Creditors with judgments are often discouraged when they hear that the company that owes them money has gone out of business. Fortunately, the state legislature has passed laws restricting corporate debtors from engaging in certain transactions involving the company’s owners and shareholders once a lawsuit has been filed against the company. If an “insider” at the company engages in such a transaction, it can open the door for creditors to hold the individual owners liable on the judgment entered against the corporate entity. In this post, we examine these provisions of the Debtor Creditor Law (the “DCL”) that created the concept of constructive fraud to recover fraudulent conveyances.
A fraudulent conveyance occurs when a debtor, often either a defendant in a lawsuit or a judgment debtor, transfers its assets to a 3rd party related to or affiliated with the debtor when transfer is outside the scope of the debtor’s ordinary business practices. As opposed to actual fraud, which requires intent, many fraudulent conveyances are constructive frauds, meaning that the action alone constitutes a fraud regardless of the actor’s intent. While there are many examples of conduct that could be considered a fraudulent conveyance, we will provide illustrations of some common scenarios, and show how creditors can use this type of claim to collect on a judgment from the individual owners, shareholders, or related entities of a corporate judgment debtor, even if the debtor itself is defunct.
As one example, a creditor may find, upon reviewing the debtor’s bank records, that the company issued a large check to an entity with the same owners as the failed business. If the check was issued after the lawsuit was filed, this may constitute a constructive fraud, which would allow the creditor to pursue a claim not only against the other entity but also against the common owners, even though the debtor is no longer in business.
Similarly, a creditor may discover evidence that the corporate debtor made repayments of a shareholder loan during the pendency of a lawsuit against the company. Since shareholders, as a class, are considered insiders of the company, it is considered a constructive fraud for them to receive preferential repayments of their debts while leaving other creditors unpaid.
Another example of a fraud and a common practice of closing businesses is to make an unscheduled distribution of assets to shareholders, outside of any regular salary or wages which may be lawfully paid. When a company makes itself insolvent by distributing or otherwise disposing of its assets, such conduct may give rise to a claim under the DCL for fraudulent conveyance or fraudulent transfer. In such a situation, creditors of the liquidated judgment debtor can hold the debtor’s owners and affiliates liable for the judgment by bringing a secondary lawsuit.
Having a claim or judgment against a company that appears to be out of business does not mean that all hope is lost. Even if you believe that you have a worthless judgment or claim, it’s always worth a discussion with a qualified attorney to see what steps can be taken to collect the debt.
Kenneth J. Katz