Reverse Veil Piercing

Under Delaware law, the doctrine of “piercing the corporate veil” has traditionally been used only in circumstances where there has been serious misconduct, and in such cases the Delaware courts have only applied this doctrine to put aside the limited liability of an entity in order to hold its equityholders or directors personally liable for the company’s actions or debts. Until recently, the Delaware Chancery Court has not taken on a case where a plaintiff sought to pierce the corporate veil in order to attach to the assets of a company’s subsidiaries, which has been referred to as “reverse veil piercing”. This changed in the case of Manichean Capital v. Exela Technologies, where the Delaware Chancery Court issued an opinion on reverse veil piercing that leaves buyers and legal practitioners wary of the potential liability of subsidiaries in veil piercing cases.

Background of Case

In Manichean, former stockholders of SourceHOV Holdings, Inc. dissented in a merger of SourceHOV with Exela Technologies, Inc. After seeking statutory appraisal of their SourceHOV shares, the former stockholders were awarded an appraisal judgment which reflected that their shares were worth well in excess of what Exela offered them in the merger. The former stockholders prevailed again on appeal, but were unsuccessful in collecting against SourceHOV and sought to collect instead against Exela and its affiliated entities (including the subsidiaries of SourceHOV). The former stockholders alleged that Exela, lacking in corporate formality, acted to prevent funds that would otherwise flow from SourceHOV’s subsidiaries to SourceHOV to instead flow directly to Exela. It was asserted that this lack of formalities resulted in SourceHOV being unable to satisfy the former stockholders’ appraisal judgment. The former stockholders also alleged that SourceHOV’s subsidiaries participated in this scheme, thus providing the former stockholders with the hook they needed to reel in the Chancery Court’s first ever reverse veil piercing case.

The former stockholders pointed to the following veil-piercing factors in their allegations: (i) Exela undercapitalized its subsidiary, and (ii) Exela failed to honor corporate separateness and subsequently attempted to divert funds away from SourceHOV in order to avoid creditor claims. The Chancery Court acknowledged that while its traditional veil-piercing factors are useful in the analysis (and that no single factor is determinative), it looks to a combination of factors and to the overall “element of injustice or fairness”.

The Chancery Court cited other courts who have declined to allow reverse veil-piercing, with such courts referencing a desire to protect innocent parties. While the Chancery Court was sympathetic to their underlying reasoning, including the risk that such cases will bypass normal judgment collection procedures by “permitting the judgment creditor of a parent to jump in front of the subsidiary’s creditors”, the Chancery Court nonetheless views reverse veil piercing as a service to the interests of equity.

Reverse Veil Piercing Analysis

The Chancery Court did note that reverse veil piercing should only be used in “exceptional circumstances” and where there is not real and substantial prejudice to third parties, otherwise the application of this doctrine could lead to unpredictable outcomes. In addition, only “outsider” reverse veil piercing is allowed, where an outside third party urges a court to render a company liable on a judgment against its member. In analyzing a reverse veil piercing case, the Chancery Court will consider the traditional veil piercing factors but will also ask whether the owner has utilized the corporate form to perpetrate fraud or injustice. Additional factors that the Chancery Court will consider (bearing in mind that as with traditional veil piercing, no single factor is determinative) include:

1. The degree to which a reverse veil piercing would impair the legitimate expectations of any adversely affected shareholders who are not responsible for the conduct in question, and the degree to which allowing the piercing would establish a precedent that is troubling to shareholders generally;
2. The degree to which the entity whose disregard is sought has exercised dominion and control over the insider subject to the claim;
3. The degree to which the injury is related to the corporate entity’s dominion and control of the insider;
4. The degree to which the public convenience would be served by allowing a reverse pierce;
5. The extent and severity of the wrongful conduct engaged in by the corporate entity whose disregard is sought;
6. The possibility that the person seeking the reverse pierce is himself guilty of wrongful conduct;
7. The extent to which the reverse pierce will harm innocent third-party creditors; and
8. The extent to which other claims or remedies are practically available to the creditor.

Key Takeaway

The Manichean case broadens the risk of inter-corporate liability, so companies and their legal counsel should be aware of the factors that Delaware courts will consider and work to prevent any reverse veil piercing that could occur. This new reverse veil piercing doctrine is still young in Delaware, so it remains to be seen how plaintiffs’ lawyers will try to push the limits of when this doctrine applies.