In difficult times such as now, many struggling companies want to "push the reset button" and re-start their businesses, either with a new business or a redesigned existing business. A recent case from the 7th Circuit Court of Appeals, located in Chicago, is a good illustration of how not to re-start a business. (Laborers' Pension Fund et al. vs. Lay-Com et. al., Case Nos. 06-3711, 06-3821 and 07-1071 decided September 2, 2009)
King & Larsen Construction, Inc. was a unionized subcontractor that worked on residential properties. In late 2000, King & Larsen began missing benefits contributions and dues payments to the union funds. In a complicated series of transactions, the owners of King & Larsen decided to start a new business, called M.A. King Construction, Inc. But they did so in a very convoluted way.
The owners of King & Larsen arranged for the transfer of over $1 million in assets and some of its liabilities (but not the obligations to the funds) to an Illinois company called Lord & Essex, Inc. In turn, Lord & Essex transferred the assets to Lay-Com, which then transferred them to M.A. King Construction, Inc., where they remained. M.A. King Construction was not successful. It eventually dissolved.
The union funds then obtained a default judgment against M.A. King Construction. The union funds also obtained a judgment against King & Larsen, the original obligor to the union funds, which was left an empty shell. The judgments were not satisfied, with King & Larsen and M.A. King both "judgment proof," with no assets for the judgment creditors to reach.
The union funds then sought to "pierce the corporate veil," i.e., to require Lay-Com and Lord & Essex (the conduits used to transfer assets to M.A. King Construction) to pay King & Larsen's and M.A. King's obligations to the union funds.
At trial, the court agreed with the union funds and imposed a judgment against Lay-Com and Lord & Essex of around $2.5 million. On appeal, the 7th Circuit Court of Appeals agreed and upheld the judgment. In upholding the judgment, the court cited some key evidence:
- The investors in M.A. King Construction, which included Lay- Com, put no equity capital into M.A. King Construction. Calling "undercapitalization the single most important factor in the veil-piercing analysis," the court stated, "If the shareholders do not invest enough equity, such that the corporation is undercapitalized, there is no basis for rewarding them by limiting their liability, and, in fact, doing so would only encourage risky behavior. . .. Whatever else might be said about how much equity capital is enough, here it is clear that M.A. King had no equity capital at all. It was unquestionably undercapitalized." [emphasis in original]
- Although M.A. King's nominal owners loaned money to M.A. King, the court drew a sharp distinction between equity capital and loans. "Treating debt as in investment is not unheard of, but it is unfavored by courts because by doing so, the lenders cum investors (here, the defendants) give up nothing by way of profits if the corporation succeeds, but have assured themselves the preferred status of creditors if it fails, thus shifting to the legitimate creditors of the corporation a part of the risk that in fairness should be borne by the proprietary interest. . . . . For the need for a shareholder loan at the outset of a new business signals that the initial equity was insufficient. Here that was clearly the case - again, there was no initial equity in M.A. King at all."
- Lay-Com, one of the conduits used to transfer assets from King & Larsen to M.A. King, "controlled M.A. King's purse strings, if not its operations, and that it did so at least in part to avoid M.A. King's (and King & Larsen's) pension benefit and union dues obligations . . . . M.A. King never operated separately and independently from Lay-Com." [emphasis in original]
For a corporate attorney, some of the court's language raises concerns. In spite of the court's statement about loans to a new company, it is not at all unusual for a start-up to be financed with both equity and loans. It is also common for a parent to control its subsidiary's "purse strings." Should we be concerned about claims of "piercing the corporate veil" in these types of situations?
Perhaps not. After its extensive analysis, the court states, "All of this discussion risks ignoring the forest for the trees. M.A. King shut down less than a year after it set up shop, following a series of transactions that, admittedly, avoided King & Larsen's union obligations . . . Right off the bat, M.A. King needed a steady influx of cash loans from the defendants to keep going. These are all marks of an undercapitalized corporation, propped up by its parent or shareholders."
So, in the end, the court does not condemn a business starting afresh or the means by which it may do so. But, given the suspicious circumstances of the start-up in this case, the court does give caution to new start-up businesses that leave behind unpaid and unhappy creditors of the old business.