October 25, 2012

Piercing the corporate veil

Posted in Commercial Litigation, Corporate Litigation by Gene Killian |

Kertesz v. Korn is a case with a long and bitter history.  One of the written decisions relating to the case succinctly describes the background of the dispute as follows:  “Two men engaged over a period of years in a business venture that was profitable for a time but ended in insolvency and disagreement.  One of them (who was the minority owner) finally quit in order to start a similar venture at a far distant location.  Several years later, the majority owner, and the insolvent entity began a series of lawsuits, claiming rights in the new venture and breach of a number of alleged agreements…[T]he court was required to try this case for three full days…[T]he court finds that the plaintiffs’ claims factually and legally baseless and enters judgment in favor of the defendants.”

As many who have enjoyed the pleasures of litigation know, even winning is often losing.  Kertesz, the “victor” at trial but unhappy with the expense and aggravation, then brought a claim against the corporation under Section 145 of the Delaware General Corporation Law for reimbursement of his legal expenses in successfully defending the lawsuit against him.  (The New Jersey equivalent is N.J.S.A. 14:3-5.)  The statute basically allows a present or former director or officer of a corporation to recoup legal fees incurred in suits resulting from performing corporate duties.  The New Jersey Appellate Division has stated that such statutes “are intended to provide indemnification to protect persons who exercise binding managerial authority and discretion on behalf of a corporation in matters involving third parties.”  Cohen v. Southbridge Park, Inc., 369 N.J. Super. 156, 174 (App. Div. 2004).  The idea is  “to encourage capable and responsible individuals to accept positions in corporate management, secure in the knowledge that expenses incurred by them in upholding their duties will be borne by the corporation.”  Id. at 174.

The Kertesz case, however, presented a conundrum.  Kertesz wanted indemnification for the lawsuit that he had successfully defended.  But he also wanted his former co-officer, Korn, to pay the fees personally, on an alter-ego (“piercing the corporate veil”) theory.  Kertesz argued (1) that Korn had transferred corporate assets into other corporations Korn solely owned, and (2) that Korn revived the “old” corporation, which had no assets, simply to purse baseless litigation against him.  The District Court held that Kertesz’s positions were inconsistent, and dismissed the complaint, disallowing the indemnification.   On the one hand, according to the Court,  Kertesz argued that the he should be reimbursed by the corporation; yet on the other hand, he argued that the corporation was a sham.

The Second Circuit reversed, writing:  “An action to pierce the corporate veil does not deny a corporation’s legal existence…Rather, such an action charges that the corporation’s owner’s used the corporation as ‘a mere instrumentality or alter ego’ and disregarded corporate formalities.  Where a corporation’s owners abuse the corporation’s legally limited liability to effect injustice, the corporation may be ‘considered as an agency, adjunct or instrumentality of’ its owner, and a court may disregard the privilege of the corporate form to reach the owner’s assets…the claim does not affect the corporation’s legal structure or existence as against all persons…it would be perverse to hold that an abuse of the corporate form sufficient to defeat the corporate privilege of limited liability exempts the corporation from the obligation of a corporation to its officers.” (You can read the full Second Circuit decision here.)            

Of course, as the Second Circuit noted, it may be very difficult for ex-corporate officers like Kertesz actually to succeed on an alter-ego theory.  To win on such a theory, the claimant has to prove that there was a mingling of the assets of the entity and its owner, plus an overall “element of unfairness”.  A corporate officer is more likely to have inside knowledge of the corporation’s activities, which could make it tough to prove the overall injustice necessary to win on an alter-ego claim.  Nevertheless, said the Second Circuit, Kertesz should be given the chance.

All of which goes to prove a theory I’ve long held: the breakup of a closely-held corporation can be nastier and more expensive than an actual divorce.  Pick your friends carefully.  

-- Gene Killian