Daily Development for Monday, August 26, 2002

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

LANDLORD TENANT; LANDLORD'S REMEDIES; PIERCING THE VEIL: A company that establishes a subsidiary to act as an assetless tenant under a lease, but which treats the lease as its own and acts in ways that the landlord believes the company, not the subsidiary, will be liable under the lease, will be held liable for the obligations of the subsidiary to the landlord.

OTR Associates v. IBC Services, Inc., 353 N.J. Super. 48, 801 A.2d 407 (App. Div. 2002).

A restaurant franchisor had a corporate subsidiary that was created for the single purpose of holding a lease on premises occupied by a franchisee. With the landlord's consent, the subsidiary-tenant subleased the space to its franchisee. The franchisee accumulated a substantial rent arrearage and was evicted.

The landlord then sued the franchisor and its leasing subsidiary for back rent. For good measurel, it added as a defendant a second leasing subsidiary of the franchisor to which the first subsidiary had assigned the lease without notice to the landlord in violation of the terms of the lease itself.

The lower court pierced the corporate veil of the leasing subsidiaries and entered a judgment against the franchisor as well as against its two judgment-proof subsidiaries. As expected, the franchisor appealed, but the Appellate Division allowed the judgment against the parent company to stand.

"... [T]he basic finding that must be made to enable the court to pierce the corporate veil is 'that the parent so dominated the subsidiary that it had no separate existence but was merely a conduit for the parent.' ... But beyond domination, the court must also find that the 'parent had abused the privilege of incorporation by using the subsidiary to perpetrate a fraud or injustice, or otherwise circumvent the law.' ... And the hallmarks of that abuse are typically the engagement of the subsidiary in no independent business of its own but exclusively the performance of a service for the parent and, even more importantly, the undercapitalization of the subsidiary rendering it judgment-proof."

The parent company conceded that it formed each subsidiary for the sole purpose of holding the lease on the premises. It was also clear that the subsidiary "had virtually no assets other than the lease itself, which, in the circumstances, was not an asset at all but only a liability since [the subsidiary] had no independent right to alienate its interest therein but was subject to [its parent company's, the franchisor's] exclusive control.

It had no business premises of its own, sharing the New York address of [its parent company]. It had no income other than rent payments by the franchisee, which appear to have been made directly to [the landlord]. It [did not] appear that it had its own employees or office staff." Further, the Court noted that the parent company not only retained the right to approve the premises that were occupied by its franchiees and leased by its subsidiary, but had actually managed all of the leases held by its subsidiaries on franchisee premises. In fact, an officer of the parent company testified that the company was "exclusively a franchising corporation with 'hundreds and hundreds' of leases held by its wholly- owned leasehold companies which [were], however, overseen by [the franchisor's] administrative assistants, that is 'people in our organization that ... do this [communicate with landlords] as their everyday job."

Further, the individual leasing subsidiaries didn't "make a profit. There's no profit made in a leasehold."

Based on that set of facts, the Court held that domination and control by the franchisor of its leasing subsidiary was "patent and was not, nor could have been, reasonably disputed."

This then led to a question as to whether the parent company "abused the privilege of incorporation by using [its] leasing subsidiary to commit a fraud or injustice or other improper use." Here, the Court agreed with the lower court that the evidence "overwhelmingly require[d] an affirmative answer." The landlord believed at all times that it was dealing with a national and financially responsible franchising company, "and never discovered the fact of separate corporate entities until after the eviction." Although it was true that the subsidiary "never apparently expressly claimed to be [the parent company], it not only failed to explain its relationship to [the parent company] as a purported independent company but it affirmatively, intentionally, and calculatedly led [the landlord] to believe that it was [the franchisor]." For example, when the landlord was pre-leasing space in its mall, two men in uniforms bearing the franchisor's logo announced that they wanted to open the store. According to the Court, "[i]t hardly required a cryptographer to draw the entirely reasonable inference that [the initials of the leasing subsidiary] stood for [the name of the franchisor]." The name of the leasing subsidiary used the initials of the franchisor and identified its address as "care of" the franchisor. Further, during the course of dealings, all letters from the tenant on the lease were on stationary headed only by the franchisor's logo. There was nothing on the correspondence that would have suggested the existence of an independent company standing between the franchisor and the franchisee.

In addition, letters from the franchisor's subsidiary typically referred to its subtenant as, "our franchisee." Presumably as a warning, the Court also stated, "We note that the creation of a judgment-proof wholly-owned subsidiary as the leaseholding entity for a solvent retail chain is not a novel device. Nor is it a successful one."

Comment: Many lawyers have been faced with a similar problem when their landlord client discovers it's been hoodwinked and has executed a lease with "Honey Baked Chicken Fingers No. 66," instead of its famously solvent parent. And piercing the corporate veil is a very tough claim to make.

This case, on first blush, doesn't appear to make things any easier. It seems that the court stacked up a lot of facts that aren't necessarily going to be present in every situation to support the conclusion that the use of the subsidiary here was an intentional fraud. But remember that the court has the freedom to study the whole transcript and to pick out pieces of the evidence that support its conclusion. Thus, lawyers shouldn't despair if their client got fooled by a device not quite as elaborate as the one in this case.

The important thing here is the emphasis on the need for independent economic substance in order for the court to set aside other factors suggesting that the corporate veil should be pierced. There aren't that many really good cases supporting landlords' lawyers in their quest to get around the "shell tenant." Here's a good one.

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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