'Personal' Alter Ego Claims in Bankruptcy

Despite the very real stumbling blocks to bringing a creditor alter ego suit, there are examples of creditor suits proceeding on the basis that the claims asserted were inherently “personal.” The courts permitting such suits have determined either that the debtor corporation suffered no injury or that the creditor's injury was more significant than any injury suffered by the debtor. In Steinberg v. Buczyniski, 40 F.3d 890 (7th Cir. 1994), Judge Posner held that a pension fund's claim against the debtor's principals to recover money owed to the fund was a personal claim that could not be asserted by the bankruptcy trustee. Id. at 892-93. Because the trustee did not offer any evidence that the principals had “looted” the debtor corporation and could not articulate any injury to the corporation itself, Judge Posner reasoned that the corporation had no standing to sue. Id.

In Ashland Oil, Inc. v. Arnett, 875 F.2d 1271 (7th Cir. 1989), the Seventh Circuit held that the creditors' RICO complaint alleged injuries sufficiently personal to make separate prosecution of their suit appropriate, despite the fact that part of the alleged scheme was the general diversion of corporate assets. Id. at 1280. Specifically, the court noted that the creditors' complaint alleged “the fraudulent taking from the plaintiffs of exceptionally large quantities of fuel,” an injury that other creditors did not suffer. Id. Although there are very few alter ego cases conferring standing on a creditor to bring suit, other cases are instructive:

'Instructive' Cases

In E.F. Hutton & Co., Inc., 901 F.2d 979 (11th Cir. 1990), the Eleventh Circuit held that the bankruptcy trustee had no standing to bring creditors' claims for securities fraud. Id. at 980. In Hutton, the debtor sold investors' securities, which it obtained through a margin account at E.F. Hutton. Id. at 981. Instead of applying the money received from investors to the unpaid balance on its margin account, the debtor diverted the money received to other purposes. Id. Because the debtor's margin account remained unpaid, E.F. Hutton exercised its right to sell the securities (for which the investors, unaware of the debtor's scheme, had paid in full). Id. After the debtor filed for bankruptcy, the trustee sued E.F. Hutton for conversion of the securities. Id. The Eleventh Circuit held that the trustee had no standing to sue because the debtor had no property right in the securities. Id. at 987.

In Williams v. California 1st Bank, 859 F.2d 664 (9th Cir. 1988), the Ninth Circuit determined that a Chapter 7 trustee had no standing to assert the claims of creditors against the debtor's accomplice (the bank acting as the debtor's depository) in a Ponzi scheme. Id. at 667. The court reasoned that, because the debtor could not itself assert a claim against its accomplice, the trustee had no standing to do so. Id. Furthermore, the court voiced its concern with the risk of inconsistent judgments if both the trustee and other creditors were permitted to sue. Id.

Conclusion

The unfortunate reality is that courts rarely allow creditors to proceed on individual alter ego suits where there is an allegation of corporate mismanagement, since there is always a possibility that the debtor-in-possession or the trustee can recover more assets for the estate by bringing a general alter ego claim on the same facts. Because most state laws require an allegation of corporate mismanagement to establish an alter ego claim, this problem is perfectly circular. For those creditors who wish to control the alter ego litigation or want to bring the action in a non-bankruptcy form, the best bet is to seek abandonment of the estate's alter ego claims and, if necessary, agree to hold any recovery in trust for the benefit of creditors generally.

Although the case law makes clear that a determination of the “personal” nature of an alter ego suit is fact-specific, we can glean a few immutable rules from prior cases:

• Where state law does not vest a corporation with standing to pierce its own corporate veil, a trustee in bankruptcy has no standing to bring an alter ego claim in bankruptcy.
• Where the trustee and a creditor have filed competing alter ego claims, the creditor must seek abandonment of the trustee's claim prior to proceeding.
• Where the debtor corporation has not been injured by the alleged wrongdoing, the debtor has no standing to bring suit.

When crafting an alter ego pleading, a creditor should personalize the allegations as much as possible – by, for example, alleging direct dealings with the alleged alter ego, alleging injuries separate and apart from other creditors, and avoiding general allegations of “looting” and corporate mismanagement.

Part Two of a Two-Part Article

Last month's article discussed the unfortunate fact that bankruptcy courts have made it virtually impossible for creditors to maintain individual alter ego claims against the debtor's shareholders and affiliates – and that as a result, crafting an alter ego claim that will survive an attack requires finesse. This month's article continues with a discussion of “personal” claims.

Examples of 'Personal' Claims

Despite the very real stumbling blocks to bringing a creditor alter ego suit, there are examples of creditor suits proceeding on the basis that the claims asserted were inherently “personal.” The courts permitting such suits have determined either that the debtor corporation suffered no injury or that the creditor's injury was more significant than any injury suffered by the debtor. In Steinberg v. Buczyniski , 40 F.3d 890 (7th Cir. 1994), Judge Posner held that a pension fund's claim against the debtor's principals to recover money owed to the fund was a personal claim that could not be asserted by the bankruptcy trustee. Id. at 892-93. Because the trustee did not offer any evidence that the principals had “looted” the debtor corporation and could not articulate any injury to the corporation itself, Judge Posner reasoned that the corporation had no standing to sue. Id.

In Ashland Oil, Inc. v. Arnett , 875 F.2d 1271 (7th Cir. 1989), the Seventh Circuit held that the creditors' RICO complaint alleged injuries sufficiently personal to make separate prosecution of their suit appropriate, despite the fact that part of the alleged scheme was the general diversion of corporate assets. Id. at 1280. Specifically, the court noted that the creditors' complaint alleged “the fraudulent taking from the plaintiffs of exceptionally large quantities of fuel,” an injury that other creditors did not suffer. Id. Although there are very few alter ego cases conferring standing on a creditor to bring suit, other cases are instructive:

'Instructive' Cases

In E.F. Hutton & Co., Inc., 901 F.2d 979 (11th Cir. 1990), the Eleventh Circuit held that the bankruptcy trustee had no standing to bring creditors' claims for securities fraud. Id. at 980. In Hutton, the debtor sold investors' securities, which it obtained through a margin account at E.F. Hutton. Id. at 981. Instead of applying the money received from investors to the unpaid balance on its margin account, the debtor diverted the money received to other purposes. Id. Because the debtor's margin account remained unpaid, E.F. Hutton exercised its right to sell the securities (for which the investors, unaware of the debtor's scheme, had paid in full). Id. After the debtor filed for bankruptcy, the trustee sued E.F. Hutton for conversion of the securities. Id. The Eleventh Circuit held that the trustee had no standing to sue because the debtor had no property right in the securities. Id. at 987.

In Williams v. California 1st Bank, 859 F.2d 664 (9th Cir. 1988), the Ninth Circuit determined that a Chapter 7 trustee had no standing to assert the claims of creditors against the debtor's accomplice (the bank acting as the debtor's depository) in a Ponzi scheme. Id. at 667. The court reasoned that, because the debtor could not itself assert a claim against its accomplice, the trustee had no standing to do so. Id. Furthermore, the court voiced its concern with the risk of inconsistent judgments if both the trustee and other creditors were permitted to sue. Id.

Conclusion

The unfortunate reality is that courts rarely allow creditors to proceed on individual alter ego suits where there is an allegation of corporate mismanagement, since there is always a possibility that the debtor-in-possession or the trustee can recover more assets for the estate by bringing a general alter ego claim on the same facts. Because most state laws require an allegation of corporate mismanagement to establish an alter ego claim, this problem is perfectly circular. For those creditors who wish to control the alter ego litigation or want to bring the action in a non-bankruptcy form, the best bet is to seek abandonment of the estate's alter ego claims and, if necessary, agree to hold any recovery in trust for the benefit of creditors generally.

Although the case law makes clear that a determination of the “personal” nature of an alter ego suit is fact-specific, we can glean a few immutable rules from prior cases:

• Where state law does not vest a corporation with standing to pierce its own corporate veil, a trustee in bankruptcy has no standing to bring an alter ego claim in bankruptcy.
• Where the trustee and a creditor have filed competing alter ego claims, the creditor must seek abandonment of the trustee's claim prior to proceeding.
• Where the debtor corporation has not been injured by the alleged wrongdoing, the debtor has no standing to bring suit.

When crafting an alter ego pleading, a creditor should personalize the allegations as much as possible – by, for example, alleging direct dealings with the alleged alter ego, alleging injuries separate and apart from other creditors, and avoiding general allegations of “looting” and corporate mismanagement.