Protection Of Creditors Flashcards
Why protect Creditors?
- We want people to lend and they wouldn’t if they weren’t protected against debtor misbehavior
- Everyone is aligned with the creditors (employees, suppliers, customers, members of the community) protection of other stakeholders
- Mechanisms for protection: (1) capital structure, (2) statutory protection, (3) duties owed to creditors
Stated vs Surplus Capital
Stated par value X # shares
Surpluscapital surplus + retained earning
o Capital surplus = (price of share – par value) x (total # of shares outstanding) if stock is sold for more than its par value, excess amount is capital surplus
Credit Lyonnais Bank (still good law)
• Facts: company going towards insolvency and has possession of $5.1-million-dollar judgement. Weighing litigation options to try and get more to satisfy SH/creditors based on the amount and potential of settlement.
• Holding: directors should always accept any settlement offer with values greater than the expected value of litigation
o Problem: In insolvency, the BOD doesn’t have the incentive to take low settlement and will want to risk it b/c shareholders elect them and they want to risk it because the corp. will probably go bankrupt anyways. Therefore, the court creates a “zone of insolvency” that creates a fiduciary duty to the corporation as an economic/legal entity – not to any specific shareholders. This company was in the zone because it had a 75% chance of going bankrupt.
This rule stops BOD from risking bankruptcy for SHs
Here, there is a huge divergence between stakeholders and shareholders. Shareholders don’t want to accept the settlement offers and stakeholders’ best interest is to accept the settlement so that bondholders get repaid and there is enough to keep financing the company’s operations.
Equitable subordination
if equitable to do so, bankruptcy courts will recognize a shareholders’ claim against the corporation, but will require that these claims are satisfied only after all other creditors (and perhaps preferred shareholders) have been fully satisfied.
Costello v. Fazio
o Facts: Defendant director/creditors file voluntary bankruptcy and file claims for money based on promissory notes, leaving the company grossly undercapitalized. P claims that owners/SHs were trying to put themselves in the same class as unsecured creditors and their interest should have been unsubordinated. o Holding: in situations involving undercapitalization, equity holders cannot convert to debt so that they get paid earlier. The “debt layer” gets paid back first – i.e. creditors get paid first. Court says the company is grossly undercapitalized and they just made it into a corporation so that they would not be individually liable.
Veil Piercing
court setting aside entity status of the corporation so that individual SHs can be held directly liable on K or tort obligations [only brought by those that are owed money and when there is a comingle of funds
Van Dorn Test
o Can Peirce the corporate veil IF:
(1) Disrespect corporate form such that “unity and interest of ownership such that separate personalities of the corporation and individual are merged” AND
• Failure to maintain adequate corporate records or to comply with corporate formalities (certif of incorp.; assemble BOD)
• Co-mingling of funds or assets
• Undercapitalization
• One corporation treating the assets of another corporation as its own
(2) Circumstances are such that adherence to the fiction of separate corporate existence would sanction fraud or promote injustice
• Inability to pay judgment in itself is insufficient to satisfy the prong
To satisfy Van Dorn, you need to have intentional harm or the promotion of injustice – HIGH BAR
• Sealand Services v. The Pepper Source (7th Circuit 1991)
o Facts: Sealand shipped goods for Pepper Source and PS could not collect substantial freight bill b/c PS had been dissolved and apparently had no assets. SL filed another lawsuit seeking to pierce the corporate veil and hold Marchese, sole SH of PS and other corporations, personally liable (“reverse veil piercing” – piercing through the corporation to the SH, then back to his other corporation)
o Held: Cannot pierce the corporate veil here. Court is not satisfied that SL showed evidence that honoring separate corporate existence would sanction fraud as required by the Van Dorn Test (although the first prong—shared unity of interest and ownership—was met). Remanded back to district court where they say you can pierce b/c of franchise taxes.
For 1st Prong of VD Test, the court looks to: (1) failure to maintain adequate corporate records or to comply with corporate formalities, (2) commingling of funds or assets, (3) under capitalization, (4) 1 corporation treating the assets of another as its own
• Held that these factors satisfied the 1st prong
For 2nd Prong for VD Test:
• The court makes clear that an unsatisfied judgment is NOT sufficient to promote injustice because then injustice would exist in every case
• Court wants to be careful because of innocent SHs who would be harmed
Laya Test
o (1) disregard of corporate formalities – unity of interest such that no separate personality of corporation and individual
o (2) refusing to impose liability on the SH would cause “an inequitable result” [basic unfairness]
o (3) OPTIONAL – if a reasonable investigation would have revealed that the company is undercapitalized, you cannot pierce the veil (assumed risk)
o This is a much lower bar than the Van Dorn Test
Kinney Shoe Corp. v. Polan (5th Circuit 1991)
o Facts: Polan formed IR company and Polan Industries. Charters were issues but no meetings were held and no officers elected. Company had an agreement with KS, and he defaulted the lease. KS goes after Polan b/c the company has no assets. He was the sole SH who controlled the corp. Polan made first rental payment out of personal funds but no other payments.
o Holding: Can pierce the corporate veil – court uses Layla test and notes that the corporation was just a shell and since he didn’t put anything into it, he shouldn’t get protection.
Role of insufficient capitalization is enough to satisfy the 2nd prong of the Laya Test
Gentile: this was decided wrong – Polan was optimistic, not sneaky
This clearly would have failed under the Van Dorn Test because the 2nd prong would not have been satisfied (1st prong would have been because insufficient capitalization is enough)
Court did not apply the third prong
• K did not conduct an investigation because he did not care – 1 payment from Polan was better than no payments
He could have protected himself by including a statement in the loan or had two bank accounts
Walkovszky v. Carlton
o Facts: C runs a cab company. He has 10 cab companies and 20 cabs. W gets injured by the cab and would like to sue C. W would like to “reverse veil pierce” by piercing veil of cab corporation up to C and collecting all the assets from each of the 10 cab companies. Problem with this: C kept everything in order – he satisfies corporate formalities and therefore, the 2nd prong cannot be brought into discussion.
o Holding: W cannot pierce the corporate veil and hold a C liable for the debts of the company if the company is a dummy corporation, whose interests are not distinguishable from those of the owner does not satisfy the 1st prong of “substantial unity of interest between the corporate and the individual”
If it is not fraudulent for the owner/operator of a single cab corporation to take out only the minimum required liability insurance, the enterprise does not become either illicit or fraudulent merely because it consists of many corporations
• The fact that Seon Cab Company was undercapitalized and carried only the bare minimum amount of insurance required by law does NOT allow W the pierce the veil
