Legal Update

May 2022

For more than 400 years, the limited liability protection of corporate entities has been perhaps one of the greatest accelerators of economic growth and capital formation in the industrialized world. Despite the benefits, corporations have also been used as vehicles to cheat creditors with bad guys hiding behind the “corporate veil.” Over time, courts have developed a strategy for creditors to “pierce the corporate veil” to satisfy their claims from the personal assets of malicious shareholders, but until recently, creditors have been unable to pursue recovery against other affiliated entities.

For more than 400 years, the limited liability protection of corporate entities has been perhaps one of the greatest accelerators of economic growth and capital formation in the industrialized world. Despite the benefits, corporations have also been used as vehicles to cheat creditors with bad guys hiding behind the “corporate veil.” Over time, courts have developed a strategy for creditors to “pierce the corporate veil” to satisfy their claims from the personal assets of malicious shareholders, but until recently, creditors have been unable to pursue recovery against other affiliated entities.

That is beginning to change. In Pennsylvania, for example, the Supreme Court finally recognized an “enterprise” theory of liability in Mortimer v. McCool, 255 A.3d 261 (Pa. 2021). While the Mortimer court decided that the theory did not apply in that case, Judge Haines of the Federal District Court for the Western District of Pennsylvania used the theory of liability to allow a plaintiff to pursue the shareholders and affiliated entities of a now defunct construction company in Seven Springs Mountain Resort, Inc. v. Hess, et al., 2022 U.S. Dist. LEXIS 62763 (W.D. Pa. April 4, 2022).

Piercing the Corporate Veil

Historically, there is “a strong presumption … against piercing the corporate veil.” Lumax Industries, Inc. v. Aultman, 669 A.2d 893, 895 (Pa. 1995). “The corporate form will be disregarded only when the entity is used to defeat public convenience, justify wrong, protect fraud or defend crime.” First Realvest, Inc. v. Avery Builders, Inc., 600 A.2d 601, 604 (Pa. Super. 1991) (emphasis added). What is clear from the cases on piercing the corporate veil is that there is not a single, ironclad rationale. Rather it is like the famous line from Supreme Court Justice Potter Stewart about identifying obscene materials: you know it when you see it.

Courts have identified four basic factors to hold shareholders liable for the obligations of the corporation: undercapitalization, failure to conform to corporate formalities, substantial intermingling of corporate and personal affairs, and use of the corporate form to perpetrate a fraud. Lumax at 895, quoting College Watercolor Group, Inc. v. William H. Newbauer, Inc., 360 A.2d 200, 207 (Pa. Commw. Ct. 1976). Within those broad categories are some more specific tests, including:

1. Absence or inaccuracy of corporate records;
2. Concealment or misrepresentation of members;
3. Failure to maintain arm’s length relationships with related entities;
4. Non-functioning corporate officers and/or directors;
5. Siphoning of corporate funds by the dominant shareholder(s);
6. Treatment by an individual of the assets of corporation as their own;
7. Use of the corporation as a “façade” for dominant shareholder(s) personal dealings;

It is not sufficient to identify isolated instances of these violations. A party seeking to pierce the corporate veil of an opponent must show that the actions are consistent and pervasive. By way of example, a corporation is not undercapitalized, for purposes of piercing the corporate veil, because it sustained losses in a few years that resulted in its balance sheet showing negative equity. To meet the “undercapitalization” test, the corporation must have been undercapitalized from inception or as a result of specific actions by the shareholders. For example, if the shareholder took excessive dividends knowing that the distributions would leave the corporation insolvent, it might satisfy the undercapitalization standard. This is especially true if the shareholder adopted this as a regular strategy. Similarly, the personal use of a “company car,” alone, would be insufficient to warrant piercing the veil. On the other hand, providing “company cars” to all of the shareholder’s family members who use the vehicles solely for personal purposes, might satisfy the test. There is no single test that predominates over the others, and none of them are individually determinative. The decision to pierce is based on the entirety of the facts and circumstances. As Justice Stewart suggested, you will know it when you see it.

The Enterprise Theory of Piercing

Difficult as it is, piercing the corporate veil is not always a viable strategy even when significant misconduct has taken place. Piercing the corporate veil has traditionally been a direct line from the subject entity to its shareholder. The piercing strategy has not been helpful where the manipulation has taken place across a group of companies, and not just between the subject corporation and its shareholder(s). Such was the case in Seven Springs litigation.[1]

Seven Springs Mountain Resort, Inc. (“Seven Springs”) is a real estate developer located in Somerset County, Pennsylvania. Seven Springs hired Dynamic Building Company (“DBC”) to construct a $77 million townhome project called Southwind at Lake Tahoe (“Southwind”) on its property. DBC’s shareholders were John and Terry Hess. As DBC completed construction on various phases of the project, the homes were sold. As buyers moved into the homes, they discovered significant water infiltration problems. When presented with these construction flaws, DBC made superficial repairs but did nothing to address the underlying issue. As the problems mounted, John Hess responded to the continuing complaints with threats of declaring bankruptcy and told the Seven Springs’ CEO that he “will just close up [his] company, file for bankruptcy, and just walk away, and you guys can, you know, deal with it.”

Faced with significant damages to their homes, the Southwind residents sued plaintiff in several different cases. Seven Springs resolved those claims and, as part of the settlement, the residents assigned their claims to Seven Springs. Seven Springs, in turn, sued DBC asserting both the residents’ claims and its own under several legal theories. Seven Springs and DBC agreed to arbitrate the dispute. The arbitration panel awarded Seven Springs approximately $14,000,000 in damages. That award was then affirmed by the Somerset County Court of Common Pleas. As Seven Springs pursued execution on the judgment, DBC filed to liquidate under Chapter 7 of the United States Bankruptcy Code. Seven Springs filed an action against John and Terri Hess, DBC Construction LLC (“DBC Construction”) and DBC Real Estate Management, LLC (“DBC Real Estate”) asserting that these defendants operated, along with DBC, as a single enterprise.

According to plaintiff, the Hesses operated an enterprise that promoted itself as the “DBC Group.,” which consisted of over 70 entities, including DBC, DBC Construction, and DBC Real Estate, and they drained money from DBC, transferring to themselves and their other entities, to make DBC unable to make proper repairs at the Southwind project. Among the facts alleged in support of plaintiff’s enterprise theory of liability:

• John Hess is the sole owner and manager of the 70+ entities in the DBC Group;
• All the DBC Group entities, including DBC, operated from the same location;
• The DBC Group entities share equipment and employees;
• DBC Group members’ computer data and other records are maintained on a single server;
• The Hesses routinely moved money—“often hundreds of thousands of dollars”—between their personal bank accounts, DBC Real Estate bank accounts and DBC Construction bank accounts.
• The Hesses used DBC funds to pay for personal expenses; and
• The Hesses deliberately drained DBC of its assets by transferring them to other entities within the DBC Group.

In analyzing whether Seven Springs had adequately pleaded its claim for enterprise liability, the court looked to the recent decision in Mortimer v. McCool, which set out a five-prong test as the basis for enterprise liability: (1) identity of ownership, (2) unified administrative control, (3) similar or supplementary business functions, (4) involuntary creditors, and (5) insolvency of the corporation against which the claim lies. Defendants argued that Seven Springs had not pleaded sufficient facts to hold DBC’s sibling corporations liable. Judge Haines, however, dismissed those arguments since plaintiff’s complaint had been filed before the Pennsylvania Supreme Court issued its decision in McCool. Based on the facts alleged in plaintiff’s complaint, that established a basis for piercing the corporate veil, the court was satisfied that plaintiff had met its burden.

Mortimer explained that “enterprise liability in any tenable form must run up from the debtor corporation to the common owner, and from there down to the targeted sister corporation(s)…[b]ut this requires a mechanism by which liability passes through the common owner to the sibling corporation.” In this case, Plaintiff has alleged liability between the [sic] DBC and Hess and from there down to DBC Real Estate and DBC Construction. The Court finds Plaintiffs allegations are sufficient to satisfy a claim for veil piercing under the enterprise theory at this preliminary stage.[2]

Conclusion

Seven Springs Mountain Resort, Inc. v. Hess opens new opportunities for financial forensics professionals to analyze potential liability of sibling corporations under the enterprise theory of piercing the corporate veil.

[1] It is important to note the procedural posture of the litigation. This opinion is a ruling on defendants’ motion to dismiss. For purposes of this ruling, plaintiff’s factual allegations are assumed to be true and all reasonable inferences that may be drawn from them are interpreted in favor of plaintiff. At this stage, none of the allegations have been proven by supporting evidence.

[2] 2022 U.S. Dist. LEXIS 62763 at 28, internal citations omitted.

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Michael J. Molder, JD, CPA, CFE, CVA, MAFF, applies 30 years of experience as a Certified Public Accountant and litigator to help investigate and analyze cases with complex financial and economic implications. He has acted as both counsel and accounting expert in pending and threatened litigation as well as participating in internal investigations of financial misconduct. As a litigator, Mr. Molder helped co-counsel understand complex financial and accounting issues in dozens of cases. In 2006, Mr. Molder returned to public accounting applying his unique skills to forensic engagements. He has also performed valuations of business interests in a wide variety of industries.

Mr. Molder has served as valuation expert for both plaintiffs and defendants in commercial litigation matters and owner and non-owner spouses in matrimonial dissolutions. He has participated in the valuations of businesses in a wide variety of industries, including: food service, wholesale and retail distribution, literary development and production, healthcare, manufacturing, and real estate development.

Mr. Molder has also investigated and valued damages in a wide variety of litigation contexts ranging from breach of contract claims to personal injury cases, and from employment disputes to civil fraud. He has consulted on many matters which have not involved the issuance of a report for litigation or resulted in deposition or trial testimony. Accordingly, the identity of these matters is protected by attorney client privilege.

Mr. Molder has also lectured widely on a variety of accounting and litigation related topics including business valuation, financial investigations in divorce proceedings, accountant ethics, financial statement manipulation and “earnings management.”

Mr. Molder can be contacted at (610) 208-3169 or by e-mail at Molder@lawandaccounting.com.