The U.S. Bankruptcy Court for the Eastern District of Tennessee ruled in August that an LLC’s creditor could not pierce the LLC’s veil to assert its claim against the LLC’s sole member. In a twist, the LLC’s member, not the LLC, was the debtor in bankruptcy. In re Steffner, No. 11-51315, 2012 WL 3563978 (Bankr. E.D. Tenn., Aug. 17, 2012).

Veil-piercing cases arise frequently, but Steffner presents an unusual posture. Veil-piercing claims are often asserted when an LLC’s creditor wants to add a claim against someone with more assets than the LLC, such as a member of the LLC. But when the object of the veil-piercing claim (the LLC member) is in bankruptcy, even a successful attempt to pierce the LLC’s veil will result in the plaintiff being an unsecured creditor in the bankruptcy, likely receiving only cents on the dollar.

Hulsing Hotels Tennessee, Inc. obtained a state court judgment against Sleep Quest Diagnostics, LLC in 2009. Edward Steffner, Sleep Quest’s sole member, filed for bankruptcy in 2011. Hulsing then commenced an adversary proceeding in Steffner’s bankruptcy, to pierce the veil of Sleep Quest and assert Hulsing’s Sleep Quest judgment against Steffner. Hulsing also requested denial of Steffner’s bankruptcy discharge, which would have allowed Hulsing to continue to assert its claim post-bankruptcy.

Hulsing based its veil-piercing claim on the following: (1) Sleep Quest and Specialty Respiratory Services, LLC (SRS), another entity owned by Steffner, shared the same office building, bank, and accountant; (2) on the day that Hulsing served a garnishment on Sleep Quest’s bank account, Sleep Quest transferred $4,886 from the account to SRS, leaving a balance of only 17 cents; (3) when Steffner learned that Hulsing had garnished funds owed to Sleep Quest by two insurance companies, Steffner informed Sleep Quest’s bank, which held a perfected security interest on Sleep Quest’s accounts receivable, and the bank filed a motion in state court to quash Hulsing’s garnishment; (4) there had been numerous transfers of funds between Sleep Quest and SRS; (5) Sleep Quest had filed a number of reimbursement claims with the two insurance companies under a third-party physician’s provider number; and (6) Steffner’s initial filing of the list of his creditors in the Bankruptcy Court included the business debts of Sleep Quest and SRS.

The Bankruptcy Court applied Tennessee law, which will disregard the veil of an LLC’s liability shield and hold its members liable for the LLC’s debts when it “is a sham or a dummy or where necessary to accomplish justice,” when there is misconduct on the part of officers or directors, when the entity is created or used for an improper purpose, or when the entity’s form has been abused. Id. at *4 (quoting Schlater v. Haynie, 833 S.W.2d 919, 925 (Tenn. Ct. App. 1991)). The standards are the same for an LLC as for a corporation, and are to be applied cautiously and with a presumption of corporate regularity. Id.

A number of factors should be considered in determining whether to pierce the veil of a corporation or an LLC: undercapitalization, diversion of corporate assets, and the failure to maintain arm’s-length relations among related parties, among others. No one factor is conclusive, and it is not required that all of the factors weigh in favor of piercing the veil. Id. at *5.

The Steffner court systematically analyzed Hulsing’s contentions. Although Sleep Quest and SRS operated out of the same building (in different suites) and used the same bank, attorneys, and accountants, the two companies were formed at different times and for different purposes. The court pointed out that closely held businesses often use the same professionals for convenience, and the professionals and businesses who dealt with Steffner and the two companies treated them as separate entities. Id.

The transfers between Sleep Quest and SRS were documented as loans in the companies’ internal accounting records. The transfer of $4,886 on the day of Hulsing’s garnishment of the bank account was documented as a loan, with the result shown as a receivable on Sleep Quest’s books. The court saw that the timing of that transfer may have been “more than coincidental” but found that was not enough to pierce the veil. Id.

The court found Steffner’s disclosure to Sleep Quest’s bank that Hulsing had garnished Sleep Quest’s receivables that were the subject of the bank’s perfected security interest to be nonobjectionable. “Merely preferring one creditor over another is not a basis for piercing the corporate veil.” Id. at *6. And Sleep Quest’s use of an identifier number other than its own was not illegal or fraudulent, and did not divert or conceal any funds due to Sleep Quest.

The Steffners had initially listed the debts of Sleep Quest and SRS in their bankruptcy schedules, but the court saw that as a common practice, intended to give notice to all creditors who might have a claim against the debtor. Those debts would normally be listed as disputed, but Steffner made that clear at the meeting of creditors and in subsequent amendments to the schedules.

The court concluded that Sleep Quest was not a sham or a fraud and that the corporate formalities had been observed. Steffner had not used the LLC form of Sleep Quest for an improper purpose, and there was no misconduct by Steffner. Id. at *8. The court therefore dismissed Hulsing’s veil-piercing claim against Steffner.

Comment. Veil-piercing cases are noted for their lack of predictability, and sometimes courts strain to pierce the veil when the LLC has only a single member. For example, earlier this year I posted here about Colorado’s Martin v. Freeman case, where the veil of a single-member LLC was pierced without any showing of wrongdoing.

The Bankruptcy Court in Steffner took a more even-handed approach. The court put no undue emphasis on Steffner’s sole ownership of the LLC and rejected the veil-piercing claim, implicitly recognizing the legitimacy of an LLC’s liability shield even for single-member LLCs.

The court’s analysis also underscores the importance of properly documenting transactions between affiliated companies. There were numerous transfers of cash between the two companies in Steffner, but they were all reflected as loans in their accounting records. If those cash flows had not been properly booked, the case likely would have come out the other way.