Reverse Piercing:
Creditors of Colorado Entities Gain Another Weapon for Their Arsenal

August 2006

The Colorado Supreme Court recently adopted the doctrine of “reverse piercing” for Colorado. This decision could have a major impact on investors and lenders who do business with Colorado companies whose investments or loans now are at greater risk. As a result of the recent decision, creditors of shareholders of Colorado businesses now may seek to obtain corporate assets to satisfy the shareholder’s liabilities.

Reverse piercing of the corporate veil occurs when a claimant seeks to disregard the separate existence of a corporation or other business entity to obtain the assets of such entity due to the actions of a dominant shareholder or corporate insider. Not all jurisdictions recognize reverse piercing, and before In re Phillips: Connolly v. Englewood Post No. 322 Veterans of Foreign Wars of the United States, Inc., no Colorado court had addressed the issue.

In Connolly, certain asset transfers out of a closely held business, including transfers to the majority shareholder’s wife (who also was a shareholder), rendered the corporation insolvent. Subsequent to the transfers, the majority shareholder filed for bankruptcy. The bankruptcy trustee sought to avoid the asset transfers, and reverse pierce the corporate veil to get such assets into the bankrupt majority shareholder’s individual estate. The corporation did not keep separate business records and the company did not have separate bank account or written bylaws. In addition, the company failed to provide written notice of board meetings and removed directors at will.

The Colorado Supreme Court reviewed traditional veil piercing doctrine, which is well established in Colorado, as its basis for determining the requirements of reverse piercing. The Court, in a 4-3 decision, determined that a claimant may reverse pierce the corporate veil and obtain the assets of a corporation for the obligations of a controlling shareholder or corporate insider if there is a “clear showing” that: 1. The controlling insider and the corporation are alter egos of each other 2. Justice requires recognizing the substance of the relationship over the form because the corporate form is used to perpetrate a fraud or defeat a rightful claim 3. An equitable result is achieved by the reverse piercing

The Connelly Court found all three requirements to be met. The majority opinion stressed, however, that if any innocent shareholders or creditors would be prejudiced by reverse piercing, than an equitable result would not be achieved and reverse piercing could not occur.

The Connolly Court further emphasized that like traditional veil piercing, which is an extraordinary remedy, reverse piercing should be used only as a last resort, and a court first should consider the availability of alternative remedies, such as conversion, fraudulent conveyance, respondent superior or agency.

Notably, the Court did not address whether this decision could apply if the shareholder(s) of the business were parent companies. As such it is possible that creditors of parent companies could seek to hold subsidiaries liable under this doctrine, which could have a significant impact on a variety of business joint ventures.

This recent decision should serve as a further reason for companies and controlling insiders to observe proper corporate formalities. This doctrine is contrary to the traditional expectancy that a shareholder’s creditors can only reach the stock in the corporation issued to the shareholder and not the corporation’s underlying assets. As the dissenting opinion suggested, future Colorado courts may limit the doctrine to closely held companies with no outside shareholders or creditors to minimize its impact. In the interim, however, businesses, investors and creditors all should carefully consider the implications of this new doctrine in establishing and operating businesses in Colorado and the risks to which their investment or collateral may be subject.

This legal update is for informational purposes only as a service to clients and other friends, is not a complete summary of the rules relating to the subject matter discussed above, and is neither to be construed as legal advice nor intended as basis for decisions in specific situations. For more information about this subject matter or other recent developments, please contact the attorneys in our Colorado Coporate Law practice group or any other attorney in our firm with whom you normally consult by calling (303) 825-4200.