“Informal Dissolution” and Individual Liability
March 08, 2021
Section 1007 of the Business Corporation Law (the “BCL”) has a procedure for dissolved corporations to publish “notice requiring all creditors and claimants . . . to present their claims in writing and in detail at a specified place and by a specified day.” Under the statute, a creditor’s failure to make a timely claim results in the claim being “forever barred as against the corporation, its assets, directors, officers and shareholders.” The statute employs the word “may,” not “shall,” indicating that corporation’s provision of notice to creditors is optional, not mandatory. What happens to a corporation’s creditors’ claims where the entity or its controllers fail to publish notice of dissolution under BCL § 1007?
Long before enactment of the BCL, New York’s highest court held in Darcy v Brooklyn & N.Y. Ferry Co. (196 NY 99 ), that where directors of a corporation carry out a “voluntary dissolution of the corporation and the distribution of its assets without taking the steps to that end which are prescribed by law” – specifically, providing prior notice to creditors – the directors may be individually liable for the corporation’s debts based upon the principle that it is a “violation of duty on the part of the directors of a corporation to divest it of all its property without affording a reasonable opportunity to its creditors to present and enforce their claims before the transfer shall become effective.”
A recent decision from Manhattan Commercial Division Justice Robert R. Reed, Morse v LoveLive TV US, Inc., 2020 NY Slip Op 51481(U) [Sup Ct, NY County Dec. 15, 2020], considered Darcy‘s concept of “informal dissolution” and its implications for individual controller liability. Morse is a reminder to owners and controllers of closely-held corporation, and lawyers who advise them, that it is a risky proposition not to comply with the statutory notice provisions of BCL § 1007 (or the analogous creditor notice statute applicable to judicial dissolution, BCL § 1106).
Pursuant to a written employment agreement, Morse, an attorney, was Senior Vice President of Business Affairs and Strategic Development for LoveLive, a now-defunct agency that produced audio-visual content. According to her amended complaint, Morse’s employment agreement provided that at the end of 2016, if she had met certain performance targets but her employment was not renewed, she would be entitled to a lump sum payment equal to a percentage of her annual 2016 salary.
In late 2016, Morse was notified that LoveLive was “downsizing” and her employment would not be renewed. A few weeks later, LoveLive ceased doing business altogether. LoveLive did not formally dissolve. It did not file for bankruptcy. Instead, according to Morse, “after defaulting on creditors by informal dissolution, LoveLive disbursed cash assets to select employees as payroll compensation,” leaving the company without any assets to pay creditors, including Morse.
Morse, pro se, sued Cohen, whom she alleged to be LoveLive’s Chief Executive Officer and sole Director, alleging a single cause of action against him, styled as one for “Director Liability under BCL § 1006 and NY Doctrine,” alleging that LoveLive “informally dissolved without undertaking formalities” required by statute; “liquidated various material assets after its informal dissolution;” “never produced an accounting of assets to its creditors;” “breached the Employment Agreement between LoveLive” and Morse; and “[b]y virtue of the foregoing, Defendant Cohen remains liable to Plaintiff for LoveLive’s breach of contract due to LoveLive’s informal dissolution.”
The Dismissal Motion
Cohen moved to dismiss the amended complaint. You can read the parties’ legal arguments here, here, and here. Aside from various procedural arguments, Cohen argued that the amended complaint failed to state a viable claim against him because it lacked any allegation that Cohen personally received a distribution of any money or assets of LiveLive. He argued that “a director cannot be held liable simply for the misfortune of having been at the helm as the ship took on water and ultimately sank.”
Justice Ruchelsman disagreed. The Court explained that LoveLive and Cohen “mischaracterize the facts that must be pled to sufficiently allege” what the Court referred to as a “BCL § 1006 claim,” and held that it “rejected defendants’ argument that a director must receive a transfer of assets for liability to accrue.” The Court held that the “Darcy court was unequivocal in its determination that it is the neglect to afford creditors an opportunity for court review of their claims that constitutes a violation of the directors’ duties,” and that Darcy did not “say anything about transferring assets to the directors” as a prerequisite to pleading a viable claim.
Quoting Parent v Amity Autoworld, Ltd., 15 Misc 3d 633, 640 [Dist Ct, Suffolk County 2007], Justice Reed held that the “cost of an informal dissolution is that directors cannot shield themselves against corporate creditor liability. Directors who undertake to divest a corporation of all its property without taking the proceedings for a voluntary dissolution do so at their peril.” As a result, the Court denied Cohen’s dismissal motion.
Implications of Morse
Individual liability under the doctrine of “informal dissolution” is distinct from the common-law doctrines of piercing the corporate veil or joint participation in the tort, both of which require either a showing of fraud or wrongdoing by the officer / director / shareholder, or his or her direct involvement in the corporation’s tortious conduct.
In Darcy, the Court of Appeals ruled that individual director liability where the corporation liquidates its assets without providing notice to creditors is essentially strict: the “motives which induced the omission are immaterial” and “good faith constitutes no defense.” The lesson: while it is “certainly correct” that corporate officers, directors, and shareholders are “not required by New York Business Corporation Law to provide notice to all of its creditors upon dissolution,” when they choose not to do so, they “put themselves at risk for being held liable for the obligations of their dissolved company” (In re Hartley, 479 BR 635 [SD NY 2012]). So think twice before declining to provide corporate creditors notice of the entity’s dissolution.
Morse and Business Divorce
What does Morse‘s concept of “informal dissolution” and individual controller / shareholder liability to creditors have to do with business divorce cases? Let’s begin with the applicable statutes:
- BCL § 1117 (a) provides that the rules of BCL §§ 1006 and 1007 governing notice to creditors and survival of remedies upon dissolution “shall apply to a corporation dissolved” under the judicial dissolution statutes of article 11 of the BCL;
- BCL § 1106 (a) states that in an order to show cause accompanying a petition for judicial dissolution of a New York corporation, the Court “may order the corporation, its officers and directors” to “furnish the court with a schedule” of “each creditor and claimant, including any with unliquidated or contingent claims and any with whom the corporation has unfulfilled contracts.”
- Subsections (b) and (c) of § 1106 state that the order to show cause “shall be published” in a newspaper for three consecutive weeks and “shall be served upon . . . each person named . . . any schedule provided for in paragraph (a), as a shareholder, creditor or claimant” prior to the hearing on the order to show cause.
- BCL § 1111 (c) provides that in the final order or judgment of dissolution, the court “may, in its discretion, provide therein for the distribution of the property of the corporation to those entitled thereto,” including creditors, “according to their respective rights.”
Though I have never seen it done, I can envision a corporate creditor who did not receive notice of the petition for dissolution under BCL § 1106 analogizing to case law like Morse to allege a claim against a corporate officer, director, or shareholder where it did not receive notice of the dissolution petition. So while BCL § 1106, like BCL § 1007, uses permissive language (the order to show cause for dissolution “may” require a listing of creditors), best practice to insulate the corporation’s controllers / shareholders from personal liability is to carefully schedule all potential creditors, and to then provide those creditors notice of the proceeding in accordance with the statute. Otherwise, creditors may come out of the woodwork post-dissolution, asserting claims for individual liability that might have been thwarted with a little extra effort at the outset of the dissolution process.