Corporate Dissolution: New Year Brings New Worries
The New Year brings thoughts of a fresh start. For corporations, this may translate into acts to dissolve and re-form under a new name. Care should be exercised when dissolving a company. Otherwise, the shareholders (or members of an LLC) could become personally liable to creditors.
Causes of action against a dissolved corporation (or LLC), whether arising before or after the dissolution, may be enforced against shareholders (or members) to the extent of company assets distributed to them upon dissolution. (Cal. Corp. Code, § 2011(a)(1)(B) (corporations) and § 17707.07(a)(1)(B) (limited liability companies). The dissolution and winding up of affairs must be done in an orderly manner that is fair to creditors. Only after all known debts and liabilities have been paid or adequately budgeted, the remaining assets can be distributed to shareholders or members according to their respective interests.
Like a marriage, it’s easy to incorporate. And like a divorce, it’s time-consuming and difficult to unwind and dissolve. For this reason, formal dissolution rarely occurs. Most owners simply cease operations, leaving creditors holding the bag. If the debt is large enough, a creditor may try to assert personal liability against shareholders using the “alter ego” doctrine or the fraudulent transfer statute.
Alter ego provides a mechanism to “pierce the corporate veil” to hold individuals liable for corporate debts. Courts are to apply the doctrine only in limited circumstances to avoid an injustice. (Mesler v. Bragg Mgt. Co. (1985) 39 Cal.3d 290, 301.) The inquiry is fact-intensive: adequacy of capitalization, commingling of assets, and observance of corporate formalities, among others. Thus, alter ego does not always provide an effective remedy for creditors.
The Uniform Fraudulent Transfer Act (UFTA, Civ. Code § 3439 et seq.) can be used to void a transfer of property to a third person undertaken with the intent to prevent a creditor from reaching that interest to satisfy its claim. A transfer made by a debtor is fraudulent if the debtor made the transfer with actual intent to hinder, delay, or defraud any creditor of the debtor or without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor lacked adequate resources to conduct business or pay its debts. (Civ. Code, § 3439.04, subd. (a).)
Another weapon may be used by creditors to collect corporate debts: “de facto” dissolution. Recall that claims against a corporation may be prosecuted against shareholders to the extent of any assets distributed upon dissolution. But when does dissolution occur? That question was addressed in CB Richard Ellis, Inc. (“CBRE”) v. Terra Nostra Consultants (2014) 230 Cal.App.4th 405), an opinion authored by Justice Ikola of the Fourth Appellate District, Division Three, located in Santa Ana, California. CBRE claimed it was owed a broker’s commission after its client, Jefferson 38, LLC, received $11 million from the sale of land in Murietta, California. The LLC, which denied the claim, transferred nearly all of the sale proceeds to its members, then promptly ceased operations, and filed a certificate of cancellation with the Secretary of State. CBRE sued the individual shareholders, arguing the transfer was, in effect, a distribution made upon dissolution of the company. Thus, CBRE argued, the assets were reachable under § 17355. The Court agreed.
The statute lists three events upon which an LLC shall be dissolved and its affairs wound up: when specified in the operating agreement or the articles of organization; by majority vote of members; or by judicial decree of dissolution. (§ 17350.) The Court found the statute ambiguous on whether those were the only grounds for dissolution. It therefore interpreted the statute in light of its purpose: “to prevent the unjust enrichment of members of limited liability companies when such members have received assets the dissolved company needs to pay creditors.” (Id., at p. 414.) In other words, the members cannot loot the company and leave its creditors, even contingent, disputed creditors, high and dry.
The same holds true for shareholders under § 2011. CBRE’s rationale was extended to corporations in Pension Plan for Pension Trust Fund for Operating Eng’rs v. Giacalone Elec. Servs., Inc., 2015 U.S. Dist. LEXIS 84140 (N.D. Cal., 6/29/15). The Pension Plan sought to impose liability on the owners of a closely-held corporation that went out of business. Like many corporations, it was simply suspended for nonpayment of taxes; the owners did not file formal documents to dissolve, surrender or cancel the corporation. Upon ceasing operations, the owners received equipment and cash. Plaintiff argued those were equity distributions, not repayment of debt. It sought to recover those funds under § 2011(a)(1)(B). Quoting from CBRE, the district court agreed that “companies (and their members) cannot avoid the force of [§ 17355 or § 2011] by the simple expedient of transferring assets out of the company the day before voting to dissolve.” (Id. at * 22, quoting CBRE, 230 Cal.App.4th at 415.)
The bottom line is this: corporate creditors have another weapon in their arsenal. Careful attention must be paid to resolving debts and liabilities of the corporation as part of the orderly dissolution and liquidation of assets. Simply going out of business and transferring whatever assets remain to the owners will trigger a lawsuit to collect against the corporate shareholders or LLC members.