California limited liability company disputes | Courtroom war stories and lessons learned

LLC Money-Shuffling and “Alter Ego” Liability

The “alter ego” doctrine allows a creditor of a business entity to “pierce the corporate veil” and enforce the debt against the company’s individual owners.  The standards for proving alter ego liability are high, and the default rule respects the separateness of an entity and its owners.  But when proven, alter ego provides a creditor with a potent debt enforcement sledgehammer.

The LLC Jungle has covered the alter ego doctrine in prior posts:

  • An LLC And Its Owner Are Not the Same Legal “Person” — Unless alter ego is proven, an LLC and its owner are not the same legal “person.” When an LLC and its owner sign separate — albeit related — legal documents, they each have their own rights and remedies.
  • “Reverse Veil Piercing” to Reach an LLC’s Assets — “Reverse veil piercing” is similar to traditional veil piercing in that corporate separateness will be disregarded by the courts when the ends of justice so require. But instead of seeking to hold an individual liable for the acts of an entity, reverse veil piercing seeks to satisfy the debt of an individual through the assets of his or her entity.

In an opinion recently published by California’s Second Appellate District — Triyar Hospitality Management, LLC v. WSI (II) – HWP, LLC (order modifying opinion and certifying for publication here) — the court addressed how “money-shuffling” between individual owners and their various business entities (withdrawing or adding money at will) can lead to a finding of “undercapitalization” and alter ego liability.

Facts: LLC gets hit with judgment; creditor files motion to amend judgment to add LLC’s owners under alter ego doctrine

Triyar Hospitality Management, LLC (Triyar) signed a contract to purchase a hotel property from WSI (II) – HWP, LLC (WSI) for $39 million.  When the purchase agreement was signed, the property was subject to a hotel management agreement in favor of Hyatt Corporation.  The purchase agreement gave Triyar a period in which it could investigate and do its due diligence.  During the investigation period, and unknown to Triyar, Hyatt’s management agreement terminated.

Triyar decided not to go forward with the purchase and allowed the purchase agreement to expire by its own terms.  Triyar later learned that Hyatt’s management agreement had terminated.  Triyar claimed that the Hyatt management agreement was so burdensome that its termination increased the value of the hotel property by $11 million, and had it known of the Hyatt agreement’s termination it would have completed the purchase of the hotel.

Triyar sued WSI, seeking specific performance of the purchase agreement.  The trial court ruled in favor of WSI, holding that Triyar’s failure to learn of the Hyatt agreement’s termination was due to Triyar failing conduct a sufficient investigation.  Pursuant to an attorney fee clause in the purchase agreement, the court awarded WSI $2,172,615 in fees and costs.  That judgment was affirmed on appeal.

After the appeal and an additional award of $193,273.20 in fees and costs, WSI was unable to collect any amount of its judgement against Triyar.  WSI filed a motion to amend the judgment under Code of Civil Procedure section 187 to add brothers Steven Yari and Shawn Yari, who owned and controlled Triyar, to the judgment as judgment debtors.

Trial court: money-shuffling between entities and owners leads to alter ego liability

The trial court granted WSI’s motion, and added the Yari brothers to the judgment as alter egos of Triyar.

During the underlying trial on the claim for specific performance, Triyar offered financial evidence to prove it had the financial ability to complete the purchase of the hotel property.  The evidence showed that Triyar itself lacked that ability, but Steven Yari testified that his family had the cash on hand to complete the purchase even without financing.  The Yari family controlled several other entities, and had over $52 million in available cash.

When asked about his ability to access cash from the other family-owned entities, Steven Yari testified: “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.”  The Yaris’ attorney acknowledged that the Yaris agreed to “personally be on the hook” for the hotel purchase price.

The evidence also showed that all of the Yaris’ entities had the same address, and shared common employees.  Money earned by Triyar for managing hotel properties was paid over to other properties and entities controlled by the Yaris.  The Yaris also personally funded Triyar’s litigation against WSI.

Taking the evidence into consideration, the trial court held that alter ego was a fair outcome because Triyar itself was “not capitalized for buying major hotels.”

The Yaris appealed.

Court of Appeal: affirmed

The Court of Appeal affirmed the trial court’s order.

The court noted that in the underlying litigation, the evidence showed that the Yaris “had complete control” over Triyar and the hotel purchase transaction, and the Yaris “made it abundantly clear that they could fund Triyar or not as they please.”  The court pointed to Steven Yari’s testimony regarding the ability to transfer and commingle funds among the Yari entities, which showed “the Yaris were willing and able to disregard corporate formalities” in order to “accomplish whatever purpose they wish.”

The Yaris argued that infusing a legal entity with capital does not make them alter egos of the entity.  The court rejected that position, noting that normal capital contributions were not at issue here:

In fact, it is undisputed that the Yaris never infused Triyar with capital.  That is the problem.  Triyar has never had sufficient capital to purchase the hotel, or, for that matter, to pay the judgment.  An important factor in imposing alter ego liability is that a legal entity is so undercapitalized that it is likely to have no sufficient assets to meet its debts.

On top of the “overwhelming evidence of a unity of interest and ownership such that the separate personalities of the entity and the owners do not exist,” the court also determined that it would be inequitable to preclude WSI from collecting its judgment from the Yaris under the alter ego doctrine because Triyar was highly unlikely to ever have sufficient assets to satisfy the judgment.

The court concluded: “Here the Yaris represented that they would be personally liable for Triyar’s debt relating to the hotel purchase.  Now that the bill has come due, they should not be able to avoid that responsibility.”

Lesson

Undercapitalization has always been an important factor in the alter ego analysis.  But “undercapitalized” doesn’t always simply mean that funds are completely nonexistent.  As illustrated by the Triyar opinion, even if the owners are willing to contribute funds to the entity “as needed,” the entity can still be considered undercapitalized.  Where the entity’s owners have a practice of capitalizing the entity with personal funds only when convenient or beneficial to the entity, they might be held liable for the entity’s debts under the alter ego doctrine.