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    The Lawletter Blog

    BUSINESS LAW UPDATE: Effect of Corporate Bankruptcy Filing on Creditor's Alter Ego Claims

    Posted by Gale Burns on Wed, Dec 7, 2011 @ 11:12 AM

    December 6, 2011

    Charlene Hicks, Senior Attorney, National Legal Research Group

    In a civil lawsuit against a close corporation, it is relatively common for the plaintiff to allege that the corporate veil should be pierced and the corporate officers or shareholders be held personally liable for the corporation's wrongful actions.  If the corporation files a bankruptcy petition in the midst of the proceedings, the civil action against it is automatically stayed pursuant to 11 U.S.C. § 362(a).  The question then arises as to whether the automatic stay in bankruptcy extends to the alter ego claims against the corporate officers or shareholders.

    Generally speaking, the automatic stay provided by § 362(a) does not extend to third parties such as officers of the debtor corporation.  However, courts have carved out certain important exceptions to this general rule.  Because state law determines whether a specific claim belongs to the bankruptcy estate or to an individual creditor, these exceptions are not uniformly recognized but, rather, vary from state to state.

    In a recent illustrative case, Shaoxing County Huayue Import & Export v. Bhaumik, 120 Cal. Rptr. 3d 303 (Ct. App. 2011), the California Court of Appeal addressed the effect of a corporation's bankruptcy filing upon a creditor's alter ego claims against an individual who controlled the corporation's business operations.  In that case, a corporate creditor filed a state court complaint for breach of contract against both the corporation and the company's general manager.  In regard to the manager, the creditor alleged that the corporate veil should be pierced because the manager was responsible for the corporation's actions and he used the company as a device to "avoid individual liability and for purposes of substituting a financially insolvent entity in place of himself."  Id. at 306.  After suit had been commenced, the corporation filed a Chapter 7 bankruptcy petition, and the creditor voluntarily dismissed the corporation from the action.  The manager then moved for a stay, arguing that the creditor's alter ego claims belonged to the bankruptcy estate and that the bankruptcy trustee had exclusive standing to pursue the action against him.

    In addressing this issue, the court acknowledged that the line separating claims of the debtor, which the bankruptcy trustee has exclusive standing to assert, and claims of an individual creditor against a third party is not always clear.  To determine the nature of the claim, the focus of the inquiry must be on whether the injury to be redressed is one that was suffered by the debtor corporation.  Id. at 309.  If the corporation has not sustained an injury but, rather, the creditor alone has been injured by the alleged conduct, then the claim does not belong to the bankruptcy estate and, by extension, the bankruptcy trustee.  Id.

    Even if the corporation has sustained some injury, it does not necessarily follow that the alter ego claims against the corporate officer will be stayed.  Id. at 310.  Instead, the Shaoxing court ruled that under California law, the bankruptcy trustee will have standing to maintain an action against the corporate officer on an alter ego theory of liability only if the allegation of injury to the corporation "gives the corporation a right of action against the defendant."  Id.  This may occur where the bankruptcy trustee seeks to "recover property or pursue a right of action belonging to the bankrupt corporation, including an action to set aside fraudulent transfers or an action for conversion to recover assets of the bankrupt corporation."  Id.

    If the corporation has not sustained an injury that gives rise to a cause of action against the corporate officer, "the asserted cause of action belongs to each creditor individually."  Id. (internal quotation marks omitted).  Because the corporate manager in question had not argued that the alter ego allegations seeking to hold him liable for the corporation's breach of contract constituted a substantive right of action belonging to the corporation, the court held that the alter ego claims were not the property of the corporation's bankruptcy estate.  Id. at 311.  As a result, the creditor's action against the corporate manager was not subject to the automatic stay, and the creditor was free to pursue its claims against the manager in state court.  Id.

    As Shaoxing demonstrates, whether a creditor may pursue civil claims against a corporate officer or shareholder of a bankrupt corporation turns upon the nature of the alleged injury and, specifically, whether the alleged wrongful conduct gives rise to a right of action by the corporation against the officer or shareholder.  This determination is not an easy one to make, as it turns upon rather subtle distinctions.  In any event, whenever a corporation files a bankruptcy petition after the commencement of a civil lawsuit, careful reference should be had to governing state law in order to determine the exact nature of the creditor's claim and the probable effect of the corporation's bankruptcy filing on any alter ego claims asserted against corporate officers or shareholders.

    Topics: legal research, Charlene Hicks, business law, close corporation, piercing the corporate veil, has corporation sustained some injury, corporation's right of action against alter eg, officer orshareholder alter ego, automatic stay of bankruptcy proceedings extending, state law determines, nature of claim

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