Introduction: The Doctrine of Alter Ego and Federal Bankruptcy Preemption
Piercing the corporate veil is a poetic term for an attempt by a creditor to legally prove that a corporate entity lacks a separate identity from its owner or principal.
In Chapter 7 or Chapter 13 bankruptcy matters, it is sometimes necessary to prove that an individual filing for bankruptcy is a mere “alter ego” of a corporate entity.
This may be necessary in order to either recover assets that have been fraudulently transferred from the bankrupt individual to the corporation or to prove bad faith in a motion to dismiss the bankruptcy case.
Chapter 7 and Chapter 13 bankruptcy are forms of bankruptcy that allow individuals acting in good faith to obtain a Federal injunction known as a discharge that relieves them of the legal obligation to pay most of the debt owed prior to the filing of the bankruptcy case.
Bankruptcy is a Federal legal process.
That is, it operates under a Federal statute called the U.S. Bankruptcy Code that preempts state law in terms of the question of whether or not a pre-bankruptcy debt is owed and whether or not a judgment ordered by a California state court may be executed.
However, the Bankruptcy Code does not answer every conceivable legal question that may arise in a bankruptcy proceeding.
When an issue that is not preempted by the Bankruptcy Code arises in a bankruptcy proceeding, the U.S. Bankruptcy Court considering the matter will turn to the law of the state in which the bankruptcy case was filed for guidance.
What, then, does California law have to say about piercing the corporate veil?
And when is the doctrine of alter ego useful for a judgment creditor in a Chapter 7 or Chapter 13 bankruptcy case?
Piercing the Corporate Veil in California
As we have written before here, California courts have elaborated a two-part test for use in considering whether or not to allow a creditor to pierce the corporate veil in a collection effort.
This test requires the creditor pursing the assets of an individual debtor to prove that:
- There is a “unity of interest and ownership” between the debtor and the corporate entity; and
- That it would be unfair if acts in question are treated as those of the corporation alone.
This is obviously a fairly vague and elastic “test.”
California courts have thus also enumerated a series of factors for use in determination of whether or not this Alter Ego Test is met. Some are more or less useful to the pursuit of the corporate assets of individual debtors.
These factors include:
- The commingling of funds or assets;
- The treatment of the assets of the corporation by the individual as his or her own;
- The failure to obtain authority to issue stock;
- Representations by the individual that he or she is personally liable for the debts of the corporation, and/or the failure to maintain minutes or adequate corporate records and general confusion of the two parties;
- Identical equitable ownership in two entities;
- The use of the same business or office location for two entities or the same directors or officers;
- The failure to adequately capitalize the corporation;
- The use of the corporation as a mere shell for the single business venture of the individual or another corporation;
- The concealment and misrepresentation of the identity of the responsible ownership of the corporation;
- The disregard of legal formalities and failure to operate the corporation at arm’s length;
- The use of the corporate entity to procure labor or services for the individual or another entity;
- The diversion of assets between the parties to the detriment of creditors, or the manipulation of assets and liabilities to concentrate them in one entity;
- The contracting with another with intent to avoid performance by the use of a corporate entity as a shield against personal liability;
- The creation of the corporate entity to transfer existing personal liability.
This is a non-exhaustive list, and all of these factors needn’t be considered by a California court in any one case. See Associates Vendors, Inc. v. Oakland Meat., Co, 210 Cal. App. 2d 825 (1962).
These “unity of interest” factors essentially represent the idea that a court may examine a variety of circumstances in determining whether or not corporate assets are reachable by an individual’s personal creditors.
The 2nd component of the Alter Ego Test reinforces the underlying proposition that the piercing of the corporate veil is limited to those cases in which the individual (or parent corporation) has acted in bad faith.
The concept of “bad faith” is one that appears nowhere in the U.S. Bankruptcy Code but is often discussed in bankruptcy case law.
An individual debtor who happens to trip over one too many of California’s alter ego factors may be found by a Bankruptcy Court to exhibit bad faith.
So when is it useful in a Chapter 7 or Chapter 13 bankruptcy case for a creditor to attempt to pierce the corporate veil?
Creditor Standing in California Bankruptcy Cases
The U.S. Bankruptcy Code does not address or govern the requirements for formation of a corporate entity in California.
As noted above, it therefore California law that will govern a creditor’s action to determine whether an individual debtor or a parent or subsidiary entity is a mere alter ego.
Although a bankruptcy judge will render a decision regarding a creditor’s attempt to pierce the corporate veil in a bankruptcy proceeding, California state law provides the relevant analysis.
This is the alter ego or unity of interests test described above.
However, the extent to which creditors can litigate this issue in a bankruptcy case varies depending upon what Chapter bankruptcy has been filed.
In a Chapter 7 bankruptcy proceeding, the Chapter 7 Trustee assigned to the case is the sole actor empowered to recover any assets of the bankruptcy estate created with the filing of the case. Likewise, the Chapter 7 Trustee is solely empowered to unwind or avoid fraudulent transfers or so-called preference payments.
Creditors of a Chapter 7 debtor are limited to filing motions denying the debtor’s discharge entirely or denying the dischargeability of the specific debt held.
A creditor may also provide information to the Chapter 7 Trustee regarding possible fraudulent transfers or other “bad faith” debtor activity for the Trustee’s consideration as to his or her own next steps in the case.
However, any alter ego allegations against the debtor initiated by a creditor would occur within the context of a motion or adversary proceeding seeking denial of discharge or non-dischargeability of the specific debt in question.
A piercing of the corporate veil in a Chapter 7 bankruptcy, in short, would be attempted attendant to a claim that the debt owed by the bankruptcy debtor is one that arose fraudulently.
Debts incurred fraudulently are not dischargeable in bankruptcy.
In Chapter 13 individual and Chapter 11 corporate reorganization bankruptcies, on the other hand, the debtor filing the bankruptcy case remains in possession of the assets of the bankruptcy estate.
Creditors retain standing to file motions for turnover of assets as well as motions or adversary proceedings to deny discharge or for non-dischargeability orders in Chapter 13 and 11 bankruptcies.
A motion for an order of non-dischargeability is the course of action in a bankruptcy proceeding most likely to succeed.
The effect of such an action will essentially be to remove the creditor’s collection efforts from Federal bankruptcy court back to state court, where the Bankruptcy Code’s mandated presumption in favor of the dischargeability of debt is not an issue.
If the matter has not already been adjudicated in California state court and the question of alter ego remains pertinent, the Bankruptcy Court’s order will estop the debtor’s arguments against a unity of interests in that forum.
If the matter is post-judgment in state court, the creditor will be able to resume execution of its state court judgment once the bankruptcy case is dismissed or administratively closed by the Bankruptcy Court.
In any instance, the assistance of a collection attorney experienced in state and Federal Bankruptcy Courts will be invaluable.
Contact collection attorney Ronald P. Slates today to discuss your collection matter.