Contributed by Eleanor H. Gilbane and Maurice Horwitz
Can a creditor go straight to state court and sue a debtor’s sole shareholder on an alter ego theory? Or does the alter ego claim belong exclusively to the debtor? Because these are ultimately questions of state law, the answer will vary depending on the state. Delaware law allows a subsidiary to maintain a veil piercing action against its corporate parent; consequently, several courts have held that such claims belong to the debtor’s estate if the subsidiary is in bankruptcy. As is now clear from a recent Ninth Circuit decision, however, where California law applies, it may be possible for creditors to pierce the corporate veil and sue a debtor’s shareholder directly, bypassing the bankruptcy court altogether.
In AHCOM, Ltd. v. Smeding, Case No. 09-16020 (9th Cir. Oct. 21, 2010), the Ninth Circuit was posed with the question “of whether a creditor of a corporation in bankruptcy has standing to assert a claim against the corporation’s sole shareholders on an alter ego theory, or whether that claim belongs solely to the corporation’s bankruptcy trustee.” The plaintiff in this case had entered into a contract to buy almonds from the debtor, a California corporation. When the debtor failed to deliver the almonds, the plaintiff brought an arbitration action in Germany (pursuant to an arbitration clause in their contract) and won. Shortly after the arbitration, the debtor commenced its bankruptcy case in the United States.
Rather than file a claim in the debtor’s bankruptcy, the plaintiff sued the debtor’s sole owners in state court, seeking to pierce the corporate veil. The defendants, having removed the suit to the Northern District of California, moved to dismiss the action. They argued that the plaintiff was “asserting a claim that harms not just [the plaintiff itself] but all creditors and thus [that the alter ego claim] is exclusively the property of the trustee.” The District Court agreed the defendants and dismissed the action.
On appeal, the Ninth Circuit began with the general proposition that whether a claim belongs to the debtor or to individual creditor is a question of state law, but then identified “a crucial problem with [the defendants’] argument: it assumes the existence of a general alter ego claim.” In fact, as the Court of Appeals concluded, “California law does not recognize an alter ego claim or cause of action that will allow a corporation and its shareholders to be treated as alter egos for the purposes of all the corporation’s debts.”
While veil piercing is a cognizable theory in California, “[a] claim against a defendant, based on the alter ego theory, is not itself a claim for substantive relief, e.g., breach of contract or to set aside a fraudulent conveyance, but rather, procedural.” Thus, in California, an alter ego claim cannot be asserted alone as a “general alter ego claim,” but can be relied upon in order to bring substantive claims, such as breach of contract, against a corporation’s shareholder. Because the District Court’s decision to dismiss the action was premised on the existence of a general alter ego claim in California, the Ninth Circuit reversed and remanded the case to the District Court so that the plaintiffs could submit an amended complaint.
While the Ninth Circuit’s decision in AHCOM is straightforward enough, it is worth noting that a different result could be obtained in jurisdictions where veil piercing is recognized as a standalone cause of action that the subsidiary may bring against its parent. Indeed, the Second Circuit has held that “[w]here a debtor has a right to assert an alter ego claim to pierce its own corporate veil under applicable state law, that claim is property of the debtor’s estate and the claim may only be asserted by the trustee or debtor-in-possession.” For example, in Duke Energy, the bankruptcy court held that the trustee or debtor in possession had exclusive standing to bring a veil piercing action against the debtors’ corporate parent, also a debtor. In reaching that conclusion, the court considered who would have standing under Delaware law (the applicable law) to bring a veil piercing action outside of the bankruptcy context. The court held that “[b]ased on the fact that Delaware law allows a subsidiary to maintain an action against a corporate parent, courts have found that a Delaware court would permit a debtor corporation to assert a claim to pierce its own corporate veil. Thus, the trustee or debtor-in-possession would have exclusive standing to maintain a Delaware corporation’s alter ego claim of a general nature.”
Additionally, in Murray v. Miner, relied upon by the Duke court, the District Court for the Southern District of New York dismissed a cause of action brought by the debtor’s former employees seeking to hold the debtor’s controlling shareholders liable for the debtor’s contractual obligations to the employees. The Murray court held that because several Delaware cases had permitted a subsidiary to maintain an action against its corporate parent or controlling shareholder, the trustee had exclusive standing to pursue an alter ego claim. Specifically, the Murray court noted that because under these cases “the subsidiary may institute proceedings against the parent if it has sustained liability to third parties as a result of the parent’s control. One can only conclude that for purposes of applying federal bankruptcy law, Delaware courts would permit a debtor corporation to ‘assert  an alter ego claim to pierce its own corporate veil.’”
In Periera v. Cogan, the debtor’s trustee sought to pierce the corporate veil and hold the debtor’s shareholder liable for the debtor’s obligations under an alter ego theory. Periera denied the defendant’s motion to dismiss and held (citing Murray v. Miner) that the trustee had standing to pursue the alter ego claim, because under Delaware law (the applicable state law in that case) a subsidiary could bring causes of action for breach of fiduciary duties and of loyalty and fair dealing. Thus, it concluded, as did Murray v. Miner, that a Delaware court would permit a corporation to pierce its own veil, and therefore the trustee had standing to bring its cause of action.
Finally, a more recent case, In re Alper Holdings USA, denied plaintiffs’ cause of action seeking to pierce the corporate veil of the debtor, citing Murray v. Miner, Duke v. Enron, and Pereira v. Cogan for the same proposition, i.e., that Delaware law would permit a debtor corporation to assert an alter ego claim and pierce its own corporate veil. Interestingly, the plaintiffs in that case argued unsuccessfully that the law of Tennessee, rather than Delaware, should apply, noting that under Tennessee law, a debtor does not have the ability to pierce its own corporate veil. The court rejected that argument because the debtors were incorporated in Delaware, and under New York choice of law principles, the law of the state of incorporation controls the analysis of alter ego claims.
The moral of the story: double check to see where a debtor is incorporated before getting carried away with your alter ego theory.