Piercing the Corporate Veil: The Bankruptcy Impact
By Peter Hall
Piercing a corporate veil is not complicated but is frequently improperly raised as a cause of action rather than as a remedy. To succeed in piercing, a litigant must understand what a chosen piercing theory requires and what other obstacles may arise. Additionally, the unique circumstances of bankruptcy cases may significantly affect who may seek to pierce and who will reap the benefits if successful.
Although piercing is traditionally sought in order to hold individuals personally liable for corporate obligations, Texas does recognize the concept of reverse piercing where a corporation’s assets may be reached to satisfy the personal obligations of a shareholder or director. Reverse piercing is most commonly used in closely held corporation cases where the alter ego theory is raised and adequately proven, but only after proving the underlying substantive cause of action.
Without delving into the state law theories on piercing, state court lawsuits typically become subject to the jurisdiction of the bankruptcy court as soon as a petition for bankruptcy is filed. The case may also be removed to the bankruptcy court and become a part of the bankruptcy estate. At this point, the case may or may not remain in the hands of the original plaintiff. The bankruptcy estate consists of all of the debtor’s legal or equitable property interests as of the commencement of the case. Adversary proceedings in bankruptcy frequently allege alter ego theories against defendant debtors. If the theory is proven, the assets of the alter ego may be treated as those of the debtor, regardless of whether the debtor is a business or the individual behind the business.
In corporate bankruptcy situations, ownership of a cause of action against the debtor is an important determination. The answer depends upon whether the debtor could have raised the underlying substantive claim at the commencement of the case under applicable state law. If the claim alleges only indirect harm to a creditor (i.e., an injury which derives from harm to the debtor), and the debtor could have raised the claim for a direct injury under applicable law, then the cause of action belongs to the bankruptcy estate. Conversely, if the claim does not explicitly or implicitly allege harm to the debtor, then the cause of action could not have been asserted by the debtor as of the commencement of the case, and is not property of the estate.
For actions belonging to the estate, only the trustee may seek to pierce the veil. This seems somewhat counter-intuitive. The suggestion that the estate might sue itself is essentially correct. The estate stands to gain additional assets from, or have existing liabilities shifted to, the debtor’s alter ego identity. The possibility of piercing and reaching shielded assets increases the estate assets and allows for a better return to creditors. The Fifth Circuit Court of Appeals, construing Texas law, held that an alter ego theory, under such circumstances, was property of the estate to be asserted by the debtor corporation. See Matter of S.I. Acquisition, Inc., 817 F.2d 1142 (5th Cir. 1987). The holding was that the piercing action belonged to the estate and the automatic stay provision prevented the debtor’s creditors from bringing a state court action against the debtor and its non-bankruptcy co-defendant based on the alter ego doctrine because the action was not personal to any one creditor.
Properly raising a theory of piercing the veil is critical to any suit; in bankruptcy or otherwise. Litigants must understand that piercing is a remedial action and not a substantive cause of action. Piercing merely expands the scope of potential sources of relief by extending to individual shareholders or other business entities what is otherwise only a corporate liability. As the Court of Appeals in Beaumont put it very succinctly, “[w]ithout an underlying cause of action creating corporate liability, evidence of an abuse of the corporate form is immaterial.” In re StarFlite Management Group, Inc., 162 S.W.3d 409 (Tex.App.-Beaumont 2005, no writ).
Piercing the corporate veil is an attractive remedy where a corporate defendant does not appear to have the ability to satisfy a judgment. However, these theories are too frequently misapplied by attempting to pursue them as the substantive causes of action and misunderstanding their concepts. Additionally, plaintiffs too frequently spend large amounts of time and money pursuing a remedy for which they commonly lose standing once the defendant has filed for bankruptcy protection.
Peter C. Hall is Vice President of Product Development, National Bankruptcy Services, LLC. He can be reached at Peter Hall firstname.lastname@example.org.