how old the business entity may be.

But in fact, inadequate capitalization only applies to the initial capitalization of the corporation; a new corporation must have sufficient capital with which to pay for operating costs that it can reasonably expect to incur.  Over time, however, creditors have the opportunity to examine the creditworthiness of the corporation, and in extending credit, have the option of requiring a guarantor.  For these reasons, courts are not especially prone to give great weight to this factor in most contract cases, particularly when those contracts were formed well after the corporation has been in business for some length of time. 

Moreover, by itself, this factor is extremely unlikely to support a veil-piercing claim.  An additional showing of an intent to use the corporate entity to defraud creditors would almost certainly be required.

In the LLC context, it is quite tempting to seek to apply the same rationale. Although there do not appear to be any published North Carolina cases specifically addressing this issue under the LLC Act, there is no reason why the policy of protecting creditors from fraud would be any less important - or treated differently - in situations involving LLC creditors. 

For attorneys defending LLCs in contract, fraud and/or Chapter 75 cases in North Carolina, it is important to be aware that plaintiffs will attempt to allege these factors in order to reach the assets of the individual members of the LLC, and that courts could well be persuaded to overlook the LLC's protection in cases where undercapitalization is alleged.  This is why a motion to dismiss should be filed, and the court made aware that there is no precedent for applying these factors to pierce an LLC.  Even if the motion is unsuccessful, the rationale behind it can be re-employed when your opponent is seeking to draft a jury instruction at trial.  The judge might not have granted your motion, but may be unwilling to instruct a jury on a doctrine whose applicabilty to an LLC has not been clearly established. 

Absent specific facts alleging fraud by a member, a motion to dismiss as to the LLC members should be filed, along with a motion for sanctions under Rule 11. 

In the next installment in this series, I will go into further detail about Rule 11 and how it applies to contract, fraud and Chapter 75 suits involving individual LLC members.