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Legal Strategies for Debt Recovery when Abuse of the Legal Entity has Occurred
by Romelio Hernández
Disclaimer: The information in this article is not, nor is it intended to be legal advice. Our Law Office (HMH Legal) will only provided legal advice after having entered into an attorney client relationship. It is imperative that any action you take be done on the advice of counsel, and not based solely upon this article.
Abuse and Disregard of the Legal Entity (i.e. corporation)
One of the main privileges of a legal entity is the limited liability it provides its shareholders or investors, who are not held responsible for any of the company’s obligations.
The abuse of this privilege generally takes place when one or more shareholders, or a controlling parent company, use the legal entity as an “alter ego” or puppet instrument to wrongfully and illegally conduct personal business or to defraud third parties for their own benefit, and to the detriment of their company.
This kind of fraud can take a number of forms:
- Significant under capitalization of the business entity
- Failure to observe the corporate formalities in terms of behavior and documentation
- Intermingling of assets of the corporation and the shareholder
- Treatment of the corporation’s assets as an individual’s own assets
- Siphoning of corporate funds by the dominant shareholder
- Non-functioning corporate officers and/or directors
- Concealment or misrepresentation of members
- Absence or inaccuracy of corporate records
- The corporation being used as a façade for the dominant shareholder’s personal dealings
- Failure to maintain arm’s length relationships with related entities
- Manipulation of assets or liabilities in order to concentrate them
In the case of a seller-buyer (creditor-debtor) relationship, abuse of the legal entity by the debtor can include:
- A shareholder or controlling party using the corporation to obtain goods or credit for their own personal interests
- Goods or other assets of the “abused” company being siphoned off or transferred to another company
- Commingling of the assets of several companies, making it impossible to identify the entity to which they belong
Many countries have already identified and addressed these problems of abuse and, consequently, have provided specific remedies, referred to as piercing of the corporate veil. Most of these remedies will tend to hold a shareholder, or any other controlling party, liable for the debts of the abused corporation. In such cases, the abused company is considered an alter ego of the real and controlling party.
Absence of “Alter Ego” Doctrine in Mexico
Problems related to the abuse of the legal entity are not uncommon in Mexico. The bigger problem is that the Mexican legal system has not yet specifically addressed these issues. Therefore, no explicit remedy in law (substantive, procedural, or case law) exists which allows a party to effectively recover due to a loss resulting from an abuse of the legal entity. As a result, any strategy and legal action to that effect will have to consider the use of general legal institutions designed to sanction civil fraud.
The following analysis will point out, and attempt to clarify, problems associated with the abuse of the legal entity in Mexico. I will also present and support alternative legal action as a remedy and strategy for debt recovery and punishment of debtors who have willingly participated in this fraudulent activity.
Mexican Corporations Act (Ley General de Sociedades Mercantiles)
The Mexican Corporations Act that governs all commercial corporations in Mexico ascribes “legal personality” to all corporations that properly follow the process of incorporation. Once the company’s charter is registered at a public registry, it is deemed that the company is a “legal personality”. As a result, all obligations incurred, or rights or benefits gained by the company will be attributed to the company only, not its shareholders. The Corporations Act provides that this “legal personality” will continue unless the corporate form is sanctioned and ruled null by a court with proper jurisdiction and after due process of law. Such a decision would only be made if the corporation is found to have an illegal purpose or habitually commits illegal acts.
The Act provides that a ruling of nullity will force the corporation into a liquidation process. However, it does not provide for any direct and personal liability of the shareholders or any other controlling parties for the company’s debts. The consequence is that any injured parties are impeded from taking any legal actions against the shareholders for acts apparently executed by and legally attributed to the corporation.
Impracticalities of Pursuing a Civil Action in Mexico for Abuse of Legal Entity
The remedies afforded by civil actions within the current legal system in Mexico are inadequate, impractical, and ineffective in dealing with and solving problems resulting from an abuse of legal entity.
In Mexico, an action brought against a party (such as the nullity action mentioned above) cannot be amended after contestation. Therefore, the defendant can easily transfer assets during the course of the case to another individual or company. Also, no pre-judgment attachment order is allowed. This provides the defendant the opportunity to bury the assets so deep that it is practically impossible to track them down.
Other aspects of Mexican civil law that inhibit a result in the creditor’s favor in cases of abuse of a legal entity include:
- Mexican rules do not allow the subpoena of documents before the formal action is filed.
- Rules derived from Mexico’s General Constitution prohibit authorities from molesting or perturbing any citizen from his property or rights without due process of law before a court. This requires a creditor to bring an action against every entity and all shareholders involved in the abuse.
- Judges are forbidden from redirecting an action against a third party if he was not the main defendant in the case.
- The General Corporations Act provides no sanctions for failing to: keep corporate records; make them public; liquidate a company when it ceases operations; or, report a state of insolvency or possible bankruptcy.
- It is easy to close down operations and create or incorporate new companies, and then transfer the money from the first to the next.
All of the above actually work to motivate shareholders of Mexican corporations to participate in this fraudulent behavior.
Strategies in Mexico for Punishing Abuse of the Legal Entity
Many times in Mexico the only option for relief in these situations is through a criminal course of action – providing the acts of the debtor constitute a crime as defined under the state or federal criminal codes. The results might be prison for the perpetrator or, hopefully, relief for the injured parties by allowing a restitution incidental action for damages within the same criminal case.
Whether specific monetary relief is available, or a prison sanction, our opinion is that a criminal course of action is a better alternative than civil action.
General allegations of abuse of the legal or corporate entity are not included in the criminal code per se. Therefore, a thorough analysis by the plaintiff’s attorney will be necessary to determine if the particular abuse of the corporate entity constitutes a crime in Mexico. If it does, it will generally fall under crimes of fraud under the Mexican Penal Code. These include:
- Generic Fraud. Fraud is committed when someone, deceiving another or taking advantage of an error, illegally takes a thing or reaches a wrongful profit. The penalty is 3-12 years in prison and about USD 2,550.
- Specific Fraud for Endorsement of Documents. This Rule states that the same sanctions for general fraud will be imposed on anyone who obtains money or any other earnings or gain, through the issuance or endorsement of a title document against an “apparent” person, or someone else whom the issuer knows will not pay.
- Specific Fraud for Simulation. The same sanctions for fraud will be made on those who simulate a contract, an act, or a judicial petition with injury to another or to obtain any wrongful benefit.
- Specific Fraud for Transfer or Sale of a Commercial Establishment (Commingling of Assets between Companies). The same sanctions for fraud are imposed on those who sell or transfer a negotiation without authorization from its creditors, or without any guarantee of payment of those credits by the assignee, as long as those credits are unpaid and owed. Furthermore, when the transfer is made by a legal entity (corporation), the responsible parties will be those individuals that have “authorized” such transfer, as well as principals.
- Specific Fraud for Intentional Insolvency. Prison sanction ranging from six months to four years on those who intentionally put themselves into a state of insolvency for the purpose of avoiding their creditors.
The next two crimes that can apply to this situation are provided for under the Insolvency Proceedings Act.
- Aggravated Insolvency by Intentional Acts. A businessman who formally declares a state of insolvency through a final judgment, will be sanctioned with a prison sentence of one to nine years, for any intentional act of conduct that causes or aggravates the generalized default in the performance of the company’s obligations. Unless proof to the contrary is presented, it will be presumed that the businessman has caused or intentionally aggravated the generalized default in the performance of its obligations when his accounting documentation does not meet the proper form necessary to allow uncovering its real financial situation, or when it is altered, forged or destroyed.
- Failure of Exhibiting Requested Documents. The businessman against whom an insolvency proceeding is scheduled will be sanctioned with a prison sentence of one to three years, when he refrains from providing or exhibiting his accounting books within the term granted by the insolvency court after a formal request during insolvency proceedings, unless the businessman proves that it was impossible to present such documentation for causes beyond his control.
Problems of abuse of the corporate entity are common in Mexico. However, there are no specific remedies in Mexican Civil Law that adequately and effectively provide relief to those injured or defrauded.
Absent an adequate remedy in civil law, the creditor must look for alternative ways to obtain relief. One way is to explore the specific acts of abuse to determine if these are considered a crime in the jurisdiction where the events took place.
Romelio Hernández is president and director of litigation for HMH Legal. Based in Tijuana, Baja California, Romelio works extensively with foreign exporting companies and collection agencies, assisting with their out-of-court and legal collection efforts throughout Mexico. He provides guidance and general counsel to foreign companies in mitigating the various risks of selling internationally. Romelio is a member of the CLLA, the International Bar Association, the OtayMesa Chamber of Commerce, and Rotary. He is a graduate of Universidad Autonómade Baja California, and was admitted to practice law in Mexico in 1997.
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