Alter Ego Liability for LLC Managers: the Facts Matter
Alter ego liability is a frequent topic covered in The LLC Jungle — see here for a list of all prior “alter ego” related posts.
The alter ego doctrine allows a court to disregard a corporate entity (including LLCs) and hold the individual owners liable for the actions of the entity. Alter ego generally requires proof of: (1) a unity of interest and ownership such that the separate personalities of the entity and individual do not exist, and (2) an unjust or inequitable result if the corporate entity is not disregarded.
In a case recently published by California’s Court of Appeal for the First Appellate District — JPV I L.P. v. Koetting — the court addressed an alter ego claim arising from a failed contractual relationship, emphasizing the importance of the specific facts of the case.
Facts: LLCs breach contractual duties and divert customers from contract client
The Big Lagoon Rancheria Tribe (a federally recognized tribe of Yurok and Tolowa Native Americans) formed tribal lending entities (TLEs) to engage in marketing and servicing of small-dollar short-term loans made over the Internet.
The TLEs retained two LLCs — Redondo Management, LLC (Redondo) and Rockhill Consulting Group, LLC (Rockhill) — to manage the online lending programs. Mark Koetting and Daniel Koetting were the managing members of the Redondo and Rockhill LLCs.
The parties’ relationship deteriorated, leading to litigation. The TLEs alleged that the Koettings and their LLCs implemented a diversion scheme, telling loan customers that the TLEs would no longer be making loans and persuading the customers to continue borrowing from new lenders unaffiliated with the tribe, which were affiliated with the Koettings. The TLEs also alleged that the Koettings operated the LLCs as their alter egos.
The TLEs obtained an arbitration award against the LLCs awarding over $14 million in damages. The arbitrator ruled that the LLCs breached the covenant of good faith and fair dealing by diverting the TLEs’ loan customers to other entities controlled by the Koettings and writing off loans belonging to the TLEs so that new business could be generated for the other Koetting entities. The arbitration award also found that the Koettings, as the managing members of the defendant LLCs, were jointly and severally liable with the LLCs as their “alter egos.” The superior court confirmed the arbitration award and entered judgment.
In a prior appeal, the award against the Koettings as alter egos of the LLCs was vacated on procedural grounds (they were not contractually bound to arbitration), and the case was remanded back to the trial court for further proceedings.
The TLEs assigned the judgment to JPV I L.P. (JPV). JPV filed a motion to amend the judgment to include the Koettings as alter egos.
Trial court: motion to amend denied; insufficient evidence of alter ego
The trial court denied the motion to amend the judgment.
The court noted that alter ego is “an extreme remedy, sparingly used” and held that LLCs generally are not required to adhere to corporate formalities, the Koettings’ LLCs were adequately capitalized when formed and during most of their operations, and the LLCs were not “sham” entities.
JPV appealed.
Court of Appeal: reversed; trial court botched the alter ego determination
The Court of Appeal reversed the trial court’s ruling, holding “the trial court misunderstood and misapplied the proper scope of its discretion” in ruling on the alter ego issue.
The court first held that in the trial court proceedings, the Koettings should not have been allowed to “relitigate the arbitral findings made against the LLCs” because the arbitration findings provided the basis for issue preclusion (a form of the res judicata doctrine). Those findings included determinations that the LLCs did not own the TLEs’ customer data and that the LLCs wrongfully diverted the TLEs’ customers to the Koettings’ other entities.
Addressing the alter ego factors, the court held that the trial court’s findings painted with too broad a brush and failed to consider all of the relevant facts. The court held that in appropriate circumstances, it was proper to use a more narrow focus on “certain inequitable uses of the corporate form for specific purposes.” The issue is not whether the entity is the alter ego of its owners for all purposes, but rather, “whether in the particular case presented and for the purposes of such case justice and equity can best be accomplished and fraud and unfairness defeated by a disregard of the entity….”
With those guiding principles in mind, the court went on to hold that the trial court “misapplied” the alter ego doctrine in several respects and failed to give proper weight to key facts, including:
- The LLCs failed to comply with certain relevant formalities, such as maintaining current registration during the relevant time periods featuring misconduct.
- While the LLCs might have been adequately capitalized, that did not minimize the binding arbitration award’s adjudication that the LLCs engaged in wrongful diversions of the TLEs’ customers and business opportunities to the Koettings’ other entities.
- The evidence showed that both Daniel Koetting and Mark Koetting were personally involved in the diversion of the TLEs’ customers.
- JPV was not required to prove that the LLCs were a “sham” from the outset for alter ego to apply; instead, alter ego can apply whenever “the corporate form is used to perpetrate a fraud, circumvent a statute, or accomplish some other wrongful or inequitable purpose.”
- JPV presented adequate evidence of an “unjust or inequitable result” if the alter ego doctrine was not applied, which went above and beyond the simple inability to collect on the judgment.
The court remanded the case to the trial court “for a fresh consideration” of the alter ego issue in light of its holding.
Lesson
The JPV opinion illustrates several key concepts of the alter ego doctrine in California. Alter ego is not a “one size fits all” issue, and cannot be resolved by applying general principles. The specific facts of the case will determine the outcome.