Theories of Liability Against Principals of Debtor

All too often, businesses cease operating, leaving creditors with little or no ability to

collect on their debts. Fortunate creditors may have collateral or personal guaranties

signed by a person or entity that is not judgment-proof. For the vast majority of creditors,

however, their recourse is limited to collecting from the failed business. Especially

where the amount owed is significant, creditors will want to consider ways that they

might collect from—or credibly threaten collection from—the debtor’s principals.

These materials will explore eight theories under which principals of a debtor may be

held liable on trade debt, absent an express contractual undertaking on their part to pay

the debt. They are: failure to designate representative capacity, piercing the corporate

veil, breach of fiduciary duty, deepening insolvency, fraudulent transfers, excessive

salaries, illegal dividends and insider preferences.

Under certain forms of business the owners are liable anyway for all of the business’s

debts. These will be explored first, followed by the eight theories of liability noted

above.

Business Forms

The principal forms of business and the nature and extent of the liability of their

owners are as follows:

Sole Proprietorship. A business owned by an individual. The individual owns or leases

the business’s assets and is liable for all of its debts.

General Partnership. A business owned by two or more persons or other entities not as a

corporation or other limited liability entity. The partnership owns or leases the assets and

is liable for the debts. The partners do not own the assets but are liable for all of the

debts, absent an agreement with the creditor to the contrary. Partnership law is governed

in most states by the Uniform Partnership Act.

Limited Partnership. This is the same as a general partnership except that all except one

of the partners can be limited partners. Limited partners are passive owners in a limited

partnership and are not liable for the partnership debt absent an agreement with the

Theories of Liability Against Principals of Debtor creditor to the contrary. General partners

manage the partnership business and are liable for the partnership debts. Limited partners can

be treated as general partners if they take an active role in the partnership’s management or if

they permit their name to be used in the partnership name. Where the limited partner’s name

appears in the partnership name the limited partner is liable to the creditor unless the creditor

has actual knowledge that the partner is a limited partner. Where liability is sought against a limited

partner because the limited partner plays an active role in management the limited partner can be

held liable if the creditor reasonably believed that the limited partner was a general partner.

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