The US Court of Appeals for the Ninth Circuit recently held that a creditor of a bankrupt corporation may assert alter ego claims against the corporation’s sole shareholders. The California Court of Appeals for the Second Appellate District not only supports the Ninth Circuit’s decision but has recently taken it one step further, holding that alter ego allegations are not even subject to the automatic bankruptcy stay. This is a major change in bankruptcy practice, which has long held that alter ego claims were property of the bankruptcy estate and that these claims could only be pursued by a bankruptcy trustee or, in certain cases, an Official Committee of Unsecured Creditors, and not by individual creditors. Because of this, when creditors have sued principals on alter ego theories to enforce corporate debt, the corporation’s principals have sometimes caused the corporation to commence a bankruptcy case so that they could benefit from the Bankruptcy Code’s automatic stay of litigation. The new ruling may block these tactics.

The Ninth Circuit decision is Ahcom, Ltd. v. Smeding (9th Cir. Oct. 21, 2010, Docket No. 09 16020). Ahcom, a creditor of Nuttery Farms, Inc. (NFI), had obtained an arbitration award against NFI, which subsequently filed for bankruptcy. Ahcom responded by suing the sole owners, Hendrik and Lettie Smeding, in California state court under an alter ego theory, seeking to pierce the corporate veil and enforce the arbitration award and hold the Smedings responsible for the corporation’s actions. Hoping to overcome Ahcom’s claim based on a lack of standing, the Smedings removed the collection action to the district court and responded with a motion to dismiss. Ahcom argued that its alter ego claim affected not just Ahcom but all creditors of NFI’s bankruptcy estate, and therefore the claim was exclusively the property of the bankruptcy estate. The lower courts, consistent with prior caselaw, agreed and dismissed the shareholder action.

The Ninth Circuit, however, carefully examined California law and concluded that California does not recognize a general alter ego claim that would render a shareholder liable for all of a company’s debts, but instead recognizes only a particularized alter ego claim. The distinction is critical, because if under California law an alter ego claim were a general claim belonging to the corporation, then it could only be asserted by the trustee or another representative of the corporate debtor. But because the Ninth Circuit found that an alter ego claim is a particularized claim that can only be pursued by an individual claimant, it held that only the individual claimant and not the bankruptcy trustee will have standing to assert the claim. In so holding, the Ninth Circuit expressly rejected two prior bankruptcy cases, Stodd v. Goldberger and In re Davey Roofing, Inc.

At first blush, Ahcom, Ltd. v. Smeding and now Shaoxing County Huayue Import & Export v. Bhaumik, 2011 WL 135844 (Cal.App. 2 Dist., January 18, 2011), may seem like a victory for creditors, since they pave the way for creditors to pursue alter ego claims against the shareholders of a bankrupt corporation. However, they also raise a number of significant questions. For example:

  • Alter ego claims could previously be pursued by debtors or, under certain circumstances, a Creditors’ Committee, all at the expense of the debtor’s estate. It now appears that each injured creditor, at least in the Ninth Circuit, will have to pursue its own, individual alter ego claim. Will the cost of these individual claims be prohibitively expensive, allowing principals of bankrupt companies to escape justice? And how will the cost and expense of administering multiple, individual causes of action be controlled?
  • Could creditors elect to transfer their individual alter ego claims to the bankruptcy trustee or a creditors’ trust? For what value? Could this be done under a plan, and if so, would the transfer provisions be enforceable if the plan were accepted by the necessary majorities, if the plan were crammed down, or if creditors were given an opportunity to opt out?