Second Circuit Court of Appeals Evaluates Alter Ego Liability of Aircraft Fractional Owner
The issue of liability for an individual who has an ownership stake in a corporate entity that has an interest in an aircraft is one that arises in claims involving both torts and contracts. Although individuals may be most concerned with protecting their assets against liability arising out of an aircraft accident, they should not ignore that disputes arising out of purchase or leasing contracts may result in individual liability if a court pierces the corporate veil.
Piercing the corporate veil is an equitable doctrine which allows courts (1) to disregard the corporate form whenever necessary to prevent fraud and (2) to hold corporate owners liable for the obligations of the corporate entity. The doctrine applies to all business entities that limit the liability of their owners, not just corporations. Although the law varies slightly from jurisdiction to jurisdiction, a party seeking to pierce the corporate veil generally must establish that the individual dominated the corporate entity in such a way as to perpetrate an injustice against the claimant.1
The Second Circuit Court of Appeals recently rendered a decision of particular significance to owners of interests in business jets. NetJets Aviation, Inc. and NetJets Sales, Inc. (collectively “NetJets”), a lessor of fractional aircraft interests, appealed a United States District Court judgment that dismissed claims against an individual, as alter ego of LHC Communications, LLC (“LHC”), for breach of contract and account stated.2 The individual was the sole member of LHC, a Delaware limited liability company (LLC). NetJets appealed to the Court of Appeals on the basis that the District Court erred in concluding that there was not enough evidence to support claims against the individual (“Sole Member”) as LHC’s alter ego.
Background of the Transaction
In 1999, LHC entered into lease and management contracts with NetJets under which LHC leased a fractional interest in an aircraft for a five-year term and NetJets managed LHC’s interest in the aircraft by providing maintenance and piloting services. In addition to a fixed monthly rental fee, the contracts required LHC to pay NetJets’ fees for monthly management, fuel, and taxes. LHC was allotted approximately 100 hours of aircraft use per year. Approximately one year after the parties entered into the contracts, LHC terminated the agreements but failed to pay amounts due under the contracts in excess of $300,000. The contract also permitted NetJets to recover its attorneys’ fees in pursuing collection of the amounts owed under the contracts.
The District Court Decision
During the District Court litigation, NetJets moved for summary judgment on the breach of contract claims, asserting that the Sole Member was liable as LHC’s alter ego based on the frequent use of air hours by the Sole Member and his family and friends, the frequent transfer of funds between LHC and the Sole Member’s other companies, the Sole Member’s frequent withdrawal of LHC funds for his personal use and LHC’s winding down of its business. The District Court not only denied NetJets’ summary judgment motion but sua sponte (on its own accord) granted summary judgment dismissing all claims against the Sole Member.
The Second Circuit Appeal
On appeal, the Court of Appeals reversed the District Court, ruling that there was sufficient evidence to send the corporate veil piercing claim to a full trial for determination. Although the contracts were governed by New York and Ohio law, the Circuit Court applied Delaware law because LHC was a Delaware limited liability company. At the outset, the Court of Appeals noted that members generally are not liable for the debts of an LLC and that a plaintiff seeking to persuade a court to disregard the corporate form may face a difficult task. The Court of Appeals defined the standard as “whether the two entities operated as a single economic entity such that it would be inequitable for the court to uphold a legal distinction between them.” This standard is based on a two-pronged test: (1) whether the entities operated as a single economic entity, and (2) whether there is an overall element of injustice or unfairness.
Evidence of Operation as a Single Economic Entity
With respect to the first element, factors considered by a court include the control and use of the entity, adequate capitalization, solvency, the payment of dividends or other distributions of the assets of the company and the existence of proper company records. Although the observation of corporate formalities is also utilized when the entity is a corporation, the Court of Appeals noted that less emphasis is placed on this factor with respect to an LLC because fewer formalities are normally required.
The use of air hours by the Sole Member was an important element in the Court of Appeals’ analysis of whether the LHC and its sole member operated as a single entity. The evidence indicated that of the approximately 40 flights invoiced by NetJets, at least 12 were either for the Sole Member’s personal vacations or had no relationship to LHC’s business. Other evidence before the Court demonstrated that LHC was originally capitalized with approximately $20,000 and that the Sole Member deposited and withdrew money in accordance with his needs and not the needs of the LLC. For most of its operating life, LHC shared office space with other companies owned by the Sole Member, and some of the employees worked for both LHC and the other companies.
Although LHC had a chief financial officer, that individual was paid by the Sole Member or another one of the companies, and ran LHC’s day-to-day operations based on instructions from the Sole Member. Ultimate decisions concerning LHC’s investments were always made by the Sole Member. For most of its existence, LHC’s operations consisted only of making investments for the Sole Member and carrying on the member’s personal business. Each of the transfers of money between LHC and the Sole Member were labeled “loan receivable” in LHC’s ledger regardless of the actual use of the money, and there were no written agreements regarding any of these loans. The Court concluded: “This evidence is ample to permit a reasonable factfinder to find that [the Sole Member] completely dominated LHC and that he essentially treated LHC’s bank account as one of his pockets, into which he reached when he needed or desired funds for his personal use.”
Evidence of Fraud, Illegality, or Injustice
The Court of Appeals made two important points that contradicted the District Court’s reasoning for dismissing NetJets’ claim. First, it stated that a plaintiff does not need to prove that the corporate entity was created with fraud or injustice in mind – it merely needs to prove that the corporate entity was used for such purposes. Second, contradicting the District Court’s holding that the element of fraud/unfairness requires its own evidence, the Court of Appeals held that a court may use overlapping evidence to determine both single entity operation and fraud/unfairness. The Court of Appeals stressed, however, that the underlying cause of action, such as breach of contract in this case, does not supply the necessary fraud or injustice.
The Court determined that a reasonable factfinder, in addition to drawing the inference that the Sole Member’s payments were mischaracterized as loans to mask withdrawals, could determine that the Sole Member operated the LLC in his own self-interest in a manner that disregarded the rights of its creditors. For instance, although LHC was unable to make its contract payments to NetJets, the LLC bought and gave the Sole Member title to a $350,000 automobile. And in the year-and-a-half following the contracts’ terminations, the Sole Member withdrew $750,000 more than he deposited into the company.
The Court of Appeals decision was not an ultimate victory for either party. Although finding that the District Court should not have entered summary judgment dismissing NetJets’ claims against the Sole Member, the Court of Appeals rejected NetJets’ contention that the evidence entitled NetJets to summary judgment in its favor. Instead, the Court of Appeals remanded the case to the District Court to make additional factual findings.
Interest Holders in Aircraft Should Take Certain Steps to Prevent a Court From Disregarding the Corporate Form
The NetJets case demonstrates that veil piercing is a fact-driven exercise. Stripped to its core, alter ego liability rests on whether it is fair for the interest holder in the corporate entity to stand apart from the corporate entity itself. Thus, sole members of LLCs or other limited liability entities, such as interest holders in business jets, may be subjected to extensive discovery concerning their relationship with the corporate entity, particularly in cases where the company cannot repay its debts.
To ensure the viability of the corporate form, adherence to good corporate practices is essential. The mere formation of a corporate entity, whether a large public company or closely-held corporation, is not enough. The individual should avoid using the corporate entity’s bank account for personal expenses, and should properly document all transfers of funds in and out of the corporate entity. Accounting for assets and corporate records cannot be an ex post facto exercise contemplated after a claim of alter ego has already been made.
1 In addition to assessing liability against an individual, a court may pierce the corporate veil to assess liability against one corporate entity that dominates another corporate entity.
2 The District Court granted NetJets’ motion for partial summary judgment for account stated but denied summary judgment on NetJets’ breach of contract claim against LHC. NetJets also appealed that denial. This article focuses on the aspect of the appeal pertaining to the alter ego claim against the individual.