This Case Arises From Property In Cambria, CA
The legal theory known as reverse veil piercing posits that the assets of the BKS entities would be available to satisfy the judgment against their owner. This theory is distinguished from, and is the exact flip-side of, traditional veil piercing, which means that the liability of an entity would be extended to its owner so that its owner’s assets would be available for collection. Both theories are really just another way of saying that the owner of an entity is it’s legal alter ego, and the courts of most states have discarded any distinction between reverse and traditional veil piercing and simply looked at whether the legal barrier between the entity and its owner should be disregarded for purposes of getting to a just and equitable result.
The California Court of Appeals decided to go the other route, probably to nobody’s particular surprise since the land of fruits and nuts seems to sometimes carry a connotation that is legal as well as agricultural, and in Postal Instant Press, Inc. v. Kaswa Corp. 162 Cal.App.4th 1510 (2008) (commonly referred to as “PIP“), held that California would not recognize reverse veil piercing largely on the grounds that there is no need for the theory ? at least as it relates to corporations ? since, among other things, the creditor could simply levy and liquidate the debtor’s interest by way of a judicial sale of the debtor’s corporate shares. Nonetheless, the PIP court mused in its opinion that it might someday have to revisit the issue of reverse veil piercing in the circumstance of a single-member limited liability company.
Revisit the issue the Court of Appeals did, less than a decade later and this time with a different panel of judges in Curci Investments, LLC v. Baldwin, 14 Cal.App.5th 214 (2017). The Curci court instead seized on the small gap in the doorway left by the PIP court and held that reverse veil piercing could be used in appropriate circumstances to add a limited liability company to a judgment where the judgment debtor was the sole member of that LLC — or, actually an LLC that was 99% owned by the judgment debtor and 1% owned by his wife.
Having chipped away at the PIP opinion with a ruling that a 99/1%-owned LLC could be the alter ego of its owner, it was then of course just a matter of time before yet another Court of Appeals has nudged the reverse veil piercing door just a little further back in the case that follows.
Bernd Schaefers and his wife Karen were married in 1981, and signed a separation agreement in 1986. Nonetheless, five years later the couple formed two limited liability companies known as the BKS entities, with Schaefer owning a 50% interest and Karen owning a 50%. Later, in 2019, Karen would file a complaint in New Jersey, where she lived, seeking a dissolution of her marriage to Schaefer.
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Meanwhile, in 2005, one of the two BKS entities, BKS Cambria LLC, with Schaefers being its manager, purchased 34 acres of land in Cambria, California, which is located on California’s central coast just a few miles down from the Hearst Castle in San Simeon. Schaefers and his son lived on the property, some of which was leased to wireless carriers for cell phone towers.
Fast forward now to 2017, when a Kansas jury awarded $3.825 million in fraud damages against Schaefers and other defendants arising out of a project to reduce old tires to energy by, essentially, melting them down and then using the residue as fuel, but which project apparently melted itself down and left Blizzard Energy, Inc., as angry residue in the form of a judgment creditor. Blizzard Energy immediately domesticated the judgment to California, and sought to enforce the judgment against Schaefers. After a few years of skirmishing, in June 2019, Blizzard Energy moved the California Superior Court for San Luis Obispo County to amend the judgment so as to add the two BKS entities as the alter egos of Schaefers under the aforementioned theory of reverse veil piercing.
The following month, July 2019, Schaefers filed for Chapter 11 bankruptcy protection to try to keep the Superior Court from hearing the motion to amend, but in September of that same year the bankruptcy court granted Blizzard Energy leave from the automatic stay so that the motion could be heard. And heard it was, in February 2020, with the Superior Court granting the motion to amend and adding BKS Cambria LLC to the judgment, as well as BK Energy LLC which was the other of the BKS companies. Schaefers appealed, and this led to the published opinion of the California Court of Appeals which shall next be discussed.
Schaefers argued that since Blizzard Energy had simply registered its judgment in California, as opposed to bringing a new lawsuit on the Kansas judgment, Blizzard Energy had waived any right to amend the judgment in any way, including to add the BKS companies as additional judgment debtors. This argument flopped, with the Court of Appeals basically stating to the effect that a judgment is a judgment is a judgment, and a judgment which exists by way of registration may be amended like any other. But the court also noted that when a creditor seeks to amend a judgment to add an alter ego defendant, what it is really doing is just adding another name of the judgment debtor, being that of the judgment debtor’s alter ego.
The next argument made by Schaefers was a common one, and one which is commonly rejected by the courts, being that alter ego should not be allowed because the charging order statute itself mandates that the charging order be the “exclusive remedy”. Indeed, if we look at ? 17705.03(f) of the California Revised Uniform Limited Liability Company Act (“RULLCA”), we see the following:
“(f) This section provides the exclusive remedy by which a person seeking to enforce a judgment against a member or transferee may, in the capacity of judgment creditor, satisfy the judgment from the judgment debtor’s transferable interest.”
At first glance, this would seem to support Schaefers’ position rather strongly. As it usually is, however, the devil is once again found in the details. For starters, “exclusive remedy” is quite different than “exclusive outcome” as the term remedy has a specific meaning that relates to certain categories of relief that may be afforded to a litigant by a court. If something is not technically a remedy, then the exclusivity of the section does not apply.
Next is the phrase “satisfy the judgment from the judgment debtor’s transferable interest”, which means that the creditor is trying to do something against the debtor’s interest in the LLC itself, as opposed to doing something against the assets of the LLC which of course is entirely different.
Citing to the Curci opinion, which is mentioned at the top of this article, the Court of Appeals noted that the “exclusive remedy” language simply has no application in an alter ego challenge. The purpose of an alter ego challenge is to disregard the separate legal nature of the LLC so as to allow a creditor to get at the LLC’s assets, not to do anything with the debtor’s membership interest in the LLC. Thus, Schaefers’ argument failed.
Schaefers’ next argument was not as bad as his exclusivity argument, but it was still pretty bad. This argument is based on one of the oldest tenets of Anglo-American law, which is that an equitable remedy is not available to a party who can be satisfied by a legal remedy. This actually goes back to the very long period of time (roughly 1100 to 1900 A.D.) when there were separate courts of law and courts of equity, and the chancery courts (equity) would not interfere with the courts of law so long as they could get the job done. In modern day, however, most U.S. states and the federal courts have “merged” law and equity into single courts, and although the distinction still technically exists between law and equity, the aforementioned tenet doesn’t carry anywhere near the weight that it once did.
As argued here by Schaefers, since Blizzard Energy could get the legal remedy of a charging order against Schaefer’s interests in the BKS companies, there was no need for the equitable remedy of alter ego to give Blizzard Energy relief. The court, however, saw right through this argument and pointed out that if Blizzard Energy got a charging order then it would be stuck waiting for distributions from the BKS companies which might never be made, and thus never receive any satisfaction on its judgment for a long period if ever. The court also pointed out that is exactly why alter ego was allowed in the Curci case. But even further, Schaefers had made a serious blunder when he wrote a letter to his accountant, recalling that there is no privilege for client-accountant communications outside of tax law:
“Respondent did not have an adequate legal remedy. Schaefers had filed for bankruptcy protection, and he intended to make it as difficult as possible for respondent to collect on the Kansas judgment. In a letter to his accountant dated August 5, 2018, Schaefers wrote: ‘[T]he only asset I have at this moment is my 50% interest in the 2 BKS companies [BKS Cambria and BKS Energy]. [?] … In case we lose in the Kansas appeal, the worst thing that can happen [is] that they get a charging order for my interests…. [T]hey will get nothing, because the LLCs will not make distributions for a long time and I will stay on as manager and I will then appoint my successor as manager.’ The trial court found that ‘that there is in fact evidence of bad faith and attempts to avoid paying this judgment, including the letter to Schaefers’ accountant.’ “
All this finally brings us to Schaefers’ main argument, which was that BKS Cambria LLC (the entity which held the Cambria property) was not his alter ego. To win on this issue, Blizzard Energy had to prove the existence of two conditions:
. First, a unity of interest and ownership between Schaefers and BKS Cambria LLC such that the separate personalities of the LLC and Schaefers did not exist; and
. Second, that an inequitable result would occur if the acts in question were treated as those of Schaefers alone.
There is actually some difficulty by the court in the writing of its opinion, which I am going to try to spare you by paraphrasing the court as necessary, because the vast bulk of alter ego decisional law derives from opinions involving corporations and which sometimes is not easily translated to limited liability companies.
Anyway, the court took up the first condition of the unity of interest and ownership and noted the Superior Court’s finding that Schaefers had “used BKS Cambria’s bank accounts as if they were his own personal accounts.” While Schaefers claimed that he was entitled to a $2,500 per month stipend for managing BKS Cambria’s property, the court noted that the account had been used to pay Schaefers’ taxes, and taxes and fees for other companies associated with Schaefers and his wife, moneys from BKS Cambria were loaned to other defendants in the Kansas litigation, and also were used to pay attorney’s fees and other litigation expenses in Kansas.
Moving on to the second condition, that respecting the legal separateness of BKS Cambria LLC would lead to an unjust result, the court noted that Schaefers’ wife Karen had moved to intervene in the Superior Court case to challenge the motion to add the BKS entities to the judgment, on the basis that she was not a judgment debtor but held a 50% interest in the entities, i.e., she would suffer negative consequences if the judgment was amended. Karen’s argument was that she and Schaefers had been physically separated since 1996, and the money which funded BKS Cambria LLC came from the sale of her personal real estate in New Jersey.
However, the Superior Court had not allowed Karen to intervene because the property was presumptively community property and thus available to the creditors of either spouse, including Blizzard Energy. The Superior Court also noted that despite having signed a separation agreement, the couple had treated the BKS Entities as if they were community property for tax purposes. Moreover, the Superior Court had also held to the effect that if Karen indeed had any separate property interest, that interest would be protected by her tracing the property of BKS Cambria LLC back to her own separate property.
The Court of Appeals agreed with some of this, but not all of it, such as noting that the tax returns were prepared and signed only by Schaefers and not also by Karen, and so would not be dispositive of her own intent. It was also dubious that a community property presumption had been created only by filing tax returns for the BKS entities as so-called “disregarded entities” whose taxable activity passes on to its ultimate beneficial owner, when the IRS’s tax treatment of such entities was for its own purposes and not intended to affect state family law issues.
The biggest problem with the Superior Court’s ruling was that community liability for debts does not include debts that are incurred by one spouse after a period of separation, and here there was substantial evidence that the couple had physically and legally separated some 15 years previously, and well before Schaefers’ Kansas adventures. Thus, the Superior Court had erred in its conclusion that the community property was liable for Schaefers’ Kansas liability, and that part of its decision would be reversed.
Yet, even if Karen owned a 50% interest in BKS Cambria LLC, it still might be possible, thought the Court of Appeals, that the entity could still be the alter ego at least in some part as to Shaefers. Here, the court referred back to the aforementioned Curci case where the court had affirmed reverse veil piercing where the judgment debtor had owned 99% of the entity and his wife had owned the other 1%.
Let me digress for a moment and say that reading between the lines, essentially the court is here saying something like, “If we are going to allow reverse veil piercing at 99%, then we’d probably allow it at 98%, and 97% and so forth and so on to where we’d eventually have to consider it even at 50%.” Now, back to the readable text of the opinion.
The problem with the Curci decision is that the 1% interest of the debtor’s wife there was also available as community property, and so there was not a true non-debtor interest involved — as contrasted with Karen’s situation here in that she as a 50% owner would be an “innocent spouse” adversely affected by adding BKS Cambria LLC to the judgment. Faced with this conundrum — a very difficult legal issue to figure out — the Court of Appeals did what so many other appellate courts do in this precise situation: It dodged the issue entirely, and instead remanded the case back to the Superior Court to try to itself figure it out:
“We must remand the matter to the trial court for further proceedings on the equitable issue consistent with the views expressed in this opinion. We do not suggest that wife is, or is not, an innocent third party. Nor do we suggest that the court should deny respondent’s motion if on remand it finds that wife is an innocent third party who would be harmed by the addition of BKS Cambria as a judgment debtor. Whether the motion should be granted or denied is within the trial court’s sound discretion. The court must weigh the equities to accomplish ultimate justice.” [Internal quotations and citation omitted.]
Schaefers made several other arguments, but the only one of any possible merit was that Kansas law should have applied instead of California law. The Court of Appeals took up this issue by first determining whether there was a conflict between California law and Kansas law such that it might have made any difference in the outcome However, the court could not identify any Kansas ruling on the subject of reverse veil piercing, and then stated that it would not presume a conflict where one might or might not exist. The court then stated that as far as it was concerned, this was a “false conflict” situation where there was difference in the laws of the two states, and thus Schaefers’ conflicts argument failed as well.
The opinion ends with the Court of Appeals reversing the Superior Court to the extent that BKS Cambria LLC was added to the judgment, and remanded the case back to the Superior Court to determine whether Karen’s 50% membership interest in the entity prevented it from being Schaefer’s alter ego.
As mentioned at the top of this article, the opinion in Blizzard Energy here must be read in the context of a trilogy of opinions from the California Court of Appeals on the issue of reverse veil piercing.
In the first case, the PIP court reached the correct result that reverse veil piercing should not be allowed in the case of corporate entities, because there is simply no need for it: The creditor can just levy on the debtor’s stock shares in the corporation and the purchaser of those shares at the ensuing judicial sale and realize complete value by either taking control of the corporation and its assets or else liquidating the corporation and triggering a final distribution of its assets. However, the PIP court went too far when it essentially stated that California would not recognize reverse veil piercing at all.
The second case, Curci, involved an LLC which was owned 99% by the debtor and 1% by his wife (or 100% by the community if one chooses to look at it that way). Seizing on language from the PIP opinion that perhaps reverse veil piercing might be revived in the case of a single-member LLC, the Curci court reached the correct conclusion to add the LLC in that case to the judgment as the alter ego of the debtor.
The third case was of course that of Blizzard Energy which we just discussed, and is frankly one giant mess of an opinion on the alter ego issues which frankly has made the California position on reverse veil piercing about as foggy as a California coastal city after the thick marine layer has rolled in. Not that the Blizzard Energy court did not get a lot of things right, as it did, and particularly as to recognizing that Karen shouldn’t be held liable decades after her separation from Schaefer for his liabilities, but when it comes to discussing reverse veil piercing the opinion is just a total mess.
The opinion should have, frankly, ended right there. As the court explained, the first element of alter ego is that there be a substantial identity of ownership and control between the debtor and the entity. Schaefers essentially conceded the control part of this element, but “and” of course being conjunctive, that still left the issue of ownership. But if Schaefers only owned 50% of BKS Cambria, then there was no substantial identity of ownership between the two. Schaefers was a non-majority partial owner at best, but a half-owner does not result in a substantial identity any more than half a canoe will still float.
Note that the test is that of substantial identity which is something different than complete identity which is not required. For instance, the Curci court seemed willing to allow reverse veil piercing where the debtor only owned a 99% interest (as opposed to a 100% interest) on the theory that a 99% interest was a substantial identify, but then engaged in a belt-and-suspenders analysis by pointing out that the wife’s 1% was community property and so there was complete identity in that case.
Going back to the canoe analogy, cut 1% off the tip of the canoe and you may end up with something that is cosmetically unattractive, but it will still float. In fact, you can start snipping away at bits and pieces of the canoe and whittle it down some considerable percentage, and it will still float. But at some point, you’ve obviously cut too much and the canoe will sink. What the percentage is when the canoe will finally take on water is somewhere between 50% and 99% and future courts will have to find that point.
A factor to take into consideration on this point may bring us full circle and back to the issue of control. Again, Schaefers essentially conceded the control issue so it was not a factor in this case. In another case, however, the court may need to examine the requirements for control under the RULLCA (or the RULPA for limited partnerships) as well as the entity’s operating agreement to see at what point the debtor has enough of an ownership interest that ultimate control is present. The control point might be as little as 50.1% ownership, or it might be a 66.7% super-majority interest. But it’s not an exact 50%, since there is no control at 50% unless the entity’s operating agreement is really weird. And at any rate, once ownership has dropped down into the 50% range, the identity of ownership has long been lost.
Personally, having read a lot of cases in this area and been intimately involved at various levels on drafting committees and other groups who have dealt with the uniform legislation, it strikes me that to get a combination of substantial identity of both ownership and control, the debtor’s membership interest will need to be at or north of at least 66.7%, since it is at that point when the debtor has a super-majority interest, and thus likely has some substantial modicum of control under the statutes and many normal operating agreements, and the debtor’s ownership is 2/3rds of the entity. Under 66.7%, and there is hardly any identity of ownership and may not be any identity of control either. So, 66.7% strikes me as the legal sweet spot for determining cases such as this one.
That issue is a tough one, and it will probably take many more court opinions before we have firm answers about the subject. What is not a particularly difficult legal issue ? though it very often is factually ? is that of an unjust result occurring if the debtor and the entity are not treated as one and the same. The court seemed to find that factor to be present in the form of Schaefers’ admission in his letter to his CPA that Blizzard Energy would be stuck with a charging order and would never get a cent. However, because the court ultimately ruled that factor might not be present because of Karen’s 50% interest, the court’s ruminations on this subject appear to then amount to obiter dicta which should not be given any effect in future rulings.
Here we must divert to the seminal opinion which discusses alter ego law in California, being Sonora Diamond Corp. v. Superior Court, 83 Cal.App.4th 523 (2000), which stated:
“The alter ego doctrine does not guard every unsatisfied creditor of a corporation but instead affords protection where some conduct amounting to bad faith makes it inequitable for the corporate owner to hide behind the corporate form. Difficulty in enforcing a judgment or collecting a debt does not satisfy this standard.“
Id., at 539 [emphasis added].
The Sonora Diamond opinion also warns: “Alter ego is an extreme remedy, sparingly used.” Id., at 538. If every creditor who had an unpaid judgment could assert that alone to prove an unjust result, then literally every post-judgment case where the debtor had large interest in an entity would be subject to an alter ego challenge. Then, alter ego would go from being a sparingly used extreme remedy to an everyday common remedy.
Unfortunately, the Blizzard Energy court did not address this argument, but instead seemed to presume that because the creditor was not being paid on its judgment (and did not intend to pay its creditor on the judgment) that such was satisfied. But that logic runs directly afoul of Sonora Diamond’s mandate that the debtor have done something “in bad faith” that would satisfy the unjust result test. If anything, that was Schaefer telling the court that Blizzard Energy had an adequate legal remedy by way of the charging order attaching his distributions, having privately admitted that he would never make any distributions to the charged interest. Perhaps that was what the court was talking about, or perhaps it was the odd financial transactions of BKS Cambria in essentially financing some of the Kansas litigation costs, but the opinion was drafted in a way that it was hard to tell. It is also difficult to image that merely taking such a legal position could rise to the level of some sort of “bad faith” action, which really is meant to convey that the entity was in some way used in some sort of fraud or other wrong against the creditor, and which would further Sonora Diamond’s mandate that the remedy be “sparingly used”.
As I wrote above, legally the issue of unjust result is not difficult, but factually it often is. The creditor is basically required to present evidence that the creditor was in some way harmed by the legal separateness of the entity and not merely that it is not being paid on its judgment. That is admittedly difficulty, but that’s what one would expect for an “extreme remedy”.
The last issue of interest in this opinion is that of the conflict, or rather false conflict, between California and Kansas law. Here, the Court of Appeals reaches the correct conclusion, but it’s path to that decision was through the ditch and not the adjoining paved highway. Issues of alter ego are typically deemed to be an “internal affair” of the entity (corporation, LLC, partnership, whatever), and under what is known as the Internal Affairs Doctrine, courts will typically look to the laws of the state of formation to decide alter ego issues. In other words, the conflicts “pointer” is not determined by general conflicts-of-laws principles, but rather by a specific entity choice-of-law principle. The court here followed the former (the ditch) when it could easily have followed the latter (the paved highway) to settle the issue of which state’s laws applied, although of course that is all a giant non sequitur since Kansas law is silent on the issue of reverse veil piercing, and thus the pointer in either case would have swung back to California law.
It is worth noting, however, that in either case (general conflicts-of-law principles or the Internal Affairs Doctrine), it is possible that the “pointer” will swing back to the litigation state (California) if the laws of the forum state evince a result that is against the public policy of the litigation state. Thus, if BKS Cambria had been, for example, a Wyoming LLC where the laws have been made anti-creditor to an extreme degree, it might well be that the California courts would assert the California public policy that creditors be paid on their judgments and simply apply California law without regard to Wyoming law.
But for us to see how that pans out will require waiting for a future case. Stay tuned.
Blizzard Energy, Inc. v. Schaefers, 2021 WL 5366815 (Cal.App., Distr. 6, Nov. 18, 2021).