Cleaning Up

Molly and Ruth were partners in the operationof a dry cleaningstore. Recent government environmental regulations relating to dangers posed by dry cleaning fluids increased their exposure to liability and caused a decline in their business. Molly and Ruth decided to convert their partnership into Dryco, Inc. (“Dryco”),a corporation, to limit their potential personal liability.

Molly and Ruth each contributed $20,000in cash to Dryco. In return, each received a $15,000 promissory note from Dryco and 5,000 shares of stock with a value of $1 per share.

Prior to incorporation, Molly entered into a contract on behalf of Dryco with Equipment Company (“EC”) for the unsecured credit purchase of an environmentally safe dryer for $100,000. EC was aware that Dryco had not yet been formed. EC delivered the dryer one week after the incorporation, and Dryco used it thereafter and made monthly installment payments.

Dryco had been incorporated in compliance with all statutory requirements, and Molly and Ruth observed all corporate formalities during the period of Dryco’s existence. One year after incorporation, however, Dryco became insolvent and dissolved. At the time of the dissolution, Dryco’s assets were valued at $50,000. Its debts totaled $120,000, consisting of the two $15,000 notes held by Molly and Ruth and a $90,000balance due EC for the dryer.

1. As among EC, Molly and Ruth, how should Dryco’s $50,000 in assets be distributed? Discuss.

2. On what theory or theories,if any, can Molly and/or Ruth be held liable for the balance owed to EC? Discuss.

Answer 3

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1. Generally, secured creditors take priority over unsecured creditors at bankruptcy. In this case, Molly and Ruth have promissory notes from Dryco and are thus secured creditors. EC is an unsecured creditor. Therefore, under the general rule, the obligations of Molly and Ruth would be satisfied fully first. Each would receive $15,000. The remaining $20, 000 would be paid to EC.

However, when creditors are shareholders, bankruptcy courts have developed three equitable doctrines that could alter the general rule.

A. Disallow the insiders’ claims. Courts disallow the insiders’ claims when they feel the balance of equities dictates it. In this case, if the court did not step in, M and R would walk away with $30,000 and would lose only $5,000 each for their now worthless shares. EC would get only $20,000 out of its $90,000 claim. This is clearly inequitable, especially in light of M and R’s culpability in undertaking so much debt when the corporation was undercapitalized. If the remedy were imposed, EC would obtain $40,000 out of $90,000 and M and R would take nothing.

B. Subordinate the insiders’ claims to those of outside creditors. “Equitable subordination” is for the same reasons as for piercing the corporate veil, but this equitable remedy is invoked more liberally. Where the corporation was inadequately capitalized or there was fraud or other wrongdoing or the corporate formalities were not observed, the courts may subordinate the insiders’ claims.

Here, M and R appeared to fund Dryco with $40,000, but actually $30,000 of that were loans, leaving actual funding of only $10,000. They immediately took on a debt of $100,000. They did this at a time they knew that the dry cleaning business was becoming less profitable. This proves Dryco was undercapitalized. As to fraud or other wrongdoing, M entered into the $100,000 contract before Dryco was incorporated, thus depriving EC of the ability to examine Dryco’s books and determine its financial health.

Therefore, the combination of undercapitalization and inequitable business practices justifies the bankruptcy court remedy of equitable subordination. In this case, EC is owed $90,000 and Dryco has only $50,000 in assets. EC would receive the entire $50,000 and M and R would receive nothing.

C. Treat the insiders’ loans as capital of the corporation. Courts do this in circumstances where the corporation was obviously inadequately capitalized.

Here, M and R knew that their business was declining and was likely to continue to do so because of new federal environmental regulations. While it appeared that Dryco has $40,000 of operating capital, $30,000 of that were actually loans. This means they capitalized Dryco with only $10,000. Yet they took on $100,000 in debt. Further, because M entered into the contract with EC before Dryco was incorporated, EC would have no way of knowing that Dryco was undercapitalized.

Therefore, there are sufficient grounds for the court to transform M and R’s loans into capital. In this case, EC would receive the entire $50,000.

2. M’s liability as promoter

A promoter is liable for contracts entered into on behalf of corporations unless the contracting party agrees that it is contracting solely with the corporation-to-be-formed. This depends on the intent of the parties to the contract. The intent of the parties is determined by:

Party knew the corporation was not yet formed. Here, EC did know that Dryco was not yet formed. This factor favors absolving M of personal liability.

Contract expressly states that corporation-to-be-formed is exclusively liable for the contract. Here, we do not know what the contract terms are. Assuming that this is not expressly stated, M would be more likely to be held personally liable.

Promoter expressly stated she was signing for the corporation to be formed. Here, we do not know if M expressly stated she was signing for Dryco. If she did not, she is more likely to be held personally liable.

Conclusion: We do not have enough information to conclude that EC intended to look only to the corporation. Absent that information, M is personally liable as a promoter.

The corporation becomes jointly and severally liable with the promoter if it ratifies the contract or accepts benefits under it. Here, it appears Dryco accepted the benefits of the contract. This makes Dryco jointly and severally liable under the contract with M.

A promoter is relieved of liability only if the corporation enters into a novation of the contract, substituting the promoter with the corporation. It does not appear that Dryco entered a novation.

Therefore, it appears that EC and M are jointly and severally liable under the contract.

R and M’s liabilitypiercing the corporate veil

The purpose of incorporating is to shield individuals from personal liability. However, in certain circumstances, courts will set aside this shield to hold individuals liable for the corporation’s debts. The factors a court examines are whether:

The creditor is a tort or contract creditor. The court is more likely to pierce the corporate veil when it is a tort creditor, because he did not voluntarily enter into a relationship with the corporation. Here, EC is a contract creditor, so this does not favor piercing the veil.

Corporate formalities were ignored. Here, M and R observed corporate formalities, so this does not favor piercing the veil.

Insiders engaged in fraud or wrongdoing. On one hand, M honestly told EC that Dryco did not yet exist. We do not have enough information to determine whether M attempted to eliminate personal liability in the wording of the contract or the manner in which she signed it. On the other hand, because Dryco was not yet formed, EC had no way of finding out whether Dryco was adequately capitalized.

However, there is no indication that M intended to mislead EC by entering into the contract before Dryco was incorporated. If this were the only factor, it would probably be insufficient to pierce the veil.

Inadequate capitalization

When a corporation does not have reasonable capital for its foreseeable business needs and the creditors had no opportunity to ascertain this fact, capitalization is said to be inadequate and the corporate veil may be pierced, holding individuals liable for the corporation’s debts.

When Dryco was incorporated, it was already carrying $100,000 in debt. M and R provided $40,000. If business were profitable, this may have been sufficient to pay off the loan and to remain profitable. But M and R knew that business was declining due to the new federal law. Furthermore, of the $40,000 capital, $30,000 of it was IOUs to M and R who would have priority over any later creditors. EC had no way of knowing Dryco’s financial position because it entered into the contract before Dryco’s corporate filings were available for inspection. This means the corporation really only had $10,000 at the time it took on a $100,000 obligation. This is probably inadequate capitalization in the given business climate. Inadequate capitalization is the single most important factor in determining whether to pierce the corporate veil, but when it is the only factor present, a majority of courts will not pierce the veil.

Conclusion: Because M and R observed corporate formalities and the evidence of fraud is weak, a court would probably refuse to pierce the veil, and M and R would not be personally liable to EC for the $90,000 outstanding on its contract.