Friday, April 26, 2013

Smith v. Bear, Inc. - Trust Fund Doctrine Applied to Corporate Funds Held by Shareholder

Smith v. Bear, Inc. Returns to Court of Appeals for Application
of the Trust Fund Doctrine Against Smith

      The case of Bear, Inc. v. Smith has returned to the Court of Appeals for consideration of challenges to the trial court’s determination of Smith and Smith Services, Inc.’s liability on an account that has grown from $26,000 to $90,863.22.  Smith v. Bear, Inc., __ S.W.3d ___, 2013 WL 1352148, No. 2010-CA-001803-MR (April 5, 2013).
      Smith Services, Inc., a Kentucky corporation of which Smith was the sole shareholder, had an account with Bear, Inc. for the purchase of fuel.  Smith did not personally guarantee the corporation’s debt.  The account grew to $25,000, at which point Bear required that all purchases be satisfied on a monthly basis.  The outstanding account was not, however, satisfied.  Smith closed Smith Services, Inc. in 2003, but did not either file articles of dissolution or notify its creditors of its dissolution.  Bear Inc. filed suit on the open account.
      On the first appeal, while holding that the statutory mechanism for giving notice to creditors is optional rather than mandatory, the Court as well held that Bear, Inc. could have a claim against Smith individually on either a theory of piercing the veil or on the basis that Smith held corporate assets in trust for the corporation’s creditors.  At the time the corporation ceased its activities there were “shareholder loans” of $173,000 due from Smith.  Bear, Inc. v. Smith, 303 S.W.3d 137 (Ky. App. 2010).
      On remand Smith proceeded pro se on his own behalf and on behalf of the (long dissolved) corporation.  The trial court granted summary judgment as to the liability of both Smith and the corporation on the account; Smith did not attend the hearing on that issue and he filed no opposition to the request for summary judgment.  The determination of liability was to the extent of the un-repaid shareholder loans.
      At a bench trial Bear Inc.’s president testified as to the amount of the open account, it having with interest grown from the initial $28,000 to $90,863.22, and legal costs and expenses in the amount of $42,330.38.  Smith offered no contrary evidence, called no witnesses and introduced no exhibits.  Judgment was entered against Smith and the corporation, and this appeal followed.
      On appeal, in an amazing demonstration of chutzpah, Smith objected that the trial court permitted him to proceed pro se.  As for Smith individually, the Court of Appeals, while reciting all the problems involved in pro se representation, held that he could not avoid the consequences of his decision to so proceed.  However, as to the corporation, it was held that it could not proceed pro se, it requiring a legal representation, and that it could not be represented by one who, like Smith, is not an attorney.  On that basis the Court of Appeals reversed the judgment against Smith Services, Inc.

      From there the court proceeded to consider the substance of the determination that Smith is personally liable on Smith Services, Inc.’s debt to Bear, Inc.  Sadly, the decision is muddled.  It begins by reciting facts as to the lack of corporate formalities (annual meeting minutes, reasonable salary, dividends), all of this could support an equitable remedy of piercing the veil.  Then the Court pivoted, describing the “shareholder loans,” a corporate asset, and described how the trust fund doctrine imposes a constructive trust on those assets:
Generally, when a  shareholder receives assets of a corporation that dissolves, such assets are hold in trust for the corporation’s creditors, and the shareholder remains personally responsible for the corporate debt to the extent of the value of the corporate property received.
      Applying this principle (more on that below), the summary judgment granted by the trial court as to liability was affirmed.  2013 WL 1352148, *6.
      Finding that the trial court was proceeding in equity, rather than law, the Court of Appeals affirmed the decision to proceed without a jury.  Further, applying the rules of equity governing restitution, the award of attorney fees was affirmed.That of itself is an interesting topic, one to which I will return to in a future post.
      While the outcome of this case is clearly correct, I do feel it fair to observe that the Court of Appeals’ decision is far less clear than it could have been.  That lack of specificity may in future disputes lead to arguments for an over-broad application.  That would be unfortunate.
      Initially, it is important to appreciate what this case is not about.  First, this is not a piercing decision.  While the Court initiated a piercing analysis in addressing the absence of corporate formalities in Smith Services, Inc., it never completed the analysis.  Notably, it did not make the injustice finding required by Inter-Tel Technologies.

            Second, while discussed in terms of the shareholder receiving corporate property before dissolution, I’m not sure that is the crux of the matter.  First, KRS § 271B.6-400, it addressing limits on dividends, and KRS § 271B.8-330, it addressing the liability of directors for declaring an improper dividend and the limited right of indemnification from the recipient shareholders, are not at issue in this case – the funds at issue were treated as loans to the shareholder and not dividends.
            Smith Services, Inc. held an account receivable from Smith.  At the time of the corporation’s dissolution, irrespective of giving notice to creditors, the corporation, it is to collect its assets and discharge its liabilities.  KRS § 271B.14-050(1).  As such it had an obligation to convert that account receivable into cash.  Although it does not appear that a Kentucky court has directly addressed the point, it may be credibly argued that the obligation to pay creditors, especially if the corporation’s liabilities exceed its assets, imposes fiduciary obligations upon the board of directors to harvest those assets.  Were, as here, the director(s) entirely fail to pursue collection of the debt due the corporation, a claim for breach of duty (perhaps a fiduciary duty) exists.
            The imposition of a constructive trust upon the funds in Smith’s possession, the proceeds of these “shareholder loans,” is somewhat problematic.  Now in this case, due to the unity of Smith as the sole shareholder (the debtor) and the sole director, the imposition of a constructive trust is unassailable.  The Court did not, however, condition the imposition of the trust upon that unity.  Rather, it broadly stated that corporate assets received prior to dissolution “are held in trust for the corporation’s creditors.”  2013 WL 1352148, *6.
            This likely is an overstatement of the law.  Slightly altering the facts, imagine that the debtor was an independent business venture to which the corporation had extended various loans.  Would the creditor’s dissolution, of itself, convert the proceeds of those loans into a trust fund for the corporation’s creditors?  I can’t believe that is the case, but I’m sure the argument will soon be made.
            Regardless, this decision and that previously rendered by the Court of Appeals provide important guidance on dissolution of business organizations, especially when creditors are left unsatisfied.  Clearly directors will (as they should be) be held to account for not taking necessary steps to the greatest possible resolutions of those claims.

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