Flushed Away

Flushed Away

Personal liability for corporate debt has been all the rage in the Ninth Circuit.  Within the last year, at least two appellate decisions (discussed here and here) have clarified the doctrine of alter ego liability – the idea that a corporate entity and its principals ought to be treated as one and the same, and therefore equally liable for corporate obligations.

It is easy to see why interest in alter ego liability has become so fashionable: When a business slips into insolvency and cannot pay its creditors in full, those creditors naturally go looking for other pockets from which to satisfy their claims.

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If creditors can show that the business’ officers effectively ran the business for personal economic purposes rather than as a separate and distinct corporate entity, the doctrine of alter ego permits creditors to hold the officers responsible for the business’ obligations.  This is especially the case where it appears the officers used the business to perpetrate a fraud or some other inequity on creditors.  One California court noted that “[t]he general purpose of the doctrine of alter ego is to look through the fiction of the corporation and to hold the individuals doing business in the name of the corporation liable for its debts in those cases where it should be so held in order to avoid fraud or injustice.”

Earlier this year, Judge Clarkson of California’s Central District followed this fashion trend by offering his view on a non-dischargeability claim based on alter ego liability.

The facts of In re Munson are relatively straightforward.  Robert and Kimberly Munson were the owners – and corporate officers – of Munson Plumbing, Inc. (“MPI”), a plumbing subcontractor on several public works projects in the Los Angeles metropolitan area.  As is typically required of public works contractors, MPI’s work was backed by surety bonds issued by SureTec Insurance Company (“SureTec”).  As part of the consideration for the issuance of the surety bonds, the Munsons and MPI signed a General Agreement of Indemnity (“SureTec Indemnity Agreement”), in which the Munsons agreed to jointly and severally indemnify SureTec and to deposit collateral with SureTec upon its demand.  The SureTec Indemnity Agreement contained language that all project funds received by MPI would be held in trust for the benefit of SureTec.

Eventually, MPI encountered financial difficulties and could not pay its own subcontractors – thereby requiring SureTec to make payments under the bonds and finish MPI’s work.

Concurrent with MPI’s demise, the Munsons commenced individual Chapter 7 proceedings.  SureTec, which had been left with over $436,000 in losses related to various MPI projects, asserted claims against the Munsons individually.  It also sought to have at least a portion of those losses deemed non-dischargeable in the Munsons’ Chapter 7 case.  Specifically, it claimed:

– The SureTec Indemnity Agreement created an express trust which placed fiduciary duties upon the Munsons.

– Further, because the Munsons had allegedly defrauded SureTec by diverting at least $95,000 in progress payments on the projects to non-bonded expenses, including their own personal expenses, applicable fiduciary duties upon the Munsons arose by California statutes (including Business & Professions Code §7108 and Penal Code §§§ 484b, 484c and 506.)

– The Munsons were alter egos of MPI, and therefore were liable for MPI’s obligations under the surety bonds.

– The Munsons’ obligations were non-dischargeable because they arose as a result of the Munsons’ breach of their fiduciary duties.

The Debtors sought dismissal of SureTec’s lawsuit.  In a brief, 9-page decision, Judge Clarkson found that:

–  The SureTec Indemnity Agreement did not impose fiduciary duties upon the Munsons.  “If a trust was created, it imposed the fiduciary duty obligations on the corporation, the receiver and disburser of the project funds. The [Munsons,] [in] signing the [SureTec Indemnity Agreement] were creating only a creditor-debtor relationship (and a contingent one at that) between SureTec and the [Munsons]. They were “indemnifying” SureTec, as SureTec accurately indicates  . . . .”

– Any alleged trust relationship created on a constructive, resulting, or implied basis (i.e., arising legally as a result of the Munsons’ allegedly bad acts) is not the sort of trust relationship which gives rise to a non-dischargeable debt.  “The core requirements [for asserting non-dischargeability based on breach of a fiduciary duty] are that the [fiduciary] relationship exhibit characteristics of the traditional trust relationship, and that the fiduciary duties be created before the act of wrongdoing and not as a result of the act of wrongdoing.”

– SureTec’s allegations of alter ego liability were likewise insufficient to tag the Munsons with the sort of fiduciary obligations that would give rise to a non-dischargeable claim.  “If a finding of alter ego were to be considered as imposing fiduciary duties, any such imposition would be ex maleficio, i.e., trusts that arose by operation of law upon a wrongful act.”

Judge Clarkson also found that SureTec’s separate non-dischargeability claim for fraud had not been pleaded with the requisite particularity, and dismissed it with leave to amend.

The Munson decision is important in several respects:

– It emphasizes the relatively narrow scope of non-dischargeability claims based on breaches of fiduciary duty in the Ninth Circuit.

– It also emphasizes the similarly narrow scope of liability derived from alter ego status.

– It highlights the importance of the alter ego doctrine as a strategic tool for both creditors and trustees in bankruptcy litigation – as well as litigants’ varying success in using it.  As detailed in other posts, alter ego liability has been employed (i) unsuccessfully as a “blocking device” in an attempt to capture recoveries for the corporation’s bankruptcy estate; and (ii) successfully to preserve recoveries from self-settled trusts to which the debtors attempted to convey assets out of the reach of creditors.  Here, alter ego was employed (again, without success) to “bootstrap” a creditor’s claim into “non-dischargeable” status.

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