A Fresh Start After Bankruptcy Does Not Include The Right To Escape Fraud: An Individual Debtor Can Not Defeat an Alter Ego Claim Based Upon a Prior Bankruptcy Discharge Unless the Claim Was Adjudicated in the Bankruptcy

Consider the following facts. For many years a company provides services to a corporation. The corporation is a small business, owned and controlled by one individual. A substantial balance is incurred by the corporation which the corporation refuses to pay. A familiar scenario is then played out. The owner opens a new corporation in a similar business and dissolves the first corporation. The service provider creditor commences an action against the first corporation. The law suit is ignored by the first corporation. Thereafter, the creditor obtains a default judgment against the first corporation, but is unsuccessful in finding any assets.

The creditor then deposes the owner and requests bank and financial records. These records reveal that after the commencement of the action against the first corporation, the owner caused the first corporation to transfer a significant amount of cash to the new corporation. The owner cannot establish a credible explanation for the transfers. Thereafter, further discovery reveals that the owner has been using funds in the new corporation to pay directly for personal expenses.

Unbeknownst to the creditor, shortly prior to the deposition of the owner, the owner was granted a discharge in bankruptcy. The creditor was not aware of the owner’s bankruptcy filing and the bankruptcy petition reveals that the owner did not list the creditor as having a claim against either the first corporation or against the owner.

Consultation by the creditor with its attorney reveals that the creditor has a claim against the owner for fraudulent transfer of assets from the first corporation to the new corporation and that the owner’s use of the new corporation for the direct payment of personal expenses exposes the owner to a claim of alter ego liability, all of which makes the owner personally liable for the judgment against the first corporation.

The creditor sues the owner, claiming the owner is liable for the judgment on the basis of fraudulent transfers under New York’s Debtor and Creditor law and on a theory of alter ego liability. Among other defenses, the owner alleges that the personal bankruptcy discharge the owner was granted acts as a complete bar to the creditor’s claim even though the creditor’s claim was not listed in the bankruptcy petition in large part because the owner’s case was a no-asset case. The matter is tried before a judge and a decision is rendered in favor of the creditor for the full amount of the judgment plus interest. FedEx Techconnect v. Ontrend International, Inc., 11 Civ. 3359, S.D.N.Y., decided July 28, 2015 (“Ontrend”).

After finding that the owner had transferred assets from the first corporation to the new corporation in violation of New York’s Debtor and Creditor Law and that the owner was the alter ego of the new corporation, the Ontrend court turned next to the bankruptcy defense. First, the court noted that owner had failed to list the creditor’s claim in the bankruptcy case and therefore the claim was never administered by the bankruptcy court. In fact, the court went on to find that not only had the owner failed to list or have the claim adjudicated in the bankruptcy case, the owner did not want the creditor to know that the bankruptcy case had been commenced. Next, the court considered the case of In re Goodman, 873 F.2d 598 (2nd Cir. 1989) (“Goodman”), where the Second Circuit determined that a principal of a company which had been held liable by the National Labor Relations Board for damages could be held liable for those damages as an alter ego of the violator company even though the principal had obtained a discharge in bankruptcy. Applying the reasoning of Goodman, the court in Ontrend held that the owner’s bankruptcy had not discharged the debts of either the first corporation or the new corporation; nor had the bankruptcy adjudicated the issue of alter ego.

The Ontrend court also applied reasoning from the case of Jackson v. Corporategear, LLC, WL 3527148 (S.D.N.Y. 2005) stating that because a corporate debt cannot be extinguished under the Bankruptcy Code, the owner’s bankruptcy could not have extinguished the debt of either the first or the new corporations. Simply put, the Ontrend Court held that if the owner wanted to “avoid alter ego liability for Ontrend’s debts or OTI’s responsibility for those debts by virtue of a constructive trust, she should have put Ontrend into bankruptcy rather than dissolving it and transferring its assets to OTI. At the very least she should have listed potential alter ego liability in her personal Chapter 7 filing.”

Finally, the court in Ontrend also rejected the owner’s argument that because the bankruptcy case was a no-asset case, non-disclosure of the creditor’s claim was immaterial, finding that for unscheduled fraudulent debts, the no asset status of the case was of no avail to the owner.

So justice was had. A debtor cannot have it both ways: seek a personal discharge in bankruptcy while at the same time fail to disclose potential allegations of fraud and deceit.