Notes & Comment
Vol. 2008, No. 2
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Business Entities
Going Postal in California: No to Outside Reverse Corporate Piercing!
A three-judge appellate court panel in California recently reversed an Orange County trial court which had invoked a theory called "outside reverse piercing" in business litigation. Using that theory, the trial judge allowed a judgment creditor to hold a corporation accountable for a shareholder’s personal debt. Normally, "corporate veils" are pierced the other way: holding a shareholder accountable for the obligations of the corporation. The trial court’s theory of "outside reverse piercing" turned that concept upside down, permitting a corporation to be held responsible for a shareholder’s debt.
Not so fast in California, said the Court of Appeal for the Fourth District in a 3-0 ruling. Postal Instant Press, Inc., v. Kaswa Corporation, 162 Cal. App. 4th 1510; 77 Cal. Rptr. 3d 96; 2008 Cal. App. LEXIS 753 (4th Dist. May 20, 2008). It’s one thing to allow a third party to pierce a corporate veil holding an "alter ego" shareholder accountable for the corporation’s obligations. It’s another permitting a third party to pierce that same veil in reverse, making the corporation responsible for a shareholder’s personal obligations.
The Facts
Shahid Rangoonwala (Shareholder) and a partner purchased a Postal Instant Press, Inc. (PIP) franchise in 1998, each personally taking an assignment from the prior franchisee. Later in 1998, they formed Kaswa Corporation (Kaswa), apparently to own and run the PIP franchise. The partner left the arrangement and sold his interest in the PIP franchise to Shareholder, who became the sole owner of the franchise. Shareholder subsequently asked PIP’s permission to assign the PIP franchise to Kaswa. PIP refused, and Shareholder continued as the sole owner of the franchise.
Sometime in 2002, Kaswa Corporation merged into another company which had been owned by Shareholder’s new business partner. The merged company kept the Kaswa name, and Kaswa (the merged company) continued to run the PIP franchise personally owned by Shareholder. About that same time, Shareholder "walked away" from Kaswa, and claimed not to own shares in Kaswa anymore.
In 2004, a dispute arose between PIP and Shareholder about unpaid franchise royalties. The case went to arbitration and resulted in an award against Shareholder. PIP confirmed the award and took entry of judgment in California state court. After judgment was entered against Shareholder, Kaswa -- Shareholder was now an-ex shareholder of Kaswa -- sold the franchise assets to another company.
PIP sought to collect, from Kaswa, the judgment for unpaid franchise royalties it had obtained against Shareholder. The trial court authorized this under the theory of "outside reverse piercing", finding that because Kaswa was effectively an "alter ego" of Shareholder, PIP was entitled to collect the unpaid franchise royalties also from the corporation. Again, Kaswa was never an authorized franchisee, and years earlier PIP had even refused Shareholder’s request to transfer the PIP franchise to Kaswa. On appeal, the Court reversed the trial court’s order.
Piercing the Veil: Outside Reverse Piercing
The Court began by noting the basic distinction, on the one hand, between standard "alter ego" principles, which seek to make shareholders accountable for obligations of the corporation when they’ve improperly "hidden" behind a corporate structure, and "outside reverse piercing", on the other hand, which seeks to hold the corporation accountable to outside third parties for its shareholders’ debts.
There was no issue in Postal Instant Press, Inc., v. Kaswa Corporation about corporate guarantees or contractual promises to pay Shareholder’s debt. Rather, this case was about extending reverse "alter ego" liability to a corporation under common law.
As the Court explained, "[T]he alter ego doctrine traditionally is applied to pierce the corporate veil so that a shareholder may be held liable for the debts or conduct of the corporation. Some courts recognize the corporate veil may be pierced in reverse so that a corporation may be held liable for the debts or conduct of a shareholder. "The typical ‘reverse pierce’ case involves a corporate insider, or someone claiming through such individual, attempting to pierce the corporate veil from within so that the corporate entity and the individual will be considered one and the same." This is sometimes called "[i]nside reverse piercing." A variant of the reverse piercing theory, sometimes called "outside" or "third party" reverse piercing, occurs when a third party outsider seeks to reach corporate assets to satisfy claims against an individual shareholder." 162 C.A.4th at 1518 (citations omitted, emphasis added).
The Court acknowledged that several states had adopted a form of outside reverse piercing (in federal tax cases, and in Idaho, Virginia, Connecticut, New York and Colorado, among perhaps others), but said the California Supreme Court has not ruled on the theory. To the extent "reverse piercing" has been imposed by a few California cases, the Court wrote, those were traditional "alter ego" cases, where a judgment creditor sought to hold the corporation accountable for the debts of a sole shareholder -- and the "alter ego" facts would have supported a traditional piercing of the corporate veil to reach the sole shareholder.
In contrast, the Court held that the theory behind outside reverse piercing -- allowing an outside judgment creditor or other third party to reach the corporation’s assets to satisfy a shareholder debt -- was fundamentally flawed. Traditional alter ego concepts permit one to reach individual shareholders to satisfy corporate obligations when the individual shareholders have abused the corporate form. Outside reverse piercing, on the other hand, generally punishes "innocent" shareholders by allowing recourse against company assets to satisfy obligations of "guilty" and even possibly former shareholders -- assets that "belong" to all current shareholders, not "guilty" shareholders alone.
As the Court wrote, "[T]he true issue that outside reverse piercing seeks to address is not the misuse of the corporate form to shield the shareholder from personal liability. Rather, the issue addressed by outside reverse piercing is the shareholder's transfer of personal assets to the corporation to shield the assets from collection by a creditor of the shareholder. In other words, outside reverse piercing seeks to protect the judgment creditor from the shareholder's fraudulent transfer of assets to the corporation. But, as explained in [citations omitted], conversion and fraudulent conveyance already afford judgment creditors protection in that situation. Outside reverse piercing, accomplished by the expedient means of a postjudgment motion, is an unacceptable shortcut to pursue those remedies." 162 C.A.4th at 1523.
Summary and Conclusion
The California Court of Appeals analysis in Postal Instant Press, Inc., v. Kaswa Corporation is sound when the interests of all corporate stakeholders are taken into account. Key facts in the case likely were the remoteness of then-current Kaswa stakeholders to the underlying issues in the franchise royalty dispute and Shareholder’s debt, plus the availability to PIP of other legal remedies to help execute the judgment against Shareholder. While this case highlights the importance of proper corporate governance, particularly to small and private businesses with multiple stakeholders, it also achieves a commonsense outcome that protects company assets and the interests of all stakeholders against third party claims based on one shareholder’s misdeeds.
© Matthew Joseph 2008. Law Offices of Matthew Joseph, San Mateo, California, practices in the areas of intellectual property licensing, commercial real estate leasing, corporate formations and business transactions. No legal advice is intended by the information provided herein and recipients should independently consult counsel before taking any action related to this subject matter.