Creditor Proofing Leads to Shareholders’ Personal Liability

An attempt to avoid payment of a company’s debt by setting up a new corporation to continue the company’s business can cause the company’s shareholders to be personally liable for the debt incurred.

The decision of the Ontario Superior Court in Chan v. City Commercial Realty Group Ltd., 2011 ONSC 2854, illustrates the “piercing of the corporate veil” to remove the limited liability of a company’s shareholders.    

In the Chan case, two bothers, Martin and Samuel Wygodny, were the directors, officers and shareholders of a Toronto real estate brokerage company City Commercial Realty Services (Canada) Ltd. (“City 1”) which unsuccessfully sued Chan and others, with costs being awarded against City 1. The cost award went unpaid. A new real estate brokerage company, City Commercial Realty Group Ltd. (“City 2”), of which Martin was the sole officer, director and shareholder, was set up to continue the business of City 1. Martin resigned as an officer and director of City 1 and transferred his shares in City 1 to Samuel. City 1 became inactive and its brokerage registration lapsed, while City 2 engaged in the same business as City 1, using the same premises, furniture, phone number, business name, signage, and some of the same personnel.

Chan and the others sued City 1, City 2 and the two brothers for the unpaid cost award, requesting the Superior Court to “pierce the corporate veil” and find Martin and Samuel personally liable for it.

In deciding against the brothers and making them personally liable for the unpaid cost award, the Court held that the “affairs of the companies appear to have been ‘dominated’ by one (Martin in the case of City 2) or both (in the case of City 1) brothers at the time of the alleged wrongful conduct”.

In holding that their conduct was improper and unjustly deprived the plaintiffs of their rights, the Court found (at para. 54 and 56) as follows:

I agree with the defendants that Martin and Samuel were not obligated to inject their own funds into City 1 to pay the cost awards. What they were not entitled to do was to quietly organize their corporate affairs in a way which provided them with all of the benefits of their real estate activities and none of the burdens. … The reorganization has enabled Martin and Samuel to continue their real estate business without interruption and without adverse financial consequences. The structure was developed and implemented while both were directors, officers and shareholders of City 1.  

Creditor proofing schemes which are designed to protect the assets of a business from the claims of creditors are often attacked under provincial fraudulent conveyance and creditor preference legislation, or by way of the oppression remedy afforded under corporation legislation. Although the plaintiffs in the Chan case initially sought an order setting aside the transfer of City 1’s business under the Ontario Fraudulent Conveyances Act, Assignments and Preferences Act, and Bulk Sales Act, those claims were not pursued at trial. Instead of pursuing an oppression remedy under the Ontario Business Corporations Act, the plaintiffs requested the Court to pierce the corporate veil using common law principles, arguing that City 1 was really the alter ego of Martin and Samuel.

In applying these principles, the Court (at para. 19, 20 and 22) stated as follows:

It is trite to say that generally a corporation is a separate legal person. Most of the time the identity, rights and obligations of companies and their shareholders are distinct. However, the rule is not inviolate and will not be applied if its result would be “too flagrantly opposed to justice”. The alter ego theory is designed to prevent the use of a corporate vehicle to achieve an objective which offends a right minded person’s sense of fairness. …Two elements must be proven by the plaintiffs in this case: first, that the activities of the companies were completely dominated by Martin and Samuel, and second, that they engaged in improper conduct that unjustly deprived the plaintiffs of their rights.  

In short, the Chan case is another useful reminder of the perils that the owners and managers of private companies may be inviting when they attempt to implement a creditor proofing scheme. Despite the ordinary expectations of company owners that they will not, as shareholders, be responsible for company liabilities, they may become personally liable, and their personal assets may then become subject to seizure, in particular circumstances should their creditor proofing efforts unjustly deprive a creditor of its rights.