RECOVERY WHEN THE BROKERAGE GOES OUT OF BUSINESS
By: Leslie Trager
All too often, after a favorable arbitration award, a defunct brokerage attempts to fold its tent to avoid payment to its wronged customer. Its owners may do everything from retiring, joining another brokerage firm or reincarnating a new brokerage firm. This article will focus on the ability to recover on a judgment, entered as a result of an arbitration award, from the owner and/or the new entity.
Since New York law is often applicable either because the brokerage house was located in New York, did business through a clearing firm in New York, or the customer agreement provided for New York law to apply, this article will emphasize New York law. The remedies discussed can be brought either by the judgment creditor or, if there has been a filing in bankruptcy, by the bankruptcy or SPIC trustee.
There are three ways to recover on a judgment against a defaulting brokerage firm: (A) the New York State Debtor and Creditor Law; (B) Piercing the Corporate Veil; and (C) Continuation of Business Doctrine.
A. The New York State Debtor and Creditor Law
The easiest and cleanest claim against the former owners and other transferees is under Section 273-a of the New York State Debtor and Creditor Law. Section 273-a provides:
Every conveyance made without fair consideration when the person making it is a defendant in an action for money damages or a judgment in such an action has been docketed against him, is fraudulent as to the plaintiff in that action without regard to the actual intent of the defendant if, after final judgment for the plaintiff, the defendant fails to satisfy the judgment. (emphasis supplied)
This statute allows a creditor to question all transfers made by the debtor back to the date when the arbitration was first filed. See Dixie Yarns, Inc. v. China Grove Cotton Mills Co., 906 F. Supp. 929, 936 (S.D.N.Y. 1995) (“the arbitration proceeding qualifies as ‘an action for money damages’” under section 273-a); See also, JSC Foreign Economic Association Technostroyexport v. International Development and Trade Services, Inc., 295 F. Supp. 2d 366, 379 (S.D.N.Y. 2003).
Transfers subject to this statute include not only transfers made to the owners, but transfers made to anyone without fair consideration, and includes antecedent debt.. While antecedent debt may constitute fair consideration, it must be made in good faith. “Transfers to a controlling shareholder, officer or director of an insolvent corporation [even for antecedent debt] are deemed to be lacking in good faith and are presumptively fraudulent....” In re The CIT Group/Commercial Services, Inc. v 160-09 Jamaica Avenue Ltd., 25 A.D. 3d 301, 302 (1st Dept. 2006). Julien J. Studley, Inc. v Lefrak, 66 A.D. 2d 208, 213 (2nd Dept. 1979), aff'd on lower court opinion, 48 N.Y. 22d 954, held that corporate assets are a trust fund for creditors and “dealings of a dominant stockholder with the corporation are subjected to close examination.”
Salaries paid to the owners can be questioned in light of all of the financial circumstances of the brokerage house. See Gilmore Distilliries Co. v. Seidman, 267 F.Supp. 915, 919 (E.D.N.Y. 1967), holding that transferees were liable under various sections of the New York State Debtor and Creditor Law, including Section 273-a with respect to salaries, stating:
The compensation paid to a corporate officer must be in proportion to his ability, services and time devoted, corporate earnings and other relevant facts and circumstances. (emphasis supplied).
The Gillmore case went on to hold:
It is common knowledge and experience that salaries of officers in an efficiently managed corporation must bear a reasonable relation not only to the services rendered but to the income of the business, both gross and net. Corporate directors and officials, in fixing their own salaries, must have some regard for the financial condition of the corporation. Backus v. Finkelstein, D.C., 23 F. 2d 531, 537.
Although the statute uses the words “fraud” and “fraudulent”, the vast majority of the courts have recognized that this is constructive fraud and does not require either proof of intent to defraud or pleading with specificity as is generally required for fraud. See Eclaire Advisor Limited v. Daewoo Engineering & Construction Co. Ltd., 375 F.Supp.2d 257, 268 (S.D.N.Y. 2005); Sullivan v. Kodsi, 373 F.Supp.2d 302, 307 (S.D.N.Y. 2005); Institution Consolidated Group, Inc. v. Davis Publishing Co., 2004 U.S. Dist. Lexis 4821 at 11 (S.D.N.Y. 2004); Drenis v. Haligiannis, 452 F.Supp.2d 418, 428, 429 (S.D.N.Y. 2006).
Another useful section of the Debtor and Creditor Law is Section 273. This section provides:
Every conveyance made and every obligation incurred by a person who is or will be thereby rendered insolvent is fraudulent as to creditors without regard to his actual intent if the conveyance is made or the obligation incurred without a fair consideration.
This section allows the creditor to go back to transfers as of the date the creditor first became a creditor. For a brokerage house, this means the date the customer was first defrauded. Section 270 of the New York State Debtor and Creditor Law defines creditor as a “person having any claim, whether matured or unmatured, liquidated or unliquidated, absolute, fixed or contingent.” In Marcus v. Kane, the Court held:
‘Creditor,’ as used in the statutes against fraudulent conveyances ...
means one having a contingent liability as well as one whose claim is certain and absolute. When colloquially expressed, a creditor may be considered one to whom money is due, but, in the more extensive sense of the term, a creditor is one who has a right to recover money of another on any account whatever. .... One who has a right by law to demand either presently or at some future contingency the fulfillment of any obligation or contract, or one who has a legal right to damages capable of enforcement by judicial process, is a creditor.... When the judgment is obtained, it relates back and establishes the date as of the time when the original cause of action accrued.
Marcus v. Kane, 18 F.2d 722, 723 (2d Cir. 1927)
While the Marcus case dealt with an earlier statute, the court specifically noted that the result would not change under the present statute still in existence, and that the statute does not distinguish between tort and contract creditors. See also Shelly v. Doe, 249 A.D.2d 756, 757 (3d Dept. 1998), holding:
[U]nder the Debtor and Creditor Law=s broad definition of ‘creditor’, it is now accepted that in tort cases the relationship of debtor and creditor arises the moment the cause of action accrues (SeeMarcus v. Kane, 18 F. 2d 722, 723 ...)
For section 273 purposes, insolvency is defined in section 271 of the Debtor and Creditor Law to be “when the present fair salable value of his assets is less than the amount that will be required to pay his probable liability on his existing debts as they become absolute and matured.” Naturally, the broker will point to its Focus Reports to show that it was not insolvent under this definition. In today=s world of SIVs and other derivatives, it is certainly conceivable that such assets may never have been worth the value assigned to them in an earlier Focus Report, e.g. Bear Stearns.
Where a transfer is found to be “fraudulent” under one of the above sections, any transferee is liable under Section 278 of the New York State Debtor and Creditor Law unless the transferee paid fair consideration and is without knowledge of the fraud. Even if the transferee is without “actual fraudulent intent,” a transferee who paid less than fair consideration will have liability for the value above the purchase price. Such liability is limited to the value of the property received in an amount sufficient to satisfy the claim.
Finally, it should be noted that attorney’s fees may be recovered if actual intent to defraud is proved. Section 276-a of the New York Debtor and Creditor Law. Here, actual intent to defraud must be pleaded with specificity. But proving such actual intent is often not too difficult. As the court in Shelly v Doe held:
Because direct proof of actual intent is rare, creditors may rely on 'badges of fraud'to establish an inference of fraudulent intent ... Factors that are considered 'badges of frau are (1) a close relationship between the parties to the transaction, (2) a secret and hasty transfer not in the usual course of business, (3) inadequacy of consideration, (4) the transferor's knowledge of the creditor's claim and his or her inability to pay it, (5) the use of dummies or fictitious parties, and (6) retention of control of the property by the transferor after the conveyance....
Shelly v Doe, 249 A.D. 2d. 756, 758 (3rd Dept. 1998)
B. Piercing the Corporate Veil
Another important way of imposing liability on the former owners is to pierce the corporate veil. The leading case in this area is Williams Passalacqua Builders, Inc v. Resnick Developers South, Inc., 933 F 2d 131, 139 (2nd Cir. 1991), which sets out the following factors to consider in determining whether to pierce the corporate veil:
[T]he triers of fact are entitled to consider factors that would tend to show that defendant was a dominated corporation, such as: (1) the absence of the formalities and paraphernalia that are part and parcel of the corporate existence, i.e., issuance of stock, election of directors, keeping of corporate records and the like, (2) inadequate capitalization, (3) whether funds are put in and taken out of the corporation for personal rather than corporate purposes, (4) overlap in ownership, officers, directors and personnel, (5) common office space, address and telephone numbers of corporate entities, (6) the amount of business discretion displayed by the allegedly dominated corporation, (7) whether the related corporations deal with the dominated corporation at arms length, (8) whether the corporations are treated as independent profit centers, (9) the payment or guarantee of debts of the dominated corporation by other corporations in the group and (10) whether the corporation in question had property that was used by other of the corporations as if it were its own.
Id at 139.
The William Passalacqua case has been consistently followed in New York. See, e.g., Morris v. New York State Department of Taxation and Finance, 82 N.Y.2d 135, (1993); Solow v. Domestic Stone Erectors, Inc., 269 A.D.2d 199; 703 N.Y.S.2d 94 (1st Dept. 2000)(finding that one person dominated three corporations, and that the plaintiff had been wronged by making the corporations “incapable of honoring its obligation to plaintiff”).
Under the standards set out in Willliam Passsalacqua, the corporate veil can be pierced when a corporation is used to commit a fraud or when the corporation is the alter ego, or dominated by, the corporation=s owner. As one court explained:
Piercing the corporate veil requires a showing that (1) the one corporation exercised complete domination of the other with respect to the transaction attacked, and (2) that such domination was used to commit a wrong against plaintiff which resulted in the plaintiff=s injury.
Anderson Street Realty Corp. v. RHMB New Rochelle Leaving Corp., 243 A.D.2d 595, (2nd Dept. 1997) (citing Passalacqua)
The Anderson Street Realty Court went on to hold that the evidence showed the defendant appellant was the alter ego of another corporation stating:
In the role of tenant the appellant dominated RHMB's affairs with respect to the subject premises which lead to the wrong now complained of by the plaintiff, that is, the nonpayment of rent. The evidence revealed: (1) an overlap in ownership of the two corporations; (2) an inadequate capitalization of RHMB; (3) payments of some if not all of RHMB=s rent by the appellant; (4) the appellant's reference to itself as the parent company; and (5) that the appellant obtained insurance regarding the subject leased premises (which named the appellant as the insured on the policy).
In evaluating the alter ego, the courts have made it clear that it is not the title of officer, or shareholder which determines the results, but the control exercised by that person. For example, in the case of Dominick & Dominick, Inc. v. George Town Securities Ltd., the Court held:
[W]henever anyone uses control of the corporation to further his own rather than the corporation=s business, he will be liable for the corporation=s act upon the principle of respondent superior applicable even where the agent is a natural person.
Dominick & Dominick, Inc. v. George Town Securities Ltd., 1992 U.S. Dist. Lexis 5150, at 11 (S.D.N.Y. 1992). See also, Sweden AB v. Oakley Furniture Design Ltd., 1987 U.S. Dist. Lexis 1785 (S.D.N.Y. 1987)(finding that the key to upholding a claim against an individual defendant was his control over the corporation and in effect the conversion of funds by that defendant otherwise belonging to the plaintiff).
The Court in Austin Powder Company v. McCullough, found facts that supported many of the arguments for piercing the corporate veil. Upon review of the facts, the Court held:
In view of McCullough=s testimony showing his complete control and domination of Tristate, and the under-capitalizing of the corporation, along with his disregard of corporate formalities and personal use of corporate funds, we find that plaintiff has produced sufficient evidence of wrongdoing to justify piercing the corporate veil as to McCullough.
With respect to Anfo, it is clear from the record that McCullough operated Tristate and Anfo as one entity by co-mingling assets, conducting operations from the same office and paying management fees to Anfo from Tristate which served to divert these funds away from Tristate's creditors, confirming plaintiff's contention that the two corporations were inextricably intertwined and justifying a disregard of the corporate structure.
When a corporation has been so dominated by an individual or another corporation and its separate entity so ignored that it primarily transacts the dominator=s business instead of its own and can be called the other=s alter ego, the corporate form may be disregarded to achieve an equitable result.
Austin Powder Company v. McCullough, 216 A.D.2d 825, 827 (3rd Dept. 1995)
The most common fact pattern for piercing a corporate veil is to show that the formalities of the corporate existence were not complied with, particularly corporate minutes, and the use of the corporation's funds for personal purposes. Personal purposes include putting family members and other similar relationships on the payroll, or otherwise paying them, paying for apartments, country clubs, credit cards, etc. and paying high compensation to the owners relative to the corporation's income. The aggregate dollar amount does not need to equal the amount of the judgment in order to be sufficient to warrant piercing the corporate veil.
C. Continuation of Business Doctrine
Where a new company is formed, which has at least some of the same assets and ownership or control as the debtor company, this new company may be responsible for the judgment under the doctrines of “mere continuation” or “de facto merger.” As the Court in Miller v. Forge v. Mench Partnership Ltd. held:
To determine whether such a 'de facto merger' or 'mere continuation' of the predecessor's business has occurred, courts consider (1) continuity of ownership; (2) cessation of ordinary business by the predecessor; (3) assumption by the successor of liabilities ordinarily necessary for continuation of the predecessor=s business; and (4) continuity of management, personnel, physical location, assets, and general business operation. Nettis v. Levitt, 241 F.3d 186, 193-94 (2d cir. 2001)(citations omitted). The determination of successorliability is "fact-specific," Ryan, Beck & Co. v. Fakih, 268 F.Supp.2d 210, 229 (E.D.N.Y. 2003), and courts are to analyze the facts "in a flexible manner that disregards mere questions of form and asks whether, in substance, 'it was the intent of [the successor] to absorb and continue the operation of [the predecessor].
Miller v. Forge v. Mench Partnership Ltd., 2005 U.S. Dist. Lexis 1524.
It is not necessary that ownership be identical, so long as there is continuity. See Glynwed, Inc. v. Plastimatic, Inc., 869 F.Supp. 265, 276-77 (D.N.J. 1994)(finding continuity where three minority shareholders of predecessor were also shareholders of successor; Allen Morries Commercial Real Estate Services Co. v. Numismatic Collectors Guild, Inc., 1993 U.S. Dist. Lexis 7052 (S.D.N.Y. 1993) (continuity established where 40% of prior ownership in the successor company).
The second factor, cessation of operations means that the debtor company has in effect become a corporate shell, even if not in fact dissolved. See Fitzgerald v. Fahnestock & Co., 286 A.D.2d 573, 575 (1st Dept. 2001).
The third factor, assumption of liabilities necessary for continuation of the predecessor=s business means assuming those liabilities necessary to continue the business. See Miller v. Forge Mench Partnership Ltd., supra, at 28-29. This would include payment of ongoing leases, prior telephone bills to insure continued telephone service and various financial services to insure their continuation.
The fourth factor - continuity of management, personnel, physical location, assets and general business operation - “provides what is arguably the most telling indication” of successor continuation. Miller v. Forge Mench Partnership Ltd., supra, at 30. This information is readily available from the BD report, the websites and general knowledge as to the locations of the former and present brokerage firm offices. The court will look at the facts to determine who is running the operation and whether it is essentially the same operation as the former firm. See generally, Marvel v. Scan-Optics Inc., 509 F. Supp.2d 183 (D. Conn. 2007)(granting a preliminary attachment of the successor company=s assets) and Society Anonyme Dauphitex v. Schoenfelder Corp., 2007 U.S. Dist. Lexis 81496 (S.D.N.Y. 2007).
Not only may the successor company be liable for the debt, but the transfer itself may result in liability imposed on the original owners who approved that transfer under Section 273-a of the Debtor and Creditor Law cited above, up to the amount of the value of the assets at the time of transfer. This is particularly important where the successor company’s assets have declined by the time judgment is entered against it. In RTC Mortgage Trust, 1995 - S/N1 v. Sopher, the court, in imposing liability not only on the transferee corporation but on the sole shareholder owner, held:
The evidence establishes that Sopher, as the sole shareholder of Sopher & Co., sought to transfer substantially all of Sopher & Co.'s assets in order to frustrate the mortgagee=s collection efforts. It also demonstrates that Sopher actively participated in planning and executing the transaction. While not a direct transferee, Sopher plainly benefitted from the transaction. By operation of the transfer, Sopher removed millions of dollars of assets from Sopher & Co. and, thereby, was able to continue his real estate brokerage business until it was sold for $1,500,000. Sopher also benefitted from the transaction because it prevented (or at least forestalled) circumstances that required repayment of the loan advanced to him by Sopher & Co. Accordingly, Sopher also is liable in money damages up to the value of the Judgment, but limited to the extent of the value of the assets transferred by Sopher & Co. to Sopher Realty.
RTC Mortgage Trust, 1995 - S/N1 v. Sopher, 171 F.Supp.2d 192, 202 (S.D.N.Y. 2001), aff’d 31 Fed Appx. 37, 2002 U.S. App. Lexis 4373. See also, Stochastic Decisions, Inc. v. DiDomenico, 995 F.2d 1158, 1172 (2d Cir. 1993) (holding “The New York Court of Appeals has made it clear that the pertinent provisions of the New York Debtor and Creditor Law provide a creditor's remedy for money damages against parties who participate in the fraudulent transfer of a debtor's property and are transferees of the assets and beneficiaries of the conveyance.”); In re Montclair Homes, Goscienski v. LaRosa, 200 B.R. 84, 97 (E.D.N.Y. 1996), where the court imposed liability on the defendant, La Rosa, who had Atransferred all or substantially all of the assets of Montclair Homes, Inc. to other corporate entities which he controlled...."; UFCW Local 174 Commercial Health Care Fund v. Homestead Meadows Foods Corp., 2005 U.S. Dist. Lexis 25922, where the court upheld a complaint against a person alleged to control a corporation making a fraudulent transfer.
Gathering Information
The basic sources of financial information are the debtor's financial records, the debtor's accountant, the debtor's banks, and the debtor's clearing firm.
With respect to the debtor, the following records should immediately be subpoenaed for the relevant time period: tax returns, all of the financial records, and particularly the general ledger and the general journal, all banking records, minute books, BD filings and Focus Reports. (BD filings and Focus Reports can also be subpoenaed from the NASD, but the broker can get these easier than the attorney.)
In addition to subpoenaing records of the company, owner or others in control may also be compelled to produce these corporate records because they have control over the records. See In re Flag Telecom Holdings, Ltd, Securities Litigation, 236 F.R.D. 177 (S.D.N.Y. 2006) holding that a former officer, who during the litigation became a consultant, was required to produce corporate documents. In order to demonstrate that a party has control over documents, it is not necessary for the party to have physical ownership of the records, just the right to obtain them. See, In re NTL, Inc. Securities Litigation, 2007 U.S. District Lexis 6198 (S.D.N.Y. 2007) at 59-60 (holding the defendant had control over a non party=s documents, AUnder Rule 34, >control does not require that the party have legal ownership or actual physical possession of the documents at issue; rather, documents are considered to be under a party's control when that party has the right, authority or practical ability to obtain the documents from a non-party to the action)( citing Bank of New York v Meridien Biao Bank Tanzania Ltd, 171 F.R.D. 135, 146-47 (S.D.N.Y. 1997).
With respect to the financial records, these records will most likely be on a computer. It is important to gain access, if possible, to those computerized records. Sitting at a terminal, an attorney or an accountant can look at trial balances and go to any subaccount that looks suspicious. A search can also be made by names of owners to determine salaries and other payments. Even a searchable CD of the basic records can be very useful in terms of locating the payments to owners and the owners' families.
Get the banking records from both the debtor and the banks. Initially ask for all the monthly statements and then go back and ask for checks that look relevant. Very often, the last four months or so before a broker's dissolution are when fraudulent transfers will be found, so look closely at this period. Check carefully to see whether the banking deposits and withdrawals agree with the debtor's financial records. In addition, it is often worthwhile looking at the checks and/or wires themselves to see where the money went in the final days. Make sure to obtain all the records from all of a broker's banks. An examination of intra company transfers can act as a guide to finding all of the bank accounts.
The broker-dealer (BD) forms will pinpoint who was reported as a controlling person. Also, obtain the BDW (broker-dealer withdrawal) form which will disclose the name of the person who has custody of the records of the broker. These are required to be kept for 6 years. An attorney may want to subpoena this person to make sure where those records are and whether the broker has complied.
While Focus Reports are filed monthly, the important Focus Reports are the quarterly reports and the annual report because they require a financial statement. The financial statement attached to the annual report is audited and filed with both the SEC and NASD. These financial statements will give a general idea as to the assets of the company and changes in the assets over a period of time, which may pinpoint when transfers were made. Subpoena all the accountants disclosed by the annual Focus Reports and the tax returns. Get the entire audit file for each of the relevant years, the accountants’ notes relating to the preparation of the tax return, the trial balance and all adjusting journal entries. Adjusting journal entries can be particularly revealing in pointing to areas where improper transfers may have been made.
Lastly, the records from the clearing firm should also be subpoenaed, particularly the records of all the payments made to the brokerage firm. Trace these payments into the bank account records of the brokerage to make sure that they are all accounted for. Also, ask for any records relating to any loans made by the clearing firm to the brokerage. It is apparently not unusual for clearing firms to make such loans. It is important to determine who actually got the money, who was responsible for paying it back and who paid it back.
CONCLUSION
As the old joke goes, “where are all the customers’ yachts.” Brokerage owners usually manage to save themselves. Thus, it is often worthwhile pursuing these remedies to collect the arbitration awards.
Leslie Trager practices in New York., NY. He has been assistant chief counsel to the NY State Commission of Investigation and a deputy director in the Office of the Attorney General for Medicaid Fraud. In addition to securities arbitration, he handles commercial litigation and asset recovery.