Monday, July 14, 2003

One Tough Veil

With the possible exception of claims for intentional infliction of emotional distress, I doubt that there is no action that is bruited around more often and results in fewer successful prosecutions than attempts to pierce the corporate veil. The recent opinion in the case of Iceland Telecom, Ltd. v. Information Systems & Network Corp. illustrates the rather restrictive limits placed on this doctrine, particularly in Maryland.

Iceland Telecom brought the action against Information Systems & Networks Corp. ("ISN"), ISN Global Communications, Inc. ("Global"), and an individual, Arvin Malkani ("Malkani") for breach of contract and unjust enrichment. Neither ISN nor Malkani were parties to the disputed contract. Iceland Telecom sought to hold them liable for the obligations of Global via the application of the piercing the corporate veil doctrine, seeking to apply either the "instrumentality" theory or the "alter ego" theory, or because Global allegedly acted as the agent for ISN and Malkani.

To say the least, Global was operated on a fairly informal basis. It never held stockholder or director meetings. Two of the three individuals who the extant corporate documents indicated were directors (Malkani's mother and sister) apparently did not know that they were directors. ISN picked up most of Global's expenses and Malkani, Global's president, had his salary paid directly by Global. Global shared ISN's office space, with the rent being paid by ISN without any contribution from Global. Indeed, Global used ISN's phone numers, office furniture, and some of its office staff.

Significantly, in the negotiations leading up to the execution of the contract, it often appeared that Iceland Telecom was dealing with ISN. For instance, Malkani, negotiating on behalf of Global frequently referred to that company as ISN. In fact, the court specficially stated that Iceland Telecom "thought it was dealing with ISN." However, the written contract executed by Iceland Telecom identified Global as the other contracting party.

Nevertheless, the court concluded that neither the piercing the veil doctrine nor the agency doctrine applied to this case. The court emphasized that the Maryland courts had set the bar high with respect to the ability to pierce the corporate veil (quoting Dixon v. Process Corp., 38 Md.App. 644, 645 (1978) to the effect that it is a "herculean task" for a creditor to attempt to "rip away the corporate facade.") The court rejected the approach outlined in the well-known 4th Circuit case of DeWitt Truck Brokers v. W. Ray Fleming Fruit Co., 540 F.2d 681 (1976) where the court, applying South Carolina law, allowed the corporate veil to be pierced because of such factors as the lack of corporate formalities, gross undercapitalization, and the non-functioning of officers or directors other than the sole shareholder. Instead, the court concluded that, under Maryland law, nothing short of actual fraud would suffice to sustain a veil piercing effort.

Iceland Telecom's attempts to rely on an agency or an agency by estoppel theory to impose liability were similarly unavailing. Iceland Telecom had, after all, entered into a written contract that had clearly identified the other party as being Global. There was no evidence that it believed that Global was acting as ISN's agent nor that it entered into the contract upon reliance upon a belief that Global was acting as ISN's agent. Thus, neither of these two "agency" theories could apply.

Even though I've used it as authority, I've always thought that DeWitt Truck Brokers was problematic. After all, most, if not all, closely-held corporations have significant gaps in their adherence to corporate formalities. The rationale behind veil piercing should be anchored in the rational expectancies of the various actors. A plaintiff should not be able to look beyond the limited liability shield of a limited liability entity if it entered into a contract with full knowledge that there were limited liability walls in place. Only if the plaintiff suffers loss that is unexpected (e.g., being told that the entity was solvent, when, in fact, the owners were draining it of assets) should it be able to avoid the limitations in collectability that it tacitly acknowledged when it entered into the deal.

No comments: