Protection of Corporate Creditors

Question 1

What are the basic strategies to protect corporate creditors?

Answer 1

1) Mandatory Disclosure
2) Capital Regulation (Distribution Constraints, like the nimble dividend test)
3) Standard-Based Duties (Zone of insolvency/ fraudulent transfers/shareholder liability)
4) Substantive consolidation
5) Sucessor Liability

Question 2

What is mandatory Disclosure?

Does state law require mandatory disclosure?

Answer 2

1) Financial statements made available to creditors by federal securities law.
2) No.

Question 3

What is on the right side of the balance sheet?

What is on the left side?

Answer 3

1) Assets

2) Liabilities and shareholder’s equity.

Question 4

What is accounted for in shareholder’s liability?

Answer 4

1) Stated Capital
2) Capital Surplus
3) Retained Earnings

Question 5

What is Stated Capital?

Answer 5

Stated Capital is the par value of the shares multiplied by the total number of those shares. (What shareholders contributed when the company was formed.)

Question 6

What are retained earnings>

Answer 6

The net profits that the company keeps for later distributions.

Question 7

What is capital surplus?

Answer 7

The amount by which the value of the shares exceeds the par value (or stated capital). So, when shares increase in amount and are sold for a higher amount than the par value/stated capital, this goes into the capital surplus account.

Question 8

What is surplus?

Answer 8

The sum of the capital surplus and retained earnings accounts. These are usually paid out in dividends.

Question 9

What is the nimble dividend test?

Answer 9

The nimble dividend test states that if the amount of the retained earnings and capital surplus is negative (less than zero), the company may make dividend payments from the positive value of the net profits from the current or preceding fiscal year, whichever is higher.

Question 10

Nimble Dividends test example: Retained earnings is -200 and stated capital is 100. Therefore, there is a -100 surplus. On the income statement in the previous year, net profits were 100. One the income statement in the current year, net profits were 50. Can we pay dividends? If so, how much?

Answer 10

Yes, we can pay dividends from the year net profits were higher out of the current year or the preceding year. So, we may pay out 100 in dividends

Question 11

What is the maximum amount that a company can pay out in dividends under the DGCL?

Answer 11

The total value of the retained earnings and the capital surplus account. If the nimble dividends test applies, the higher of the current or preceding year’s net profits.

Question 12

What may a company apply its net profits too?

Answer 12

Either the retained earnings account, or dividends to shareholders.

Question 13

What limits on distributions exist when a company is in the zone of insolvency?

Answer 13

According to Credit Lyonnais, when a company is in the zone of insolvency, the director owes a duty to consider the community of interests of the corporation, not just the shareholders.

Therefore, when selection options, the directions should choose one that is both the highest in value, but also the highest in value based on the total expected value to the residual risk bearers.

Question 14

What is the most important protections for corporate creditors?

Answer 14

The most important is contract, but that can be expensive. Therefore, the actual most important protection is the fraudulent transfers doctrine.

Question 15

What is the fraudulent transfers doctrine?

Answer 15

It is a doctrine that voids transfers made by insolvent debtors.

Question 16

What are the conditions for the fraudulent transfers doctrine?

Answer 16

1) Actual intent to defraud

2) Constructive Fraud.

Question 17

What are the main presumptions for constructive fraud?

Answer 17

1) The debtor did not receive a “reasonably equivalent value (usually less, but can be more); and
2) The total remaining assets of the debtor are unreasonable small.

Question 18

Will constructive fraud be a triggering condition for the fraudulent transfers doctrine for creditors that a company may acquire in the future?

Answer 18

No. For the doctrine to apply to future creditors, we need actual intent to defraud. Future creditors can check the public statements to see whether or not the debtors assets are unreasonably small or if they got reasonable value for its exchanges.

Question 19

What are the two legal doctrines that may be employed to render a controlling shareholder liable for the debts of the corporation?

Answer 19

1) Equitable subordination

2) Corporate Veil Piercing

Question 20

What is equitable subordination?

Answer 20

One of the two ways to hold a controlling shareholder personally liable. It gives priority to outside creditors over the shareholder during the dissolution of the company in bankruptcy.

Question 21

What are the conditions for equitable subordination?

Answer 21

1) Major shareholder
2) Makes a loan to the corporation
3) And in doing so, he behaved unfairly to the creditors of the corporation.

Question 22

Why would a shareholder make a loan to the company? How would this action be unfair?

Answer 22

He may make a loan to the corporation for legitimate reasons. It may be unfair of the shareholder is trying to put himself on equal footing with the corporate creditors.

Question 23

What does the third condition (that the behaved unfairly to corporate creditors) of the equitable subordination doctrine require?

Answer 23

Well, it doe not require fraud. Something short of fraud. There are two tests to determine if the third condition (fairness) has been satisfied:

1) Whether it can be justified fairly and reasonably.
2) Whether all the circumstances indicate that it was an arms-length deal.

Question 24

Is undercapitalization alone sufficient to prove that a shareholder acted unfairly by loaning to a corporation?

Answer 24

No. For example, if a company is limping along, he could actually be trying to save it. However, it does suggest (1) That the shareholder is intentionally trying to exploit the limited liability and (2) that it is trying to save the reputation of the firm to outside creditors.

Question 25

What are the two general conditions that will allow a creditor to “pierce the corporate veil?”

Answer 25

1) Lack of separation between the shareholder and the corporation.
2) Corporate form used as an instrument for unfair or inequitable treatment of corporate creditors.

Question 26

What are the typical presumptions for the first condition of the veil piercing doctrine (lack of operation between shareholder and corporation?)

Answer 26

1) Shareholder has domination of the corporate decisions
2) Shareholder disregards corporate formalities.
3) Undercapitalization
4) Co-mingling of corporate funds and shareholder funds (either the shareholder mixes his funds to the corporation, or the shareholder uses corporate funds)
5) No corporate records keeping.

Question 27

Is undercapitalization alone sufficient to find the first condition of the veil piercing doctrine satisfied? (Lack of separation between shareholder and the corporation)

Answer 27

No. Undercapitalization by itself is insufficient.

Question 28

What has to happen to satisfy the second condition of the veil pricing doctrine? (That the corporate form was used as an instrument for unfair or inequitable treatment?)

Answer 28

If it doesn’t involve fraud, it is an open question. But possible interpretation is: strategic behavior to avoid liability ex-post (after the fact, considering the results).

Question 29

What are some examples of strategic behavior to avoid liability ex-post? (Relating to the second prong of the veil piercing doctrine; the corporate form was used as an instrument for unfair in inequitable treatment.)

Answer 29

Some examples include:

(1) Incorporating to avoid liability (from an LLC)
(2) Shifting assets to another corporation.
(3) Misrepresenting assets.

Question 30

What are the three different formulations of the veil piercing doctrine that Prof. Restrapo cares about?

Answer 30

1) The Lowendahl test
2) The Van Dorn Test
3) The Laya Test

Question 31

What is the Lowendahl formulation of the veil piercing doctrine?

Answer 31

1) Complete shareholder domination of the corporation

2) Corporate wrongdoing that proximately causes creditor injury.

Question 32

What is the Van Dorn formulation of the veil piercing doctrine?

Answer 32

1) Unity of interest so that the separate personalities of shareholder and corporation no longer exist.
2) Adherence to the fiction of the separate corporation would sanction fraud or injustice.

Question 33

What is the Laya formulation of the veil piercing doctrine?

Answer 33

1) Unity of interest so that the separate personalities of the shareholder and the corporation can no longer exist.
2) There would be injustice or an inequitable result if the acts were treated as those of the corporation alone.
3) Was there an assumption of risk (voluntary exposure to risk after conducting an investigation) by the creditor? When it would be reasonable for a particular type of organization (e.g., a bank) to conduct an investigation of the corporation, such party will be charged with the knowledge that a reasonable investigation would disclose. (The sophisticated creditor will be charged will the knowledge that a reasonable investigation would have disclosed.)

Question 34

What is reverse or horizontal piercing? What are those doctrine tests?

Answer 34

Reverse piercing is when a creditor “pierces through” a shareholder to get at the corporate assets. (I.e., an individual shareholder wants corporate funds)

Horizontal piercing is when a corporate creditor wants to pierce into a sister company’s assets.

The test is the same. Use the majority formulation: (1) There is a lack of separation between the shareholder/sister corporation and the corporation; (2) The corporate form is being used as an instrument for unfair or inequitable treatment of corporate creditors?

Question 35

Is fraud enough to satisfy the second condition of the corporate veil piercing test (That the corporate form is being used as a vehicle for the unfair or inequitable treatment of corporate shareholders)

Answer 35

Yes. Definitely. Ya schmuck.

Question 36

Is a creditor’s unsatisfied judgment against the shareholder/corporation enough to declare the second condition of the veil piercing doctrine satisfied? (The corporate form is being used as a vehicle for unfair or inequitable treatment of corporate creditors)

Answer 36

No, according to Seabank.

Question 37

What is the third prong of the veil piercing doctrine for more sophisticated entities.

Answer 37

3) Was there an assumption of risk (voluntary exposure to risk after conducting an investigation) by the creditor?

When it would be reasonable for an entity of a particular type (e.g., a bank) to conduct an investigation, such entity will be charged with the knowledge that a reasonable investigation would disclose. The creditors lack of investigation cuts against piercing. If nothing was uncovered in the investigation (i.e., gross undercapitalization), then it cuts towards it.

This third prong is permissive and not mandatory. Depends on the facts.

Question 38

What default rule for the second condition of veil piercing (the corporate form was used for an instrument unfairness or inequity to the corporate creditors) does the professor suggest?

Answer 38

1) Creditors should generally be able to rely on the corporate assets as of the date of the creditor’s agreement. (Therefore, shifting around of assets will give us enough reason to pierce.)
2) Future corporate transactions should generally preserve this value. (Subject to normal wear and tear. Therefore, if the assets declined due to normal business operations, just because it is undercapitalized doesn’t mean we can pierce now.)

Question 39

Is an enterprise fraudulent simply because it consists of multiple entities? (Second prong of veil piercing: The corporate form is being used as an instrument of unfairness and inequity to corporate creditors.)

Answer 39

Nope! According to Walkovszky. Bundling up assets to avoid liability is essentially a cheap replacement for insurance for tort creditors.

Question 40

What is an involuntary creditor?

Answer 40

A tort creditor trustee in bankruptcy would be an example.

Question 41

Is there a difference in veil piercing for tort creditors vs. contract creditors?

Answer 41

Yes, they did not rely on the corporate’s credit worthiness and the cannot negotiate ex ante (based on investigations/forecasts)

Therefore, it is harder to satisfy the conditions in these cases. However, the same test will apply: (1) Is there a lack of separation between the shareholder and the corporation; (2) Is the corporate form being used as an instrument of unfairness or inequity to the corporate creditors?

Question 42

What is substantive consolidation?

Answer 42

A bankruptcy remedy used in 50% of cases where a public company goes bankrupt. The subsidiaries are consolidated to satisfy creditor claims of one of the subsidiaries.

It is a form of horizontal veil piercing.

However, this definitely undermines assets separation and increases monitoring costs.

Question 43

What is successor liability?

Answer 43

If a tort was committed before or while a company was being liquidated, shareholders remain liable pro-rata (proportionately) after the company is liquidated on the liquidating dividends. (The residual value of their dividends.)

Question 44

What is the product line test?

Answer 44

It’s not accepted in many jurisdictions, but if you purchase a dissolved company’s assets and continue to operate the company (i.e., manufacture the same line of goods) then you will be liable for torts committed before. (A purchaser of this corporation will thus pay less for a type of company)