California Courts Cracked The Corporate Shield Giving Judgment Creditors a Better Chance of Collection

August 10, 2011

In today’s climate, California judgment creditors are finding that debts of business entities are uncollectable and that the debtor is nothing more than a shell business entity. Facing the frustration of collecting against a company with marginal assets, creditors have been abandoning their judgments. Recently, the appellate courts cracked open the corporate shield giving judgment creditors a better chance of collection. Two recent Court of Appeal cases opined on the tactics for collecting against business owners evading financial responsibility through the use of shell companies.

In Misik v. D’Arco, 197 Cal. App. 4th 1065, as modified by 2011 Cal. App. LEXIS 1028 (Cal. App. 2d Dist., Aug. 9, 2011), the appellate court cracked the corporate shield, increasing a judgment creditor’s chance of collection. The appellate court held that a trial court, using its general powers under Code of Civil Procedure Section 187, can amend a judgment to add a judgment debtor who is found to be an alter ego of the business defendant. In Misik, the plaintiff filed a motion to amend the judgment to add a corporate officer, D’Arco, as a judgment debtor. Unbeknownst to Misik, he made a loan of money to a shell company owned by D’Arco. After D’Arco’s company defaulted on the loan, Misik sued D’Arco and his company for breach of contract and fraud. Misik did not prevail on the fraud claim against D’Arco and ended up with a judgment against D’Arco’s company only.

Unable to collect against D’Arco’s worthless company, Misik filed a motion to add D’Arco to the judgment based on the alter ego doctrine. Whether the business is an alter ego of an individual is a factual question. First, there must be sufficient unity of interest and ownership between the individual and the business such that their separate personalities no longer exist. Secondly, treating the business as separate will sanction a fraud, promote injustice, or cause an inequitable result. The Misik court found D’Arco to be an alter ego of his company. The Court relied on the facts that D’Arco was the only officer and employee of his business, that he made all decisions for the business, and that he even paid some business debts with personal checks. The Misik court futher noted that D’Arco participated in and controlled the litigation filed against his company by Misik.

The court in Phillips Spallas & Angstadt LLP v. Fotouhi (197 Cal. App. 4th 1132) approved of the use of charging orders to grab corporate assets to satisfy a judgment against an individual shareholder. There, the court approved a charging order, finding that a new corporation was merely a continuation of a partnership. Phillips Spallas & Angstadt, a law firm, obtained a judgment against Fotouhi, a departing partner, for breach of the partnership agreement. Fotouhi left the firm with its major clients and formed a new partnership with several associates of the firm. The firm won an arbitration award against Fotouhi. Fotouhi attempted to discharge the award in bankruptcy, but was unsuccessful when his bankruptcy was discharged for fraud. He then swore that the firm would never collect a dime. He formed a law corporation which “bought” the assets of his new law partnership.

A judgment was entered in favor of the firm based on the arbitration award. The firm then sought a charging order against Fatouhi’s interest in his new law partnership and against his corporation as a “continuation” of the partnership. The firm also filed a motion to amend the judgment to add, as alter egos, Fatouhi’s partnership and corporation. The court refused to add the partnership and corporation as alter egos because they did not exist at the time of the arbitration award. But, using its powers under Code of Civil Procedure Section 187, the trial court did issue charging orders against the partnership and the corporation as a successor in interest to the partnership. Noting that, although, a judgment creditor cannot look to a corporation’s assets to satisfy a judgment against a shareholder, the charging order here was properly applied to Fatouhi’s assets in the corporation because corporation was merely a continuation of his partnership.

It is clear from these two cases that the courts are willing to stop the corporate shell game by disregarding the corporate fiction in cases of alter ego. Judgment creditors should explore the use of Code of Civil Procedure Section 187 to amend their judgments or seek charging orders against the true debtors hiding behind their shell businesses.

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