A recent New York bankruptcy case holds that shareholders, directors and officers who dissolve a corporation to avoid paying a judgment against the business may be jointly and severally liable for a non-dischargeable debt in their personal bankruptcies. Although this decision is from a bankruptcy court and involves egregious conduct on the part of the debtors, the lesson here is that directors, officers and shareholders may be jointly and severally liable for corporate debts if they fail to provide notice to existing creditors upon dissolution of a closely held corporation and those debts may be non-dischargeable in the their respective personal bankruptcies. Ordinarily, a corporation is dissolved by giving notice of its dissolution, which requires the creditors to present a claim within a specified period of time.

Notice, however, is not required—but at a cost. Where a corporation does not give formal notice to its creditors, Southern District of New York Bankruptcy Judge Cecilia Morris explained that the shareholders are jointly and severally liable to the creditors because they hold the assets in trust for the benefit of creditors. The Court further held in the case of In re Hartley that a shareholder, director or officer may be personally liable for the corporate debt, even though a personal bankruptcy was filed. In other words, the corporate debts may not be discharged in a bankruptcy.

Facts of the Case

Hartley’s Catering was a New York corporation, and its directors, officers and shareholders were Richard and Kara Hartley (the "Debtors"). The New York State Commission of the Division of Human Rights found that Hartley’s was liable to Jennifer Esposito (the "Plaintiff") in the amount of $300,000, and the Appellate Division confirmed the award amount of approximately $350,000, including interest.

While the appeal was pending, the Debtors dissolved Hartley’s even though the business was still operating as a deli for approximately 14 months. The certificate of dissolution was signed by the Debtors. While the appeals process was still pending, and after the closing of the deli, the Debtors filed a chapter 13 petition under the Bankruptcy Code, which was later converted to a chapter 7 liquidation.

On their petition, the Debtors listed as personal property their stock in the two businesses and indicated that their home was subject to mortgages. They did not, however, list the Plaintiff’s lawsuit. As a result, the Plaintiff requested from Judge Morris that the $350,000 debt be declared non-dischargeable. In other words, despite the fact that debtors typically receive a "fresh-start" once emerging from bankruptcy, the Plaintiff was seeking to have these particular Debtors liable for the $350,000 despite the bankruptcy.

Judge Morris, in finding that the debt was non-dischargeable, explained that shareholders who dissolve a corporation, without giving formal notice to creditors, and do so in order to avoid paying a judgment against the business, end up with a non-dischargeable debt in their personal bankruptcies.

Directors and Officers Can Be Held Jointly and Severally Liable Upon Dissolution of an Entity for Failure to Give Creditors Formal Notice

After analyzing New York law, the Bankruptcy Court concluded that the Debtors, as directors and officers of Hartley’s, were jointly and severally liable for the Plaintiff’s $350,000 claim. In New York, upon dissolution of a corporation, either notice may be given to creditors to present claims within a specified period of time, or an informal dissolution may take place where all assets may be transferred without notice to creditors. If no notice is given, directors and shareholders are jointly and severally liable for the corporate debt. The shareholders that receive the assets of the corporation are said to hold them in trust for the benefit of creditors. A creditor must exhaust his remedies by obtaining a judgment against the corporation, unless it would be futile.

In this case, Judge Morris explained that the Debtors did not afford the Plaintiff the opportunity to enforce her judgment against the corporation. Instead, the Debtors dissolved Hartley’s in secrecy. Moreover, Hartley’s has been dissolved for three years and any attempt to enforce the $350,000 judgment would be futile. Finally, any attempt of the Plaintiff to pursue her rights in state court would certainly have violated the automatic stay.

The Judgment was Non-Dischargeable Under the Bankruptcy Code for Three Reasons

Once Judge Morris found that the Debtors could be held jointly and severally liable under New York law, she evaluated whether the $350,000 debt could be deemed non-dischargeable under the Bankruptcy Code. The Court found three reasons why the debt was non-dischargeable.

First, under section 523(a)(2)(A) of the Bankruptcy Code, the Debtors made a knowingly false representation with intent to deceive, the creditor justifiably relied on the misrepresentation, and a loss was sustained that was proximately caused by the misrepresentation. The false pretense here was that the Debtors continued to operate the business for over a year after dissolving the company, making it appear that the corporation was still in existence. The Court explained that concealment of a material fact qualifies as a misrepresentation. The Plaintiff also relied on the fact that Hartley’s was a going concern and continuing to do business, as well as the fact that it was pursuing litigation in the Appellate Division.

Second, under section 523(a)(3) of the Bankruptcy Code, if a debtor fails to list or schedule a debt of the kind specified above (i.e., a debt where property was obtained under false pretenses), then the debt is non-dischargeable. The Court easily found that the Debtors were aware of the above debt and that Debtors should have listed the $350,000 judgment on their schedules.

Finally, under section 532(a)(4), the Court found that the Debtors engaged in fraud while acting in a fiduciary capacity and, therefore, the $350,000 debt is non-dischargeable. For the purposes of this provision, the Court explained that the definition of a fiduciary relationship is much more narrow for bankruptcy purposes: (1) the relationship must have existed before the act that created the liability; (2) the act that created the liability was done during the course of the fiduciary relationship; and (3) the debt from the breach of trust must have been based on an express, technical or statutory trust. Specifically, a "trust" relationship was formed here after the corporation was dissolved and concurrently to the Debtors’ liability to the Plaintiff.

In sum, the Debtors were held to be jointly and severally liable for the debts of Hartley’s Catering arising from the $350,000 judgment based upon the above-mentioned reasons.

What Shareholders, Directors and Officers Should Know

There are two very important principles that the Bankruptcy Court reinforced in the In re Hartley decision. First, shareholders, directors and officers are jointly and severally liable for corporate debt where the corporation does not provide notice of dissolution to its creditors. The reason is that they hold the assets of the business in "trust for the benefit of creditors." The dissolution of a corporation requires the advice and assistance of counsel to determine the proper manner to wind down a corporation’s affairs.

Second, the dissolution of a corporation may have adverse effects on a shareholder’s, director’s or officer’s ability to obtain a discharge in bankruptcy. Typically, chapter 7 liquidations offer debtors a discharge from most debts once the case is closed. However, as explained above, there are exceptions to obtaining a discharge, such as where the debtor fails to list the creditor and nature of the debt on the petition. Courts may also deem a debt non-dischargeable where fraud or defalcation is committed. Filing for bankruptcy or restructuring a company necessitates the advice and expertise of bankruptcy counsel to avoid pitfalls that the Debtors described above faced.