Back to Newsletter

Reverse Piercing of the Corporate Veil

In 2008, the California courts first considered the theory of "outside reverse piercing of the corporate veil," which I have decided (perhaps with a bit of tongue in the cheek) to abbreviate herein as ORP. The Court of Appeal for the Fourth Appellate District refused to adopt ORP in Postal Instant Press, Inc. v. Kaswa Corporation, 200 Call App LEXIS 753 (May 20, 2008).

In 1998 two individuals, Rangoonwala and Ahmed, purchased a PIP francise from a franchisee and PIP consented to the assignment of the franchise. The individuals formed Kaswa Corporation and requested the consent of PIP to replace Rangoonwala as the franchisee, but such consent was not granted. In a later dispute between PIP and Rangoonwala, an arbitrator ruled in favor of PIP in the amount of approximately $77,000, and the trial court confirmed the award. In a subsequent judgment debtor's examination of Rangoonwala, he testified that Kaswa had been formed to operate the PIP franchise, that Kaswa owned the franchise assets, that Kaswa had merged in 2002 with another company, owned by Michael Haxton, that the resulting company retained the name Kaswa and continued to operate the PIP franchise, and that Rangoowala no longer owned shares of Kaswa, although he still received monthly draws of $2,600 for several years. Haxton testified that Kaswa sold its assets in August 2005 to other third parties for $300,000, payable $50,000 at closing and the balance in 31 monthly installments.

Kaswa then sought to amend its judgment against Rangoonwala to include Kaswa as a judment debtor. After analyzing cases both following and rejecting ORP, the Court of Appeal reversed the amended judgment against Kaswa.

Normally, the shareholders of a corporation are not liable for the corporation's obligations. However, in certain circumstances, generally involving the corporation acting as an "alter ego" for the shareholder, the "corporate veil" will be disregarded - that is, "pierced" - so that the claimant(s) can directly pursue the shareholder for the obligations of the corporation. The test for the traditional piercing of the corporate veil in California was stated by another California Court of Appeals in 2000:

First, there must be such a unity of interest and ownership between the corporation and its equitable owner that the separate personalities of the corporation and the shareholder do not in reality exist. Second, there must be an inequitable result if the acts in question are treated as those of the corporation alone."

_{Sonora Diamond Corp. v. Superior Court, 83 Cal. App. 4th 523, 538 (2000).}

The court went on to enumerate some of the factors to be considered in applying the alter ego doctrine, including the commingling of funds and other assets, inadequate capitalization, and disregard of corporate formalities. The court warned, however, that "No one characteristic governs, but the courts must look at all the circumstances to determine whether the doctrine should be applied." Id.

One variant of the standard alter ego doctrine that has been adopted by some courts, including Colorado, is third party or "outside" reverse piercing of the corporate veil. In such an instance, the corporate veil is pierced "outside in" to permit a creditor of a shareholder to reach the corporation's assets to satisfy claims against the shareholder. (This differs from "inside reverse piercing," in which an insider of the corporation seeks to pierce the corporate veil.) The Court of Appeal noted that there in fact have been cases in California in which a corporation was held liable for the obligation of a shareholder, but these cases used the traditional alter ego doctrine rather than ORP to accomplish this. See, e.g., Taylor v. Newton, 117 Cal.App.2d 752 (1953); NEC Electronics Inc. v. Hurt, 208 Cal.App3d 772 (1989).

The Court of Appeal agreed with other courts rejecting the ORP doctrine that there were several significant problems with the doctrine: (1) it bypasses normal judgment-collection procedures, whereby judgment creditors attach the judgment debtor's shares in the corporation and not the corporation's assets; (2) to the extent the corporation has other, non-culpable shareholders, they will be prejudiced if the corporation's assets could be attached directly; (3) existing legal remedies adequately protect creditors from fraud, such as fraudulent conveyance of assets, respondeat superior, aiding and abetting, and agency law; and (4) the prospect of losing out to an individual shareholder's creditors will unsettle the expectations of corporate creditors.

The Court of Appeal noted that traditional piercing of the corporate veil is justified as an equitable remedy when shareholders have abused the corporate form to evade individual liability. In contrast, there is no similar abuse of the corporate form in OPR cases. The court concludes:

The true issue that ourside reverse piercing seeks to address is not the misuse of the corporate form to shield the shareholder from personal liability. Rather, the issue addressed by outside reverse piercing is the shareholder's transfer of personal assets to the corporation to shield the assets from collection by a creditor of the shareholder. In other words, outside reverse piercing seeks to protect the judgment creditor from the shareholder's fraudulent transfer of assets to the corporation. But…conversion and fraudulent conveyance already afford judgment creditors protection in that situation.

_{PIP, supra, at 14-15.}

Since there was no need for the ORP doctrine, the Court of Appeal rejected it. In doing so, the Court noted that counsel for PIP had acknowledged during oral argument that it amended the judgment to add Kaswa as a judgment debtor instead of seeking its other legal remedies because this was "simply more expedient." Id. At 15.

_{Mr. Swanson is a corporate and securities law attorney who has been involved with the CCBA for more than 20 years. In 2008, Mr. Swanson was a recipient of the CEB "Spirit of CEB" award for his many years of service to CEB as a speaker and author. He can be reached at etswanson@att.net.}

Back to Top

Back to Newsletter