On Command Video Corp. v. Roti, Nos. 12-1351 and 12-1430 (7th Cir., Jan. 14, 2013)

CASE SNAPSHOT

The United States Court of Appeals for the Seventh Circuit recently overturned a District Court ruling that had permitted the claimant to pierce the corporate veil to collect on a judgment from the sole member of the judgment debtor. The case, On Command Video Corp. v. Roti, Nos. 12 1351 and 12-1430 (7th Cir., Jan. 14, 2013), arose under Illinois law, and is the latest in a line of decisions from the Seventh Circuit limiting the use of veil-piercing to situations where it is required to remedy harm resulting from fraud or inequitable conduct.

FACTUAL BACKGROUND

The plaintiff, On Command Video (OCV), supplied equipment and licensed software to hotels, motels and resorts permitting guests to watch movies and play video games from their rooms. In 2002, Markwell Hillside, a limited liability company owned by Samuel Roti, bought a Holiday Inn in a Chicago suburb. This Holiday Inn had already been a customer of OCV, and this relationship continued under Markwell Hillside’s ownership. Several years later, OCV requested that a new contract be signed in order to cover some new equipment to be installed. After Markwell Hillside identified itself as the contract counterparty, OCV inadvertently conducted a search of state corporate records for the former owner of the Holiday Inn instead.

After OCV failed to find a current listing for the previous owner, OCV informed the hotel’s manager that there was an unidentified "problem." The hotel manager mistakenly assumed that OCV meant that it had concerns about Markwell Hillside’s credit and therefore substituted Markwell Properties, another Roti-owned limited liability company, as the party to the new contract. The contract identified Markwell Properties as the owner of the hotel, even though the hotel was actually owned by Markwell Hillside. Thereafter, OCV did not conduct a credit check on Markwell Properties or seek information from Roti about Markwell Properties’ financial condition.

OCV continued to send its invoices to the hotel, although the invoices were not in the name of either Markwell entity, and Markwell Hillside continued to pay those invoices. A few days after the new contract was signed, Markwell Hillside declared bankruptcy. OCV was on notice of the bankruptcy and continued doing business with the hotel. It continued to accept payments from Markwell Hillside and later from its bankruptcy trustee, but it never filed a claim in the bankruptcy case. The trustee eventually sold the hotel, and the buyer continued paying OCV until it had a falling out with OCV and refused to assume its contract.

Collection Efforts

OCV sued Markwell Properties, the party named in its contract, in Colorado for breach of contract. This resulted in a default judgment against Markwell Properties that could not be satisfied because the entity had been dissolved with no remaining assets. OCV then filed a complaint against Roti in the Northern District of Illinois seeking to enforce its judgment personally against him through piercing the corporate veil.

OCV contended that Roti had shielded Markwell Hillside’s assets from creditors by substituting the assetless Markwell Properties on the contract. OCV also claimed that Roti had personally benefitted from this arrangement through receiving his salary as sole manager of Markwell Hillside. The District Court entered summary judgment in favor of OCV on its veil-piercing claim, and Roti appealed.

COURT ANALYSIS

Illinois Standards for Piercing the Corporate Veil

Veil-piercing claims are governed by the law of the state of organization of the entity whose veil is sought to be pierced. In this case, both Markwell entities were Illinois limited liability companies, and Illinois law therefore applied.

Illinois law, like that of a number of other states, requires that two conditions must be satisfied in order to pierce the corporate veil of a limited liability entity:

  1. The owner failed to operate it as a separate entity, neglecting such requisites of the corporate form as adequate capitalization, election of directors and officers, and separation of corporate from personal funds; and
  2. Refusing to pierce the veil would "sanction a fraud or promote injustice."

Judge Richard Posner, writing for the panel, noted that the first condition had been unquestionably satisfied, leaving only the second condition at issue. The opinion notes that whether adhering to the fiction of the corporate separateness of Markwell Properties would "promote injustice" is a "vague test . . . [that] is best understood as asking whether there has been an abuse of limited liability, as when owner of a party to a contract strips the party of assets so that if it breaks the contract the other party will have no remedy."

The Veil Had Been Pierced in the Wrong Direction

The District Court had permitted the piercing of Markwell Properties’ veil because Roti had used it "to avoid contractual responsibilities . . . ." But Judge Posner pointed out that the responsibilities that had been avoided were not Roti’s but those of Markwell Hillside. "[B]y substituting assetless Markwell Properties for Markwell Hillside on the contract, Roti did not shield his personal assets from OCV or other creditors; he shielded Markwell Hillside’s assets."

The Seventh Circuit’s opinion explained that OCV’s attempt to pierce the veil was a non-starter because Roti was "not holding assets that OCV expected to be available to pay the hotel’s debt to it." Roti had received a salary from Markwell Hillside, but there was no evidence that the salary was excessive for the work he performed. In the absence of proof that Roti had personally benefitted from using Markwell Properties to shield Markwell Hillside, there was no authority to hold him personally liable for the debts of the Markwell entities.

Judge Posner acknowledged that OCV would have had a compelling argument for a "sideways piercing" between the two Markwell companies on the theory that they were really a single business enterprise, with one entity holding all the assets and the other holding the liabilities. OCV could have filed a proof of claim against Markwell Hillside on that basis and participated in its bankruptcy as an unsecured judgment creditor, for whatever that may have been worth.

Lack of Reliance

The opinion also focuses on whether OCV was justified in relying on Markwell Properties having assets. "There is no fraud or injustice, hence no basis for piercing a corporate veil, with reliance by the would-be piercer." Particularly in the case of a contract creditor such as OCV, "[a] creditor will not be heard to complain about having extended credit to an assetless corporation if he knows or should have known it was assetless." During the contract negotiations, OCV could have taken various actions to protect itself, such as running a credit check on Markwell Properties, requiring submission of the company’s balance sheet certified by a reputable accountant, insisting that Markwell Hillside or Roti guarantee Markwell Properties’ obligations to it, but OCV did none of these things. Even after OCV learned of Markwell Hillside’s bankruptcy, it did nothing to protect its rights.

Markwell Properties had made no representations regarding its solvency one way or the other. The court acknowledged that in some instances, a party may not be in a position to determine whether it is dealing with a solvent entity. "But a person who signs a contract after months of negotiation is in a position to determine whether his counterparty is solvent, and if he makes no effort to do so, though not deflected from doing so by representations by the party he’s negotiating with, he’s on weak ground complaining if the other party turns out to be insolvent."

PRACTICAL CONSIDERATIONS

In overturning the District Court’s judgment, the Seventh Circuit clarified that veil-piercing should be permitted only with careful application of the pertinent legal standards. The decision emphasizes that a creditor has responsibility for its own credit decisions and that reliance is a critical element of veil-piercing. An extension of credit to a limited liability entity needs to be based on the understanding that there may be only limited recovery in the event of a default, in the absence of fraud or inequitable conduct that induced the creditor to justifiably rely on repayment from other sources. Accordingly, this decision reinforces the need for creditors to protect themselves by making reasonable efforts to confirm a counterparty’s financial condition and ability to pay its debts, and seeking security or guaranties where appropriate.