Protecting a New Generation of Entrepreneurs Created by the Economic Dislocations of the Pandemic Against Predatory Piercing Claims: How New Jersey Can Respond

The consequences of the COVID-19 pandemic are many. They include not just widespread disease resulting in the long-term illness and death of millions, including at least half a million in the United States, but also disruption of the economic structures in this country and elsewhere. Whether seeing new, previously-unavailable opportunities, or being forced by circumstances like loss of employment or business closure (small and large), many in the United States are forging new paths by forming small businesses of their own, operating out of their homes or in spaces left vacant by businesses, like restaurants, that have not survived lockdowns and capacity restrictions.

The organization many of these entrepreneurs employ is the limited liability company, or LLC, essentially a stripped-down version of the corporate form that grants greater freedom and flexibility to the small business owner. In struggling to make new lives for themselves out of the debris left by the pandemic, the last thing these pioneers need to concern themselves with are the myriad legal niceties typically attached to the corporate form. A good reason to turn to the LLC.

One perk of the LLC is how easy it is to form, allowing limited liability for a single-person entity where ownership, management, and operation are combined in one. But just as essential is the liability protection on the backend, when an LLC’s failure could be seen as occasion for a creditor (especially a contract creditor) to claim piercing and reach the personal assets of the owner behind the LLC. Some states enacted their LLC statutes with a provision that the failure to observe typical company formalities is not a basis for piercing the corporate veil to hold LLC members personally liable for the entity’s debts. But most states are silent on reconciling the LLC form with veil piercing. This is an area where clarity to the law would be helpful. Less public, perhaps, than stimulus measures undertaken by Congress and the states to send money to people and businesses, it is no less important to new small business owners that they be shielded from predatory lawsuits seeking to take unfair advantage of the very flexibilities LLC statutes allow and that those shields be formalized, whether by Code change or by judicial interpretation.

New Jersey’s LLC statute is silent on piercing, neither limiting its application nor incorporating corporate standards for imposing alter ego liability. But that is not the end of the story, nor should it be. New Jersey courts and practitioners should take another look, and a close one, at the comprehensive and persuasive treatment of LLC piercing law offered sixteen years ago by then-Superior Court Judge Ostrer in D.R. Horton Inc.-New Jersey v. Dynastar Development, LLC, No. MER-L-1808-00, 2005 WL 1939778 (L. Div. Aug. 10, 2005). It may also be time for the New Jersey Legislature to step in and codify the commonsense protections for small business owners set forth in Horton.

Judge Ostrer begins by giving a lay of the land on corporate veil piercing, prefacing his discussion with the conclusion “that the traditional standard for piercing a corporation’s veil must be modified to accommodate the special characteristics of a limited liability company.” Then, as now, the leading New Jersey Supreme Court case on piercing was State Dep’t of Environmental Protection v. Ventron Corp., 94 N.J. 473, 468 A.2d 150 (1983). There, the Supreme Court adopted a two-part test that had to be met before piercing the corporate veil, an extraordinary exception to the fundamental rule of limited liability. First, the plaintiff must prove that the subsidiary was a mere instrumentality or alter ego of its owner, that is, that the parent or owner so dominated and controlled the subsidiary that it had no separate existence and was merely a conduit for the parent.

Second, after satisfying the first prong, the plaintiff must prove that the parent or owner abused the privilege of incorporation by using the subsidiary to perpetrate a fraud or injustice or to otherwise circumvent the law. According to Ventron, New Jersey “courts will not pierce a corporate veil” except “in cases of fraud, injustice, or the like.” And, as New Jersey’s federal court explained in Allied Corp. v. Frola, 701 F. Supp. 1084 (D.N.J. 1988), in discussing “non-fraud circumstances that would allow a piercing of the [corporate] veil,” the Ventron Court’s focus was on “intentional conduct that is very close to fraud, such as illegality or impropriety.”

In deciding if the first prong has been met by clear and convincing evidence, courts have focused on a corporation’s failure to adhere to corporate formalities. The LLC, though, was created to eliminate many typical corporate formalities and streamline business processes. As Judge Ostrer wrote in Horton: “Lesser weight should be afforded the element of domination and control and adherence to corporate formalities, because the statute authorizing limited liability companies expressly authorizes managers and members to operate the firm.” In other words, you can’t penalize the principals of an LLC because they operated in conformance with the purpose of the LLC statute. Think of it this way: The normal operation of an LLC would usually satisfy the piercing doctrine’s alter ego factor. Members are managers are authorized agents. The liberality the LLC law allows is the very structure the piercing doctrine seems to forbid. That cannot be.

Not least of all because there is a real world out there. Quoting a commentator with approval, Judge Ostrer noted that a “small-business owner’s failure to adhere to formalities may simply reflect disregard of formalities ‘irrelevant to their actual operation,’ and lack of funds to hire lawyers and others to keep track of statutory obligations.” None of that, Judge Ostrer emphasized, “evidence[s] misuse of the [LLC] statute.” Indeed, Judge Ostrer emphasized, LLCs, designed to facilitate freedom and flexibility, have “few statutorily mandated formalities.” This “informality,” which the statute encourages, cannot be a basis for defeating limited liability.

In short, the conclusion reached in Horton is that the veil-piercing formula for limited liability companies should be molded to account for that business form’s special attributes. What was right in 2005, when Horton was decided, remains true today (and perhaps never more important). Current conditions only further support reform of the LLC piercing doctrine. The corporate veil piercing standard cannot be perfectly applied to the LLC form. In New Jersey, at least, Horton gives other courts, including New Jersey’s highest court, the tools they need to protect the integrity and utility of the LLC form that has become even more critical now than ever to survival of small business and the entrepreneurial engine of America.

Arthur F. Fergenson is a Senior Counsel in our Maryland office.
Ryan R. Corkery is a Partner in our Philadelphia office.
Heather L. Williams is an Associate in our Maryland office.