PURSUING CORPORATE INSIDERS AND BUSINESS SUCCESSORS ON CORPORATE DEBT

DEBTORS’ CreditorsA Creditor’s chance of collecting from a defunct DEBTOR corporation lies somewhere between “slim and none”, unless a Creditor can impute the debt to Third Parties, including DEBTOR officers, directors, shareholders, spouses, family members (collectively called Insiders) and/or successor businesses. Such debt imputation can be based on either their receipt of fraudulently transferred DEBTOR assets, ownership of a successor business, or by piercing the DEBTOR’s corporate veil.

Officers and directors of solvent corporations owe fiduciary duties exclusively to the shareholders, generally expressed in terms of the duty of care, loyalty, and the duty to maximize the shareholder’s return. The duty of care is satisfied by following a reasonable, informed, deliberative process, attending meetings, keeping themselves informed, and discussing important issues. The duty of loyalty requires directors to act in good faith in the best interests of the corporation and its shareholders. Violations would be the misappropriation of corporate assets or opportunities, or self-dealing. The duty to maximize return is self explanatory.

People incorporate because they believe, “like the gospel”, that they are fully protected from liability for any corporate debt by the “shield of limited liability.” Well, as the George Gershwin song title laments, “It ain’t necessarily so.”

As long as a corporation pays its creditors, no “outsider” (except maybe the IRS) has any right to inquire into the corporation’s finances.  However, when a corporation stops timely paying its bills (cash flow insolvency) or, if its liabilities exceed its assets (balance sheet insolvency), it is legally insolvent as a matter of law, and the “shield of limited liability” disappears.

As a DEBTOR enters the “vicinity of insolvency” the directors’ fiduciary duties begin to shift from the shareholders to the DEBTORS’ Creditors. This shift in fiduciary duties is referred to as the “insolvency exception.” Upon insolvency (balance sheet or cash flow), the DEBTOR’s assets become a trust fund for its Creditors, and the Insiders are the Trustees.  Insiders cannot “self-deal” by paying themselves over trade creditors. Even shareholder loan repayments and compensation may be fraudulent transfers.

If Insiders of a solvent DEBTOR engage in self-dealing, only the corporate shareholders may pursue them (in a derivative action). But if a DEBTOR is insolvent, Insider self-dealing can be attacked by the DEBTOR’s Creditors.

In post Judgment discovery, the DEBTOR’s business records are discoverable and it is “amazing” what one can find; DEBTOR asset transfers to Insiders, DEBTOR payments of Insider personal expenses, capital distributions to Insiders, shareholder loan re-payments, and nonexempt compensation payments, and general misuse of corporate assets.  All of these can make the transferees or the benefitted Insider liable for the transfer.

 

DEBT IMPUTATION TO CORPORATE PRINCIPLES

DEBT IMPUTATION TO CORPORATE PRINCIPLES DEBT IMPUTATION TO CORPORATE PRINCIPLES                                                        

 

A Creditor’s chances of collecting a debt from a defunct or insolvent corporation are somewhere between “slim and none”.  Collection of such debt invariably requires imputing the corporate debt to Third Parties using various collection remedies.

 

Proceedings supplementary is such a Debt collection remedy, commenced by a Judgment Creditor against either fraudulent transferees of a Debtor’s assets, (usually the Debtor’s officers, directors, and/or shareholders) or a successor business owned by the same people, known as INSIDERS. And if the Debtor’s INSIDERS used the corporation to perpetrate a fraud on Creditors, that can also be a basis to pierce the corporate veil and hold the Insiders liable for the debt.

 

Tax advantages aside, people incorporate businesses because they believe, “like the gospel”, that they are fully protected from liability for corporate debt by the “shield of limited liability”, the ultimate corporate prophylactic.  This “gospel” is proof that “a little bit of knowledge is a dangerous thing”.

 

As long as a corporation pays its Creditors, its financial transactions are exempt from outside scrutiny (except for the IRS).  However, when a corporation becomes insolvent, either by not timely paying its debts (cash flow or equitable insolvency), or if its liabilities exceed a “fair valuation” of its assets (balance sheet insolvency), corporate fiduciary duties and obligations are radically affected. The Insiders’ fiduciary duties shift from the Debtor’s shareholders (to maximize share value) to its Creditors (to preserve assets to pay debts). The corporate assets become a trust fund for the benefit of the corporation’s Creditors and the INSIDERS are the Trustees. The Debtor’s financial transactions are now subject to scrutiny by its Creditors (even before Judgment) and, like the Chief of Police in “Casablanca”, one would be “shocked” to find fraudulent transfers to INSIDERS, their families, and successor businesses as well as use of the Debtor’s assets to pay Insider personal debts, among other abuses.  Well, they are all fraudulent transfers and provide bases to impute liability to the INSIDERS.

 

How many professionals, business people, trades people, (or anyone for that matter), when facing financial difficulty, close their corporate doors and take up a new, unrelated vocations.  “None”, you say?  Yes, it’s true; leopards don’t change their spots and old dogs rarely learn new tricks!  People almost always re-open businesses that are “remarkably similar” to the Debtor.  These new businesses are successor entities, and successors may be held liable for the predecessor’s debt.

 

What about the Debtor who incorporates today, defaults on a credit line next month, and is defunct a few months later? Insiders may be held liable if they either set up or used the corporation to perpetrate a fraud on Creditors. It is the basis to pierce the corporate veil.

 

Obtaining a Default Judgment against a defunct or insolvent corporation is not exactly rocket science, but for too many attorneys, pursuing collection of such a Judgment is analogous to a dog chasing a car.  What does the dog do when he catches it?

 

Debt imputation requires more than chasing some poor debtor with a credit report that screams “Debtor’s Prison”.  There are corporate Tax Returns to analyze, asset trails to follow, and legal issues (sometimes of first impression) to argue.  It’s not just a job, it’s an adventure!

 

 

 

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