Feb. 1, 2010 – A 2004 supreme court decision shields corporate officers accused of extracting more than $10 million for themselves at the expense of their company from lawsuits by the corporation or its creditors.

In Polsky v. Virnich, 2007AP203, the Wisconsin Court of Appeals said that it was bound by the holding in Beloit Liquidating Trust v. Grade, 2004 WI 39, in which the Wisconsin Supreme Court ruled that a corporation must be both insolvent and no longer a going concern before a duty is owed to creditors.

That two-part precondition for a fiduciary duty had not fully occurred in Polsky because Communications Products remained a going concern while Daniel Virnich and Jack Moores allegedly enriched themselves until the company defaulted on a loan to its largest creditor, American Trust and Savings Bank.

The court of appeals remarked that Beloit sets Wisconsin outside of the general rule that insolvency alone will trigger a directors’ and officers’ fiduciary duty to creditors. The court noted that it had certified this case to the supreme court so that it could address this issue, but the justices could not accept review after they deadlocked in a three-to-three vote with one justice not participating. The court of appeals reiterated its position that Beloit does not “set forth a sensible rule” and urged the justices to bring Wisconsin “into line with the majority of other jurisdictions.”

Indistinguishable

In its Jan. 28 opinion authored by Judge Paul Lundsten, the court of appeals found that the receiver appointed at American Trust’s urging could not distinguish this case from Beloit.

The receiver, Michael Polsky, had argued that Beloit barred creditors’ claims on their own behalf, but the case did not apply to a receiver’s claims on behalf of the corporation itself. The circuit court had agreed with Polsky’s interpretation of Beloit and allowed the lawsuit to proceed. After presenting evidence that Virnich and Moores used a combination of salaries, management fees, “loans,” dividends, and excessive lease rates to take more than $10 million from the corporation between 1990 and 2003, a jury awarded the receiver $6.5 million.

But the court of appeals noted that the creditors in Beloit had similarly argued that they were asserting a claim on behalf of the mismanaged Beloit Corporation after taking “title” to its assets, including the corporation’s claim for breach of fiduciary duty.  The Beloit court said the creditors had failed to identify an actionable injury to the corporation in the claims it hoped to bring in the corporation’s name.

The court of appeals remarked that Polsky asserts a harm to Communications Products that is different from that done to Beloit Corporation, but fails to say what that difference is. To make this distinction, the court suggested, the Beloit decision itself needs more explanation. “The receiver’s argument simply begs the question, however, why the Beloit Liquidating court concluded that there was no harm to Beloit Corporation,” the court wrote. “In order to identify a principled distinction between Beloit Liquidating and this case, we must identify a meaningful difference in harm to the respective corporations. We are unable to identify such a difference.”

“In both situations, so far as we can tell, the only identified harm to the corporation was its diminished ability to pay its creditors,” the court observed.

Effects of Beloit

Beloit incentivizes bad behavior, the court of appeals said.

“The problem, as we see it, is this: A business can be run as a ‘going concern,’ well after it is insolvent, thus making it a relatively simple matter for the officers and owners of a closely held corporation to strip many of the remaining assets of the ‘sinking ship’ without fear of running afoul of a duty to creditors,” the court wrote.

“At oral argument before the supreme court, counsel for amicus Wisconsin Bankers Association explained that one consequence of diminished creditor protection is that creditors will make it more difficult and more expensive for many corporations to borrow money,” the court continued. “For example, according to the Association’s counsel, more ‘personal guaranties, regular audits, periodic examinations, [and] stricter underwriting’ will be imposed on corporate borrowers.

“Therefore, it appears to us that corporations as a whole would benefit if our supreme court modified the Beloit Liquidating holding to bring it into line with the majority of other jurisdictions,” the court concluded.