In an issue of first impression, the Delaware Court of Chancery held that Delaware law allows for "reverse veil-piercing" in limited circumstances. The court laid out a framework that it then used to hold subsidiary LLCs liable for an appraisal judgment that stockholders held against the LLCs’ member. A circumscribed reverse-veil-piercing rule balances the need to protect corporate separateness with a policy against allowing the corporate form to facilitate fraud or injustice (Manichaean Capital, LLC v. Exela Technologies, Inc., May 25, 2021, Slights, J.).
The plaintiffs were stockholders of SourceHOV Holdings, Inc., who dissented from a merger between the company and Exela Technologies, Inc. They launched a successful appraisal action that valued their shares substantially above the merger consideration, resulting in an appraisal judgment of nearly $58 million, plus interest. SourceHOV Holdings never paid the judgment despite a charging order entered by the Court of Chancery, and the plaintiffs’ shares were transferred to Exela despite their dissent. Arguing that Exela essentially seized the plaintiffs’ property without paying for it, the plaintiffs filed parallel actions seeking to hold Exela and its affiliated entities accountable for the appraisal judgment. Specifically, the plaintiffs asked the court to pierce the SourceHOV Holdings corporate veil both upwards, to reach Exela, and downwards to reach the solvent subsidiaries of Holdings.
The court first explained the rationale for Delaware’s appraisal right, which allows dissenting shareholders to receive fair value for their shares without holding up the transaction and thereby "holding the majority hostage to their whim." To make this work, the dissenting shareholder should actually get paid that fair value. The court thus contemplated what remedies are available if the appraisal judgment remains unpaid even after the plaintiff receives a writ of execution or, as here, a charging order.
Traditional veil-piercing. Delaware law allows traditional veil-piercing—up the chain to the parent entity—in exceptional cases. Here, the plaintiffs made a compelling case that Exela and Holdings operate as a single economic entity: first, it was reasonably conceivable that Holdings was insolvent in part as a result of Exela’s undercapitalization of the entity. Furthermore, the complaint alleged that Exela knew that dissenting shareholders would be entitled to the fair value of their shares and disclosed as much in its SEC filings, but still deliberately undercapitalized SourceHOV Holdings. The plaintiffs also alleged that the entities failed to observe certain corporate formalities such as maintaining separate headquarters and personnel or keeping proper business registrations for Holdings.
The court also found that the plaintiffs compellingly alleged that fraud and injustice resulted from diverting funds from SourceHOV to Exela by entering into an accounts receivable facility weeks before entry of the appraisal judgment in an explicit attempt to avoid payment. Although the defendants disagreed with the plaintiffs’ characterization of the A/R facility, at the motion-to-dismiss stage the court took the plaintiffs’ well-pleaded description as true and determined that it was reasonably conceivable that traditional veil-piercing would be required to avoid fraud and injustice.
Reverse veil-piercing. As to the remedy of reverse veil-piercing, the court faced an issue of first impression in that Delaware courts had yet to accept or deny litigants’ request for reverse veil-piercing. Examining other courts’ case law on reverse veil-piercing, the chancery court observed that several have rejected the concept in a desire to protect innocent shareholders and third-party creditors. Reverse veil-piercing may bypass normal judgment collection, allowing the creditor of a parent to jump in front of the creditors of the subsidiary. While these risks are real, the chancery court wrote, they do not justify the outright rejection of the remedy. Those cases that have allowed it did so mindful of the risks and placed limits on the doctrine to manage those risks.
The court accordingly set out a rule for reverse veil-piercing and specifically one applying only to "outsider" reverse veil-piercing, in which an outside third party such as a creditor urges a court to render a company liable on a judgment against its member. The court also emphasized that the doctrine should only be used in exceptional circumstances and that its framework expressly recognizes the risk to third-party creditors and innocent shareholders. Availability of outsider reverse veil-piercing should begin with the Delaware "alter ego" factors for a traditional veil-piercing claim; the court should then ask whether the owner is using the corporate form to perpetuate fraud or an injustice. This should focus on additional factors:
- the degree to which allowing a reverse pierce would impair the legitimate expectations of any adversely affected shareholders who are not responsible for the conduct of the insider that gave rise to the reverse pierce claim, and the degree to which allowing a reverse pierce would establish a precedent troubling to shareholders generally;
- the degree to which the corporate entity whose disregard is sought has exercised dominion and control over the insider who is subject to the claim by the party seeking a reverse pierce;
- the degree to which the injury alleged by the person seeking a reverse pierce is related to the corporate entity’s dominion and control of the insider, or to that person’s reasonable reliance upon a lack of separate entity status between the insider and the corporate entity;
- the degree to which the public convenience, as articulated by [the Delaware General Corporation Law and Delaware’s common law], would be served by allowing a reverse pierce;
- the extent and severity of the wrongful conduct, if any, engaged in by the corporate entity whose disregard is sought by the insider;
- the possibility that the person seeking the reverse pierce is himself guilty of wrongful conduct sufficient to bar him from obtaining equitable relief";
- the extent to which the reverse pierce will harm innocent third-party creditors of the entity the plaintiff seeks to reach; and
- the extent to which other claims or remedies are practically available to the creditor at law or in equity to recover the debt.
The case is No. 2020-0601-JRS.