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When One Solution Is Better Than Two

Over the years, clients have sought my advice after they have obtained a judgment against a limited liability company or a corporation and after they have tried, without success, to collect on that judgment.  All of the typical judgment enforcement methods have already failed.  Because judgment debtors generally do not volunteer payment and sometimes will take steps to make it much more difficult for a creditor to collect, this scenario is somewhat common.  In response, clients will ask what they can do. There are a number of options. These include putting the judgment debtor into an involuntary bankruptcy; another option is to seek to have the judgment amended to add the principals of the debtor as additional judgment debtors. The case of In re O’Reilly & Collins (discussed below) is interesting because it shows that although both options are available, a creditor might run into problems trying to do both.

Involuntary Bankruptcy

An involuntary bankruptcy can be effective in the right case because it creates some judicial supervision over the debtor’s disposition of assets. It triggers the possibility of an orderly process for paying creditors. When compared to trying to chase down assets of the debtor as the debtor moves them around, this approach can be appealing.

Section 303 of the bankruptcy code allows even a single creditor, under certain circumstances, to force a judgment debtor into bankruptcy.  However, this is risky because if the bankruptcy court finds that the correct circumstances did not exist, the bankruptcy court can sanction the creditor in the form of attorneys’ fees and other damages.  More commonly, at least three creditors are required in order to file the involuntary bankruptcy petition.  This is a much safer approach, and counsel for petitioning creditors generally prefer to have even more than three creditors join in the bankruptcy petition. Under the circumstances described above, where assets are being moved around to the detriment of the judgment creditor, it is certainly worth considering whether there are other creditors that might be interested in joining in the filing of an involuntary bankruptcy petition.

Adding Additional Judgment Creditors

A second option, amending the judgment to add the principals of the judgment debtor as additional judgment debtors, is authorized by section 187 of the California Code of Civil Procedure. This provision has been interpreted to allow a judgment creditor to demonstrate that the principals of the debtor should be held liable as alter egos of the judgment debtor. If successful, the court will add the principals as judgment debtors for the full amount of the judgment.

Lessons from In re O’Reilly & Collins

As a creditor in a recent case in the Northern District of California learned the hard way, it can be important to be selective when deciding which of the above methods to utilize and not to try to combine them.  In the bankruptcy case of In re O’Reilly & Collins, Michael Danko sued his former law firm, O’Reilly & Collins (“OC”), for wrongful termination. Judgment was granted in favor of Danko for over $3.25 million.  OC, the former law firm, then filed an assignment for the benefit of creditors (a state law insolvency proceeding). In response, Danko and two other creditors filed an involuntary bankruptcy petition against OC.  Just over one month later, Danko filed a motion in the state court to amend his judgment against OC to add Terry O’Reilly, personally, as a judgment debtor under section 187.  Four months after that, the state court granted the motion and entered an amended judgment against the original judgment debtor (OC), and against O’Reilly personally.  The amended judgment imposed joint and several liability in an amount greater than $4.5 million.

Back in the bankruptcy court, a bankruptcy trustee had been appointed.  The Trustee filed a notice in the state court asserting that because of the bankruptcy automatic stay, “any attempt to obtain a judgment or enforce a judgment against defendant O’Reilly for claims based upon fraudulent conveyances and/or alter ego, are property of bankruptcy estate and are subject to the stay imposed under 11 U.S.C. § 362(a)(3).”

Danko then filed a motion in the bankruptcy court asking for an order stating that the Trustee’s notice was legally incorrect and that the automatic stay was inapplicable to Danko’s judgment and to his underlying claims against O’Reilly. The bankruptcy court denied Danko’s motion, and on appeal, the district court upheld the bankruptcy court’s decision.

It is well established in the Ninth Circuit that a fraudulent transfer claim to recover assets of a debtor in bankruptcy belongs to the bankruptcy estate, giving the Trustee exclusive standing to bring such claims.  A creditor’s attempt to bring such a claim would be barred by the automatic stay.  The principal issue raised by Danko’s appeal was whether his alter ego claim against O’Reilly was also property of the estate, and thus subject to the automatic stay, merely because the underlying facts in his alter ego claim were the same as those that would have given rise to a fraudulent transfer lawsuit.

Danko argued that the mere overlap of facts was insufficient.  However, the District Court disagreed.  In his section 187 motion, Danko had specifically argued to the state court that “the reason [Danko] is having trouble collecting is that O’Reilly stripped the firm of assets in the three years since Danko was fired, and particularly in the period leading to and following trial, in order to create that ‘trouble.’”  The state court’s reliance on this particular evidence convinced the District Court that the alter ego judgment was similar enough to a fraudulent transfer claim that it belonged not to Danko but to the bankruptcy trustee.  Accordingly, the automatic stay barred Danko from enforcing the judgment against O’Reilly, personally.

In re O’Reilly & Collins is an interesting case because the creditor involved, Michael Danko, attempted to both add an additional judgment debtor from whom he might collect, and put the original debtor into bankruptcy. These solutions were in conflict. Danko’s potential recovery from O’Reilly implicated property of the bankruptcy estate – namely, the assets which O’Reilly had allegedly transferred from the original debtor, OC. This created a potential fraudulent transfer claim by the bankruptcy trustee to recover those assets. Therefore, Danko was barred by the automatic stay from enforcing his judgment against O’Reilly. Sometimes one solution can undercut another.

Categories: Alter Ego, Fraudulent Transfers, Involuntary Bankruptcy