By Michael A. Siskin and Richard E. Miller
Companies incorporated in the State of New York that fail to file annual corporate tax reports[i] for two consecutive years or pay corporate franchise taxes[ii] owing to New York State for any two years may be involuntarily dissolved, automatically, without notice, by proclamation of the Secretary of State.[iii] A corporation so dissolved is authorized only to wind up its affairs, and may not carry out other business.[iv] Either through ignorance of the corporation’s dissolution or knowingly, some shareholders and officers of dissolved corporations carry on the business of their corporations, entering into agreements with other businesses and incurring debts in the names of these corporations, as if they had not been dissolved. In some, if not all such circumstances, the shareholders and officers may be held liable for debts incurred in the name of the dissolved corporations.
To date, the Court of Appeals has not addressed this issue, despite an apparent split in authority between State court decisions and Federal court decisions applying New York State law. In October, however, the Supreme Court[v] and the Civil Court[vi] of New York County followed state precedent and ignored a line of federal cases in holding the shareholders of two dissolved corporations liable for debts incurred after the corporations were involuntarily dissolved by action of the Secretary of State. This article will discuss the historical basis for those decisions and the reasoning behind them.
Poritzky v. Wachtel
In 1941, in Poritzky v. Wachtel, the issue of the liability of individuals for the debt of a corporation dissolved pursuant to Section 203-a of New York Tax Law for failing to pay franchise taxes, was first addressed.[vii] The corporation had no assets at the time the action was initiated. Thus, if the plaintiff creditor could not collect from the individual, the corporation’s president, who entered into the debt, then the debt could not be collected.[viii] The Court charged the president of the corporation with knowledge of the corporation’s dissolution, whether or not he had such actual knowledge.[ix] Given that knowledge, the Court reasoned that the president “had no further right to obligate the corporation or to continue its business while it remained dissolved.”[x] The Court held the president personally liable for debts incurred while the corporation was dissolved and reasoned that to hold otherwise “would encourage fraud and abuse.”[xi]
[A] former officer of a dissolved corporation could obtain credit and then upon subsequent discovery of the non-existence of the corporation, by merely paying arrears in franchise taxes, could shift the personal liability which the law would otherwise impose upon him back to the corporation.[xii]
Prentice Corp. v. Martin
In 1986, in Prentice Corp. v. Martin, the District Court for the Eastern District of New York rejected the holding in Poritzky.[xiii] Unlike the corporation at issue in Poritzky, the corporation in Prentice had been reinstated sometime after entering into two contracts with the plaintiff.[xiv] Although the District Court recognized that Poritzky was the only case on point,[xv] it chose to follow what it perceived as dictum.[xvi] The District Court adopted the reasoning of the New York Court of Appeals, in another context, that individual shareholders and officers are shielded from personal liability, absent a showing of fraud, because a dissolved corporation that continues its business becomes a de facto corporation – that is, an entity that is still recognized as a corporation due to its good faith attempts at reinstatement or good faith efforts to maintain its corporate status, but is without the legal status of a “de jure” corporation as a result of some unintentional defect. In addition, the Federal Court opined that the New York legislature would have explicitly created a private remedy had it intended for individuals to become liable.[xvii]
Two Lines of Reasoning Emerge
In 1987, in J.M. Lynne Co., Inc. v. Geraghty, the Supreme Court of Connecticut, applying New York law, chose to follow Poritzky and rejected Prentice[xviii] It found that “the New York district court’s disregard of Poritzky in Prentice Corporation v. Martin…is critically suspect.”[xix] The Court expressed its concern that the Prentice decision was based on cases factually distinguishable.[xx] Moreover, it found that, “[t]he policy concerns underlying Poritzky of discouraging fraud and abuse are certainly legitimate considerations and are as important today as they were in 1941, the year Poritzky was decided.”[xxi]
Two years later, the Appellate Division, Second Department, in the case of Brandes Meat Corp. v. Cromer, without reference to Poritzky or J.M. Lynne, rejected the concept of de facto existence of a corporation dissolved pursuant to § 203-a, and held the individual purporting to act as an agent of the corporation personally liable for the obligations incurred.[xxii] The Court observed that the corporation had not been reinstated, and also found it significant that the transactions at issue were not part of the process of winding up the corporation’s affairs.[xxiii] The Appellate Division, Second Department held that the corporation therefore lacked the capacity to be sued and held the individual defendant liable for the obligations.[xxiv]
In Annicet Assocs., Inc. v. Rapid Access Consulting, Inc., in 1997, the Supreme Court in Rockland County specifically followed the holdings in Poritzky, J.M. Lynne and Brandes, and rejected the holding in Prentice.[xxv] The Court based its decision on the analysis in J.M. Lynne and, “The salient premise of the Poritzky case…that fraud and abuse would be encouraged if an officer of a dissolved corporation were allowed to conduct business in the corporate name.”[xxvi]
In 1999, the United States Court of Appeals for the Second Circuit, in the case of L-Tec Elec. Corp. v. Cougar Elec. Org., Inc., followed the Prentice opinion.[xxvii] Curiously, it did so without mention of the growing New York case law on personal shareholder and officer liability. Instead, the Second Circuit discussed a number of factually distinguishable New York State cases concerning recognition of de facto corporations, and concluded that reinstatement retroactively validated those contracts entered into during the corporation’s period of dissolution.[xxviii]
Just four days after the Second Circuit’s decision, in Worldcom, Inc. v. Sandoval, the Supreme Court in New York County chose to follow instead the holdings in Poritzky and J.M. Lynne.[xxix] “The Connecticut Supreme Court, in applying New York law, concluded that New York courts today would still follow Poritzky. The court agrees with that conclusion.”[xxx] The Court noted that Prentice has been criticized and rejected as a proper statement of New York law on this subject.[xxxi] Following Poritzky, the Supreme Court held the individual defendants personally liable for the contractual obligations of the dissolved corporation.[xxxii]
In February of 2001, in Department 56 v. Bloom, one State Court cited Prentice with approval.[xxxiii] Department 56, however, involved a factual twist. The corporation at issue was a dissolved New Jersey corporation that was being run during its dissolution by its president, who was a New York resident. The Richmond County Supreme Court relied upon the reinstatement of the dissolved corporation in rejecting what it recognized to be the undisputed New York law as articulated in Poritzky.[xxxiv] In fact, the Court distinguished Brandes on the sole basis that “it involved a corporation that had been dissolved but not reinstated.”[xxxv] Despite the Court’s focus on Poritzky and Prentice, however, the corporation at issue was not dissolved pursuant to Tax Law § 203-a, but pursuant to New Jersey law. Notwithstanding the New York residence of the corporation’s president, the Court ultimately found “no merit in plaintiff’s contention that New York law should control,” and applied the law of New Jersey, thus transforming its opinion on New York case law into dicta.[xxxvi]
Digital Nation Media, Inc. v. Ploni & Assocs., Inc.
On October 4, 2001, in the case of Digital Nation Media, Inc. v. Ploni & Assocs., Inc., the Civil Court of New York County held, counter to the holding in Department 56, that New York law applied when a Delaware corporation doing business in New York was voided for failure to pay taxes. Citing Poritzky and its progeny, and ignoring Prentice, L-Tec Elec. and Department 56, the Civil Court held without further discussion that, “In New York State, shareholders and officers of a corporation involuntarily dissolved, are personally liable on contracts consummated while the corporation was in dissolution.”
Klein v. Guglielmi
Two weeks after the Digital Nation Media opinion, the New York County Supreme Court issued its opinion in the case of Klein v. Guglielmi. Citing to Brandes,[xxxvii] the Supreme Court held that the dissolved corporation had neither a de jure nor a de facto existence. The Court recognized a split in authority when corporations have been reinstated,[xxxviii] but held the individual shareholders personally liable for the debts incurred in the name of the dissolved corporation as a matter of law, because there was no dispute that the corporation had not been reinstated.
De Facto Corporations
The distinction in the case law between reinstated and dissolved corporations can most easily be explained by an understanding of de facto corporations. “In every decision treating a business as a de facto corporation despite the absence of de jure corporate status, the business either inadvertently failed to meet the requirements of the law or was operated with the formalities of a corporation and was attempting to achieve legal status.”[xxxix]
De facto recognition requires both a good faith exercise of corporate powers and colorable compliance with the enabling statute [citations omitted]. A delinquent corporation lacks both prerequisites. There is neither a good faith exercise of corporate duties, nor compliance with statutes requiring the payment of franchise taxes for the privilege of conducting business in the corporate form (Tax Law § 209).[xl]
The reasoning is that when the corporation has been reinstated, by payment of its unpaid franchise taxes, penalties and interest, it has arguably been acting in good faith as a corporation and within “colorable compliance with the enabling statute.”
Thus, in L-Tec Elec., despite its holding, the Second Circuit realized that, “some Appellate Division cases…hold that a corporation dissolved for failure to pay taxes has no de facto existence.”[xli] The Second Circuit noted, however, that New York courts often recognize the significance of acting to reinstate the dissolved corporation.
[E]ven those cases recognize that where the corporation later pays its taxes and is reinstated, its corporate status is restored nunc pro tunc, and any contracts into which it may have entered are retroactively validated…Thus, the district court did not err when it held that reincorporation relieved the individual defendants of any personal liability….[xlii]
This is seemingly consistent with the language of Tax Law § 203-a that reinstatement procedures, “shall have the effect of annulling all of the proceedings theretofore taken for the dissolution of such corporation.”[xliii]
The Split in Authority
The true split in authority in this area is with those cases concerning reinstated corporations. Whereas in Worldcom and Poritzky, the individuals are held liable, the individuals are shielded from liability in L-Tec Elec. and Prentice. It is not merely Federal courts that believe that individuals should be protected from liability when corporations have been reinstated. Although expressed in dicta, the State Court in Department 56 makes it clear that it would have shielded the individuals from liability even if it found that New York law applied.
Parsing out the factual differences between these cases sheds little light on the different outcomes. Although it is interesting to note that the corporations in both Worldcom and Poritzky were not reinstated until after the complaint had been filed against them, and that, in the L-Tec Elec. and Prentice opinions, it is not apparent whether the corporations were reinstated before or after commencement of the actions against the individuals, the corporation in Department 56 also was reinstated only after the dissolution “was brought to [the president’s] attention by plaintiff.”[xliv] Further, none of the opinions rely on this fact in their analysis.
A Recommendation to Resolve the Split in Authority
It is difficult, if not impossible to reconcile these decisions. There is no hint of significant factual differences. These decisions contain little, if any, discussion of the circumstances that led to the dissolution of the corporations. In order to attempt to understand these cases, it is helpful to look to case law involving corporations dissolved for failure to comply with the corporate tax laws, but where the issue was not whether individuals may be held liable for the debts of dissolved corporations.
Where defendants seek to deny the existence of corporations to avoid corporate liability, State courts tend to find de facto existence and hold the corporations liable. For example, a corporation which was dissolved for non-payment of taxes and continued its business under a new name could not plead dissolution in order to avoid its obligations.[xlv] “Any other conclusion would allow [the dissolved corporation] to profit by its own non-payment of taxes.”[xlvi] More obviously, where, prior to default, a company made all payments necessary for reinstatement of the corporation, except the payment of a $55 reinstatement fee, the company was found to be in colorable compliance with the statute, and thus, a de facto corporation, and liable for its remaining debt.[xlvii]
In one case where the corporation sought to prove its de facto existence in order to collect on a fire insurance policy, the Second Department, Appellate Division even found that, absent reinstatement, a dissolved corporation has no capacity to sue for matters arising outside of the course of winding up the corporation’s affairs.[xlviii]
An individual aware of the dissolution of the corporation may not, for his or her own advantage, enforce an agreement entered into by that individual on behalf of the nonexistent corporation.[xlix] This is because the individual “knew, or should have known, that the Agreement was invalid, and cannot now complain that it should be enforced for his benefit.”[l]
Even in the unusual situation where an individual sought to deny the existence of a corporation in order to avoid personal liability, the Courts have held that the company was a de facto corporation and found the individual liable. Thus, where a guarantor on a line of credit, opened by a corporation that had previously been dissolved in Florida for failure to pay its franchise taxes, sought to avoid personal liability for sums still due, the corporation was found to have opened the line of credit as a de facto corporation, and the guarantor was held liable.[li]
The trend of these State cases is to provide a means for creditors to collect on their debts, but to limit the ability of individuals and corporations to manipulate the status of the corporation for their own benefit. In other words, wrongdoers do not benefit from their own misdeeds.
Following this logic, one should expect, in the context of a reinstated corporation, that if the Courts determine that the debts were incurred without knowledge of the corporation’s dissolution, and such dissolution occurred innocently and without neglect or carelessness, perhaps as evidenced by attempts to rectify the temporary lapse in compliance, and not in an attempt to use the Tax Law for personal gain, the individual will not be held liable. Otherwise, they will.
It may be argued that “colorable compliance” should be determined at the time when the debts are incurred. Such a rule would be consistent with the purpose of recognizing de facto corporations, which is to avoid penalizing innocent shareholders and officers in situations where the only intent is to act as a corporation, but corporate status fails through some inadvertent defect. How a corporation acts before and after the period of dissolution seems irrelevant to its actions while it was dissolved. The issue is, or should be, whether the shareholder can justify the failure to keep the corporation in good standing. If a corporation has made substantial efforts to pay its franchise taxes, but, for example, the check never arrived at its intended destination, and debts were incurred while the shareholders and officers were ignorant of such dissolution because they thought they were in compliance, de facto existence should be recognized for the period prior to reinstatement. If, however, corporations simply do not pay their taxes, whether purposefully or through carelessness, and are dissolved by proclamation therefor, all “colorable compliance” occurring after the fact, including reinstatement, should not transform the faulty actions of the corporation at the time that debt is incurred.
One reason for allowing collection from individual defendants is revealed in dicta in Animazing Entertainment, Inc. v. Louis Lofredo Assocs., Inc.
It would be inequitable to allow individuals who form contracts on behalf of nonexistent corporations to avoid liability because their misrepresentations resulted in a contractual defect…The plaintiffs in those cases believed that they had entered into valid contracts with corporations and since those corporations did not exist, had no remedy except against the individuals who acted as agents of those purported corporations.[lii]
To deny individual liability would be to encourage unscrupulous shareholders and officers to stop paying their franchise taxes in order to receive free goods and services from unsuspecting companies that have no reason to know whether their customers have been dissolved by proclamation. Further, “[r]ecognition of de facto status would directly subvert the effectiveness of the sanctions for franchise tax delinquency, removing all incentive for a dissolved corporation to seek reinstatement.”[liii] In order to prevent fraud and abuse, it must be the rule that individuals be held responsible for debts they incur in the name of dissolved and insolvent corporations. If a company can prove that dissolution was truly inadvertent and not due to neglect, however, and it quickly rectified the default by seeking reinstatement, creditors must be left to rely on the solvency of their customers.
[i] See, Tax Law § 192.
[ii] See, Tax Law §§ 180, et seq.
[iii] Tax Law § 203-a.
[iv] Bus. Corp. Law § 1005(a)(1), expressly incorporated by Tax Law § 203-a(10).
[v] Klein v. Guglielmi, 10/18/2001 N.Y.L.J. 20 (Col. 4).
[vi] Digital Nation Media, Inc. v. Ploni & Assocs., Inc., 10/4/2001 N.Y.L.J. 19 (Col. 2).
[vii] Poritzky v. Wachtel, 176 Misc. 633, 27 N.Y.S.2d 316 (Sup. Ct., Putnam Co., 1941).
[viii] Id., 176 Misc. at 635, 27 N.Y.S.2d at 318.
[ix] Id., 176 Misc. at 634, 27 N.Y.S.2d at 317.
[xi] Id., 176 Misc. at 635, 27 N.Y.S.2d at 318.
[xiii] Prentice Corp. v. Martin, 624 F.Supp. 1114 (E.D.N.Y. 1986).
[xiv] Id., 624 F.Supp. at 1114.
[xv] Id., 624 F.Supp. at 1115.
[xvi] Id., 624 F.Supp. at 1115-16, discussing Garzo v. Maid of the Mist Steamboat Co., 303 N.Y. 516, 104 N.E.2d 882 (1952). Significantly, in Garzo, the corporation inadvertently expired according to its charter, and was not involuntarily dissolved for failure to comply with the Tax Law. This distinction is critical in that one requirement for de facto corporation status is “colorable compliance with the enabling statute.” The corporation in Garzo apparently complied with all of its statutory requirements, unlike corporations which are dissolved for failure to file reports or pay taxes.
[xvii] Prentice, 624 F.Supp. at 1116.
[xviii] J.M. Lynne Co., Inc. v. Geraghty, 204 Conn. 361, 528 A.2d 785 (1987).
[xix] Id., 204 Conn. at 371, 528 A.2d at 791.
[xx] Id., 204 Conn. at 372, 528 A.2d at 791.
[xxi] Id., 204 Conn. at 374, 528 A.2d at 792.
[xxii] Brandes Meat Corp. v. Cromer, 145 A.D.2d 666, 667, 537 N.Y.S.2d 177, 178 (2d Dep’t 1989).
[xxiii] Id., 145 A.D.2d at 666, 537 N.Y.S.2d at 178.
[xxiv] Id., 145 A.D.2d at 667, 537 N.Y.S.2d at 178.
[xxv] Annicet Assocs., Inc. v. Rapid Access Consulting, Inc., 171 Misc.2d 861, 865, 656 N.Y.S.2d 152, 154 (Sup. Ct. Rockland Co. 1997).
[xxvi] Id., 171 Misc. at 864, 656 N.Y.S.2d at 154.
[xxvii] L-Tec Elec. Corp. v. Cougar Elec. Org., Inc., 198 F.3d 85 (2d Cir. 1999).
[xxviii] Id., 198 F.3d at 87.
[xxix] Worldcom, Inc. v. Sandoval, 182 Misc.2d 1021, 1025, 701 N.Y.S.2d 834, 837 (Sup. Ct., N.Y. Co., 1999).
[xxxii] Id., 182 Misc.2d at 1026, 701 N.Y.S.2d at 838.
[xxxiii] Department 56 v. Bloom, 186 Misc.2d 901, 720 N.Y.S.2d 920 (Sup. Ct. Richmond Co. 2001).
[xxxiv] Id., 186 Misc.2d at 903-05, 720 N.Y.S.2d at 922-24.
[xxxv] Id., 186 Misc.2d at 904, 720 N.Y.S.2d at 922.
[xxxvi] Id., 186 Misc.2d at 905, 720 N.Y.S.2d at 924.
[xxxvii] Brandes Meat Corp. v. Cromer, 145 A.D.2d at 667, 537 N.Y.S.2d at 178.
[xxxviii] The Supreme Court observed that individual shareholders and officers were held liable for corporate debts incurred while corporations were dissolved by proclamation even though the corporations were later reinstated in Worldcom, Inc. v. Sandoval, 182 Misc.2d 1021, 701 N.Y.S.2d 834 (Sup. Ct., N.Y. Co., 1999), and Poritzky v. Wachtel, 176 Misc. 633, 27 N.Y.S.2d 316, but were shielded from such liability in Department 56 v. Bloom, 186 Misc.2d 901, 720 N.Y.S.2d 920 (Sup. Ct. Richmond Co. 2001), L-Tec Elec. Corp. v. Cougar Elec. Org., Inc., 198 F.3d 85 (2d Cir. 1999), and Prentice Corp. v. Martin, 624 F.Supp. 1114 (E.D.N.Y. 1986) (wherein the District Court held that individual shareholders could be held liable upon a showing of fraud or bad faith).
[xxxix] Animazing Entertainment, Inc. v. Louis Lofredo Assocs., Inc., 88 F.Supp.2d 265, 269 (S.D.N.Y. 2000).
[xl] Lorisa Capital Corp. v. Gallo, 119 A.D.2d 99, 110-11, 506 N.Y.S.2d 62, 71 (2d Dep’t 1986); See also, De George v. Yusko, 169 A.D.2d 865, 867, 564 N.Y.S.2d 597, 598 (3d Dep’t 1991).
[xli] L-Tec Elec., 198 F.3d at 87.
[xliii] Tax Law § 203-a(7).
[xliv] Department 56 v. Bloom, 186 Misc.2d 901, 902, 720 N.Y.S.2d 920, 921 (Sup. Ct. Richmond Co. 2001).
[xlv] D & W Central Station Alarm Co., Inc. v. Copymasters, Inc., 122 Misc. 2d 453, 471 N.Y.S.2d 464 (Civ. Ct. Queens Co. 1983).
[xlvi] Id., 122 Misc. 2d at 457, 471 N.Y.S.2d at 466.
[xlvii] Ludlum Corp. Pension Plan Trust v. Matty’s Superservice, Inc., 156 A.D. 339, 548 N.Y.S.2d 292 (2d Dep’t 1989).
[xlviii] Lorisa Capital Corp. v. Gallo, 119 A.D.2d 99, 111, 506 N.Y.S.2d 62, 71 (2d Dep’t 1986).
[xlix] Animazing Entertainment, 88 F.Supp.2d at 271.
[li] National Bank v. Paskow, 75 A.D.2d 568, 427 N.Y.S.2d 262 (1st Dep’t 1980).
[lii] Animazing Entertainment, 88 F.Supp.2d at 271.
[liii] Lorisa Capital Corp. v. Gallo, 119 A.D.2d 99, 111, 506 N.Y.S.2d 62, 71 (2d Dep’t 1986); but see, Department 56 v. Bloom, 186 Misc.2d 901, 904, 720 N.Y.S.2d 920, 922-23 (Sup. Ct. Richmond Co. 2001), concluding that, since the problem only arises when corporations have insufficient funds to pay their debts, they may also have insufficient funds for reinstatement, and thus, the individual shareholders or officers cannot expect to be shielded from liability. The Court seems to ignore the reasonable possibility that a shareholder having the thousands of dollars necessary to pay the back taxes and penalties could incur substantially higher debts in the name of the corporation, and avoid substantial personal debt merely by reinstating the corporation at his or her own expense. The Court in Department 56 further suggests that the creditor who is shielded from seeking recompense from the individual shareholder and officers would be in the same position with an insolvent reinstated corporation as it would be with an insolvent corporation that was never dissolved. Of course, the corporation that was never dissolved has not attempted to manipulate the tax laws in order to avoid payment to its creditors.