Forming a Shell Company to Avoid Paying Rent Sufficient to Pierce the Corporate Veil

• Posted on: Dec 14 2022

By: Jeffrey M. Haber

In commercial and business litigation, it is common for plaintiffs to assert claims against a business entity for wrongs committed by the entity. Often, plaintiffs will try to “pierce the corporate veil,” or get behind the corporate form, to hold the entity’s officers or members liable for the alleged wrongdoing. Since a plaintiff must show that an officer or member used his/her control over the entity to commit a fraud or other wrong against the plaintiff, it is not unusual for a plaintiff to try to pierce the corporate veil in a case involving some form of wrongdoing. Such was the case in 134 Emmut Props. LLC v. Galaxy Light. 136, Inc., 2022 N.Y. Slip Op. 07026 (1st Dept. Dec. 13, 2022) (here), where the Appellate Division, First Department granted the plaintiff’s motion to amend its complaint to add, inter alia, a veil piercing claim against the individual defendants for opening a judgment proof shell company to avoid paying rent.

134 Emmut Props. was an action to recover sums due from defendant Galaxy Lighting 136 Inc. (the “Company”) as rent under a commercial lease that was signed by defendant Yuan Sheng Situ (“Yuen”), as president of Galaxy.

According to the complaint (which primarily serves as the source for the factual discussion herein), the parties signed the lease in August 2018 (“Lease”). Galaxy was listed as a tenant in the Lease.

Plaintiff alleged that Yuen’s sister, defendant Su Hua Situ (“Su”) negotiated the Lease and was actively involved in the Company’s daily operations. Su allegedly was the sole person who corresponded with and dealt with plaintiff in operating the Company. In fact, according to plaintiff, Su was seen and observed by plaintiff’s representatives occupying and operating the Company’s business within the premises.

According to plaintiff, upon occupying the premises, the Company immediately breached the terms of the Lease by failing to make rental payments and additional late fees. As a result, in August 2019, plaintiff filed and served a non-payment petition against defendants for default in rent arrears. Following the filing of defendants’ answers, the parties settled the proceeding, granting plaintiff a warrant of eviction to regain legal possession of the premises.

The settlement severed all monetary claims that plaintiff had against defendants. The stipulation of settlement specifically reserved plaintiff’s monetary claims against defendants for unpaid rent, late fees, and incurred attorneys’ fees. 

Thereafter, plaintiff filed an action in Supreme Court, New York County. The complaint asserted claims for breach of contract and attorney’s fees.

The Company and Su moved to dismiss. Plaintiff opposed the motion and moved to amend the complaint to add Yuen and a claim for veil piercing against the individual defendants. The motion court denied the motion to dismiss and granted the motion to amend.

On appeal, the First Department unanimously affirmed.

“Generally, a plaintiff seeking to pierce the corporate veil must show that (1) the owners exercised complete domination of the corporation in respect to the transaction attacked; and (2) that such domination was used to commit a fraud or wrong against the plaintiff which resulted in plaintiff’s injury.”¹ 

The first factor – domination and control over the entity – can be shown by, among other things: (1) the failure to adhere to corporate formalities (such as, making important corporate decisions without recording them in minutes of a meeting); (2) inadequate capitalization (that is, the company never had sufficient funds to operate; it was not a separate entity that could stand on its own); (3) a commingling of assets; (4) one person or a small group of closely related people were in complete control of the company; and (5) use of corporate funds for personal benefit (e.g., the owner or member pays his/her personal bills from the business bank account).² No one factor controls the consideration.³

The second factor allows courts to pierce the corporate veil where the shareholder/owner uses the corporation “to commit fraud [or other wrong], or violate other legal duty, or has been used to do an act tainted by dishonesty or unjust conduct violating plaintiff’s rights or … where such fraud or wrong results in unjust loss and injury to plaintiff ….”⁴ It is not necessary, however, for there to be an alleged fraud.⁵ Rather, it is sufficient that the alter ego “through their domination of the corporation, ‘abused the privilege of doing business in the corporate form to perpetrate a wrong or injustice against [the aggrieved party] such that a court in equity will intervene.’”⁶ 

In fact, in Wm. Passalacqua Builders Inc. v. Resnick Developers South, Inc., the court held that it would be error to instruct a jury “that plaintiffs were required to prove fraud” to pierce the corporate veil, stressing that the “critical question is whether the corporation is [a] ‘shell’ being used by the [shareholders/LLC members] to advance their own purely personal rather than corporate ends.”⁷

Applying the foregoing principles, the First Department in 134 Emmut Props. held that the facts alleged in the amended complaint sufficed to state a claim for veil piercing against the individual defendants. The Court found that “[t]he amended complaint permit[ted] an inference of corporate abuse by the individual defendants” in so far as it alleged that the Lease, which “Su negotiated on behalf of Yuan and defendant Galaxy Lighting 136, Inc. resulted in inequitable consequences” – that is, plaintiff was harmed because “defendants failed to pay plaintiff any rent for approximately one year, from the date they occupied the premises until the time plaintiff regained possession.”⁸

Notably, the Court found that the affidavits submitted by plaintiff in connection with its motion supported the allegation of control and wrongful conduct:

The affidavits and supporting text messages and emails submitted as exhibits to plaintiff’s motion identify Su as the person plaintiff’s agents communicated with to negotiate the lease. In addition, plaintiff’s affiants personally observed Su at Galaxy on almost a daily basis. The affidavits further allege that Su and Yuan conspired to perpetrate a wrong by opening a judgment proof shell company, Galaxy, to avoid paying rent.⁹ 

[Ed. Note: this Blog examined veil piercing on numerous occasions. E.g., here, here, here, and here.]

Takeaway

Business owners and entrepreneurs wishing to insulate themselves from personal liability for the acts taken in the name of their business can generally do so by forming a corporation (e.g., C-Corp. or an S-Corp.) or limited liability company. Such protection, however, is not absolute; there are exceptions to the rule. For instance, a creditor or other third party can “pierce the corporate veil” – i.e., go behind the corporate form – to hold an officer, director, or shareholder liable when he/she fails to follow corporate formalities, comingles corporate funds with personal funds, or perpetrates a fraud or other wrongdoing on a third party.

In 134 Emmut Props., plaintiff was able to pierce the corporate veil despite the absence of a fraud claim. As the First Department held almost a decade ago: “While fraud certainly satisfies the wrongdoing requirement, other claims of inequity or malfeasance will also suffice.”¹⁰ Thus, for example, courts will disregard the corporate form where the defendant abuses it to avoid a corporate obligation. In 134 Emmut Props., avoiding the payment of rent by forming a shell company is an example of such conduct.¹¹

Footnotes

1. Conason v. Megan Holding, LLC, 25 N.Y.3d 1, 18 (2015) (internal quotation marks omitted); TNS Holdings v. MKI Sec. Corp., 92 N.Y.2d 335, 339 (1998).
2. Shisgal v. Brown, 21 A.D.3d 845, 848 (1st Dept. 2005) (internal citation omitted).
3. Tap Holdings, LLC v. Orix Fin. Corp., 109 A.D.3d 167, 174 (1st Dept. 2013).
4. Lowendahl v. Baltimore & Ohio R.R. Co., 247 A.D. 144, 157 (1st Dept.), aff’d, 272 N.Y. 360 (1936); Morris v. N.Y. State Dept. of Taxation & Fin., 82 N.Y.2d 135, 141 (1993).
5. Gorrill v. Icelandair/Flugleidir, 761 F.2d 847, 853 (2d Cir. 1985). Although it is not necessary to allege fraud, the plaintiff must, nevertheless, allege “particularized statements detailing … [the] corporate misconduct” by the individuals in control of the corporation. Sheridan Broadcasting Corp. v Small, 19 A.D.3d 331, 332 (1st Dept. 2005) (internal quotation marks omitted); see also TNS Holdings, 92 N.Y.2d at 339.
6. JSC Foreign Econ. Assoc. Technostroyexport v. Int’l Dev. and Trade Servs., Inc., 386 F. Supp. 2d 461, 465 (S.D.N.Y. 2005) (quoting, Morris, 81 N.Y.2d at 142).
7. Wm. Passalacqua Builders Inc. v. Resnick Developers So., Inc., 933 F.2d 131, 138 (2d Cir. 1991).
8. Slip Op. at *1.
9. Id.
10. Baby Phat Holding Co., LLC v. Kellwood Co., 123 A.D.3d 405, 407 (1st Dept. 2014) (“Allegations that corporate funds were purposefully diverted to make it judgment-proof or that a corporation was dissolved without making appropriate reserves for contingent liabilities are sufficient to satisfy the pleading requirement of wrongdoing which is necessary to pierce the corporate veil on an alter-ego theory.”).
11. Godwin Realty Assocs. v. CATV Enters., Inc., 275 A.D.2d 269, 270 (1st Dept. 2000); 9 East 38th St. Assocs. v. George Feher Assocs., Inc., 226 A.D.2d 167, 168 (1st Dept. 1996) (finding alleged fraudulent conveyance of corporate assets to avoid the corporation’s obligations under a lease sufficient for veil piercing).

Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.