Article Archives >> Lead Stories >> August 1-31, 2007

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Jury May “Pierce Corporate Veil”
Of Nonprofit to Recover from Founder
Liability was imposed when foundation was “alter ego,”
undercapitalized, and failed to follow formalities

The Eighth Circuit Court of Appeals has affirmed a jury verdict finding the founder of a nonprofit corporation liable for $436,000 in architects fees for services ordered by the nonprofit in connection with the founder’s scheme to build a soccer stadium in Urbandale, IA.

The Court has ruled that the state’s Nonprofit Corporation Law did not preempt common law rights to pierce the corporate veil and that the veil could be pierced if the nonprofit served as the alter ego of the founder, it was undercapitalized, or it failed to follow corporate formalities.  (HOK Sport v. FC Des Moines, No. 06-2433, 8/10/07.)

Kyle Krause, president of a chain of convenience stores, owned 90% of The Des Moines Menace minor league soccer team and wanted a new stadium for the team. He created The Stadium Foundation as a 501(c)(3) supporting organization to generate contributions to build the stadium and transfer it to the City.  He planned to operate the stadium through another business that he owned. 

The Foundation entered into an architectural services contract that was signed by Krause, who was president, sole officer and sole director.  The Foundation lacked its own bank account for many months and its funds were deposited in The Menace bank account.  The Menace paid some of the Foundation’s bills.  Krause’s business loaned funds to the Foundation to pay some of its bills.  The Foundation never had a full-time employee other than Krause’s wife.  It never held a board meeting.

When the project died and the contract was not paid, the architect sued Krause, The Menace, and the Foundation.  A jury found them all liable. 

On appeal, Krause argued that the state’s Nonprofit Corporation Law preempted the right to pierce the corporate veil and that there was insufficient evidence to do so even if it was permitted.  The Court of Appeals disagreed.

In applying Iowa law, the Court said an entity’s corporate form can be disregarded either by applying the alter ego doctrine or by piercing the corporate veil. Where equity requires an examination of the purposes of a corporation, a court is not bound by forms, fiction or technical rules, it said, “we want the truth.”

The alter ego doctrine disregards an entity’s corporate form if the entity is “merely an instrumentality or device set up to ensure the avoidance of legal obligations.”  A claimant may pierce the corporate veil if the corporation is “a mere shell, serving no legitimate business purpose, and used primarily as an intermediary to perpetuate fraud or promote injustice.”  (See Ready Reference Page:  “How to Prevent Piercing the Corporate Veil.”)

Krause argued that the doctrines were inapplicable because the Nonprofit Corporation Law provision in effect at the time provided, as do many state laws, that “except as otherwise provided” by the statute, a director is not liable for the corporation’s debts, or for wrongful acts which are not a breach of fiduciary duty. But the Court held that a statute may be construed to override common law rights only when it “directly negates the common law,” and this statute did not intend to pre-empt common law rights.

Krause argued that a nonprofit could not be undercapitalized because the investment of equity capital in a nonprofit is prohibited.  But the Court ruled that nonprofits typically receive donations and have other sources of funding, such as earned income.  “Donations, a form of capital, are to a nonprofit corporation what equity capital is to a for-profit corporation.”

The corporate veil, however, can be pierced only if it is undercapitalized in the context of the business that it conducts, the Court wrote.  “Many nonprofit corporations begin with very little capital, yet are not necessarily undercapitalized, if the nonprofit corporation assumes only small liabilities and the nature of its business is not particularly risky…. Alternatively, if a nonprofit corporation engages in commercial transactions and operates as a sophisticated business entity in an area of commerce typically frequented by for-profit businesses, the nonprofit corporation may need to be capitalized at approximately the same extent that a for-profit should be capitalized.”

The Court also ruled that the failure to hold Board meetings could be considered in whether the entity failed to follow corporate formalities.  Krause argued that the Legislature had specifically provided that the failure to hold corporate meetings would not disqualify a limited liability company and that it should not be a problem for a corporation. But the Court said the Legislature knew how to eliminate the requirement for limited liability companies but did not do so for corporations.

As to the evidence, the Court found that there was sufficient evidence to find that the Foundation was Krause’s alter ego.  He “developed an elaborate plan to build a stadium to maximize his profits while shedding any liability or risk,” the Court said.  “When the proprietor of a for-profit business establishes a nonprofit corporation to assume a liability or risk that otherwise, in the ordinary course of business, would have been assumed by a for-profit business, and when the nonprofit corporation accrued liabilities, a reasonable jury may easily decide that allowing the for-profit business (or its owner) to escape the liability would be sanctioning a fraud and promoting an injustice.”

It found that the Foundation was incorporated without any capital and a $78,000 obligation to The Menace for pre-incorporation services.  Although Krause pledged a $2 million donation, it was contingent, “like all other donations and funds available” to the Foundation, on the construction being done, while the debt to the architects was not contingent.  The Foundation never had enough capital to pay for the design if the stadium were not built.

The Foundation’s finances were not kept separate from The Menace’s or Krause’s main business.  “A reasonable jury could conclude that Krause treated each entity as his own slush fund.”

There were no Board meetings or other evidence that corporate formalities were followed.  “Sufficient evidence supports imposing personal liability on Krause by piercing [the Foundation’s] veil.”

YOU NEED TO KNOW

This Court seems to make a distinction that is not normally made, between the “alter ego” theory and piercing the corporate veil.  The alter ego theory is usually viewed as a reason to pierce the corporate veil.  The ultimate result is the same, however.  Where an individual or an entity does not follow the formalities of corporate existence and a court deems that the separate entity did not function independently and was used to promote an injustice, the separate entity can be disregarded.

Article Archives >> Lead Stories >> August 1-31, 2007