Contract Law - Seventh Circuit Blocks An Attempt to Hold Shareholders Liable For Corporate Debts

On August 2, 2010, the Seventh Circuit issued an opinion (written by Judge Easterbrook) in the case captioned Fusion Capital Fund II, LLC v. Richard Ham and Carla Aufdenamp, 09-3723, reversing a decision by Judge Shadur, holding that corporate shareholders could be liable for the corporation's debts.

The Plaintiff sought to collect a debt incurred by a corporation directly from the corporation's shareholders. The debt arose as a result of an ill-fated merger transaction.

Millenium Holding corporation was insolvent. However, it had previously gone public and its stock was tradeable. Another company, Sutura, Inc., sought to go public by merging into Millenium. As the Court noted, "Sutura wanted to go public without all the fuss and bother (and expense) of a registration statement and the release of audited financials." As a part of the merger agreement, Millenium agreed to raise $15 million in new capital. Later, Plaintiff Fusion and Millenium signed a contract and agreed to provide the $15 million.

When the merger with Sutura failed to close, Fusion "wrote to Millenium that the money would not be forthcoming." Sutura then terminated the merger agreement.
Fusion prevailed in contract litigation and later sued in the Northern District of Illinois to collect its legal fees incurred.

Fusion brought its claim against Ham and Aufdenkamp, Millenium's controlling shareholders. The District Court held that the Ham and Aufdenkamp were personally liable for the debt under Nevada law. The District Court ruled that Ham and Aufdenkamp became the "alter ego" of the corporation because (a) they influenced and governed it; (b) there was a "unity of interest" between the shareholders and the corporation; and (c) "adherence to the corporate fiction of a separate entity would sanction fraud or promote manifest injustice." Opinion at 4.

The Seventh Circuit agreed with the analysis with respect to the first two elements of the alter ego test. However, there was no fraud because Fusion was well aware - when it entered into the contract - that Millenium had no assets and was insolvent.

The Court reasoned that Fusion should have been aware that it could never enforce its contract (for the payment of legal fees) because Millenium was broke.

"When Millenium signed a contract promising to reimburse Fusion's legal expenses if litigation ensued, Fusion knew beyond a doubt that Millenium would be unable to keep that promise - unless the merger closed. Someone who wants to protect himself against the possibility that a thinly capitalized corporation will be unable to pay its debts asks the investors for a guaranty. It is feckless to do business with a corporation such as Millenium without one. Yet Fusion did not get a guaranty but also did not even ask for one....A business such as Fusion that neglects to arrange for payment if the worst comes to pass is not well positioned to seek judicial aid....Fusion wants to be protected from this asymemetry [the risk that Millenium would not be able to pay], but to get this protection Fusion should have negotiated for a guaranty and refused to deal if the Hams would not give one."

The Court distinguished the situation where the debtor is solvent when the contract is signed, but later siphons off its assets to avoid payment.

Comment: This is a thoughtful opinion that takes the polar opposite view of the District Court. It is a reminder to lawyers that anything can happen on appeal and that the underlying economics of a transaction are often far more persuasive than case citations and three-factor tests.

Edward X. Clinton, Jr.