Clientron Corp v. Devon IT Inc ( 2018 )

PRECEDENTIAL
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
_____________
No. 16-3432
_____________
CLIENTRON CORP.,
Appellant
v.
DEVON IT, INC.; JOHN BENNETT; NANCY DIROCCO
______________
On Appeal from the United States District Court
for the Eastern District of Pennsylvania
(E.D. Pa. No. 2-13-cv-05634)
District Judge: Honorable Michael M. Baylson
______________
Argued: January 23, 2018
Before: GREENAWAY, JR., KRAUSE, Circuit Judges, and
JONES, District Judge.*
(Opinion Filed: July 5, 2018)
*
The Honorable John E. Jones III, United States
District Judge for the Middle District of Pennsylvania, sitting
by designation.
John D. van Loben Sels [Argued]
Fish IP Law
333 Twin Dolphin Drive, Suite 200
Redwood City, CA 94065
Counsel for Appellant
Gary M. Samms [Argued]
Obermayer Rebmann Maxwell & Hippel LLP
Centre Square West
1500 Market Street, Suite 3400
Philadelphia, PA 19102
Counsel for Appellees
______________
OPINION
______________
GREENAWAY, JR., Circuit Judge.
In this unusual case, Appellant Clientron Corp. is
actually the prevailing party below and holds a judgment
against Appellee Devon IT, Inc. worth over $7 million.
Clientron claims, however, that it is unable to recover because
Devon IT is insolvent. Before the District Court and now also
on appeal, Clientron has argued that Devon IT’s corporate veil
should be pierced, and that the two shareholders who own
Devon IT as tenants by the entirety, Appellees John Bennett
and Nance DiRocco, should be held personally liable for the
entire judgment. Although the District Court declined to
2
disregard Devon IT’s corporate form on the merits, it held
Bennett—but not DiRocco—personally liable for a portion of
the judgment as a sanction for egregious discovery misconduct.
According to Clientron, this decision to sanction only Bennett
was insufficient because he, like Devon IT, is judgment-proof.
Clientron contends that it can recover only if DiRocco is held
personally liable for the judgment as well.
As we will explain below, we hold that, irrespective of
whether the imposed sanction was sufficient to cure the
prejudice suffered by Clientron, the District Court committed
legal error in piercing Devon IT’s veil as a sanction to reach
Bennett but not DiRocco, and in holding Bennett personally
liable for only part of the judgment. We will therefore vacate
the District Court’s order sanctioning Bennett and remand so
that the District Court may impose a new sanction.
I. BACKGROUND
A. The Parties’ Contractual Relationship and This
Litigation
Clientron is a Taiwanese manufacturer and distributor
of computer components. Devon IT is a Pennsylvania
corporation that sells computer hardware and software and
whose sole shareholders are John Bennett and Nance DiRocco,
a married couple that jointly owns one hundred percent of
Devon IT’s shares as tenants by the entirety. Devon IT is one
of at least twenty-four business entities that Bennett and
DiRocco have owned together using the tenancy by the entirety
ownership form. Many of these entities bear similar names that
somehow incorporate the word “Devon.” Devon IT was
incorporated in 1999 as an S corporation. At first, its primary
function was to provide IT services to other Devon entities, but
3
by 2005, it had begun to transition from performing internal
work to providing services for other companies.
In 2010, Devon IT was awarded a contract from Dell to
sell “thin client” computer products.1 Devon IT in turn
contracted with Clientron to manufacture the computers that
Dell was to purchase. Under the arrangement, Clientron
manufactured the goods and shipped them directly to Dell, and
Dell paid Devon IT, who in turn paid Clientron. But Devon IT
stopped paying Clientron entirely in March 2012. At the time,
Devon IT owed Clientron over $6 million in unpaid invoices
for products Clientron had provided. Sometime thereafter,
Dell terminated its relationship with Devon IT and paid Devon
IT $2 million, none of which ever made its way to Clientron.
Pursuant to the parties’ agreement, Clientron submitted
a request for arbitration to the Chinese Arbitration Association
in Taiwan in September 2012, claiming that Devon IT had
breached its obligations under the parties’ agreement. The
Taiwanese arbitrators ruled in Clientron’s favor and awarded
over $6.5 million in damages.
Clientron then sued Devon IT, Bennett, and DiRocco in
the Eastern District of Pennsylvania seeking to enforce the
arbitration award. In a second suit that was later consolidated
with the first, Clientron sought an additional $14.3 million in
damages from the three Defendants for fraud and breach of
1
“Thin clients” are lightweight computers that are
dependent on a remote server to fulfill their computational
roles and are typically components of broader computer
infrastructures.
4
contract stemming from Devon IT’s refusal to pay for products
in purchase orders that were not covered by the Taiwanese
arbitration. Clientron further alleged that, under Pennsylvania
law, Devon IT was the alter ego of its two sole shareholders,
Bennett and DiRocco, and it asked the District Court to pierce
Devon IT’s corporate veil.2
B. The Appellees’ Discovery Misconduct
During pretrial discovery, the Defendants continually
failed to meet their obligations under the Federal Rules. In
response to Clientron’s requests for documents, they initially
asserted frivolous general objections before eventually making
either incomplete or non-responsive productions. At one point,
they produced ninety-three boxes of irrelevant documents
without sorting the documents into topics or categories.
Moreover, despite being properly served with two deposition
notices under Federal Rule of Civil Procedure 30(b)(6), which
requires a corporation to designate a witness to testify on its
behalf, Devon IT never designated such a witness at all, let
alone regarding basic topics relevant to Clientron’s alter ego
claims, such as the administration of Devon IT’s bank records,
general ledger, and other corporate records. Defendants’
counsel represented to the District Court that he overlooked the
second Rule 30(b)(6) notice, but both the court and Clientron
repeatedly reminded counsel and the Defendants themselves
that they needed to designate a witness on the topics in the
2
Devon IT asserted counterclaims against Clientron as
well, but Devon IT did not prevail on these claims below, and
they are not at issue in this appeal.
5
notice. Without any adequate explanation, however, the
Defendants never produced a knowledgeable witness.
Meanwhile, Bennett, who was the chairman and sole
member of Devon IT’s board of directors, claimed to be
unfamiliar with virtually all details of the case during his
deposition. He maintained, for example, that he was unaware
of whether Devon IT even maintained a general ledger. He
further stated that he was unable to testify regarding any of
Devon IT’s defenses or counterclaims. Bennett also continued
his practice of regularly deleting all of the sent and received
emails from his personal account after he knew a dispute had
arisen with Clientron, and even after Clientron had filed suit.
As a result of the Defendants’ discovery practices,
Clientron filed four separate motions to compel, as well as
multiple letters to the District Court detailing their discovery
issues. The District Court, for its part, entered four separate
orders requiring the Defendants to provide discovery. After
the Defendants failed to comply with those orders and
Clientron filed a motion for sanctions, the court concluded that
the Defendants’ conduct was willful and in bad faith, and that
the prejudice to Clientron was “obvious” because there was a
“high probability that relevant information ha[d] not been
provided.” App. 14. Accordingly, in an August 28, 2015
order, the court issued a number of sanctions against Devon IT.
First, it imposed a monetary sanction of $44,320.50
corresponding to the extra costs incurred by Clientron.
Second, it excluded Devon IT’s evidence supporting its
defense that the arbitration award should not be enforced
because the arbitration clause in the parties’ agreement did not
cover the products that were at issue in the arbitration. And
third, the District Court excluded any evidence supporting
Devon IT’s defenses to Clientron’s non-arbitrated breach of
6
contract claim that had not already been disclosed during
pretrial proceedings.
Importantly, however, the District Court initially
refrained from issuing any sanctions against Bennett
individually because he had then recently filed for bankruptcy
and was protected by an automatic stay. The court instead
stated that it would reserve consideration of whether piercing
the corporate veil would be an appropriate sanction to impose
against him. DiRocco was not a party to Bennett’s bankruptcy
case, but the court nonetheless declined to sanction her
individually because it concluded that she had not personally
participated in any of the discovery misconduct.
C. The Enforcement of the Arbitration Award and the
Jury Trial
On the same day that it issued discovery sanctions
against Devon IT, the District Court granted Clientron’s
motion for summary judgment with respect to the arbitration
award and enforced the roughly $6.5 million award against
Devon IT plus interest and costs, equaling a total amount of
$6,943,817.13. The court concluded that the award should be
enforced as a matter of comity under governing Pennsylvania
law. Clientron’s non-arbitrated breach of contract and fraud
claims then proceeded to a jury trial. The issue of whether
Devon IT’s corporate veil should be pierced also proceeded to
trial, but the District Court ruled that the jury’s verdict on that
point would be advisory only.
Despite being provided with inadequate discovery,
Clientron was nevertheless able to present a variety of evidence
at trial in support of its contention that veil piercing was
7
appropriate. Its accounting expert, Kyle Midkiff, testified that,
based on the limited discovery provided, she was able to
discern that, from 2010 to 2013, $24 million was siphoned
from Devon IT to other Bennett and DiRocco-owned entities.
And Midkiff saw that one of the Devon entities receiving the
most money from Devon IT subsequently made payments into
Bennett’s personal account. Midkiff also explained that Devon
IT’s general ledger showed that Devon IT had made a $3.5
million loan to its shareholders, Bennett and DiRocco. The
same loan appeared on Devon IT’s 2010 tax return as well.
Both Bennett and DiRocco, however, denied receiving the
loan—or any loan from Devon IT for that matter—and claimed
there must have been a mistake in the records.
Moreover, Midkiff testified that, in recent years, both
Bennett and DiRocco’s credit card purchases had exceeded the
income reflected on their personal tax returns. While the
“limited financial records” Devon IT had turned over left
Midkiff unable to conclude definitively that corporate funds
were used to pay these personal expenses, she said that it was
likely Bennett and DiRocco had received money from their
corporations and commingled personal and corporate finances.
App. 960.
Midkiff further testified that, from 2010 to 2013, there
was a total of $79 million in deposits that went into Devon IT’s
account, yet Devon IT was nonetheless insolvent from at least
2009 to 2012. Indeed, Bennett himself testified that Devon IT
did not make any money from 2008 to 2012. Midkiff also
explained that Devon IT rented office space from another
company owned by Bennett and DiRocco, but notably, no
leases or other documents appeared to exist with respect to this
arrangement, and rent payments fluctuated dramatically
between 2011 and 2013.
8
Despite pleading ignorance during discovery, Bennett
admitted at trial that he made the decision to spend the $2
million termination payment from Dell on Devon IT’s
operation costs instead of paying Clientron. Bennett similarly
admitted that he and two other Devon IT officers made the
decision to spend the proceeds from other settlements on
Devon IT operation costs and other corporate debts.
Meanwhile, DiRocco testified that she had virtually no
role in Devon IT’s operations, nor did she have any meaningful
knowledge of its activities. Instead, as DiRocco
acknowledged, she gave Bennett a proxy to act on her behalf.
He had “unfettered discretion” to spend money in the entities
that they owned together and to sign DiRocco’s name on
documents in connection with those entities. App. 924.
DiRocco testified, however, that she occasionally hosted meals
for Bennett’s business guests when they came to her home, and
she claimed $6,386 in meals and entertainment expenses on
Devon IT’s 2010 tax return.
Although Bennett was chairman and sole member of
Devon IT’s board of directors, evidence was also presented
that Devon IT employed functional officers, including a Chief
Operating Officer, and a Chief Technology Officer, who
purportedly oversaw day-to-day operations and met with
Bennett regularly. And there was evidence that, at least at one
time, Devon IT had somewhere between thirty and forty
employees.
At the conclusion of trial, the District Court instructed
the jury that it was permitted, but not required, to make an
adverse inference against Devon IT due to its earlier discovery
9
conduct; the instruction did not reference Bennett or DiRocco
by name. The jury ultimately returned a verdict finding Devon
IT liable for breach of contract, and it awarded Clientron an
additional $737,018 in damages. But the jury rejected
Clientron’s fraud claim and declined to pierce Devon IT’s
corporate veil to hold Bennet and DiRocco jointly and
severally liable for the contract judgment.
D. The District Court’s Post-Trial Rulings
In a memorandum opinion following trial, the District
Court adopted the jury’s verdict declining to pierce Devon IT’s
corporate veil. Importantly, the court did not adopt an adverse
inference. It instead emphasized that much of Clientron’s
evidence was “[s]peculative, [c]onclusory, or [i]ncomplete.”
App. 55. For instance, the court acknowledged that Devon IT
had sent more than $24 million to other Devon-related entities
between 2010 and 2013, but it stressed that Clientron had not
shown how any of that money had made its way into Bennett’s
and/or DiRocco’s personal accounts, or how the transactions
were otherwise improper. The court similarly emphasized that
it was Clientron’s burden to prove that the alleged $3.5 million
loan actually existed and was issued for some improper
purpose. Finding the evidence Clientron presented equally
consistent with “sloppy record keeping,” the court concluded
that Clientron had failed to meet that burden. App. 56.
Regarding the rent arrangement with the other company
owned by Bennett and DiRocco, the court conceded that the
payment “fluctuations were admittedly suspicious given an
apparent lack of formal leases documenting how rent was
calculated,” but absent more concrete evidence, the court could
not conclude that the rent payments represented a commingling
10
of funds. App. 58. “One possible explanation,” the court
believed, was that Devon IT’s office space “expanded once the
Dell contract was signed and then shrank dramatically
following the contract’s 2012 cancellation.” Id. 58 n.10. With
respect to the Dell money and other settlement proceeds that
Bennett had diverted away from Clientron, the court
determined that Clientron had not proven that any of the money
“was in fact used to benefit Bennett and DiRocco personally as
opposed to benefitting Devon IT, albeit in flagrant breach of
Devon IT’s contractual obligations.” App. 60. The court
concluded that, without more, Clientron had failed to establish
that Devon IT was Bennett and DiRocco’s alter ego. It
therefore declined to disregard Devon IT’s corporate form.
However, in the same opinion, the District Court
proceeded to pierce the veil to reach Bennett’s assets as a
sanction for his previous discovery misconduct. As Bennett’s
bankruptcy stay had by then been lifted, the court purported to
“join[] a number of other courts which have held that piercing
the corporate veil is an appropriate sanction for discovery
misconduct impeding a party’s ability to prove alter ego
liability,” reasoning that “Bennett’s conduct seriously impeded
Clientron’s ability to prove alter ego liability and warrants
strong sanctions.” App. 67. “Simply put,” the court stated,
“Clientron would likely have had a much stronger case before
the jury if not for Bennett’s egregious misconduct.” App. 68.
But the court did not pierce the veil to reach DiRocco,
reiterating its earlier conclusion that she had not personally
participated in any of the discovery misconduct. And the court
made Bennett personally liable for only the $737,018 damages
award from the jury trial and the $44,320 monetary sanction
earlier imposed on Devon IT; without explanation, it did not
make Bennett personally liable for the $6.9 million Taiwanese
11
arbitration award that the court had previously enforced against
Devon IT. Clientron then filed this appeal.
II. JURISDICTION
The District Court had jurisdiction under 28 U.S.C.
§ 1332(a). We have jurisdiction under 28 U.S.C. § 1291.
III. DISCUSSION
Pursuant to Pennsylvania law, property owned as
tenants by the entirety cannot be accessed by the creditors of
only one spouse. See Madden v. Gosztonyi Savings & Trust
Co., 200 A. 624, 627–28 (Pa. 1938). Thus, under the belief
that Devon IT is insolvent and that Bennett is similarly
judgment-proof because of his bankruptcy, Clientron asks this
Court to make DiRocco personally liable for the judgment so
that it can reach the property the couple owns jointly. Clientron
argues that the District Court erred in declining to pierce the
veil on the merits under Pennsylvania law, and in the
alternative, that the District Court erred in refusing to pierce
the veil with respect to DiRocco as a discovery sanction. It
further contends that the District Court should have made both
Bennett and DiRocco personally liable for the entire judgment,
including the $6.9 million arbitration award.
A. The Merits of Clientron’s Alter Ego Claim
Clientron first argues that, notwithstanding the
Appellees’ discovery misconduct, it presented sufficient
evidence at trial to pierce the corporate veil under Pennsylvania
law and reach the personal assets of both Bennett and DiRocco.
Clientron therefore contends that the District Court erred in
12
adopting the jury’s advisory verdict that declined to pierce the
veil.
We review for clear error the District Court’s findings
of fact. See McGann v. Cinemark USA, Inc., 873 F.3d 218, 223
(3d Cir. 2017). We exercise plenary review over the District
Court’s ultimate legal determination of whether to pierce the
corporate veil based on those facts. Craig v. Lake Asbestos of
Que., Ltd., 843 F.2d 145, 148 (3d Cir. 1988) (“[W]hen a district
court sitting in diversity applies state legal precepts to
determine whether to pierce the corporate veil, the legal
conclusion that it has drawn from the facts found is subject to
plenary review.”).
Piercing the corporate veil “is an equitable remedy
whereby a court disregards ‘the existence of the corporation to
make the corporation’s individual principals and their personal
assets liable for the debts of the corporation.’” In re Blatstein,
192 F.3d 88, 100 (3d Cir. 1999) (quoting In re Schuster, 132
B.R. 604, 607 (Bankr. D. Minn. 1991)). “Pennsylvania law,
applicable here, recognizes a strong presumption against
piercing the corporate veil.” Id. (citing Lumax Indus., Inc. v.
Aultman, 669 A.2d 893, 895 (Pa. 1995)). Applying
Pennsylvania law, we have previously observed that
the factors weighing in favor of piercing the veil
include: “failure to observe corporate
formalities, non-payment of dividends,
insolvency of the debtor corporation at the time,
siphoning of funds of the corporation by the
dominant shareholder, non-functioning of other
officers or directors, absence of corporate
records, and the fact that the corporation is
13
merely a facade for the operations of the
dominant stockholder or stockholders.”
Id. (quoting Kaplan v. First Options of Chi., Inc., 19 F.3d 1503,
1521 (3d Cir. 1994)); see also Lumax, 669 A.2d at 895. Not
all factors need to be present; rather, the evidence must
ultimately show that the corporation was “nothing more than a
sham used to disguise [the shareholders’] use of its assets for
[their] own benefit in fraud of its creditors.” Blatstein, 192
F.3d at 100 (quoting Kaplan, 19 F.3d at 1521).
Here, setting aside the Appellees’ discovery
misconduct, we agree with the District Court that Clientron did
not establish that Devon IT was merely a sham. Although it is
evident that Devon IT withheld funds from Clientron in
obvious breach of its contractual obligations, Clientron could
not show that such withholding benefitted Bennett’s and
DiRocco’s individual interests as opposed to benefitting Devon
IT. Indeed, Clientron presented evidence regarding money
transfers between Bennett and DiRocco-owned entities, but it
was unable to show how those transfers benefitted Bennett and
DiRocco personally as individuals. Testimony at trial,
meanwhile, indicated that Devon IT had several functional
officers, who ran day-to-day operations of the company while
regularly consulting with Bennett, as well as between thirty
and forty employees.
Admittedly, Clientron did present evidence that gives us
pause. The evidence concerning the $3.5 million loan from
Devon IT to Bennett and DiRocco, while conflicting, certainly
raises suspicions. As does the evidence regarding Bennett and
DiRocco’s credit card purchases, the fluctuations in Devon
IT’s rent payments, and the amount of money transferred from
Devon IT to other entities owned by Bennett and DiRocco. But
14
although this evidence certainly shows that Bennett and
DiRocco did not strictly adhere to corporate formalities, it fails
to prove that Devon IT was nothing more than a sham used to
disguise Bennett and DiRocco’s use of corporate assets for
personal use. Cf. Trs. of Nat’l Elevator Indus. Pension, Health
Benefit & Educ. Funds v. Lutyk, 332 F.3d 188, 196 (3d Cir.
2003) (observing that, under federal corporate law, “lack of
formalities in a closely-held or family corporation does not
often have as much consequence as where other kinds of
corporations are involved” (citation omitted)). Thus, without
more, Clientron’s evidence is insufficient to overcome
Pennsylvania’s strong presumption against piercing the
corporate veil.3
3
In arguing that it has met its burden, Clientron urges
us to adopt an adverse inference to account for the Appellees’
discovery misconduct. This argument, however, conflates the
two issues on appeal. Seeing that the District Court imposed a
different discovery sanction, we see no basis for adopting an
adverse inference at this juncture as an additional sanction. As
we will explain in detail below, we conclude that the chosen
sanction below was legally erroneous, but the choice of
whether to impose an adverse inference as an alternative
sanction will be the District Court’s to make on remand.
Accordingly, for now, we take no position on whether an
adverse inference would impact the result of the alter ego
inquiry on the merits. We hold only that, without the aid of an
adverse inference, Clientron has not established under
Pennsylvania law that Devon IT was its shareholders’ alter
ego.
15
B. The District Court’s Veil Piercing Discovery
Sanction
Clientron next argues that even if it failed to meet its
burden on the merits of the Pennsylvania alter ego claim, the
District Court should have pierced the veil as to both Bennett
and DiRocco as a discovery sanction. It contends that both
Bennett and DiRocco should be held personally liable because
DiRocco’s personal conduct was sanctionable, and because
there is no legal basis for distinguishing between shareholders
when piercing the corporate veil.
We review for abuse of discretion a district court’s
decision to impose discovery sanctions. McLaughlin v. Phelan
Hallinan & Schmieg, LLP, 756 F.3d 240, 248 (3d Cir. 2014).
“While this standard of review is deferential, a district court
abuses its discretion in imposing sanctions when it ‘base[s] its
ruling on an erroneous view of the law or on a clearly erroneous
assessment of the evidence.’” Bowers v. Nat’l Collegiate
Athletic Ass’n (Bowers II), 475 F.3d 524, 538 (3d Cir. 2007)
(alteration in original) (quoting Cooter & Gell v. Hartmarx
Corp., 496 U.S. 384, 405 (1990)), as amended on reh’g (Mar.
8, 2007).
Here, the District Court undoubtedly possessed the
authority to impose some kind of sanction against Bennett
under Federal Rule of Civil Procedure 37.4 Specifically, Rule
4
Federal courts possess inherent authority to impose
sanctions as well, and this “power . . . can be invoked even if
procedural rules exist which sanction the same conduct.”
Chambers v. NASCO, Inc., 501 U.S. 32, 49 (1991). Our
“preferred” course, however, is that when “statutory or rules-
based sanctions are entirely adequate, they should be invoked,
16
37(b)(2)(A) states, in part, that “[i]f a party . . . fails to obey an
order to provide or permit discovery . . . , the court where the
action is pending may issue further just orders” sanctioning the
offending party. The potential sanctions endorsed by the Rule
include, among others, “directing that the matters embraced in
the order or other designated facts be taken as established for
purposes of the action, as the prevailing party claims; . . .
prohibiting the disobedient party from supporting or opposing
designated claims or defenses, or from introducing designated
matters in evidence;” and “rendering a default judgment
against the disobedient party.”5 Fed. R. Civ. P. 37(b)(2)(A)(i)–
(ii), (vi).
rather than the inherent power.” In re Prudential Ins. Co. Am.
Sales Practice Litig. Agent Actions, 278 F.3d 175, 189 (3d Cir.
2002) (quoting Gregory P. Joseph, Sanctions: The Federal
Law of Litigation Abuse 428 (3d ed. 1999)). Because we find
that Rule 37 provides an adequate basis for sanctions in this
case, we decline to interpret the District Court’s imposed
sanction as an exercise of its inherent powers.
5
Rule 37(b)(2)(A) also states that courts may sanction
discovery misconduct by “striking pleadings in whole or in
part; . . . staying further proceedings until the order is obeyed;
[or] dismissing the action or proceeding in whole or in part.”
Fed. R. Civ. P. 37(b)(2)(A)(iii)–(v). Rule 37(e) is of potential
relevance in this case as well, though it is clear that the District
Court did not rely on it. That provision provides, in part, that
courts may impose an adverse inference, dismiss the action, or
enter a default judgment “[i]f electronically stored information
that should have been preserved in the anticipation or conduct
of litigation is lost because a party failed to take reasonable
steps to preserve it, . . . it cannot be restored or replaced
17
It is not evident that the District Court in this case
imposed one of the listed sanctions, though. It is apparent that
the court ultimately held Bennett liable for the $737,018 breach
of contract damages award from the jury trial and the $44,320
monetary sanction previously imposed on Devon IT, but how
it got to that outcome is less clear.
As we will explain below, one might initially think that
the District Court applied Rule 37(b)(2)(A)(i) to “establish[]
for purposes of the action” that Devon IT was Bennett’s alter
ego under Pennsylvania law. But because such a ruling would
have required the court to hold both Bennett and DiRocco
personally liable for the entire judgment—something the court
did not do—it is not a reasonable interpretation of the District
Court’s decision. Thus, as we will also explain below, we are
forced to conclude that the court’s veil piercing remedy was
grounded in federal law. Our task here on appeal, then, is to
determine whether Rule 37 authorizes the fashioning of such a
remedy. We conclude that it does not and will therefore vacate
the District Court’s sanctioning order.
1. Pennsylvania law and establishing alter ego
for purposes of the action under Rule
37(b)(2)(A)(i)
Of the sanctions expressly endorsed by Rule
37(b)(2)(A), the most plausible option in this case is that the
District Court “established for purposes of the action” under
Rule 37(b)(2)(A)(i), that Devon IT was Bennett’s alter ego
through additional discovery,” and the court “find[s] that the
party acted with the intent to deprive another party of the
information’s use in the litigation.”
18
under Pennsylvania law. But such an interpretation seems a
stretch; there is little indication that the District Court had Rule
37(b)(2)(A)(i) in mind when imposing its sanction. For one, in
its opinion, the court never used the language of Rule
37(b)(2)(A)(i) or even cited Rule 37 at all. Instead, it said that
it was “piercing the corporate veil” as a sanction “for discovery
misconduct impeding a party’s ability to prove alter ego
liability.” App. 67. The court had also just held—earlier in the
exact same opinion—that Devon IT was not Bennett’s or
DiRocco’s alter ego under Pennsylvania law. It would be odd
if the District Court, having just made an adjudication on the
merits of the alter ego issue, immediately turned around and
reversed that adjudication as a discovery sanction.
But more importantly, the District Court neglected to
even consider the implications of establishing alter ego under
Pennsylvania law for purposes of the action. Indeed, if the
court had examined Pennsylvania law, it would have seen that
two different legal consequences would necessarily follow
from establishing that Devon IT was Bennett’s alter ego.
First, establishing alter ego with respect to Bennett
would have necessarily made DiRocco personally liable for the
judgment as well, because in Pennsylvania, there is no basis
for distinguishing between two tenants by the entirety when
piercing the corporate veil based on an alter ego theory. Under
Pennsylvania law, alter ego liability does not necessarily hinge
on an individual shareholder’s personal conduct. Indeed, the
Pennsylvania Supreme Court has emphasized the “distinction
between liability for individual participation in a wrongful act
and an individual’s responsibility for any liability-creating act
performed behind the veil of a sham corporation.” Wicks v.
Milzoco Builders, Inc., 470 A.2d 86, 89 (Pa. 1983). “Where
the court pierces the corporate veil, the owner is liable because
19
the corporation is not a bona fide independent entity; therefore,
its acts are truly his.” Id. at 89–90.
Distinguishing between shareholders for alter ego
purposes is especially problematic where, as here, the
corporation is owned jointly by two tenants by the entirety.
Applying Pennsylvania law, we have previously stated that
tenancies by the entirety are “based on the legal fiction that
husband and wife are one person.” In re Brannon, 476 F.3d
170, 173 (3d Cir. 2007). The ownership form’s “essential
characteristic” is that each spouse holds “the whole or the
entirety,” and not a “share, moiety or divisible part.” Id.
(quoting In re Gallagher’s Estate, 43 A.2d 132, 133 (Pa.
1945)). The only ways the tenancy may be severed, “other than
by the death of one of the spouses, are ‘a joint conveyance of
the state, divorce, or mutual agreement,’” id. (quoting
Clingerman v. Sadowski, 519 A.2d 378, 381 (Pa. 1986)), none
of which is at issue in this case. And as long as the tenancy
remains intact, “[i]t is presumed that each tenant by the entirety
may, without specific consent, act individually on behalf of
both.” Id.
Taking all of these considerations together, a conclusion
that a corporation was the alter ego of one shareholder tenant
by the entirety, but not the other, is legally untenable in
Pennsylvania. Id. In this case, Bennett and DiRocco did not
hold equal fifty percent shares in Devon IT. Instead, they
together owned an undivided whole of the company, and they
each possessed the right to act on their spouse’s behalf. The
focus of the alter ego inquiry, meanwhile, is whether Devon IT
was a bona fide independent entity—not whether each
shareholder was personally liable for the particular injury at
issue. Thus, it is irrelevant that DiRocco chose not to
frequently participate in Devon IT’s affairs, despite her
20
unqualified right to do so at any time. Her supposed ignorance
about a corporation in which she held a one hundred percent
ownership stake cannot shield her from liability once it has
been established that the corporation was a sham.
Moreover, even if Pennsylvania law did require some
degree of personal involvement, evidence was presented at trial
regarding DiRocco’s participation in some corporate affairs.
She admitted that she occasionally hosted meals for Bennett’s
business guests. Indeed, she claimed $6,386 in meal and
entertainment expenses on a Devon IT tax return. Her name
was also signed (purportedly by Bennett) on Devon IT
documents, and she admitted that she took no issue with those
signatures. Thus, a holding on the merits under Pennsylvania
law that Devon IT was Bennett’s alter ego would necessarily
mean Devon IT was also DiRocco’s alter ego, and if the
District Court wanted to “establish” alter ego as a discovery
sanction, it needed to hold DiRocco liable together with
Bennett.
There is also a second legal consequence of establishing
alter ego under Pennsylvania law that the District Court
neglected to impose: Bennett and DiRocco would be
personally liable for the entire judgment against Devon IT—
that is, not just the $737,018 in contract damages and the
$44,320 in discovery sanctions, but also the $6.9 million
Taiwanese arbitration award. As we explained above, when
alter ego is established under Pennsylvania law, the
corporation’s acts are attributed to its shareholders, and the
shareholders are personally liable for the damages arising out
of those acts. Accordingly, establishing alter ego in this case
would mean that Devon IT’s act of breaching its agreement
with Clientron would be attributed to Bennett and DiRocco,
and they would be liable for all of the damages resulting from
21
the breach. The District Court, however, held Bennett liable
for only some of the damages. Without explanation and
without citing any Pennsylvania authority, the court did not
include in the judgment against Bennett the $6.9 million
arbitration award. Although the $6.9 million were initially
awarded in a Taiwanese arbitral forum, they are nonetheless
damages from Devon IT’s breach of contract, and the District
Court had previously decided that the award should be
enforced. If the District Court wanted to establish alter ego
under Pennsylvania law, it needed to include the $6.9 million
arbitration award in the judgment against the individual
shareholders.6
2. Piercing the corporate veil as a matter of
federal law
6
At first blush, one might think that the District Court
may have alternatively invoked Rule 37(b)(2)(A)(vi) and
rendered a default judgment against Bennett on Clientron’s
breach of contract claim that had proceeded to trial. But for
similar reasons, this too is an unreasonable interpretation of the
court’s decision. It is true that issuing a default judgment
would have had nearly the same effect as the veil piercing
sanction the court ultimately imposed: holding Bennett liable
for the $737,018 in damages from the breach of contract claim.
Importantly, however, the District Court here also held Bennett
personally liable for the $44,320 monetary sanction previously
imposed on Devon IT—something a default judgment on only
the breach of contract claim could not have accomplished. And
in its sanctioning decision, the District Court never once used
the word “default.” Thus, it is not a fair reading of the court’s
ruling to say that it entered a default judgment against Bennett.
22
Having taken account of Pennsylvania law and ruled out
Rule 37(b)(2)(A)(i), the District Court’s chosen sanction in this
case begins to come into focus. By departing from the
mandates of governing Pennsylvania law, the District Court
appears to have granted a remedy grounded, not in the
operative substantive law of the case, but in newly-developed
federal law. And the standards governing that federal
remedy—though not entirely clear—are evidently different
than those governing its state counterpart on the merits. In
other words, the District Court used judicially-created federal
law to essentially split the baby in a way that the substantive
state law at issue in the suit would not have permitted. Our
task here, then, is to determine whether Rule 37 authorizes such
an exercise of federal lawmaking. We conclude that it does
not.
Admittedly, the list of sanctions provided by Rule
37(b)(2)(A) is not exhaustive, and the decision to impose
sanctions is “generally entrusted to the discretion of the district
court.” Bowers II, 475 F.3d at 538. Thus, the District Court’s
decision to depart from the list of sanctions expressly endorsed
by the rule is not fatal. But Rule 37(b)(2)(A) is not equivalent
to carte blanche; it limits courts’ discretion in two ways: “First,
any sanction must be ‘just’; second, the sanction must be
specifically related to the particular ‘claim’ which was at issue
in the order to provide discovery.” Harris v. City of Phila., 47
F.3d 1311, 1330 (3d Cir. 1995) (emphasis in original) (quoting
Ins. Corp. of Ir., Ltd. v. Compagnie des Bauxites, 456 U.S. 694,
707 (1982)).
Both of these limitations are rooted in notions of due
process. The first “represents the general due process
restrictions on the court’s discretion.” Ins. Corp. of Ir., 456
U.S. at 707. The second requires that a “specific nexus” exist
23
between the sanction imposed and the underlying discovery
violations. Harris, 47 F.3d at 1330–31. Or put differently, it
requires that the unproduced discovery be sufficiently
“material to the administration of due process” to support a
presumption that the failure to produce constituted an
admission by the offending party that its asserted claim or
defense lacked merit. Ins. Corp. of Ir., 456 U.S. at 705
(quoting Hammond Packing Co. v. Arkansas, 212 U.S. 322,
351 (1909)).
Neither of Rule 37(b)(2)(A)’s requirements was met in
this case. We are unwilling to conclude that the “general due
process restrictions” on a federal court’s discretion permits it
to circumvent the substantive law governing a lawsuit by
developing its own, different, federal law standards based on a
party’s discovery misconduct. Likewise, no specific nexus
exists between the sanction imposed and the particular claim at
issue when the court inserts a new, judicially-created legal
remedy into the lawsuit as the means of imposing the sanction.
Rule 37(b)(2)(A) certainly allows courts to adopt conclusions,
presumptions, inferences, or evidentiary preclusion rules that
operate within the confines of the claims and defenses the
parties have already raised,7 but we cannot say that it
7
Courts may also impose monetary sanctions under
Rule 37, but only those that represent the “reasonable
expenses” and costs resulting from the discovery misconduct.
See Fed. R. Civ. P. 37(b)(2)(C); Martin v. Brown, 63 F.3d
1252, 1263–64 (3d Cir. 1995). The Appellees urge us to view
the sanction in this case as essentially a monetary sanction
imposed on Bennett. Even if we found this conception of the
sanction persuasive, we would still hold the sanction an abuse
of discretion because the monetary amount would be in no way
24
authorizes courts to create new federal law remedies that
liberate the courts from those confines entirely.8
Again, here, having already concluded that Devon IT
was not Bennett and DiRocco’s alter ego as a matter of
Pennsylvania law, the District Court proceeded to pierce the
corporate veil anyway. And it did so in a manner that, as
explained above, Pennsylvania law would not have allowed: it
distinguished between two tenants by the entirety and pierced
with respect to only part of the judgment.
None of the cases that the District Court cited supports
such a broad exercise of judicial lawmaking authority. Rather,
where courts in the past have pierced the veil due to discovery
misconduct, they have done so through the imposition of a
default judgment or legal presumption, or through the
preclusion of evidence—all of which operate within the
connected to the expenses and costs Clientron incurred as a
result of the Appellees’ discovery misconduct.
8
Indeed, we have emphasized that federal courts’
“power to formulate federal common law is implicated in two
basic types of cases: where a federal rule of decision is
necessary to protect ‘uniquely federal interests,’ and where
‘Congress has given the courts the power to develop
substantive law.’” Bowers v. Nat’l Collegiate Athletic Ass’n
(Bowers I), 346 F.3d 402, 423 (3d Cir. 2003) (quoting Tex.
Indus., Inc. v. Radcliff Materials, Inc., 451 U.S. 630, 640
(1981)). In this context, we are unable to identify a uniquely
federal interest that would justify the exercise of substantive
common lawmaking power, nor do we see any evidence that
Congress intended to authorize such power.
25
parameters of the claims and defenses raised by the parties.9
See, e.g., S. New Eng. Tel. Co. v. Glob. NAPs Inc., 624 F.3d
123, 146–49 (2d Cir. 2010) (affirming district court’s sanction
deeming that alter ego allegations had been established and
court’s rendering of a default judgment against all defendants
after issues of corporate liability and damages had already been
decided); Global NAPs, Inc. v. Verizon New Eng. Inc., 603
F.3d 71, 93–94 (1st Cir. 2010) (affirming default judgment on
alter ego claim that was entered as discovery sanction);
Compaq Comput. Corp. v. Ergonome Inc., 387 F.3d 403, 412–
14 (5th Cir. 2004) (affirming in part district court’s finding of
alter ego as a discovery sanction under Rule 37(b)(2)(A)(i));
Flame S.A. v. Indus. Carriers, Inc., 39 F. Supp. 3d 752, 766–
67 (E.D. Va. 2014) (establishing for purposes of the action,
under Rule 37(b)(2)(A)(i), that two of the corporate defendants
were alter egos of one another), aff’d sub nom. Flame S.A. v.
Freight Bulk Pte. Ltd., 807 F.3d 572, 585 n.10 (4th Cir. 2015)
(commenting that district court’s sanction “likely would have .
. . been an appropriate exercise” of discretion, but ultimately
9
Importantly, when a court enters a default judgment, it
does so by adjudicating liability with respect to a particular
claim that the plaintiff has raised and then awarding the
damages that correspond to such an adjudication of liability.
Here, as we have explained, the District Court’s sanction held
Bennett liable for not only the damages corresponding to
Clientron’s non-arbitrated breach of contract claim, but also
the monetary sanction previously imposed on Devon IT—
something a default judgment could not have accomplished.
We therefore need not decide whether it would have been an
abuse of discretion if the District Court had rendered a default
judgment here.
26
concluding that issue had not been developed sufficiently for
review on appeal); Sentry Ins. A Mut. Co. v. Brand Mgmt., Inc.,
295 F.R.D. 1, 8 (E.D.N.Y. 2013) (precluding disobedient party
from offering evidence in opposition to plaintiff’s alter ego
claim).
Those cases, as well as countless others, show that Rule
37(b) “provides a ‘veritable arsenal of sanctions’” to deter and
rectify discovery violations. Companion Health Servs., Inc. v.
Kurtz, 675 F.3d 75, 84 (1st Cir. 2012) (quoting Crispin-
Taveras v. Municipality of Carolina, 647 F.3d 1, 7 (1st Cir.
2011)). There are, however, limits to courts’ discretion. In this
case, it would be understandable if the District Court’s instinct
was to fashion a creative remedy that it thought would
correspond to the severity of the misconduct. But by failing to
ground its veil piercing remedy in the substantive state law that
governed the suit, the District Court went beyond its Rule 37
authority and abused its discretion. The sanction was based
“on an erroneous view of the law.” Bowers II, 475 F.3d at 538.
We will accordingly vacate the court’s order holding Bennett
liable for the $737,018 in damages from the breach of contract
claim and the $44,320 monetary sanction. Because the
authority to impose sanctions for discovery violations
committed in the district courts is generally entrusted to the
discretion of those courts in the first instance, we will remand
for further proceedings.
3. Considerations on Remand
On remand, it will be within the District Court’s
discretion to impose a new discovery sanction that is consistent
with Rule 37. It bears emphasis that nothing in this opinion
should be read to cast doubt on the District Court’s authority
to levy a sanction given the gravity of the misconduct, nor
27
should the opinion be read to take issue with the severity of the
sanction originally imposed. It is the legal mechanism
employed that ran afoul of Rule 37 here.
In light of our analysis regarding tenancies by the
entirety, we expect that the District Court will have little
problem imposing a proper sanction on remand that achieves
the desired effect and addresses the prejudice suffered by
Clientron. Indeed, in piercing the veil against Bennett as a
sanction, the court expressly found that “Clientron would
likely have had a much stronger case before the jury if not for
[his] egregious misconduct.” App. 67–68. Insofar as the court
declined to extend this sanction to DiRocco on the ground that
the record did not show she was personally involved in that
misconduct, this, as we have explained, was error, as tenancies
by the entirety are “based on the legal fiction that husband and
wife are one person,” In re Brannon, 476 F.3d at 173, and so
had Clientron prevailed on its alter ego claim, Pennsylvania
law would have required that both Bennett and DiRocco be
held personally liable. Thus, DiRocco undoubtedly benefitted
from Bennett’s discovery misconduct. By, as the District
Court put it, “seriously imped[ing] Clientron’s ability to prove
alter ego liability,” App. 67, Bennett protected DiRocco. That
the record did not reveal DiRocco’s personal participation in
the discovery misconduct would likely be relevant in the vast
majority of cases, but the existence of the tenancy by the
entirety changes the calculus here. While we have said that
“the extent of [a] party’s personal responsibility” is one of the
factors to be “balanced” when imposing a discovery sanction,
Poulis v. State Farm Fire & Cas. Co., 747 F.2d 863, 868 (3d
Cir. 1984), we have never held that personal wrongdoing is an
absolute prerequisite in all instances. This case is unusual
because Pennsylvania law regarding alter ego liability and
28
tenancies by the entirety make it so Bennett’s and DiRocco’s
interests are perfectly aligned, and because Clientron has made
plausible allegations that DiRocco’s passive role was part and
parcel of their abuse of the corporate form. We think, under
these unique circumstances, the limitations on the District
Court’s Rule 37 authority do not require that DiRocco be
shielded entirely from the ramifications of a sanction imposed
due to discovery misconduct committed by her co-defendant
husband.
With all this said, an adverse inference and/or the
preclusion of evidence are potential options on remand. By
allowing the consideration of the discovery misconduct within
the merits analysis, such measures would ensure that the
requisite nexus existed between the sanction imposed and the
particular claims at issue. Of course, we take no position on
how such measures might impact the outcome on the merits,
and the precise sanction imposed is ultimately up to the District
Court in the first instance.
IV. CONCLUSION
For the foregoing reasons, we will vacate the District
Court’s July 22, 2016 order that entered judgment in favor of
DiRocco and held Bennett liable for the $737,018 breach of
contract damages and the $44,320.50 monetary sanction. The
case is remanded to the District Court for further proceedings
consistent with this opinion.
29