What is the Alter Ego Doctrine and How Does it Affect Personal Liability for Officers, Directors, and LLC Members?

What is the Alter Ego Doctrine and How Does it Affect Personal Liability for Officers, Directors, and LLC Members?

The California Court of Appeals reversed a judgment of a multimillion dollar arbitration award against two individuals who weren’t signatories to their companies’ arbitration agreement.

The Court said that findings by an arbitrator of wrongful conduct by the limited liability companies (LLCs) were entitled prevent re-litigation when the lender tried to amend the judgment confirming the award to add two managing members as judgment debtors under an alter ego theory (The alter ego is a legal doctrine in which a court determines that a company lacks a separate identity from an individual or corporate shareholder, and is explained in detail below).

Background

A number of tribal lending entities of the Big Lagoon Rancheria (a federally recognized tribe of Yurok and Tolowa Indians) were formed to market and service small-dollar, short-term loans made over the Internet.

In 2013, they retained certain LLCs to manage their online lending programs. Under the agreements, the LLCs were the executive directors of the lending entities and were responsible for running their day-to-day operations. In 2017, after the parties' relationships began to deteriorate, the LLCs began winding down the loan portfolios.

About this time, the LLCs are said to have allegedly implemented a “remarketing program” in which they told loan customers the tribe would no longer be making loans and persuaded them to continue borrowing from new lenders not affiliated with the tribe. These competing loan portfolios’ managing members were the defendants, Mark Koetting and Daniel Koetting.

In January 2018, the tribal lending entities terminated the agreements and told the LLCs not to make any payments to themselves or third parties of any money derived from the lending partnership. Demands for arbitration were filed, and after a hearing, the arbitrator issued an award in favor of the tribal lending entities.

The arbitrator found that the Koettings wrongfully caused the LLCs to continue to pay themselves after the tribal lending entities ended the agreements. The arbitrator further ruled that the Koettings were jointly and severally liable with the LLCs as their alter egos. The arbitrator awarded million dollars in damages. The defendants moved for modification of the final award, arguing that the Koettings weren’t proper parties to the arbitration and that the trial court, not the arbitrator, must decide whether non-signatories may be required to arbitrate. They also challenged the amounts of the final award. The arbitrator denied the motion.

After confirming the arbitration award with the trial court and denying a motion to vacate the award, the court entered judgment in favor of the tribal lending entities. After an unsuccessful appeal from the judgment, on remand, the trial court vacated the arbitration award as to the Koettings but confirmed the award as to the LLCs. The tribal lending entities assigned the judgment to JPV, and it filed a motion under Code of Civil Procedure section 187 to amend the judgment to add the Koettings as judgment debtors under an alter ego theory.

The Decision of the Court of Appeals

Acting Presiding Judge Carin T. Fujisaki explained that the alter ego doctrine arises when a plaintiff claims that an opposing party is using the corporate form unjustly and in derogation of the plaintiff's interests. In certain situations, the court will disregard the corporate entity and hold the individual shareholders liable for the actions of the corporation. Under both California and Delaware law, the alter ego doctrine extends to LLCs. The plaintiff must demonstrate two elements:

  1. A unity of interest and ownership such that the separate personalities of the corporation and the individual do not exist; and
  2. An inequitable result if the corporate identity is not disregarded.

Turning to the tribal lending entities’ main contention that the trial court erred in its application of California law to the facts by failing to consider all circumstances relevant to the alter ego inquiry, including the arbitral findings that the LLCs wrongfully diverted the Tribal lending entities' customers to the Koettings' other entities, Judge Fujisaki examined the following factors:

1. Control of Underlying Litigation and Representation. The judge said there was no dispute that the Koettings had control of the arbitration and were represented in it: they personally attended the arbitration proceedings, submitted sworn declarations, testified, and were represented by counsel at all times.

2. Unity of Interest and Ownership. Among the many factors relevant in applying the alter ego doctrine are:

  • An individual’s ownership of all stock in a corporation;
  • The use of the same office or business location;
  • Commingling of funds and other assets of the individual and the corporation;
  • An individual holding out that he is personally liable for debts of the corporation; identical directors and officers;
  • A failure to maintain minutes or adequate corporate records;
  • Disregard of corporate formalities; absence of corporate assets and inadequate capitalization;
  • The use of a corporation as a mere shell, instrumentality or conduit for the business of an individual;
  • The use of the corporate entity to procure labor, services or merchandise for another person or entity; and
  • The diversion of assets from a corporation by or to a stockholder or other person or entity, to the detriment of creditors.

Judge Fujisaki explained that no one factor is determinative, and instead a court must examine all the circumstances to determine whether to apply the alter ego doctrine. The judge said that the trial court's order made the following findings in denying the alter ego amendment:

  • The LLCs' failure to observe corporate formalities “for meetings” was inconsequential because there was no evidence that the LLCs' articles or operating agreements required such formalities;
  • The declarations of accountants that established that the LLCs were adequately capitalized and complied with the law for LLCs, “including maintaining current registration”; and
  • There was no personal use of LLC assets.

The trial court also observed that the tribal lending entities didn’t get personal guarantees by the Koettings.

Based on this, the tribal lending entities said it was clear the trial court didn’t consider “all the circumstances” relevant to the alter ego inquiry, including the arbitral findings regarding the LLCs that were entitled to collateral estoppel effect. The tribal lending entities also highlighted part of the order that stated the court wouldn’t consider the arbitrator's findings as to the Koettings' alter ego liability. They contended the statement was ambiguous as to whether the court disregarded only the arbitrator's specific alter ego findings against the Koettings, or whether it refused to consider any of the arbitrator's findings in ruling on the section 187 motion. The tribal lending entities maintained the latter interpretation was more likely given that the rest of the court's order didn’t address or even mention any of the arbitrator's findings.

The Koettings argued that the trial court's order wasn’t ambiguous because the court made clear it was disregarding only the arbitrator's alter ego findings, and properly so, in light of the partially vacated judgment.

Judge Fujisaki and the Court of Appeals assumed the trial court considered all circumstances relevant to the alter ego inquiry that were presented by the parties on the section 187 motion. However, the Court concluded that the tribal lending entities’ remaining arguments had merit and sufficiently undermined its confidence that the trial court's ultimate decision reflected “a legally correct exercise of its discretion.”

The trial court found that one of the LLCs complied with California and Delaware law for LLCs, including maintaining current registration. But as the tribal lending entities pointed out, the evidence was undisputed that the LLC failed to maintain valid registration in Delaware from July 2015 through September 2018 due to its lack of a registered agent. The trial court finding that this LLC maintained current registration at all relevant times was thus unsupported by substantial evidence. In addition, the trial court also found there was “no personal use of LLC assets.” However, the Court of Appeals concluded the evidence on the motion, combined with the binding arbitral findings as to the LLCs, didn’t support a finding of “‘no personal use of LLC assets’” by the Koettings.

The Court of Appeals concluded the trial court misunderstood and misapplied the proper scope of its discretion in evaluating the inequitable result element of the alter ego doctrine, which constituted an abuse of discretion. As a result, the trial court order was reversed. (JPV I L.P. v. Koetting, Court of Appeal of California, First Appellate District, February 7, 2023).

Bottom Line

In determining the personal use of LLC assets and personal liability of individuals, courts may apply the alter ego doctrine that says a company lacks a separate identity from an individual or corporate shareholder. The court will then ignore the corporate status of stockholders, officers, directors, or LLC managing members (as was the case here) concerning their protection from personal liability.

This is known as “piercing the corporate veil” to hold individual shareholders personally liable for debts of the company.

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