Dealing With a Financially Weak Corporation

Knowingly dealing with a thinly capitalized corporation and not asking for a guaranty will make it tough to pierce the corporate veil. This is illustrated by the case of Fusion Capital Fund II, LLC, v. Ham, 614 F.3d 698 (7th Cir. 2010), a case decided under Nevada law.

Millenium Holding Group, Inc., a Nevada corporation, had shares that were publicly traded over the counter. Millenium had few assets and no ongoing business and was insolvent.

Millenium entered into a contract with Fusion Capital Fund II under which Fusion promised to invest $15 million, subject to certain conditions. According to Fusion, the conditions were not satisfied, and Fusion wrote to Millenium that the money would not be forthcoming. Millenium then sued Fusion in Nevada for tortious interference with a merger agreement that was dependent on Millenium receiving the $15 million. Millenium lost. The contract between the parties had an attorney’s fee clause, and upon prevailing in the litigation, Fusion was awarded its attorney’s fees. The hunter became the hunted when Fusion turned around and sued Millenium in Illinois to recover its for attorney’s fees.

Of course, a claim against Millenium wasn’t worth the paper it would be written on, and Fusion needed a deep pocket (or at least a pocket) to tap into. Not surprisingly, it chose the two owners who were majority shareholders and the sole board members. Millenium owed Fusion about $1.2 million for legal fees, and since Millenium was judgment-proof (that is, broke and unable to pay a judgment), the district court, applying Nevada law, found that the majority shareholders were personally responsible for Millenium’s obligation to Fusion for legal fees.

Unlike California, Nevada has a statute on the subject of alter ego. It provides that:

1.   Except as otherwise provided by specific statute, no stockholder, director or officer of a corporation is individually liable for a debt or liability of the corporation, unless the stockholder, director or officer acts as the alter ego of the corporation.

2.   A stockholder, director or officer acts as the alter ego of a corporation if:

(a)   The corporation is influenced and governed by the stockholder, director or officer;

(b)   There is such unity of interest and ownership that the corporation and the stockholder, director or officer are inseparable from each other; and

(c)   Adherence to the corporate fiction of a separate entity would sanction fraud or promote a manifest injustice.

Although California has no such statute, California Law is much the same as principles outlined in Nevada’s statute.

On appeal, the appellate court  reversed  the district court, saying that the evidence supported a finding of the first two elements ((a) and (b) above) but not as to third element ((c) above). As the court put it, there wasn’t any fraud because Fusion knew “that Millenium [was] a husk without any corn inside.”

The court held that this knowledge made it hard to see how limiting the shareholders’ liability would promote an “injustice.” Fusion was not deceived in any way. As far as the court was concerned, the “injustice” component comes to the fore when a creditor’s claim is based on tort law because victims rarely understand in advance that they are dealing with shell corporations (if indeed they understand before the injury that they are dealing with the corporation at all). It may be important for some contract claims too, if the corporation leads the other party to think that it is normally capitalized and will be able to satisfy its obligations. But Fusion not only understood that Millenium was a shell but it also understood that Millenium’s insolvency was the dominant feature in the deal’s structure.

The court stated that when Millenium signed a contract promising to reimburse Fusion’s legal expenses if litigation ensued, Fusion knew beyond doubt that Millenium would be unable to keep that promise (unless a merger that was a condition in fact closed).

The court observed that someone who wants to protect himself against the possibility that a thinly capitalized corporation will be unable to pay its debts asks the owners for a guaranty. It is feckless to do business with a corporation such as Millenium without one. Yet Fusion not only did not get a guaranty but also did not even ask for one. There are a number of court decisions which hold that people who knowingly deal with a corporation without getting a guaranty can’t turn to shareholders on an alter-ego or veil-piercing theory.

The wrinkle in this case is that Fusion argued a different kind of “injustice”:  Millenium took the offensive in the Nevada suit! If it had prevailed, the shareholders would have pocketed 100% of the money; when Millenium lost, the shareholders argued that they owed nothing. But the court noted that this asymmetry is common in corporate transactions. If Fusion wanted to be protected from this asymmetry, it should have negotiated for a guaranty and refused to deal if the shareholders would not give one.

Lessons Learned

This decision doesn’t break any new ground, and the result is simple common sense to most people experienced in business. Parties should get a guaranty (if they can) before entering into a contract with a corporation that is not financially strong.

Parties are often willing, however, to take the risk of the corporation going under.  What they may not realize, however, is that the lack of a guaranty may turn an attorney’s fee clause in a contract with a financially weak corporation into a one-sided proposition (notwithstanding Civil Code §1717), and the insolvent corporation may take the offensive. In that event, it’s “heads I win, tails you lose” for the financially  stronger party.

An attorney’s fee clause is standard in many business contracts, and many lawyers will include one without thinking about the consequences. But exceedingly careful counsel will think about what disputes are likely to arise from the contract and who stands to benefit from an attorney’s fee clause before including one in the agreement.

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