'Personal' Alter Ego Claims in Bankruptcy

An individual creditor's standing to bring an alter ego claim outside of the bankruptcy proceedings depends on whether the applicable state law vests the creditor or the debtor with standing to pursue an alter ego claim. Although it might seem counterintuitive to vest a debtor corporation with standing to pierce its own corporate veil (particularly when the shareholders to be held liable may be the same shareholders piercing the veil), most states recognize the corporation's right to do so. See, e.g., Kalb, Voorhis & Co. v. American Financial Corp., 8 F.3d 130 (2nd Cir. 1993) (applying Texas law); St. Paul Fire and Marine Ins. Co. v. PepsiCo, Inc., 884 F.2d 688 (2nd Cir. 1989) (applying Ohio law); Steyr-Daimler-Puch of America Corp. v. Pappas, 852 F.2d 132 (4th Cir. 1988) (applying Virginia law); Koch v. Refining v. Farmers Union Central Exch., Inc., 831 F.2d 1339 (7th Cir. 1987) (applying Illinois and Indiana law); In re Schimmelpenninck, 183 F.3d 347 (5th Cir. 1999) (applying Texas law). In these states, the inquiry then becomes whether the alter ego claim is one for generalized injuries, in which case it is property of the estate and properly prosecuted by the debtor or the bankruptcy trustee, or one for personal injuries properly prosecuted by the individual creditor.

Only the Sixth and Eighth Circuits have held that alter ego claims may only be brought by an individual creditor of the debtor corporation. In re RCS Engineered Products Co., Inc., 102 F.3d 223, 226 (6th Cir. 1996) (applying Michigan law); In re Ozark Restaurant Equip. Co., Inc., 816 F.2d 1222 (8th Cir. 1987) (applying Arizona law). Although courts are quick to point out that the divergent decisions in the Sixth and Eighth Circuits resulted from a difference in the underlying state law, a closer reading of the decisions reveals that the state laws at issue in the Sixth and Eighth Circuit decisions are not materially different from the state laws at issue in the other circuit opinions. Compare:

Michigan Law (as Applied by the Sixth Circuit)

A court may find that one entity is the alter ego of another and pierce the corporate veil upon proof of three elements: first, the corporate entity must be a mere instrumentality of another; second, the corporate entity must be used to commit a fraud or wrong; and third, there must have been an unjust loss or injury to the plaintiff. In re RCS, 102 F.3d at 226.

Illinois Law (as Applied by the Seventh Circuit)

“[T]wo traditional factors [must] be shown before a corporate veil can be pierced: first, there must be such unity of interest and ownership the separate personalities of the corporation and the individual no longer exist; and second, circumstances must be such that an adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.” Koch Refining, 831 F.2d at 1345.

What's the Lesson?

Despite the seeming similarities between these states' alter ego laws, the Sixth and Seventh Circuits reached opposite conclusions regarding the debtor corporation's right to pierce its own veil. The lesson? State alter ego law does not necessarily dictate the court's decision to confer standing on an individual creditor, despite some dicta to the contrary. As set forth below, a determination of the individual creditor's standing to bring an alter ego claim is often dictated by equitable considerations that have nothing to do with a textual reading of state law. If the estate has an alter ego claim, it must be abandoned before a creditor can proceed with its own alter ego suit.

Even if state law would normally vest an individual creditor with standing to bring an alter ego claim, in bankruptcy the creditor must compete with the debtor-in-possession or the trustee for the right to bring the claim. In nearly every case denying the creditor standing, the creditor's alter ego claim mirrors a similar claim brought by the trustee in bankruptcy. The solution? Seek the trustee's abandonment of any alter ego claims prior to proceeding in state court.

The Ninth Circuit Bankruptcy Appellate Panel's decision in In re Folks, 211 B.R. 378 (B.A.P. 9th Cir. 1997) aptly demonstrates the importance of seeking early abandonment of the estate's alter ego claims. In Folks, Chapter 7 debtor BYCA Television Distribution, Inc. (BYCA) sought a discharge pursuant to Bankruptcy Code ' 727. Id. at 381. Creditor CBS objected. BYCS argued that CBS did not have standing to object because it was not actually a creditor of BYCS. Id. CBS countered that its creditor status was based on an alter ego claim it had against BYCS's controlling officer, Bryan Allen Folks. Id. According to CBS, Folks had diverted BYCS's assets for his personal use. At a summary judgment hearing, the Bankruptcy Court tentatively held that CBS's alter ego claim was property of the BYCS estate and therefore properly prosecuted by the Chapter 7 trustee. Id. at 383. Nevertheless, the court continued the hearing to give CBS time to show either that the alter ego claim was not property of the estate, or that CBS had authorization to pursue the claim. Id. Thereafter, CBS sought and obtained the trustee's abandonment of the alter ego claim. Despite the abandonment, the Bankruptcy Court held that CBS had no standing to pursue the claim. Id. On appeal, the Ninth Circuit determined that the abandonment conferred standing on Folks to bring suit. Id. Despite this favorable finding, the Ninth Circuit ultimately held that CBS was time-barred from objecting to discharge, since it did not obtain abandonment of the trustee's claim (and thus did not obtain standing) until the time-period for objecting to discharge had already run. Id. at 388-89.

The Folks case makes clear that creditors should seek abandonment prior to filing an alter ego claim outside of the bankruptcy proceedings, not only to firmly establish their standing, but also to insure against later statute of limitations problems.

As an aside, it is worth noting that the majority of reported cases denying creditors standing to pursue alter ego claims were Chapter 7 cases, where there was a bankruptcy trustee capable of bringing the alter ego claim on behalf of the debtor's creditors. Courts might be more wary of conferring standing on a Chapter 11 debtor-in-possession to pursue an alter ego claim on behalf of creditors, since the principals in control of the debtor-in-possession are often the same individuals who are liable as the debtor's “alter egos.” As such, the principals arguably have no incentive to actively pursue an alter ego claim against themselves. In such a situation, the bankruptcy court might be more amenable to granting a contested motion to abandon the alter ego claim to a creditor or the creditor's committee.

Equitable Considerations

Often, equitable considerations dictate whether a creditor can pursue its alter ego claim; they often dictate whether the court will allow a creditor to pursue its alter ego claim outside of the bankruptcy proceedings. For this reason, in some cases, even a “personal” claim might not ensure the creditor's right to bring suit.

For example, the Seventh Circuit has stayed a creditor alter ego claim despite the court's recognition that some of the creditors' causes of action could be inherently personal. In Fisher v. Apostolou, 155 F.3d 876 (7th Cir. 1998), the court noted that it might be possible for some of the creditor plaintiffs to “show acts of fraud, cognizable under one or more of the theories raised in the complaint, that imposed a separate and distinct injury on that person.” Id. at 881. Despite this acknowledgement, the court stayed the creditors' alter ego suit pursuant to Bankruptcy Code ' 105, based on the court's determination that the creditor's claims were so closely related to the estate's claims that continued prosecution of the alter ego suit might compromise the estate's ability to recover assets. Id. at 881.

Similarly, the Fifth Circuit has resorted to equitable considerations to support its finding that the alter ego claim belonged to the debtor rather than an individual creditor. In In re Schimmelpenninck, 183 F.3d 347 (5th Cir. 1999), creditor James Byrne brought an alter ego action against the debtor's subsidiary, alleging that the debtor and its subsidiary had abused the corporate form and were therefore both liable on his claims for breach of contract and fraud. Id. at 353. The debtor's representatives sought to prevent prosecution of the alter ego suit, arguing that the suit actually belonged to the debtor. Id. at 354. Byrne insisted that the right to pierce the corporate veil could not “belong to” the debtor because the debtor was the very party that abused the corporate form. Id. at 358, n. 23. Although the Fifth Circuit acknowledged the logic of this argument, the court nevertheless determined that the alter ego claim was property of the debtor's estate:

The mere filing of a bankruptcy petition creates legal consequences for both the debtor and the creditors that are sheathed by the principles of equity. Stated differently, [the debtor's] unclean hands should not preclude pro-rata distribution of its property. Id. In other words, the policy of equitable distribution to creditors trumps the policy against rewarding a debtor with unclean hands. In an unpublished decision, the Fourth Circuit disregarded the distinction between “personal” and “general” alter ego claims in favor of equitable considerations.

In Wharton v. Commonwealth, 993 F.2d 1541, 1993 WL 192515 (4th Cir. 1993), the Commonwealth of Virginia sued the president of a debtor corporation in state court to recover environmental clean-up costs owed by the debtor. One of the Commonwealth's claims alleged that the president was the alter ego of the debtor. Prior to resolution of this suit, the bankruptcy trustee entered into a settlement with the debtor's president, pursuant to which the president agreed to pay the debtor's estate $200,000 in exchange for a release of the estate's claims against him. The release included a release of the estate's alter ego claims. Id. at *1. After executing this settlement agreement, the debtor's president brought a contempt action against the Commonwealth for violating the automatic stay by pursuing its alter ego claims against him. Id. at *2. Two central facts favored the Commonwealth's position: 1) the alter ego claim was based on damages suffered by the Commonwealth alone – the president caused his company to pollute the environment and harm state lands; and 2) the trustee chose not to pursue alter ego claims on behalf of the estate. Nevertheless, the Fourth Circuit held that continued prosecution of the Commonwealth's lawsuit would put the trustee's settlement agreement with the president into jeopardy, could deplete the estate's assets and therefore violated the automatic stay. Id. at *4.

Conclusion

These cases illustrate the inherent difficulty that creditors face in maintaining an alter ego suit outside of the bankruptcy proceedings. Even if creditors can overcome the stumbling block of standing and can convince the trustee to abandon its alter ego claims, the bankruptcy court might nevertheless stay the creditor's alter ego claim if pursuit of the claim threatens the property of the estate, however remotely. Creditors are more likely to avoid an equitable stay if they offer the bankruptcy court a reasonable alternative – for example, segregating any proceeds recovered from successful prosecution of the alter ego action for distribution at the close of the bankruptcy case.

Part Two, appearing in the September issue, discusses examples of “personal” claims.

be reached at 213-683-9193, and 213-683-9201.

With corporate fraud and bankruptcy filings on the rise, creditors are increasingly looking to related entities, corporate shareholders, directors and officers to pay their claims when the corporation goes belly-up. Unfortunately, bankruptcy courts have made it virtually impossible for creditors to maintain individual alter ego claims against the debtor's shareholders and affiliates. As a result, crafting an alter ego claim that will survive an attack by the bankruptcy trustee (or the bankruptcy court itself) requires finesse.

Test of Determination

The vast majority of courts agree on the test to employ in determining whether an individual creditor has standing to bring an alter ego action against the debtor's shareholders. If the injury alleged is “general” – that is, if the estate and its creditors are similarly injured – then the alter ego action is properly brought by the debtor-in-possession or the bankruptcy trustee. By contrast, if the injury is “personal” to a particular creditor, and no other creditor has been similarly injured, the alter ego action is properly brought by the individual creditor. Not surprisingly, many creditors have tried (and failed) to plead sufficiently personal injuries to wrest control of the alter ego action from the trustee. This begs the question: what type of injury is personal enough to confer standing on an individual creditor? The answer depends on three things: 1) the state law governing the alter ego claim; 2) the trustee's interest in the alter ego action; and 3) the equities of the case. If state law does not confer standing on the debtor to pierce its own corporate veil, then a creditor alter ego suit is permissible.

An individual creditor's standing to bring an alter ego claim outside of the bankruptcy proceedings depends on whether the applicable state law vests the creditor or the debtor with standing to pursue an alter ego claim. Although it might seem counterintuitive to vest a debtor corporation with standing to pierce its own corporate veil (particularly when the shareholders to be held liable may be the same shareholders piercing the veil), most states recognize the corporation's right to do so. See, e.g., Kalb, Voorhis & Co. v. American Financial Corp. , 8 F.3d 130 (2nd Cir. 1993) (applying Texas law); St. Paul Fire and Marine Ins. Co. v. PepsiCo, Inc. , 884 F.2d 688 (2nd Cir. 1989) (applying Ohio law); Steyr-Daimler-Puch of America Corp. v. Pappas , 852 F.2d 132 (4th Cir. 1988) (applying Virginia law); Koch v. Refining v. Farmers Union Central Exch., Inc. , 831 F.2d 1339 (7th Cir. 1987) (applying Illinois and Indiana law); In re Schimmelpenninck, 183 F.3d 347 (5th Cir. 1999) (applying Texas law). In these states, the inquiry then becomes whether the alter ego claim is one for generalized injuries, in which case it is property of the estate and properly prosecuted by the debtor or the bankruptcy trustee, or one for personal injuries properly prosecuted by the individual creditor.

Only the Sixth and Eighth Circuits have held that alter ego claims may only be brought by an individual creditor of the debtor corporation. In re RCS Engineered Products Co., Inc., 102 F.3d 223, 226 (6th Cir. 1996) (applying Michigan law); In re Ozark Restaurant Equip. Co., Inc., 816 F.2d 1222 (8th Cir. 1987) (applying Arizona law). Although courts are quick to point out that the divergent decisions in the Sixth and Eighth Circuits resulted from a difference in the underlying state law, a closer reading of the decisions reveals that the state laws at issue in the Sixth and Eighth Circuit decisions are not materially different from the state laws at issue in the other circuit opinions. Compare:

Michigan Law (as Applied by the Sixth Circuit)

A court may find that one entity is the alter ego of another and pierce the corporate veil upon proof of three elements: first, the corporate entity must be a mere instrumentality of another; second, the corporate entity must be used to commit a fraud or wrong; and third, there must have been an unjust loss or injury to the plaintiff. In re RCS, 102 F.3d at 226.

Illinois Law (as Applied by the Seventh Circuit)

“[T]wo traditional factors [must] be shown before a corporate veil can be pierced: first, there must be such unity of interest and ownership the separate personalities of the corporation and the individual no longer exist; and second, circumstances must be such that an adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.” Koch Refining, 831 F.2d at 1345.

What's the Lesson?

Despite the seeming similarities between these states' alter ego laws, the Sixth and Seventh Circuits reached opposite conclusions regarding the debtor corporation's right to pierce its own veil. The lesson? State alter ego law does not necessarily dictate the court's decision to confer standing on an individual creditor, despite some dicta to the contrary. As set forth below, a determination of the individual creditor's standing to bring an alter ego claim is often dictated by equitable considerations that have nothing to do with a textual reading of state law. If the estate has an alter ego claim, it must be abandoned before a creditor can proceed with its own alter ego suit.

Even if state law would normally vest an individual creditor with standing to bring an alter ego claim, in bankruptcy the creditor must compete with the debtor-in-possession or the trustee for the right to bring the claim. In nearly every case denying the creditor standing, the creditor's alter ego claim mirrors a similar claim brought by the trustee in bankruptcy. The solution? Seek the trustee's abandonment of any alter ego claims prior to proceeding in state court.

The Ninth Circuit Bankruptcy Appellate Panel's decision in In re Folks, 211 B.R. 378 (B.A.P. 9th Cir. 1997) aptly demonstrates the importance of seeking early abandonment of the estate's alter ego claims. In Folks, Chapter 7 debtor BYCA Television Distribution, Inc. (BYCA) sought a discharge pursuant to Bankruptcy Code ' 727. Id. at 381. Creditor CBS objected. BYCS argued that CBS did not have standing to object because it was not actually a creditor of BYCS. Id. CBS countered that its creditor status was based on an alter ego claim it had against BYCS's controlling officer, Bryan Allen Folks. Id. According to CBS, Folks had diverted BYCS's assets for his personal use. At a summary judgment hearing, the Bankruptcy Court tentatively held that CBS's alter ego claim was property of the BYCS estate and therefore properly prosecuted by the Chapter 7 trustee. Id. at 383. Nevertheless, the court continued the hearing to give CBS time to show either that the alter ego claim was not property of the estate, or that CBS had authorization to pursue the claim. Id. Thereafter, CBS sought and obtained the trustee's abandonment of the alter ego claim. Despite the abandonment, the Bankruptcy Court held that CBS had no standing to pursue the claim. Id. On appeal, the Ninth Circuit determined that the abandonment conferred standing on Folks to bring suit. Id. Despite this favorable finding, the Ninth Circuit ultimately held that CBS was time-barred from objecting to discharge, since it did not obtain abandonment of the trustee's claim (and thus did not obtain standing) until the time-period for objecting to discharge had already run. Id. at 388-89.

The Folks case makes clear that creditors should seek abandonment prior to filing an alter ego claim outside of the bankruptcy proceedings, not only to firmly establish their standing, but also to insure against later statute of limitations problems.

As an aside, it is worth noting that the majority of reported cases denying creditors standing to pursue alter ego claims were Chapter 7 cases, where there was a bankruptcy trustee capable of bringing the alter ego claim on behalf of the debtor's creditors. Courts might be more wary of conferring standing on a Chapter 11 debtor-in-possession to pursue an alter ego claim on behalf of creditors, since the principals in control of the debtor-in-possession are often the same individuals who are liable as the debtor's “alter egos.” As such, the principals arguably have no incentive to actively pursue an alter ego claim against themselves. In such a situation, the bankruptcy court might be more amenable to granting a contested motion to abandon the alter ego claim to a creditor or the creditor's committee.

Equitable Considerations

Often, equitable considerations dictate whether a creditor can pursue its alter ego claim; they often dictate whether the court will allow a creditor to pursue its alter ego claim outside of the bankruptcy proceedings. For this reason, in some cases, even a “personal” claim might not ensure the creditor's right to bring suit.

For example, the Seventh Circuit has stayed a creditor alter ego claim despite the court's recognition that some of the creditors' causes of action could be inherently personal. In Fisher v. Apostolou , 155 F.3d 876 (7th Cir. 1998), the court noted that it might be possible for some of the creditor plaintiffs to “show acts of fraud, cognizable under one or more of the theories raised in the complaint, that imposed a separate and distinct injury on that person.” Id. at 881. Despite this acknowledgement, the court stayed the creditors' alter ego suit pursuant to Bankruptcy Code ' 105, based on the court's determination that the creditor's claims were so closely related to the estate's claims that continued prosecution of the alter ego suit might compromise the estate's ability to recover assets. Id. at 881.

Similarly, the Fifth Circuit has resorted to equitable considerations to support its finding that the alter ego claim belonged to the debtor rather than an individual creditor. In In re Schimmelpenninck, 183 F.3d 347 (5th Cir. 1999), creditor James Byrne brought an alter ego action against the debtor's subsidiary, alleging that the debtor and its subsidiary had abused the corporate form and were therefore both liable on his claims for breach of contract and fraud. Id. at 353. The debtor's representatives sought to prevent prosecution of the alter ego suit, arguing that the suit actually belonged to the debtor. Id. at 354. Byrne insisted that the right to pierce the corporate veil could not “belong to” the debtor because the debtor was the very party that abused the corporate form. Id. at 358, n. 23. Although the Fifth Circuit acknowledged the logic of this argument, the court nevertheless determined that the alter ego claim was property of the debtor's estate:

The mere filing of a bankruptcy petition creates legal consequences for both the debtor and the creditors that are sheathed by the principles of equity. Stated differently, [the debtor's] unclean hands should not preclude pro-rata distribution of its property. Id. In other words, the policy of equitable distribution to creditors trumps the policy against rewarding a debtor with unclean hands. In an unpublished decision, the Fourth Circuit disregarded the distinction between “personal” and “general” alter ego claims in favor of equitable considerations.

In Wharton v. Commonwealth , 993 F.2d 1541, 1993 WL 192515 (4th Cir. 1993), the Commonwealth of Virginia sued the president of a debtor corporation in state court to recover environmental clean-up costs owed by the debtor. One of the Commonwealth's claims alleged that the president was the alter ego of the debtor. Prior to resolution of this suit, the bankruptcy trustee entered into a settlement with the debtor's president, pursuant to which the president agreed to pay the debtor's estate $200,000 in exchange for a release of the estate's claims against him. The release included a release of the estate's alter ego claims. Id. at *1. After executing this settlement agreement, the debtor's president brought a contempt action against the Commonwealth for violating the automatic stay by pursuing its alter ego claims against him. Id. at *2. Two central facts favored the Commonwealth's position: 1) the alter ego claim was based on damages suffered by the Commonwealth alone – the president caused his company to pollute the environment and harm state lands; and 2) the trustee chose not to pursue alter ego claims on behalf of the estate. Nevertheless, the Fourth Circuit held that continued prosecution of the Commonwealth's lawsuit would put the trustee's settlement agreement with the president into jeopardy, could deplete the estate's assets and therefore violated the automatic stay. Id. at *4.

Conclusion

These cases illustrate the inherent difficulty that creditors face in maintaining an alter ego suit outside of the bankruptcy proceedings. Even if creditors can overcome the stumbling block of standing and can convince the trustee to abandon its alter ego claims, the bankruptcy court might nevertheless stay the creditor's alter ego claim if pursuit of the claim threatens the property of the estate, however remotely. Creditors are more likely to avoid an equitable stay if they offer the bankruptcy court a reasonable alternative – for example, segregating any proceeds recovered from successful prosecution of the alter ego action for distribution at the close of the bankruptcy case.

Part Two, appearing in the September issue, discusses examples of “personal” claims.

be reached at 213-683-9193, and 213-683-9201.