September 25, 2008

CALIFORNIA APPEALS COURT REJECTS OUTSIDE REVERSE PIERCING OF THE CORPORATE VEIL

Individuals will often enter into franchise agreements in their individual capacity with the expectation that the individual franchisee will eventually assign the franchise agreement to a future business entity. The case of Postal Instant Press, Inc. v. Kaswa Corporation, 2008 Cal. App. LEXIS 753 (May 20, 2008) demonstrates how important it is for franchisors to closely monitor proposed assignments of this nature and to require appropriate guaranties of the franchisee’s obligations, whether the franchisee is an individual or entity.

In a case of first impression, the California Court of Appeals reversed a lower court’s decision that allowed a judgment creditor franchisor, Postal Instant Press, Inc. (PIP), to reach corporate assets that would satisfy claims of personal liability against the corporation’s former shareholder—that is, to reverse pierce the corporate veil.

“Piercing the corporate veil” is a legal doctrine under which a shareholder is liable for the debts or conduct of a corporation even though general principles of corporate law provide that shareholders are not personally liable for debts or actions of the corporation. In reverse piercing of the corporate veil, a corporation may be liable for the debts and conducts of its shareholder. “Outside” reverse piercing of the corporate veil occurs when a third party attempts to reach corporate assets to satisfy a claim against its shareholder.

The Background

In 1998, Shahid Rangoonwala and Syed Saeed Ahmed purchased a PIP franchise from an existing PIP franchisee. Rangoonwala, Ahmed and PIP executed an agreement and consent to assign the franchise agreement, which Rangoonwala and Ahmed held as general partners. PIP did not require any collateral or guaranties to secure Rangoonwala’s and Ahmed’s obligations under the franchise agreement. Later that year, Rangoonwala and Ahmed formed Kaswa Corporation (Kaswa). Kaswa was not a party to the franchise agreement.

In 2000, Ahmed sold his interest in the partnership to Rangoonwala. After Ahmed left the partnership, Rangoonwala requested that PIP approve a transfer of the franchise from Rangoonwala to Kaswa. PIP refused to consent to the transfer to Kaswa. However, notwithstanding PIP’s refusal to consent to the transfer, the facts of the case suggest that Rangoonwala transferred the franchise to Kaswa and Kaswa began operating the PIP location that was the subject of the franchise.

Kaswa subsequently merged with another company owned by Michael Haxton and Kaswa continued to operate the franchise. In September 2004, PIP and Rangoonwala had a dispute regarding the payment of royalties under the franchise agreement. PIP and Rangoonwala submitted the issue to arbitration. In February 2005, the arbitrator issued an award of $77,434.69 in favor of PIP. In June 2005, the trial court entered judgment against Rangoonwala for $79,810.12, with post-judgment interest at the rate of 10 percent per year. Not long after judgment was entered against Rangoonwala, Kaswa sold the franchise to Ward and Susan Johnson, doing business as Definite Impressions.

In October 2006, PIP moved to amend its judgment to add Kaswa as a judgment debtor. The trial court granted PIP’s motion concluding that Kaswa and Rangoonwala “were alter egos of each other” and applied the doctrine of reverse piercing the corporate veil to add Kaswa as a judgment debtor.

Appeals Court Declines to Accept Reverse Piercing Doctrine

The California Court of Appeals cited prior decisions from other jurisdictions that rejected reverse piercing of the corporate veil and joined with those courts in declining to accept it. The court concluded that the “[t]raditional alter ego doctrine and reverse piercing, while having similar goals, advance those goals by addressing very different concerns.” Citing Mesler v. Bragg Management Co., 39 Cal.3d 290, 300-301 (1995), the court stated that piercing the corporate veil is justified as an equitable remedy when the shareholders have abused the corporate form to evade individual liability, circumvent a statute or accomplish a wrongful purpose.

However, the court noted that when the judgment debtor is the shareholder, the corporation is not used to evade the shareholder’s personal liability because the shareholder did not incur the debt through the guise of the corporation. It pointed out that the “true issue” addressed by reverse piercing of the corporate veil is protecting a judgment creditor from a shareholder’s fraudulent transfer of assets to a corporation, which can be remedied by legal doctrines such as conversion and fraudulent conveyance.

Franchisors: Adequately Protect Your Interests

Of particular interest to franchisors is the court’s explicit statement that PIP “consented to the assignment of the franchise to Rangoonwala and Ahmed and knew the franchise was not being assigned to a corporation.” Furthermore, the court took note of the fact that PIP could have taken precautions to protect its interests by requiring a guaranty from Kaswa, taking Ragoonwala’s stock in Kaswa as collateral, or conditioning the assignment on Rangoonwala owning the franchise assets.

The most significant lesson in this matter: franchisors must adequately protect their interests by requiring collateral or a guaranty from a franchisee, whether that franchisee is an individual or business entity. As this case shows, piercing the corporate veil or reverse piercing of the corporate veil may not be a successful option for the franchisor to reach the party with the deep pockets.