Think a debt is uncollectible if the company goes out of business? Guess again. A recent ruling by the Arizona Court of Appeals makes it easier for creditors to collect past business debts from the owners of dissolved businesses.
For business owners dreaming of cashing out their businesses, the court sent a clear message: pay your debts, even those that are doubtful, or risk personal liability.
The Court of Appeals found that former business owners, who cash out of their limited partnership when a debt is unpaid, can and should be held personally liable to the creditor for the funds they receive.
The case stemmed from the trial court ruling in Hullett v. Cousin, a suit brought against a group of apartment complex investors. After selling the complex, the limited partnership paid its debts and distributed the profit to the owners. However, when the buyer decided to sue, the limited partnership no longer existed and defaulted. The buyer then sought to collect the judgment against the partners under the Uniform Fraudulent Transfer Act, which states that a creditor can recover a transfer of property or funds made when insolvent unless the transferring entity obtains reasonably equivalent value. The partnership paid the investors as owners ahead of the unknown creditor's claim, a classic fraudulent transfer.
The investors thought they weren't liable since the buyer had not even complained, much less sued, when they cashed out of the investment. Too bad said the appellate court, the fraudulent transfer law protects all creditors, whether their claims are known or not. The claim counts in determining whether the partnership was insolvent.
The investors thought they should not be liable since the partnership had a legal obligation to repay the investors their invested capital and any profit. But the fraudulent transfer laws protect creditors, ahead of owners. The owner is entitled to payment only after all creditor claims are paid. The investors gave no value, much less reasonably equivalent value, to the partnership when they cashed out.
The decision has several far-reaching consequences. For example, if a business owner sells the business, but innocently forgets to repay a creditor, or does not even know about a creditor, the owner can still be personally accountable for the distribution from the business, even if they have reinvested those funds into another business or property.
Fraudulent transfer laws are not just about faithless debtors trying to hide assets from creditors. These laws also provide creditors with an opportunity to look past the limited liability shell of a corporation or limited partnership to force owners to return funds they receive that legitimately should pay creditors first.