The founders of a nonprofit credit repair agency determined to be a front for their for-profit businesses and for them personally have been found personally liable for $256 million in service fees paid by their clients over a several year period.  The First Circuit Court of Appeals has affirmed a trial court decision piercing the corporate veil and imposing the liability.  (Zimmerman v. Puccio, No. 09-1416, 7/27/10.)

Brothers John and Richard Puccio had originally owned several for-profit companies in the debt management business in New York in the early 1990s, but had been ordered to cease operations by the New York Banking Department in 1996.  They then formed Cambridge Credit Corporation, using the same name as one of their old for-profits, as a nonprofit corporation in Massachusetts and obtained 501(c)(3) status. 

They had the new nonprofit purchase the “intangible assets” of the old companies for $14.1 million, including their good will and trademarks, although the old companies had no trademarks at the time.  They also founded several new for-profit corporations to provide services to the new nonprofit, using the same client forms and processes.  In 2001 and 2003, they were each paid more than $600,000 by the nonprofit.  During the period from 1996 to 2004, John was paid more than $30 million from the group of companies, while Richard was paid nearly $22 million.

Because Cambridge and the others advertised their ability to improve a client’s credit, they were found to be covered by the Credit Repair Organizations Act.  The First Circuit had held earlier in the proceedings that Cambridge was covered even though the Act specifically exempts 501(c)(3) organizations because, the Court said, the nonprofit had to “actually operate as a nonprofit organization.”  (See Nonprofit Issues®, 6/16/05.)

After trial in the class action case, the corporations and the Puccios were found liable for misrepresentation and fraud in connection with their offer of services.  The trial court found the Puccios personally liable in part on a pierce the corporate veil theory.

On appeal, the Circuit Court affirmed.  “Massachusetts has identified as relevant to the veil-piercing analysis a set of twelve factors,” the Court said.  “They are: ‘(1) common ownership; (2) pervasive control; (3) confused intermingling of business assets; (4) thin capitalization; (5) nonobservance of corporate formalities; (6) absence of corporate records; (7) no payment of dividends; (8) insolvency at the time of the litigated transaction; (9) siphoning away of corporation’s funds by dominant shareholder; (10) nonfunctioning of officers and directors; (11) use of the corporation for transactions of the dominant shareholders; and (12) use of the corporation in promoting fraud.’”  This case, it said, was “a textbook case for lifting the corporate veil.”

The evidence showed that “the Puccios owned and had ‘pervasive control’ over all of the entities involved in this litigation, including Cambridge.  John Puccio set the terms of dealing among the Puccio companies, which functioned without clear boundaries or separate corporate structures.  Those dealings were conducted without independent representatives to protect the interests of the individual corporations.”

Further, the Court said, “there was a total failure to make clear which corporation was taking action or to observe with care the corporate form.  The Puccios did not delineate between their businesses, channeling funds between them, using employees interchangeably and applying funds from one entity to pay the bills for another.  Corporate formalities of even the most basic nature were largely nonexistent, as when Cambridge purchased [the old companies’] nonexistent ‘intangible assets’ for over $14 million.”

The Court also noted that the Puccios “siphoned money from the corporate accounts to pay for personal expenses such as adult entertainment and costs associated with a yacht.”

“The money that was funneled from Cambridge into other Puccio entities and ultimately to the Puccios themselves cannot be reached by the settlement with Cambridge or the judgment against the other corporations,” the Court said.  “In order to obtain full relief, the plaintiffs must be able to reach the Puccios, who were the lead players in the scheme being carried out by their network of corporations.

“That logic is at the very heart of the alter ego doctrine….  The corporate form should not bar the plaintiffs from seeking the full relief to which they are entitled when the defendants themselves treated Cambridge and the other companies as mere shells, ignoring financial, legal and practical formalities in furtherance of their own money-making enterprise.”

YOU NEED TO KNOW

We were critical of the Court for overriding the clear language of the statute in the earlier case, imposing an operational requirement on the statute’s exemption of 501(c)(3) organizations.  Apparently, the Court knew something that was not totally apparent in its opinion at the time. 

But we still think it would be more defensible to say Cambridge’s charitable status could be disregarded if it were found to be a sham or shell organization, which was ultimately the case, than to suggest that every charity had to be examined to see if it is charitable enough.

The final result, however, shows how risky it can be if individuals establish nonprofit organizations as shams for their personal aggrandizement.