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Malcom et al. v. Franklin Drywall, Inc. et al.: US District Court : CORPORATIONS - decision after bench trial; attempt to pierce corporate veil to reach defendant fails

UNITED STATES DISTRICT COURT
DISTRICT OF MINNESOTA
Scott Malcolm, Tim McGough, Civil No. 06-4155 (PAM/JSM)
Michael Gavanda, Gary Larson,
Jeff Jewett, and John Nakasone,
Plaintiffs,
MEMORANDUM AND ORDER
v. FOR JUDGMENT
Franklin Drywall, Inc., Master
Drywall, Inc., and Philip J. Franklin,
Defendants.
This matter was tried to the Court on December 8, 2008. At issue is Plaintiffs claim
that Defendant Philip Franklin (Franklin) should be held personally liable for amounts
owing from Defendants Franklin Drywall, Inc. and Master Drywall, Inc. to Plaintiffs, trustees
of several union fringe benefit funds. At the conclusion of the bench trial, the Court issued
an oral ruling in favor of Franklin. This written memorandum accords with that ruling and
provides a more robust account of the Courts findings of fact and conclusions of law.
BACKGROUND
Plaintiffs are trustees of a number of funds that provide fringe benefitssuch as
health, pension, and vacation benefitsfor members of participating unions and trades
(collectively, the Funds). The Funds operate using contributions from employers. Under
a collective bargaining agreement, an employer calculates the total contributions it owes to
the Funds based on the hours worked by union and non-union employees. The Funds collect
the contributions and conduct audits to ensure accurate reporting.
1Although a personal guaranty would provide direct contractual liability for the debts
of Franklin Drywall, Franklin never signed such a guaranty in favor of Plaintiffs.
2
Defendants Franklin Drywall, Inc. and Master Drywall, Inc. were Minnesota
corporations engaged in the construction business. Franklin Drywall was in operation from
1988 to September 2007. Defendant Philip J. Franklin is the sole director, officer, and
shareholder of Franklin Drywall. Franklins wife, Juliet, owned Master Drywall.
Plaintiffs sought and ultimately were awarded a default judgment against Franklin
Drywall and Master Drywall in the amount of ,194,179.30 for delinquent fringe benefit
contributions and liquidated damages. At trial, Plaintiffs sought to establish Franklins
personal liability for the default judgment by piercing the corporate veil.
DISCUSSION
1. Piercing the Corporate Veil
Ordinarily shareholders of a corporation are shielded from personal liability for the
debts or obligations of the corporation. See Gunderson v. Harrington, 632 N.W.2d 695, 704
(Minn. 2001).1 In limited circumstances, however, a court may disregard the corporate
entity, or pierce the corporate veil, and hold a shareholder personally liable for what would
otherwise be the debt solely of the corporation. Piercing the corporate veil is a remedy
available when the corporate form is used to commit fraud, or when the corporation is
operated as the alter ego of the sole shareholder. Victoria Elevator, 283 N.W.2d at 512.
Victoria Elevator outlines a two step approach for the alter ego theory. First, the court
considers the relationship of the shareholder to the corporation, and the extent to which the
3
corporation was operated as a separate legal entity. Id. The court is to consider the
following factors:
insufficient capitalization for purposes of corporate undertaking, failure to
observe corporate formalities, nonpayment of dividends, insolvency of debtor
corporation at time of transaction in question, siphoning of funds by dominant
shareholder, nonfunctioning of other officers and directors, absence of
corporate records, and existence of corporation as merely facade for individual
dealings.
Id. If these factors weigh in favor of finding a shareholder personally liable, the court is then
to consider whether shielding the shareholder from personal liability would result in
injustice or fundamental unfairness. Id. The Court finds that Plaintiffs have failed to
establish that any of the factors in step one militate in favor of finding Franklin personally
liable.
A. Insufficient Capitalization
Any time a business becomes insolvent there is a capitalization problem. But the
multi-factor analysis required by Victoria Elevator clearly does not intend for a shareholder
to be held personally liable for corporate debts simply because the corporation has become
insolvent. This factor does not weigh in favor of holding Franklin personally liable to
Plaintiffs for Franklin Drywalls debts.
The evidence showed that Franklin Drywalls financial woes stemmed primarily from
credit and cash-flow problems, rather than from undercapitalization. Franklin Drywall began
using an asset-based lenderACRO Business Finance (ACRO)in 2003 in an effort to
expand Franklin Drywalls business. ACRO filed for Chapter 11 protection in 2006. Shortly
4
thereafter, ACRO stopped extending credit to Franklin Drywall. Franklin Drywall, however,
had continuing obligations to employees, landlords, and suppliers. Franklin Drywall began
depositing receivables in a bank account that ACRO could not access in an effort to have the
cash it needed to meet its obligations, but those efforts ultimately failed. These actions by
ACRO, coupled with the downturn in the construction market at about the same time, caused
significant financial hardship for Franklin Drywall and ultimately led to its insolvency.
Franklin Drywall was unable to find another asset-based lender to help it operate, in large
part because of the current lawsuit.
Franklin Drywalls use of an asset-based lender does not necessarily mean that the
corporation was undercapitalized. Rather, as Franklin testified, Franklin Drywalls
relationship with ACRO allowed Franklin Drywall to expand its business and capture a
larger share of the growing market. ACROs bankruptcy and liquidation essentially froze
Franklin Drywalls cash flow and led to the companys demise. There is no evidence,
however, that Franklin Drywall was ever undercapitalized, such that Franklin should be held
personally liable for Plaintiffs default judgment against his company.
B. Corporate Formalities
The Court is troubled by the fact that Franklin Drywalls corporate record book and
other basic corporate documents were not produced at trial and put into evidence. Franklin
testified that Franklin Drywalls former attorney has the record book and other documents.
Plaintiffs argued that they requested the records production during discovery, but the records
were never produced. The lack of corporate records in evidence notwithstanding, the Court
5
finds that Franklin Drywall was operated formally as a separate entity, and that this factor
does not weigh in favor of finding personal liability on the part of Franklin.
Both Plaintiff and Franklin introduced into evidence the accounting records of
Franklin Drywall. Franklin Drywall employed certified public accountants and a controller
to handle its finances. Franklins father made two loans to Franklin Drywall, and those loans
were documented in writing. Franklin Drywall eventually made two payments to Franklins
father for the loans to the corporation, and those payments were properly recorded. There
is nothing improper about these payments, especially in light of the fact that they were
documented and recorded.
Franklin Drywall paid ,000 a month to lease two commercial properties from
Franklin, who personally owned the properties. Franklin relied on the advice of his
accountants when structuring the lease agreement between himself and Franklin Drywall.
Franklin also reported the lease payments as income on his personal tax returns. There was
nothing improper about the lease arrangement between Franklin and Franklin Drywall, again
where each transaction was documented and recorded.
Despite the lack of corporate records before the Court, there is substantial evidence
from testimony and accounting records that Franklin Drywall was operated in a formal
manner as an entity separate from Franklin himself.
C. Nonpayment of Dividends
Franklin, as sole shareholder of Franklin Drywall, was paid approximately 0,000
in distributions, or dividends, from 2004 through 2007. A significant portion of those
2 Because Franklin Drywall was an S-corporation, Franklin was personally subject to
pass-through taxation for any tax gains by the corporation.
6
distributions were used to pay personal and pass-through corporate taxes.2 Several checks
were issued directly from Franklin Drywall to Franklins ex-wife for Franklins personal
obligations of spousal and child support. Franklin testified that those amounts were treated
as distributions to him and were properly accounted for as such on Franklin Drywalls books.
The Court credits Franklins testimony. The dividends paid to Franklin were proper and
accounted for. Therefore, this factor does not weigh in favor of piercing the corporate veil.
D. Insolvency
Except for a small loss in 2004, Franklin Drywall was profitable each year until 2006.
Due to accounting cycles and the downturn in the construction market in 2006, Franklin did
not become aware that the corporation was not profitable in 2006 until the spring of 2007.
Any distributions made before Franklin knew the company was operating at a loss cannot be
the grounds for piercing the corporate veil. Distributions made subsequent to Franklin
discovering the company was insolvent were made under the supervision of ACRO, which
had a perfected security interest in the assets of Franklin Drywall. There is no evidence that
Franklin unjustly benefitted from distributions made to him by Franklin Drywall while the
latter was insolvent.
E. Siphoning
As noted above, each of the transactions that Plaintiffs argued had siphoned funds
out of the company in favor of Franklin were proper and accounted for. Although there were
7
multiple transactions between Franklin, Franklins family, and Franklin Drywall, there was
nothing improper about any of those transactions. Franklin Drywalls payment of Franklins
spousal and child support obligations certainly gave the Court pause, but as noted above,
those payment were treated as distributions to Franklin. There is no evidence of siphoning
funds.
F. The Remaining Factors
The non-functioning of other officers and directors is inapplicable here because
Franklin was the sole officer and shareholder of Franklin Drywall. The basic corporate
documents were not produced to the Court, but the Court finds that Franklins unrefuted
testimony about the records existence, coupled with the detailed financial records that were
introduced into evidence, argue against piercing the corporate veil for failing to keep
corporate records. Finally, in light of the above discussion, the Court finds that Franklin
Drywall was not operated merely as a facade for Franklins personal dealings. Franklin
operated Franklin Drywall as a separate entity. Without some direct method of holding
Franklin personally liable, Franklin Drywall, and Franklin Drywall alone, is liable to
Plaintiffs for the default judgment they obtained against the company.
G. Master Drywall
Master Drywall was started in 2004. Its sole shareholder was Franklins wife, Juliet,
and was operated out of the Franklins home. Master Drywall performed subcontract work
on behalf of Franklin Drywall for which it was compensated. There is no evidence to suggest
that any of these payments were improper or that they occurred simply to siphon money out
8
of Franklin Drywall. The Court finds no evidence to support holding Franklin liable for the
debts of Master Drywall, a corporation of which Franklin is neither a shareholder nor officer
or director.
Having found no justification for piercing the corporate veil in the first part of the
Victoria Elevator test, the Court declines to consider whether piercing the veil is required to
avoid injustice.
CONCLUSION
Under the Victoria Elevator test, the Court concludes that there are no grounds that
require or justify piercing Franklin Drywalls or Master Drywalls corporate veils to hold
Franklin personally liable for the corporations obligations to Plaintiffs. Plaintiffs have
obtained a judgment and are entitled to enforce that judgment within the bounds of the law,
but must do so only against the corporations themselves and not against Franklin personally.
Accordingly, IT IS HEREBY ORDERED that judgment is entered in favor of
Defendant Philip Franklin on Plaintiffs claims that he is personally liable for the judgments
against Defendants Franklin Drywall and Master Drywall.
LET JUDGMENT BE ENTERED ACCORDINGLY.
Dated: March 12, 2009
/s Paul A. Magnuson
Paul A. Magnuson
United States District Court Judge
 

 
 
 

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