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Commercial Litigation Landlord Tenant Law Litigation

‘Shell Game’ Gets Away From Commercial Lease Guarantor

In the real estate business, as in many others, the question of just who is contractually responsible when things go wrong is a recurring one, particularly when a closely-held corporation or other business entity is involved.

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In the real estate business, as in many others, the question of just who is contractually responsible when things go wrong is a recurring one, particularly when a closely-held corporation or other business entity is involved. If rent goes unpaid, is the business’ proprietor on the hook, or the corporation of which he is the sole owner? Or when a guarantor fails to come through after a lessee defaults, can he and his business entities be treated as one in the same, so that satisfaction can be had through attachment of the company’s assets? A scenario similar to these played out in case recently decided by the Appellate Court of Illinois, First District, Second Division: Golfwood Square LLC v. O’Malley, 2018 IL App (1st) 172220-U (8/11/2018). In Golfwood, the court had to decide just how much responsibility a business entity could be made to shoulder that was not directly involved in a dispute between a commercial lessor and the guarantor of its lessee’s contractual responsibilities.

The Individual and His Business Entities

In 2009, defendants Michael K. O’Malley and Robert Stejskal signed on as guarantors of a commercial lease between landlord Golfwood and an entity indirectly owned by the two defendants, known as MAC Enterprises LLC. When MAC defaulted on the lease and O’Malley and Stejskal reneged on their promise to pay, Golfwood sued the two individuals for breach of contract. The parties came to a settlement, and the court in May of 2012 entered a judgment for plaintiff/landlord Golfwood in the amount of $915,000. The payment to Golfwood, however, was not forthcoming.

Golfwood then moved for the court’s assistance in collecting the judgment from O’Malley (Stejskal was not involved in this action) through O’Malley’s other business interests. Specifically, O’Malley owns 90% and Stejskal owns the remaining 10% of an entity known as Sheffield Street Group, LLC (SSG). SSG does not “do” anything, having no employees and no business to conduct. SSG’s only purpose is to be the sole member of another entity, 3 Squared LLC.

3 Squared’s only assets were a condominium and the rents the condominium generated. As O’Malley is a 90% owner and managing member of SSG, and SSG owns 3 Squared, O’Malley was in control of 3 Squared and its assets (the condominium and its rental income).

In March of 2013, the trial court issued a charging order directing SSG to pay any amounts it obtained from 3 Squared to Golfwood rather than to O’Malley, as partial payment of the $915,000 O’Malley owed on the settlement concerning the commercial lease between Golfwood and MAC.

Less than two weeks after the charging order was issued, O’Malley filed for personal bankruptcy. During that action’s pendency, the bankruptcy trustee was ordered to abandon O’Malley’s various entities, leaving SSG and 3 Squared open for access by creditors.

Later that same month, 3 Squared sold its only physical asset, the condominium. After satisfying the mortgage from the proceeds of the condo sale, approximately $224,000 remained in 3 Squared’s bank account.

Dissolved, or Not?

3 Squared’s operating agreement provided for the dissolution of the company in the following manner:

“6.1.7 Distribution of Sale Proceeds. Upon sale of the assets of the Company, … the Company will be dissolved and the net proceeds of such sale and all other Company assets, after payment of Company liabilities, shall be applied and distributed in the following order:

A. To payment and discharge of all the Company debts and liabilities to persons or organizations other than Members ….

B. To the payment and discharge of any … debts and liabilities to Members; and

C. To the Members in the amount of their respective capital account balances as of the date of distribution, adjusted to reflect the allocations of Gain on Sale or Loss on Sale upon liquidation.”

O’Malley claimed in deposition testimony that 3 Squared had “no direct liabilities” which, if true and pertinent, would have meant that in accordance with the company’s dissolution clause he was entitled to most of 3 Squared’s assets upon dissolution of the entity. During the appeal O’Malley claimed, however, that 3 Squared owed “substantial amounts” to other entities, so that if it was dissolved all its assets would be drained to pay those debts. The court rejected this argument and held O’Malley to his previous assertion in deposition testimony that 3 Squared had “no direct liabilities.” The court characterized this as a binding judicial admission that was “clear, unequivocal, and concerned a concrete fact within O’Malley’s knowledge, since he was the person in charge of 3 Squared’s management.”

But the fact remained that 3 Squared was never formally dissolved and it did not “distribute” the condominium sale proceeds, which remained in 3 Squared’s bank account. 3 Squared’s 2014 tax return stated, however, that the proceeds of the sale of the condominium were paid directly to O’Malley. O’Malley admitted that he had free access to 3 Squared’s account; in fact, he had spent approximately $80,000 from it after the trial court’s charging order was issued ordering any funds coming from the condominium and going to SSG to be paid to Golfwood. Among the things O’Malley paid for from the account were taxes and legal fees that O’Malley could not fully explain to the court, and that were possibly related to other O’Malley-owned business entities.

The Owner of the Assets

According to Golfwood, when 3 Squared sold the condominium it should have dissolved and distributed the proceeds to SSG, which would then have had to distribute them to Golfwood in accordance with the charging order; instead, by failing to disolve 3 Squared, O’Malley was circumventing the charging order so that he could keep the funds for himself. Golfwood therefore asked the court for a preliminary injunction preventing O’Malley and 3 Squared from spending any more of the proceeds of the condo sale, and that injunction was granted, following agreement by the parties, in May of 2017. In August 2017, the court ordered the proceeds of the condominium sale turned over to Golfwood, considering this the only way to give effect to the 2013 charging order. In coming to this decision, the trial court relied in significant part on Illinois Code 735 ILCS 5/2-1402 (West 2016). Section 2-1402 permits a judgment creditor to seek discovery to determine if the judgment debtor has assets that should go toward payment of the judgment, or if a third party has any funds owed to the judgment debtor that could be applied toward to satisfy judgment — and, if the latter exist, the third party can be ordered to turn those assets over to the judgment creditor.

Did the Trial Court Go Too Far?

O’Malley and 3 Squared argued on appeal that by ordering 3 Squared to turn over its assets to Golfwood, the trial court had exercised undue control over 3 Squared and SSG. The appeals court, unconvinced, concluded that since 3 Squared had been essentially nonexistent for years before the entry of the turnover order — due to the facts that its only asset had been sold and the proceeds had not been reinvested in anything, while its tax filing stated the proceeds of the condo had all been paid over to O’Mallley — the turnover order could not be said to represent an exercise of control over this practically non-existent entity, 3 Squared.

As for piercing the corporate veil, the court noted that while a corporation is generally considered a distinct legal entity separate from its shareholders, directors and officers, sometimes a corporation is not what it seems. Citing Fontana v. TLD Builders, Inc., 362 Ill. App. 3D 491 (2005), the court stated: “Where the corporation ‘is merely the alter ego or business conduit of another person,’ such that the corporation is no more than a ‘dummy or sham’ for that individual, the court may pierce the veil of limited liability to hold that individual liable for the corporation’s debts.” And, at any rate, the 2017 charging order did not order O’Malley to personally cover the corporate debt of SSG, so there was no piercing of the corporate veil, the court concluded.

O’Malley further argued that it was improper for the trial court to have pierced the corporate veil in supplementary proceedings, thereby holding a third party to the proceeding liable for the debt of a participant. He pointed to the holding in Lange v. Misch, 232 Ill.App. 3D 1077, in which an Illinois appeals court reversed a trial court that ordered a non-party to the action to cover the judgment debtor’s payment, holding that such an order affecting a third party’s holdings is permitted only where there is a showing that the third party possesses assets belonging to the judgment debtor. Lange had distinguished O’Connell v. Pharmaco Inc., 143 Ill. App. 3D 1061 (1986), in which a court in a supplementary proceeding ordered a third party to pay the judgment debtor’s debt; the decision was upheld where it was shown that the judgment debtor, a company called Pharmaco, had assigned $280,000 in its assets to its chief executive officer, Larson — and Larson had drafted the assignment documents himself. The Golfwood court considered O’Malley’s argument but concluded: “This case is analagous to O’Connell rather than Lange. Just as the trial court in O’Connell determined that Larson possessed funds belonging to Pharmaco, the trial court in this case determined that 3 Squared possessed funds belonging to O’Malley, a conclusion amply supported by the record …. Thus, the court was entitled under section 2-1402 to order turnover of those funds to satisfy the judgment against O’Malley.”

Conclusion

Individual owners of business entities may usually protect themselves from personal liability for the debts of those entities, even when solely owned by the debtor individual. The same principle applies, in general, to the personal debts of an individual who owns a business entity: The business will not be liable for the owner’s separate debts. Still, with a bit of extra sleuthing and effort, a creditor like the lessor in Golfwood may be able to reach funds held by a debtor’s business entity if, as the court there stated in regard to O’Malley, the debtor is using his business entities to play a “shell game” — in O’Malley’s case, as described by the court, “to circumvent the charging order by keeping the funds nominally under 3 Squared’s ownership while spending them freely for his own purposes.”

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Janice G. Inman is Editor-in-Chief of this newsletter.

 

The views expressed in the article are those of the authors and not necessarily the views of their clients or other attorneys in their firm.

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