Piercing the veil - WeWork style - by Thomas Kearns

Businesses often set up special purpose entities (SPE) to sign a lease as a tenant. The SPE’s are sometimes referred to as “shell” entities. The SPE is sometimes wholly owned by the ultimate parent company or co-owned with investors. SPEs give flexibility in financing the location involved and, if done correctly, help limit liability to the ultimate parent company.

A recent trial court decision dealt a surprising blow to WeWork in its use of a SPE. On a motion to amend a complaint, a New York court granted the landlord’s motion to add the WeWork parent company to its lawsuit for damages for a lease default. WeWork had created a SPE to lease space at 261 Madison Ave. The landlord claimed that it was entitled to pierce the “corporate veil” and bring a claim directly against the parent company.

Motions to amend are often granted without a deep analysis of the facts so any decision on this motion to amend is of limited help in determining whether the parent entity will ultimately be held liable due to the heavy burden of proof on the landlord. The importance of losing a motion like this one, however, is that it will permit the landlord to conduct discovery into the relationship between the two WeWork entities, a prospect no defendant in these circumstances will be happy with due to the expense and attention discovery requires. I call the decision surprising because the use of SPEs is so frequent and so obvious to the counter-party that something more than mere conclusory allegations should be needed before a claim to pierce the corporate veil is permitted to proceed to discovery.

Under New York law a SPE needs to maintain some differentiation from its parent. For example, if the SPE regularly immediately transferred all profits to its parent with no reserves for future rent, a judge or jury might determine that the SPE was not a true independent entity.

What should a tenant have done in this situation even if this particular decision is an outlier? New York law looks favorably on specific disclaimers. A lease provision similar to the following sentences might have saved WeWork from the hassle of defending a piercing claim: “Landlord acknowledges that tenant is a special purpose entity organized solely to lease this premises. Landlord agrees not to make a claim against any party other than tenant and guarantor, to the limited extent set forth in the guaranty, and specifically agrees that no claim may be made against tenant’s members, officers or managers or affiliates thereof for any reason whatsoever including, without limitation, the failure to (i) adequately capitalize tenant, (ii) treat each such entity as an independent profit center or (iii) otherwise maintain the independent management or operations of such entities.” A judge reviewing that clause could rule as a matter of law on an early motion that there is no way the parent could be held liable.

While some may object to a forthright clause like the one outlined, it’s hard to imagine that the WeWork landlord did not know of the status of the tenant. (The tenant’s name “WeWork 261 Madison LLC” should have been a tipoff!) Some tenants might be concerned about bringing the SPE issues to light in such an obvious way. Perhaps they think the landlord had not focused on the issue. It’s impossible to tell the specific facts in this decision since the key documents are under seal.

While it’s possible that a fraud claim could be brought against tenant’s members, officers and managers even with a clause like this one, New York Courts have repeatedly held that a written disclaimer that is specifically addressed to the facts involving the claim will be upheld. A more general disclaimer would likely fail, however. For example, if the above clause did not specifically list the issues contemplated such as the failure to capitalize the tenant, a court might treat it as too general. The classic example of a general specific disclaimer is where a contract to purchase a house says the house is being sold “as is”. Typically, that disclaimer is too general. If the contract is more specific such as: “No representation is made by seller as to whether the roof leaks”, then a buyer can’t sue after the closing for fraud if the roof leaks.

SPEs have their utility and will remain a tool for businesses and investors but a written specific disclaimer in the operative document should help win early motions if litigation arises.

Thomas Kearns is a partner with Olshan Frome Wolosky LLP, New York, N.Y.