Paul Porvaznik – Business Litigator

Tag: fraudulent transfer

  • 7th Circuit Provides Primer on Fraudulent Transfer and Alter Ego Doctrine In Contract Dispute

    The Seventh Circuit affirmed an almost $3M judgment against the defendants under fraudulent transfer, successor liability and alter ego rules in Center Point v. Halim, 2014 WL 697501.

    The plaintiff energy company entered into a written contract to supply natural gas to defendants’ 41 Chicago area rental properties.  The individual defendants – a husband and wife – managed the properties through a management company (Company 1).

    Over a two-year period, defendants used over $1.2M worth of plaintiff’s gas and didn’t pay for it.  Plaintiff sued Company 1 in state court and got a $1.7M judgment.  When plaintiff discovered that defendants transferred all of Company 1’s assets to Company 2, plaintiff sued Company 2 and the husband and wife in Federal court alleging a fraudulent transfer and successor liability.  The Northern District entered summary judgment for plaintiff in the amount of $2.7M on all claims and defendants appealed.

    Affirming, the Seventh Circuit first found that the defendants’ conduct violated the Illinois Fraudulent Transfer Act, 740 ILCS 160/1 (the “Act”).  The Act punishes debtor attempts to avoid creditors through actual fraud or constructive fraud.

    Constructive fraud applies where (1) a debtor transfers assets without receiving a reasonably equivalent value in exchange for the transfer and (2) the debtor intends to incur or reasonably should believe he will incur debts beyond his ability to pay them as they become due.  Halim, *2, 740 ILCS 160/5.

    The Court found that the defendants’ actions were constructively fraudulent. First, the Court noted that during a three-year time span, Company 1 (the state court judgment debtor) transferred almost $11M to the individual defendants; ostensibly to repay loans.

    But the Court found it odd there was no documentation of loans or a paper trail showing where the millions of dollars went.  The suspicious timing of defendants’ creation of a new company – Company 2 – coupled with the defendants’ inability to account for the millions’ whereabouts, bolstered the Court’s constructive fraud finding.

    Since the individual defendants’ depletion of Company 1’s assets made it impossible for it to pay the state court judgment, the defendants’ actions were constructively fraudulent under the Act. *3.

    The Court also affirmed summary judgment for the plaintiff under successor liability and alter ego theories.  In Illinois, the general rule is that a company that purchases assets of another company does not assume the liabilities of the purchased company.

    A common exception to this rule is where there is an express assumption (of liability) by the purchasing company.  Here, the record showed that Company 2 assumed all rights, obligations, contracts and employees of Company 1.  As a result, the unsatisfied state court judgment attached to Company 2 under successor liability rules.

    The Court also affirmed the judgment under the alter ego doctrine.  Alter ego applies where there is virtually no difference between the business entity and that entity’s controlling shareholders.  That is, the dominant shareholders don’t treat the corporation as a separate entity and fail to follow basic corporate formalities (e.g. minutes, stock issuance, incorporation papers, etc.).

    The individual defendants treated Company 1 as their personal piggy bank by commingling their personal assets with the corporate assets.  There were no earmarks of “separateness” between the individual defendants’ assets and Company 1’s corporate assets.  *3-4.

    Because of this, the husband and wife defendants were responsible (in the Federal suit) for the unsatisfied state court judgment entered against the defunct Company 1.

    Take-away: Halim illustrates that where a judgment debtor corporation or controlling shareholders of that corporation transfer all corporate assets to a new, similarly named (or not) entity shortly after a lawsuit is filed, it will likely look suspicious and can lead to a constructive fraud finding.

    The case also underscores the importance of following corporate formalities and keeping corporate assets separate from individual/personal assets – especially where the corporation is controlled by only two individuals.  A failure to treat the corporation as distinct from the dominant individuals, can lead to alter ego liability for those individuals.

  • Corporate Successor Liability: Continuation and Fraud Exceptions (IL Law)

    Advocate Financial Group, LLC v. 5434 North Winthrop, 2015 IL App (2d) 150144 spotlights the “mere continuation” and fraud exceptions to the general rule of no successor liability – a successor corporation isn’t responsible for debts of predecessor – in a creditor’s efforts to collect a judgment from a business entity that is twice removed from the original judgment debtor.

    The plaintiff obtained a breach of contract judgment against the developer defendant (Company 1) who transferred the building twice after the judgment date. The second building transfer was to a third-party (Company 3) who ostensibly had no relation to Company 1. The sale from Company 1 went through another entity – Company 2 – that was unrelated to Company 1.

    Plaintiff alleged that Company 1 and Company 3 combined to thwart plaintiff’s collection efforts and sought the turnover of the building so plaintiff could sell it and use the proceeds to pay down the judgment. The trial court granted the turnover motion on the basis that Company 3 was the “continuation” of Company 1 in light of the common personnel between the companies. The appeals court reversed though. It found that further evidence was needed on the continuation exception but hinted that the fraud exception might apply instead to wipe out the Company 1-to Company 2- to Company 3 property transfer.

    On remand, the trial court found that the fraud exception (successor can be liable for predecessor debts where they fraudulently collude to avoid predecessor’s debts) indeed applied and found the transfer of the building to Company 3 was a sham transfer and again ordered Company 3 to turn the building over to the plaintiff. Company 3 appealed.

    The appeals court affirmed the trial court’s judgment and in doing so, provided a useful summary of the principles that govern when one business entity can be held responsible for another entity’s debts.

    In Illinois, a corporation that purchases the assets of another corporation is generally not liable for the debts or liabilities of the transferor corporation. The rule’s purpose is to protect good faith purchasers from unassumed liability and seeks to foster the fluidity of corporate assets.

    The “fraudulent purpose” exception to the rule of no successor liability applies where a transaction is consummated for the fraudulent purpose of escaping liability for the seller’s obligations.

    The “mere continuation” exception to the nonsuccessor liability rule requires a showing that the successor entity “maintains the same or similar management and ownership, but merely wears different clothes.” The test is not whether the seller’s business operation continues in the purchaser, but whether the seller’s corporate entity continues in the purchaser.

    The key continuation question is always identity of ownership: does the “before” company and “after” company have the same officers, directors, and stockholders?

    In Advocate Financial, the factual oddity here concerned Company 2 – the intermediary. It was unclear whether Company 2 abetted Company 1 in its efforts to shake the plaintiff creditor. The court affirmed the trial court’s factual finding that Company 2 was a straw purchaser from Company 1.

    The court focused on the abbreviated time span between the two transfers – Company 2 sold to Company 3 within days of buying the building from Company 1 – in finding that Company 2 was a straw purchaser. The court also pointed to evidence at trial that Company 1 was negotiating the ultimate transfer to Company 3 before the sale to Company 2 was even complete.

    Taken together, the court agreed with the trial court that the two transfers (Company 1 to Company 2; Company 2 to Company 3) constituted an integrated, “pre-arranged” attempt to wipe out Company 1’s judgment debt to plaintiff.

    Afterwords: This case illustrates that a court will scrutinize property transfers that utilize middle-men that only hold the property for a short period of times (read: for only a few days).

    Where successive property transfers occur within a compressed time window and the ultimate corporate buyer has substantial overlap (in terms of management personnel) with the first corporate seller, a court can void the transaction and deem it as part of a fraudulent effort to evade one of the first seller’s creditors.

  • Corporate Successor Liability in Illinois: the Rule and Exceptions

    Corporate successor liability’s focal point is whether a purchasing corporation (Company 2) is responsible for the purchased corporation’s (Company 1) pre-sale contract obligations. 

    It’s an important question because the Company 1 will usually have no assets after the purchase.  Creditors of Company 1 will then try to pin liability on Company 2.

    The general rule in Illinois is that a corporation that purchases the assets of another corporation is not responsible for the debts or liabilities of a transferor corporation.  

    The rule is designed to protect good faith purchasers from unassumed liability and to maximize the fluidity of corporate assets.  

    The four exceptions to this rule are: (1) where there is an express or implied agreement of assumption; (2) where the transaction amounts to a consolidation or merger of the purchaser or seller corporation; (3) where the purchaser is merely a continuation of the seller; and (4) where the transaction is fraudulent – done for the purpose of escaping the seller’s obligations.

    The express assumption exception only applies if the plaintiff can produce an agreement where the purchasing corporation agrees to assume the selling corporation’s obligations.

    If the agreement is silent, there is no express assumption.  Implied assumption is trickier and requires an examination of the selling and buying corporations’ conduct.  

    The merger or consolidation exception applies where the plaintiff demonstrates: (a) continuity of management, personnel, physical location, assets, and business operations; (b) continuity of shareholders; (c) that the seller ceases its business operations quickly after the sale; and (d) the buyer assumes the seller’s liabilities and obligations that are necessary for seamless perpetuation of the seller’s business operations. 

    In examining the continuation exception, the court’s focus is whether the purchasing corporation is a reincarnation of the seller corporation and has same or similar management but merely “wears different clothes”. 

    The continuity calculus includes whether there is a common identity of officers, directors and shareholders between the selling and purchasing corporations.    

    Exact commonality between the selling and purchasing corporations’ management isn’t required for the court to find a continuation.

    In assessing whether the fraud exception applies to the general rule of no corporate successor liability, the court looks at multiple factors set forth in the Illinois Fraudulent Transfer Act. 740 ILCS 160/5(b)(1)-(11) including the timing of the transfer from seller to purchaser, whether the seller paid and whether purchaser received adequate consideration, whether the seller became insolvent at or shortly after the transfer, whether the transfer was to an insider (officer, director shareholder of the selling corporation), etc.

    Conclusion

    To temper the possible harsh results of a corporate transfer wiping out any chance of creditor recovery, I try to put language in a contract saying that if there is a transfer from defendant to another entity during the term of the contract, the defendant promises to both promptly notify my client in writing and make the new, purchasing company aware of the contract and its obligations under it.