Contributed by Laura Napoli
In ALT Hotel LLC v. DiamondRock Allerton Owner, LLC, No. 11 a 1469, 2012 WL 4361434 (Bankr. N.D. Ill. Sept. 25, 2012), the United States Bankruptcy Court for the Northern District of Illinois had to determine whether to recognize an unusual form of veil piercing, in which an affiliate of the debtor would be recognized as the debtor’s alter ego, making the affiliate’s creditor a creditor of the debtor. Finding that “inside reverse veil piercing”—a variation on reverse veil piercing—was too bizarre a twist on the corporate form, the court determined that the creditor of a debtor’s affiliate should not be recognized as the debtor’s creditor in the bankruptcy case.
It all started with a simple mortgage loan. In 2006, Column Financial, Inc. made a loan to debtor ALT Hotel. The loan was secured by a mortgage on a Chicago hotel owned by the debtor. At Column’s request, the debtor created a special purpose entity, Alt Hotel Mezz, LLC, which acquired the debtor’s membership interest and became the debtor’s parent. Column then used Alt Hotel Mezz to securitize the mortgage by making a mezzanine loan to Alt Hotel Mezz that reduced the mortgage loan’s balance. Column later assigned the mezzanine loan to Hotel Allerton Mezz, LLC and split the mortgage loan into two tranches, selling one tranche each to Key Bank and Wells Fargo, respectively.
The mortgage loan was to mature in 2008; however, the debtor sought two extensions from Wells Fargo pursuant to the terms of the loan agreement. Wells Fargo granted the first extension but refused the second on the grounds that the debtor had failed to meet a requirement under the loan agreement. When the debtor failed to pay the loan by the maturity date, Wells Fargo treated the failure as a default and sought to foreclose on the loan. After it filed the foreclosure action, Wells Fargo transferred the loan to DiamondRock Allerton Owner, LLC. Meanwhile, Hotel Allerton Mezz foreclosed on the mezzanine loan to Alt Hotel Mezz and became the debtor’s owner and parent as well as the holder of a deficiency claim against Alt Hotel Mezz.
The debtor filed for bankruptcy protection in May of 2011. Shortly thereafter, the debtor commenced an adversary proceeding against DiamondRock, bringing claims for, among other things, equitable subordination under section 510 of the Bankruptcy Code. Both the debtor and Hotel Allerton Mezz were listed as plaintiffs for purposes of the equitable subordination claim.
Hotel Allerton Mezz and the debtor alleged that Hotel Allerton Mezz had standing to bring the equitable subordination claim because Alt Hotel Mezz was the debtor’s alter ego. Therefore, Hotel Allerton Mezz’s deficiency claim against Alt Hotel Mezz was essentially a claim against the debtor, and Hotel Allerton Mezz was a creditor in the debtor’s bankruptcy case.
The court viewed the “alter ego” argument as a variation on a controversial form of corporate veil piercing. In a “reverse piercing” case, a corporation is held liable for the debts of an insider, shareholder, or subsidiary. In this case, the court viewed Hotel Allerton Mezz’s “alter ego” allegations to be similar to a claim of “inside” reverse piercing, where a corporate insider, shareholder, or subsidiary seeks to be considered as the alter ego of the corporation to assert a corporate claim against a third party.
Looking to Delaware law, which the parties agreed applied, the court found that Delaware has not recognized any form of reverse veil piercing. In fact, Delaware corporate law tends to respect the corporate form, and courts there are hesitant to recognize any kind of veil piercing. For these reasons, the court did not find that Delaware would recognize inside reverse piercing. Thus, Alt Hotel Mezz could not be the debtor’s alter ego, and Hotel Allerton Mezz’s claim against Alt Hotel Mezz did not make Hotel Allerton Mezz the debtor’s creditor. For these reasons, the court dismissed Hotel Allerton Mezz as a plaintiff.
That left ALT Hotel, the debtor, as the remaining plaintiff for purposes of the equitable subordination claim. The court held that this claim should be dismissed because the debtor had not alleged harm to creditors that would justify subordinating DiamondRock’s claim. Stating that actual injury to creditors was a critical element of an equitable subordination claim, the court found the debtor’s allegations inadequate because the debtor had alleged only a risk of injury to creditors stemming from DiamondRock’s actions, not actual injury.
Although some courts have recognized inside reverse veil piercing, this decision illustrates the court’s reluctance to pierce the corporate veil when doing so would require a leap far beyond the trend in Delaware case law.