The law charges bankruptcy trustees and creditors with finding the debtor’s money. That task often is difficult because debtors place assets in specially designed entities. An entire industry is dedicated to creating such vehicles to protect an owner’s assets from creditor’s claims, while still providing the owner with access to those assets.
But courts are developing legal theories to thwart such plans. For example, a debtor may enlist a professional to design an asset-protection plan and create an entity. As time goes by, the debtor forgets that he and the entity are not the same. The debtor begins to views the entity’s assets his own, since he put them there and generally controls them.
Believing that the assets are protected, he begins to use them personally. If an investigation later reveals that the debtor exercised excessive control over the entity’s assets and used the entity as a sham to perpetrate a fraud, a court may deem the entity’s assets to belong to the debtor, making them available to satisfy his creditors’ claims.
Effectively representing clients in bankruptcy requires understanding the development of the theories available to trustee and creditors and an appreciation for the direction in which the law is moving.
Courts adhere to the general principle that entities and their owners are legally separate. The rationale is that economic activity is dominated by entities that are legally separate from their owners. A universal characteristic of these businesses is this: They wield the legal power to deal with their own creditors, and they shield their assets from liquidation by their owners and the claims of their owners’ personal creditors.
Shielding the entity in this way creates various benefits, most notably protecting a business’ going-concern value. Conversely, entity shielding exacts a cost. It requires debtors to subordinate claims by their personal creditors without those creditors’ consent, and it imposes high enforcement costs for such creditors wishing to challenge the entity shield.
Courts have struggled over the years to balance these benefits and costs. While Texas courts recognize that an owner and an entity are separate, they do not hesitate to ignore the entity’s form when it "has been used as part of a basically unfair device to achieve an inequitable result." In the landmark decision in Castleberry v. Branscum, et al. (1986), the Texas Supreme Court discussed situations where the courts previously had allowed creditors to "pierce the corporate veil."
Then, the Castleberry court simplified the analysis. It approved an "alter ego" theory of recovery in situations when such unity exists between a corporation and an individual that the corporation’s separateness has ceased and holding only the corporation liable would result in injustice.
The Texas Legislature partially superseded Castleberry. Lawmakers required "actual fraud" for the shareholder’s "direct personal benefit" before imposing contractual corporate liabilities. The amendments did not, however, eliminate the right to use either actual or constructive fraud to pierce the corporate veil in tort claims cases.
After Castleberry, courts continued to develop new theories to curb disfavored practices. Two of the 5th Circuit’s include "reverse corporate veil piercing," described in Zahra Spiritual Trust v. United States (1990), and "constructive trusts," set forth in In Re: Southmark Corp. (1995).
In 2012′s In Re: IFS Financial Corp., the 5th Circuit took another step. The court found that the plaintiff/creditor could, as an alternative to piercing the corporate veil, reach an entity’s property by establishing that the property actually belonged to the debtor.
To make this determination, the court employed a two-part test, with "control being the most important factor." The first part considers whether the debtor controls determination about the disposition of funds and can designate which of his creditors can be paid from the funds. The second part is whether the debtor committed fraud in connection with the diversion of funds.
The 5th Circuit adopted a sliding scale regarding the weight courts should accord to legal title and legal boundaries in cases involving allegations of fraud by the debtor: "Where . . . evidence of fraud and the debtor’s strict control are both strong, disputed legal ownership is less compelling. On the other hand, where evidence of fraud is weak, legal ownership might weigh heavier in our calculus."
In O’Cheskey v. Housing for Texans Charitable Trust, et al. (2012), the U.S. Bankruptcy Court for the Northern District of Texas permitted the trustee for a general partner to avoid transfers made by its limited partnership. In doing so, the court wrestled with the issue of when control normally exercised by a general partner becomes excessive. The court concluded that the debtor’s "unfettered discretion to pay creditors of its own choosing, including its own creditors . . . is . . . the primary consideration in determining if funds are property of the debtor’s estate."
What is the future of piercing the corporate veil in light of IFS? Protecting an entity’s going-concern value is a legitimate legal objective. However, that goal is undermined if legally sophisticated individuals design entities not to protect going-concern value but to shield their assets from their creditors’ claims. To counter such practices, courts will continue to develop new theories of recovery and employ old theories when faced by those seeking to find the money.