30
Jan2013

Corporate Risks to Starting a New Business During Pending Litigation

We are often asked by business owners involved in litigation whether they can shutter the troubled business and start a new entity. A major concern is the liability of the individual and the newly formed business as it relates to a pending lawsuit.  Several legal concepts should be considered before embarking on such a business move.

An example will help inform the discussion. In 1990, Mary and Mike formed MMC, Inc., which designed and produced espresso machines for coffee shops. Each owned 50 shares of the corporation. An accident occurred in a Chicago coffee shop using an MMC, Inc. machine and in 2010 suit was brought against MMC, Inc. Around the same time, Mary and Mike realized the majority of their profits were derived from their designs and the production arm of the company was losing money and increasing their liability. In 2011, with the suit still pending, they dissolved MMC, Inc., selling all assets relating to the production of the machines, and formed MMC Designs, Inc.  MMC Designs, Inc. was held jointly by Mark and Mike.

Mary and Mike are individually at risk if the plaintiff is able to establish that the corporation is merely the alter ego of the shareholders by showing that “(1) there is such a unity of interest and ownership that the separate personalities of the corporation and the parties who compose it no longer exist, and (2) circumstances are such that adherence to the fiction of a separate corporation would promote injustice or inequitable circumstances” Tower Investors, LLC v. 111 E. Chestnut Consultants,Inc., 371 Ill. App. 3d 1019, 1033-1034 (Ill. App. Ct. 1st Dist. 2007).

To evaluate the unity of interest “a court generally will not rest its decision on a single factor, but will examine many factors, including: (1) inadequate capitalization; (2) failure to issue stock; (3) failure to observe corporate formalities; (4) nonpayment of dividends; (5) insolvency of the debtor corporation; (6) nonfunctioning of the other officers or directors; (7) absence of corporate records; (8) commingling of funds; (9) diversion of assets from the corporation by or to a stockholder or other person or entity to the detriment of creditors; (10) failure to maintain arm’s-length relationships among related entities; and (11) whether, in fact, the corporation is a mere facade for the operation of the dominant stockholders.” Fontana v. TLD Builders, Inc., 362 Ill. App. 3d 491, 503 (Ill. App. Ct. 2d Dist. 2005).  Thus, whether Mary and Mike face liability will depend on how MMC, Inc. and MMC Designs, Inc. are organized and how they operate.  If Mary frequently used MMC, Inc. checkbooks to pay her rent and the corporation never kept records, a court could find alter ego and individual liability could follow.

MMC Designs, Inc. could have been liable under the doctrine of successor liability if they had purchased the tangible assets of MMC, Inc. prior to its dissolution. The traditional rule of corporate liability stands in Illinois: “a corporation that purchases the assets of another corporation is not liable for the debts or liabilities of the selling corporation.”Vernon v. Schuster, 179 Ill. 2d. 338, 344-45 (Ill. 1997).  But “[t]here are four exceptions to the general rule of successor corporate non-liability: (1) where there is an express or implied agreement of assumption; (2) where the transaction amounts to a consolidation or merger of the purchaser or seller corporation; (3) where the purchaser is merely a continuation of the seller; or (4) where the transaction is for the fraudulent purpose of escaping liability for the seller’s obligations.” Id.

A purchase of MMC’s assets by MMC Designs could have triggered the third prong – where MMC Designs was merely a continuation of MMC.  But, because only intangible assets – knowledge of the industry, goodwill, customers, and employees – were transferred, it is unlikely a court would find liability extending to MMC Designs.  These types of assets could not be sold for value in a liquidation and Mary and Mike would have taken these assets to any new business they formed in their industry. See Thomas v. Eagle Sales & Serv., No. 2-11-0093, 2011 Ill. App. Unpub. LEXIS 3361 at *20 (Ill. App. Ct. 2d Dist. Sept. 30, 2011).

It is important to note that these decisions are complex and vary greatly.  Before forming a new entity, one should consider the risks of personal and corporate liability and make informed decisions regarding the sale of assets, the structure and operations of a corporation and the role of individual shareholders in the corporate structure.

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