The LLC and Alter Ego: How a Judgement Against Your Limited Liability Company Can Turn Into a Personal Judgement
The establishment of limited liability companies is a common practice used by real estate developers as a way of holding property. However, the protection afforded by an LLC is not all-encompassing and can be undone using the doctrine of alter ego, as Laine T Wagenseller explains.
Experienced real estate attorneys will often recommend that their real estate developer and investor clients form a limited liability company to hold property. Lenders often require the formation of a single-entity LLC to hold each property. Therefore, successful investors will often have numerous LLCs. Forming a new LLC is as easy as filling in the details on a new operating agreement and registering it with the State. However, real estate owners need to be careful — the protection of a limited liability company can be “pierced” through the doctrine of alter ego and lead to individual liability for the individual members if the corporate formalities are not followed.
A recent California Court of Appeal case provides a good example of how the individual members can be held liable for the obligations of the undercapitalised LLC. The case involves a family-owned LLC that signed a contract to purchase a hotel for $39 million. The LLC did not go through with the purchase and allowed the purchase contract to expire by its own terms. Later, discovering alleged concealed conditions, the LLC sued the seller for specific performance and fraud.
At trial, the court found that the LLC had failed to conduct a sufficient investigation and entered judgement in favour of the seller and awarded over $2 million in attorneys’ fees. The LLC appealed and lost. However, the seller was unable to collect anything from the empty LLC.
The seller then sought to add two of the individual members of the LLC to the judgement as judgement debtors. The trial court found that the LLC was not adequately funded to purchase major hotels and therefore granted the motion, finding the individual members to be alter egos of the LLC.
California business litigation attorneys often use Code of Civil Procedure section 187 to add additional debtors to a judgement based on a theory of alter ego. To prevail in a motion to add a judgement debtor based on alter ego, the moving party must establish that (1) the parties to be added as judgement debtors had control of the underlying litigation and were virtually represented in that proceeding; (2) there is such a unity of interest and ownership that the separate personalities of the entity and the owners no longer exist; and (3) an inequitable result will follow if the acts are treated as those of the entity alone.
In order to establish its case for specific performance, the LLC had to prove that it could have closed the transaction. However, the LLC itself did not have the money. One of the LLC members testified that his family had the cash on hand to complete the purchase. The family members introduced their personal financial statements into evidence to show they had control over $52 million in available cash.
When asked about his ability to withdraw cash from family entities, one member testified that “It’s not as formal as, you know, having to abide by some operating [document] – these are family entities that – and once again, we borrow from these family entities quite often and repay.”
On appeal the members conceded that they controlled the underlying litigation and were represented in that litigation.
The court therefore looked at unity of interest and ownership. The court found that the individual members owned and controlled the LLC. During the trial, “they made it abundantly clear that they could fund [the LLC] or not as they please.” While the members tried during appeal to argue that the LLC was a “fully independent business entity”, the court found that their testimony belied that assertion. The court especially took note of the testimony that they were not “formal”, that they did not have to “abide by” operating documents and that they borrow from the family entities quite often. The court concluded that the testimony established that the members were “willing and able to disregard corporate formalities in order to purchase the hotel” and that they could “commingle their own funds with the funds of their entities to accomplish whatever purpose they wish.”
The members countered that “infusing a legal entity with capital does not make them alter egos of that entity.” The Court of Appeal deftly countered: “But no one is suggesting the [members] are alter egos of [the LLC] because they infused it with capital. In fact, it is undisputed that the [the members] never infused [the LLC] with capital. That is the problem. [The LLC] has never had sufficient capital to purchase the hotel, or, for that matter, to pay the judgement. An important factor in imposing alter ego liability is that a legal entity is so undercapitalised that it is likely to have no sufficient assets to meet its debts.”
The members then argued that there must be some behaviour that amounts to bad faith in order to pierce the corporate veil. The Court noted that the alter ego’s acts need only cause an inequitable result.
“An important factor in imposing alter ego liability is that a legal entity is so undercapitalised that it is likely to have no sufficient assets to meet its debts.”
The first lesson to be learned by LLC members is that the protection of a limited liability company also demands that the members respect the corporate formalities of the entity. In other words, the LLC protection cannot be turned on and off to suit the members’ purposes while shielding those members from the debts and obligations of the entity.
A second lesson is that amendment of a judgement to add individual LLC members as judgement debtors is usually a difficult task. Oftentimes there will not be any testimony regarding unity of ownership during a typical business trial. It is unclear here whether trial counsel had anticipated being hoisted with his own petard. By eliciting testimony about performance necessary to establish the specific performance claim, the trial attorney also provided the fodder for the other side’s motion to amend the judgement.
An Interview With Laine Wagenseller
What is the best way to ensure a client is satisfied with your legal services?
“The skills that make an excellent business trial attorney also work with clients – and everyone else for that matter. I would rank knowing and understanding the basic human needs as the most important skill for a good lawyer to master. When new clients call me, they may not know much about the legal theories or the case law. But they want to know if I am listening to them. If I understand them. The clients do not know how we are going to solve their problem, but they want to have confidence that we can solve it.”
You decided early on to focus on real estate litigation. Why was that?
“My father was a real estate developer. He built industrial buildings in Southern California. It was something I grew up with. As a young attorney working in several big law firms, I was exposed to different areas of business litigation. Real estate always appealed to me because it involved complex and sophisticated legal issues.”
“When I founded Wagenseller Law Firm, I set a big mission statement—to become the preeminent boutique real estate litigation law firm in Los Angeles. Since then we have worked on all of the big issues in real estate—breach of contract, specific performance, partition, boundaries and easements, partnership and family lawsuits, and more.”
“Clients know that they are getting experienced real estate attorneys who handle real estate issues day in and day out.”
Laine T Wagenseller
Wagenseller Law Firm
Tel: (213) 286-0371
Wagenseller Law Firm focuses on real estate and business litigation in Los Angeles and Southern California. Its lawyers have extensive litigation and trial experience handling a variety of lawsuits, including partnership disputes, breach of contract, real property partition, and breach of fiduciary duty. As a full-service firm, its trial attorneys are trusted to handle all facets of business and real estate litigation.
Laine T Wagenseller is the founder of Wagenseller Law Firm and a trial attorney who handles real estate lawsuits. With over 28 years of experience in the sector, he has advised property owners, real estate investors and developers in the resolution of disputes. He has extensive experience in trials, arbitrations and mediations.