parent nodes: corporate finance | fiduciary duty | limited liability | piercing the corporate veil
Costello v Fazio
Facts
D owns partnership with two other promoters; partnership is heavily losing money
D and other partners withdraw nearly all of the partnership's capital by trading equity for debt (converting their capital contributions into secured notes
D and the other promoters then incorporate the company
The new corporation goes bankrupt
Costello (P) argues for the bankruptcy court to subordinate the claims of the promoters (including D) to that of general unsecured creditors
Analysis
"Claims of controlling shareholders will be deferred or subordinated to outside creditors where a corporation in bankruptcy has not been adequately or honestly capitalized, or has been managed to the prejudice of creditors, or where to do otherwise would be unfair to creditors." The court finds it clear from the record that, given the partnership's previous business records, the amount of capital left in the company at time of incorporation was clearly inadequate for its operations. The promoters were clearly aware that such undercapitalization would lead to the corporation's failure; rather, they acted in order to protect their own assets at the expense of the creditors' claims. The promoters, who held a fiduciary duty to the corporation, actually withdrew its funds in the face of adverse financial experience. Nor does it matter that the corporation survived long enough to have a turnover of creditors; the promoters owe a fiduciary duty here not to the creditors at time of incorporation, but to "present or future creditors, whoever they may be." Given that a bankruptcy court has jurisdiction in equity, it thus has discretion to subordinate the shareholder's claims to that of general unsecured creditors.
See corporate form, limited liability