The airwaves are filled with legal advice ads, some of which encourage individuals to incorporate their businesses to avoid the loss of personal assets arising from business-related debts. The message is almost one of chastisement, suggesting that those who operate a sole proprietorship are mere fools waiting to be fleeced of all their worth. What isn't made clear by the advertisers, however, is the false sense of security that incorporation may give, not to mention the looming pitfall when claims are made by business creditors against the incorporator, owner or principal--regardless of the corporate shield that was created for the intended purpose of protecting those same individuals from such claims.
We're not talking about the person who may well deserve to bear responsibility for business debts, such as those who fail to properly capitalize the business; those who commingle assets of the business with their own or use the corporate bank account for personal expenses; or the person who simply fails to follow the standard rules and regulations that govern the separate entity.
No, this article is directed at the honest (or mostly honest) businessperson who valiantly tries to maintain corporate formalities, funds the business entity with what was believed to be sufficient money to get the operations off the ground, and who maintains separate bank accounts, telephone numbers, websites and the like. It should serve as a warning of the unforeseen risks that could result from a failure to strictly adhere to such practices.
And while we reference primarily a corporate structure, the issues addressed in this article apply equally to limited liability companies formed under the California Corporations Code. See Cal. Corp. Code §§ 17701.02, et seq.
Debts Arise--So Do Lawsuits to Collect Them
Good intentions aside, businesses invariably fail, and more often than not someone or some entity remains unpaid for the goods or services that were provided at the behest of the shopkeeper, principal or owner. What often follows are lawsuits seeking to collect those unpaid claims. When a corporate defendant is served, the principals must decide how to respond, even if the debt were one for which there are few or no defenses, and even if there were no obvious threat to hold any specific individual responsible for the claims asserted against the entity.
The dilemma for principals of an insolvent entity is the prospect that they might be called upon to answer for the debts of the entity, which prospect may only arise after completion of the litigation. With that possibility in mind, difficult decisions must be made by financially strapped companies when faced with a demand for payment or service of a complaint seeking a money judgment.
To Defend Or Not Defend
In reliance on the corporate shield, many principals will simply conclude that there are no funds to oppose the collection efforts, and furthermore, no reason to expend capital to challenge the complaint as the outcome will have no impact on the now-defunct operations. While this mode of thinking may seem totally logical at the time, it may one day be found to have been extremely imprudent, especially if the principal is later confronted with an effort by a judgment creditor to impose personal liability on him or her.
Whether a judgment is entered by default, following a motion or after trial, once final, liability for the claim is no longer an issue . At that time, the judgment creditor's focus will be on enforcement or collection and, if faced with a judgment-proof, judgment debtor, a crafty and experienced attorney will likely look elsewhere for relief. The most obvious option is to try to make one or more additional persons bear responsibility for the judgment.
Amending a Judgment
The process of amending a judgment to add a debtor is grounded in a statute that was added to the California Code of Civil Procedure almost 150 years ago. We're referring to section 187, enacted in 1872, which states:
When jurisdiction is, by the Constitution or this Code, or by any other statute, conferred on a Court or judicial officer, all the means necessary to carry it into effect are also given; and in the exercise of this jurisdiction, if the course of proceeding be not specifically pointed out by this Code or the statute, any suitable process or mode of proceeding may be adopted which may appear most conformable to the spirit of this code. See Cal. Code Civ. Proc. § 187.
While section 187 does not specifically refer to judgments, courts have concluded that the above-quoted language vests them with authority to modify a judgment to impose liability on additional persons, thereby making them additional judgment debtors. This conclusion, strangely enough, was not clearly articulated until more than 50 years after enactment of the statute. See Mirabito v. San Francisco Dairy Co., 8 Cal.App.2d 54. 60 (1935)("[w]here ... the evidence is sufficient to warrant the conclusion that in effect the two corporations are identical; where ... the action was fully and fairly tried with at least the direct financial assistance of [the alter ego]; and where ... nothing appears in the record to show that [the alter ego] could have produced a scintilla of evidence that would have in any way affected the results of the trial, there is no basis for a different rule.").
The concept underlying the right to amend, following entry of judgment, is grounded in the belief that the amendment does not constitute the prosecution of a claim against a new party, but rather is a correction of the record to reflect the real name of the judgment debtor.
Section 187 contemplates amending a judgment by noticed motion, which may be brought at any time after entry of the judgment. See Danko v. O'Reilly, 232 Cal. App. 4th 732, 735-36 (2014)("As a general rule, 'a court may amend its judgment at any time so that the judgment will properly designate the real defendants.'"); see also Wells Fargo Bank, N.A., v. Weinberg, 227 Cal. App. 4th 1, 9 (2014) (same).
Contrary to what one might expect, no statute of limitations applies to a motion to amend under section 187, and the ability to modify a judgment likely exists even after the claim giving rise to liability is time barred. See Highland Springs Conference & Training Ctr. v. City of Banning, 244 Cal. App. 4th 267, 287 (2016) ("No statute of limitations applies to a section 187 motion to amend a judgment to add a judgment debtor.").
Moreover, a court is not required to hold an evidentiary hearing on a motion to amend a judgment, and may rule on the motion based solely on declarations and other written evidence. Id. However, a judgment creditor seeking to amend a judgment to add additional judgment debtors must demonstrate liability--e.g., that the individual is the alter ego or successor corporation of the original judgment debtor--by a preponderance of the evidence AF Holdings LLC v. Navasca, 2013 WL 5701104 at 9 & 18 (C.D. Cal. ), and must still effectuate proper service and establish that the court has the requisite jurisdiction over the judgment debtor to be. *Wells Fargo Bank, N.A., 227 Cal. App. 4th at 6; Mad Dogg Athletics, Inc. v. NYC Holding, 565 F. Supp. 2d 1127, 1130 (C.D. Cal. 2008).
The decision to grant an amendment lies in the sound discretion of the trial court and courts are encouraged to apply section 187 liberally "to see that justice is done." Greenspan v. LADT LLC, 191 Cal. App. 4th 486, 508 (2010).
It should also be noted that pursuant to Rule 69(a) of the Federal Rules of Civil Procedure, federal courts sitting in California have the power to amend judgments to add judgment-debtors. Mad Dogg Athletics, Inc., 656 F. Supp. 2d at 1129-30 (citing Fed. R. Civ. P. 69(a), which "permits judgment creditors to use any execution method consistent with the practice and procedure of the state in which the district court sits.").
During the past two decades, appellate courts have confirmed the willingness of trial judges to exercise their discretion to modify judgments pursuant to section 187--with the alter ego doctrine being the most common basis for adding judgment debtors. For example, in one case, the trial court amended a bank's judgment against a professional law corporation to add the principal lawyer after finding that the lawyer drained the assets of the corporation and diverted clients to himself before dissolving the entity and continued to practice in the same location. In his opposition to the motion to amend, the lawyer argued that the motion was barred by res judicata because the original complaint included a cause of action against him, and the court had previously sustained a demurrer to that claim without leave to amend. The appellate court readily rejected that argument and held that res judicata and collateral estoppel do not prevent a judgment creditor from adding a judgment debtor under section 187 because issue and claim preclusion are not substantive claims for relief, but rather procedural mechanisms available to enforce a judgment against the proper defendant. See Wells Fargo Bank, N.A., v. Weinberg, 227 Cal.App.4th 1 (2014).
One implication of the Wells Fargo ruling is that even if a principal were able to successfully defend him or herself against a suit that ultimately results in a judgment against the principal's corporation, the principal must strictly adhere to corporate formalities. Otherwise he or she risks finding him or herself on the losing end of a motion to amend the judgment, in which case they will be personally liable for what should be a corporate obligation.
In another case, the appellate court reversed the lower court's order denying a motion to amend a judgment, where the trial court found that the judgment creditor had sufficiently established that the proposed additional judgment debtors were the alter egos of the original judgment debtor, but had failed to demonstrate that equity favored modification of the judgment. In reversing, the appellate court rejected the appellees' argument that the judgment creditor should have litigated the issue of alter ego at trial since it was aware of the alter ego relationship before the judgment was entered. The appellate court reasoned that there are good policy reasons not to force a plaintiff to litigate alter ego status in an underlying action, because such a requirement would promote a fishing expedition into alter ego evidence before the plaintiff obtained a favorable judgment. See Relentless Air Racing, LLC v. Airborne Turbine Ltd. Partnership, 222 Cal.App.4th 811 (2013).
Principals should also be forewarned that a corporation cannot simply escape liability under a judgment by a mere name change or a shift of assets--particularly if it can be shown that the new corporation is, in reality, a continuation of the old. Such was the holding in McClellan v. Northridge Park Townhome Owners Association, Inc., 89 Cal.App.4th 747 (2001), where a trial court's modification of a judgment to add additional judgment debtors was affirmed in reliance on the trial court's finding that the judgment debtor ceased its operations and formed a new entity specifically to avoid liability under the judgment.
In reviewing the trial court's decision, the appellate court agreed that the new entity was nothing more than a continuation of the original judgment debtor, merely operating under a different name. Id. at 749. In that amending judgments under section 187 is an equitable procedure, the court found it appropriate to extend the section's reach beyond the typical instances of alter ego and piercing the corporate veil to permit judgment creditors to move for modification under a "successor liability" theory. Id. at 753.
As a result, if a judgment debtor corporation organizes a "successor corporation" with "practically the same shareholders and directors, and assets, but does not pay all of the first corporation's debts (or provide adequate consideration for assets received), and continues to carry on the same business," the successor may very well find itself liable for the obligations of the original corporation. (Id. at 753-54 n. 4.)
Section 187 also applies to judgments stemming from arbitration awards. See Hall, Goodhue, Haisley and Barker, Inc., v. Marconi Conference Center Board, 41 Cal.App.4th 151 (1996). In Hall, Goodhue, the appellate court reversed a trial court's denial of a motion to amend a judgment on the grounds that it did not have jurisdiction to amend a judgment that confirmed an arbitration award. The court reasoned that under the code provision that governs confirmation of such awards (see Cal. Code Civ. Proc. §1287.4), a judgment confirming an arbitration award has the same force and effect as a judgment entered in a civil action. Hall, Goodhue, at 1554. Section 1287.4 states: "If an [arbitration] award is confirmed, judgment shall be entered in conformity therewith. The judgment so entered has the same force and effect as, and is subject to all of the provisions of law relating to, a judgment in a civil action of the same jurisdictional classification; and it may be enforced like any other judgment of the court in which it is entered, in an action of the same jurisdictional classification."
Accordingly, the court concluded that while an arbitrator does not have the power to determine the rights and obligations of non-parties, upon entry of a judgment confirming an arbitration award, the state court judge is vested with the power to amend the award to add an additional judgment debtor consistent with section 187. Hall, Goodhue, at 1554-55.
Key Limitations & Defenses
There are, however, some limits to the reach of section 187. For example, a proposed judgment debtor may defend a motion to amend a judgment by asserting a timeliness defense. See, e.g., Highland Springs Conference & Training Ctr., 244 Cal. App. 4th at 282 (finding that the defense of laches can be asserted as a defense to a section 187 motion to amend a judgment).
Additionally, at least in California, a judgment creditor cannot use reverse piercing of the corporate veil to reach corporate assets in satisfaction of a shareholder's personal liability. See Postal Instant Press, Inc., v. Kaswa Corp., 162 Cal. App. 4th 1510 (2008). In the Postal Instant Press case, the court of appeal reversed an order granting a motion to amend a judgment that added a corporation in which the judgment debtor was a former shareholder, notwithstanding the trial court's finding that the corporation was the alter ego of the judgment debtor. Id., at 1516. The rationale behind the court's decision was two-fold. First, the court explained that--unlike in ordinary piercing cases where only the assets of the particular shareholder who is determined to be the corporation's alter ego are subject to attachment--reverse piercing has the high probability of prejudicing non-culpable shareholders. Id. at 1520. Second, the court noted that judgment creditors have other legal remedies available to them to recover assets improperly transferred to a corporation, such as claims for conversion or fraudulent conveyance. Id. at 1515.
Another defense that may prove successful is lack of participation in the underlying litigation that spawned the original judgment. Courts have held that there are three elements that must be shown to prevail on a motion to add a judgment debtor:
•First: "the parties to be added as judgment debtors had control of the underlying litigation and were virtually represented in that proceeding";
•Second: "there is such a unity of interest and ownership that the separate personalities of the entity and the owners no longer exist"; and
•Third: "an inequitable result will follow if the acts are treated as those of the entity alone." Highland Springs Conference & Training Ctr., 244 Cal.App.4th at 280.
Note that the second and third elements address the relationship between the proposed additional judgment debtor and the original judgment debtor, as well as the equities bearing on whether to grant the motion. In contrast, the first element focuses on participation of the proposed additional judgment debtor in the proceeding from which the judgment in hand arose. A subsidiary consideration under the first factor relates to the control of, and representation in, the underlying case.
Indeed, the lack of participation in and control of the underlying litigation is found most often in cases where the creditor obtained judgment by way of default or failure to appear for trial. In such instances, courts have found that motions to add a judgment debtor under §187 are improper. See, for example, Motores de Mexicali, S.A. v. Superior Court, 51 Cal.2d 172 (1958)(default judgment); and NEC Electronics Inc. v. Hurt, 208 Cal.App. 3d 772 (1989)(original judgment debtor failed to appear at trial or present defense by reason of intent to file bankruptcy petition). The rationale in these cases is that a party not named as a defendant has no duty to appear and defend, and therefore where it does not do so, the party cannot be found to have actively participated in the underlying proceeding.
In that there is no statute of limitations applicable to a section 187 motion to amend, litigation counsel must give considerable thought to whether to spend time and money to defend suits brought against insolvent corporations. For risk takers, particularly where successful defense of a claim is unlikely in any event, one might simply elect to allow the complaint to go by way of default, and wait to see if the creditor later seeks to add debtors to the judgment. In any event, the best defense is a good offense, so take extra care to maintain compliance with corporate formalities and avoid transfers of business operations or corporate assets until outstanding claims against the company have been satisfied or otherwise resolved.
Alan G. Tippie is a Member & Chairman of the Board, and Jessica L. Vogel an associate, at SulmeyerKupetz, a business, financial restructuring and litigation firm in Los Angeles.