Pursuing Corporate Insiders and Business Successors on Corporate Debt

A 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.