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Its My Corporation

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Much of the chapter 11 practice seems to be small businesses with a single owner. The owner often pours everything he or she has into the business—all the time, all the money, all the everything. Although our empirical work has taught us that a surprising number of people don't bother to incorporate their businesses, many entrepreneurs do form corporations. Over time, the identity between the corporation and the individual merge—at least in the mind of the owner. But the law takes a very different view when the business gets in trouble.

In re Flutie New York Corp., 310 B.R. 31 (Bankr. S.D.N.Y. 2004), was a bit more glamorous than many small businesses. Flutie NY was a management company for some of the country's top models. Indeed, the case resulted in a bench trial, and Judge Burton R. Lifland is at some pains to describe the demeanor of various supermodels, reminding us of the perks of being a bankruptcy judge in the Big Apple. "[Supermodel] Kristine Szabo...was frank and outspoken. I found her testimony credible." Id. at 50. There are times when being a bankruptcy judge must be very sweet.

Flutie NY was born out of the chapter 11 liquidation of Michael Flutie Management Enterprises (MFME). Flutie was clearly the moving force behind both corporations, and he caused MFME to transfer the model's contracts to Flutie NY, along with the trade name "Company Management" that MFME had used. Consideration for these transfers is hazy, but what's done is done. Having acquired a taste for multiple corporations, Flutie started a few more after Flutie NY. As Flutie NY began to buckle under the weight of his high-rolling expenses, he transfered the models' contracts to other businesses he controlled. After a while, Flutie NY had all the burdens and none of the benefits of running a New York modeling agency.

Perhaps remembering his earlier successes, Flutie decided to take Flutie NY into chapter 7 to dump its remaining debts and move on with his models and his life. But the chapter 7 trustee had other ideas. He sued Flutie and all of his other companies on theories of fraudulent transfer. He also tagged Flutie personally with a breach of fiduciary obligation. Judge Lifland might be whistled down for piling on as he loads one legal body blow on another—transfer with actual intent to hinder, delay or defraud; breach of fiduciary duty; piercing the corporate veil; unjust enrichment; tortuous interference; alter ego; and so on.

What happened here was that Flutie used his various corporate entities as a single business. He claimed that his bookkeeping might be sloppy, but the court wasn't buying it; the judge declared the entire operation was essentially a sham. He gave the trustee access to the assets of every other entity, and he put Flutie on the hook personally. What makes this interesting is that the opinion says almost nothing about how any creditor was fooled or what effects this piercing might have on the creditors of the other corporations or Flutie's own creditors. To Judge Lifland, as with a number of judges, these questions just do not matter. Flutie created a tangle. Draining assets out of one business was enough to make him liable for the debts of that company.

The reported case is not about Flutie's personal bankruptcy—if, indeed, there ever was one. But if Flutie files, he has a real problem, given the nature of some of Judge Lifland's findings. The judge specifically finds that the principal of this corporation had a fiduciary duty to creditors as the business entered the zone of insolvency, and transferring away assets at that point breached that duty. Of course, the kind of fiduciary duty to which Judge Lifland refers may not be the kind that triggers nondischargeability under §523(a)(4). Even so, tortuous interference might well be within the scope of deliberate injury, and the transfer with intent to hinder, delay or defraud might well be a violation of §523(a)(6). Flutie could be paying the creditors of Flutie NY for a long, long time.

The same problem of running the corporation for the personal benefit of the principal came up in In re Wilcox, 310 B.R. 689 (Bankr. E.D. Mich. 2004). In this case, Michael Wilcox owned Michigan Web Press Inc. (Web) from 1979 on. By 1994, Associated Newspapers of Michigan owed Web several hundred thousand dollars. Wilcox decided to form a new corporation, Michigan Community Newspapers (MCN), to acquire Associated. MCN assumed the debt of Associated and agreed to pay the owners of Associated. Wilcox guaranteed the debt personally, and he caused Web to do the same. The businesses rocked along for a long time, but MCN eventually failed. When it did, the holders of the debt called on Web to pay up. Web paid, but by then it was no longer under Wilcox's control, so it sued Wilcox in state court for once having caused it to make the guarantee. Wilcox headed to the bankruptcy court to discharge this and other liabilities in chapter 7; hence, In re Wilcox.

Web filed an adversary proceeding, claiming that Wilcox's decision to have Web guarantee the debt of MCN was a breach of fiduciary duty under §523(a)(4) and a willful and malicious injury under §523(a)(6). Judge Marci McIvor held that Wilcox did not have a fiduciary duty of the sort that fell within the scope of §523(a)(4). Causing the company to give out a guarantee hurt it, but not enough to qualify for nondischargeability under the §523(a)(6) standard. Wilcox got out with his discharge.

This worked out okay for Wilcox, but consider the implications of this case. We have talked for years about sister corporation guarantees, when they are fraudulent conveyances and when they are not. This one shifts the focus: whether they are fraudulent conveyances or not, the officers, directors or principals who cause those guarantees to happen may be personally liable. Although this case does not establish that Wilcox was liable, it certainly raises the specter of liability where before most lawyers had seen only voidability. If there is liability, the Michigan bankruptcy court says the liability can be discharged in bankruptcy, but that is cold comfort to the CEO who has to file bankruptcy in order to escape it.

Also notice the widespread application of this case. The recitation (and even the fact) that Web benefited from the development of MCN (preservation of a customer, etc.) did not change the fact that Wilcox was liable. Nor did it matter that the company was solvent at the time of the transfer. In fact, it did not even matter that the guarantee occurred back in 1994. The statute of limitations did not start to run until 2003, when the guarantee was called and the company had to pay up. In other words, when a director or officer causes a company to make a guarantee that is not clearly in the interests of the company, the director or officer could find that he or she is directly on the hook for the resulting payments.

And just to turn up the heat a bit, consider the language Judge Lifland used in Flutie NY: his bad faith, breach of fiduciary duty, tortuous interference and the like all have the makings of a non-dischargeable claim. Add that up, and it can mean that some directors or officers could be very, very unhappy about using the assets of one corporation to guarantee the debts of another.

A third case offers a reverse twist when it is the officer's creditors, rather than the owner, who seem at risk. In re Solomon, 300 B.R. 57 (Bankr. N.D. Okla. 2003). The case fills out the sobering implications of closely held corporations that seem fused to their owners. James and Carla Solomon had owned and operated Sabre International for many years. According to the bankruptcy court, Sabre was in the business of distributing "parts" (parts of what is not elucidated in the record—evidently, "parts is parts"). In 2000, Sabre was in big trouble, sliding deeper and deeper into insolvency. Stillwater National Bank and Trust held an $8.8 million mortgage, which it had every right to call. But Stillwater National agreed to restructure the loans. It offered no new cash, but it forbore its right to foreclose in return for the personal guarantee of Mr. and Mrs. Solomon, a mortgage on their property and the cross-collateralization of some of the outstanding debts. So far, pretty routine.

Sabre finally collapsed, also routine. When the bank called on the guarantee, Mr. and Mrs. Solomon headed to bankruptcy court, also fairly routine. But what happened next was pretty unusual: The trustee sued to set aside the guarantee and the mortgage as a fraudulent conveyance. The debtors were insolvent at the time of transfer, and the trustee claims that there was no reasonably equivalent value for the guarantee and mortgage.

"Whoa," you might say. The UFTA and Bankruptcy Code specifically make antecedent debt "value" for purposes of determining whether a transfer is fraudulent. Indeed, we have taught our classes for years that taking a mortgage to upgrade from an unsecured debt to a secured debt is okay under the UFTA because "value" is in the form of the antecedent debt. Besides, in this case, the bank agreed not to foreclose on the company the debtors owned; surely, that is value to the debtors.

All true, said the good judge, but read more closely: "Value" is not the same as "reasonably equivalent value (REV)." REV is a question of fact, and that means the court is in the business of measuring whether the value received from the forbearance is equivalent to the guarantee and mortgage the bank picked up. Yes, the Solomons were very glad that Stillwater bank didn't foreclose, but that doesn't mean they got reasonably equivalent value for their guarantee and a mortgage on their house.

The bank argued that collateralizing any antecedent debt is, by definition, reasonably equivalent value—at least up to the value of the original debt. If there is no fraudulent intent, said the bank, then there can be no attack on the collateralization as a fraudulent transfer. This may be a good argument versus the debtor company, Sabre International, but it does not wash against the estate of the guarantor. The trustee argued that REV requires an evaluation of what left the Solomon's estate and what entered the estate—and the effects those transfers have on the other creditors. REV is for the protection of the other creditors, and they clearly were not protected here.

What about the forbearance? Was that REV? Forbearance alone doesn't mean much, said the court—unless the creditor can put a dollar figure on it. One suspects that if the bank had gone ahead with the foreclosure against Sabre, the bank would not have gotten much—and Mr. and Mrs. Solomon would still have had their unencumbered land, and maybe their solvency. The court does not rule out forbearance as value; it just says that the bank needs to come up with a value and compare that value to what the bank picked up in the guarantee and mortgage.

We were surprised to discover a Chicago district court opinion that backed up the Oklahoma bankruptcy court, Anand v. National Republic Bank of Chicago, 239 B.R. 511 (N.D. Ill. 1999). "No per se rules on REV," said the district court. Stop to consider whether the lender put up more cash or forgave some debt, but do not presume REV.

Solomon is couched in terms of guaranteeing and collateralizing a loan, but think of the implications with other transfers. What if the owner of a corporate debtor pays down an unsecured loan while insolvent? We understand that may be an indirect voidable preference if there is a guarantee, but in the absence of a guarantee, is it a fraudulent conveyance under the REV standard? If so, the reachback period just jumped from 90 days to a year or longer. In these and other cases, the fusion of owner and corporation seems to swim in and out of focus, merged or separated in the dynamic interaction of economic turmoil.

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Tuesday, March 1, 2005

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