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The Court noted this approach was consistent with Ninth Circuit law, rejecting the Defendant’s purported use of the “control test” and its reliance on the estates’ substantive consolidation for purposes of analyzing the transactions. The Defendant’s substantive consolidation argument makes this case an especially unique and interesting read.
The Bankruptcy Case and the Parties
The Debtors consist of several entities: Empire Land, LLC (“Empire Land”), Aviat Homes, L.P. (“Aviat”), Empire Construction, L.P. (“Empire Construction”), Empire Global Holdings, L.P. (“Empire Global”), Empire Residential Construction, L.P. (“ERC”), Empire Residential Sales, L.P. (“ERS”), Prestige Homes, L.P. (“Prestige”), and Wheeler Land, L.P. (“Wheeler”, and collectively, the “Debtors”). The cases began in chapter 11 in April 2008, converted to chapter 7 in December 2008, and were substantively consolidated in September 2009.
In May 2009, the Chapter 7 Trustee (“Plaintiff”) filed a complaint (as amended, the “Complaint”) under 11 U.S.C. § 548 and Cal. Civ. Code § 3439.04, against Empire Partners, Inc. (“Defendant”), who served as either the general partner or managing member for Empire Global, Aviat, Empire Construction and Empire Land. Until the chapter 7 conversion, James Previti (“Previti”) served as a director of Defendant and directly or indirectly controlled all of the legal and equitable interests of each of Empire Global, Empire Land, Aviat, Wheeler, ERC, ERS, Prestige, and Empire Construction. In pertinent part, the complaint alleged four fraudulent transfers under federal and state law in the amounts of (1) $9,667,000 (“$9.6M Transfer”), (2) $4,000,000 (“$4M Transfer”), (3) $2,500,000, and (4) $1,415,032.14 (“$1.4M Transfer”, and together with the $9.6M and $4M Transfers, the “Transfers”).
The Transfers allegedly at issue can be summarized as follows:
The Issues and Arguments – Does it matter if the estates were substantively consolidated?
Four issues were put before the Court by way of Defendant’s summary judgment pleadings, including whether: (1) Defendant was merely an initial transferee as to the Transfers; (2) Defendant had the intent to hinder, delay or defraud, as required by federal and state fraudulent transfer laws; (3) Defendant provided reasonably equivalent value to the Debtors in exchange for the Transfers; and (4) the Debtors were insolvent.
- Initial Transferee
The Court first addressed Defendant’s contention that it was not an initial transferee of the Transfers. As noted in prior Blog posts (see here), the Ninth Circuit “uses the dominion test to determine whether a party is an initial transferee or a mere conduit,” as detailed in Universal Serv. Admin. Co. v. Post–Confirmation Comm. (In re Incomnet, Inc.), 463 F.3d 1064, 1069 (9th Cir. 2006). Per Incomnet, the dominion test focuses on whether the recipient of funds has legal title to them and the ability to use them as he sees fit. In determining whether an entity has dominion over funds, courts have focused on whether the entity has a legal obligation with respect to the funds and whether it received the funds without any restrictions. The Court contrasted this with the “control” test used in other circuits, “where the entire transaction is viewed as a whole to determine who truly had control of the money.”
Applied here, the Court found that Plaintiff presented evidence that Empire Land and Empire Global made the $9.6M and $1.4M Transfers to Defendant – the former’s bank accounts and tax statements showed equivalent withdrawals and distributions, while Defendant’s accounts reflected the same in deposits. Noting that Defendant may have been the entity behind the transfers, there was a material issue of fact as to whether Defendant could use the funds as it saw fit.
Furthermore, the Court found Defendant’s argument that no transfers (as to the $9.6M and $4.0M Transfers) actually occurred to be unavailing at this stage. The Court found that there was evidence that $4M was recorded as a distribution from Empire Land to Defendant, while acknowledging Defendant’s evidence that the $4M was a recharacterization of a journal entry.
As to the $9.6M Transfer, Defendant argued that it was not a transfer because Defendant was only a conduit and the funds transferred were not diverted from being available to pay the Debtors other creditors, “as every dime that Defendant received ultimately went back to Debtors.” Defendant argued, on the basis of In re Parkway Calabasas, Ltd., 89 B.R. 832 (Bankr. C.D. Cal. 1988), that because the cases were substantively consolidated, the series of transactions should be examined at as a unit. The Court rejected that for several reasons: first, Calabasas dealt with an alleged fraudulent conveyance in a substantively consolidated case where one debtor paid the defendant for a another debtor’s debt – in the present case, the very nature of the transfer is disputed and neither party alleged the transfer was a debt payment; second, because the transfers were allegedly capital distributions, and not repayment of a debt, the Court reasoned multiple Debtors’ creditor bases may have been harmed; lastly, the Court found that Defendant was seeking to utilize the “control” test by viewing the series of transaction as a whole, which the Ninth Circuit does not follow.
2. Intent to Hinder, Delay or Defraud
Defendant further contested that there was any sign of an actual fraudulent transfer. In analyzing the Transfers, the Court relied on the “badges of fraud” identified by the Ninth Circuit and statutory law as indicia of fraudulent intent at the time of a transfer. Those include “(1) actual or threatened litigation against the debtor; (2) a purported transfer of all or substantially all of the debtor’s property; (3) insolvency or other unmanageable indebtedness on the part of the debtor; (4) a special relationship between the debtor and the transferee; and, after the transfer, (5) retention by the debtor of the property involved in the putative transfer.”
Here, the Court found no evidence of actual or threatened litigation against Empire Land or that Empire Land retained possession or control of the funds, but did note Plaintiff’s evidence of Empire Land’s insolvency at the time of the Transfers; a special relationship between Empire Land and Defendant; and that the Transfers occurred shortly before substantial debt was incurred. This was sufficient to raise a disputed fact that warranted denial of summary judgment.
3. Reasonably Equivalent Value
Again relying on the substantive consolidation of the estates, Defendant argued that Plaintiff could not prove that the Debtors did not receive reasonably equivalent value for the transfers, as Defendant immediately gave the $9.6M Transfer to Aviat (Empire Land’s substantively consolidated co-debtor), which Defendant alleges was part of a series of inter-company loans. With respect to the $4M Transfer, Defendant argued that the ledger entries were reversed at the same instant, so that whatever theoretical “value” was transferred went first in one direction and then the next instant reversed and immediately flowed back, resulting in, if anything, an exchange of identical value. As to the $1.4M Transfer, the Note received by Defendant was ultimately given to Empire Land (Empire Global’s substantively consolidated co-debtor).
The Court found that without conclusively determining the proper characterization of the Transfers (inter-company loans or distributions), a disputed fact existed as to whether reasonably equivalent value was exchanged.
Defendant also contested the methodology of Plaintiff’s experts with respect to insolvency. Specifically, Defendant objected because the expert examined the insolvency of certain Debtors on an individual basis instead of all Debtors on a consolidated basis (again referring back to the substantive consolidation order). The Court was “unpersuaded by Defendant’s argument that Plaintiff must establish the insolvency of the Debtors on a substantively consolidated basis versus an entity by entity basis”, and in any event, “Defendant has not provided any legal authority in its papers to support this position.” Plaintiff cited to Total Technical Servs., Inc. v. Whitworth, 150 B.R. 893 (Bankr. D. Del. 1993) for the proposition that the Court should only examine the insolvency of the debtor who made the alleged transfers. As such, the Court again found an issue of triable fact that warranted denial of summary judgment.
Defendant’s heavy reliance on the issue of substantively consolidated estates and its inherent conflict with the Ninth Circuit’s “dominion” test make this a case to keep an eye on. Arguably, the argument could be better received in a “control” jurisdiction, where a more comprehensive picture of a fraudulent transfer is encouraged. Ultimately, the substance of the subject consolidation order would prove critical to any analysis, specifically whether there are findings that the debtors “were treated on a consolidated basis during the period in question (i.e. the time in which the transfers at issue were made).” Empire, 2016 WL 1391297 at *10 (citing Total, 150 B.R. at 900); see Cissell v. First Nat’l Bank, 476 F.Supp. 474, 479 (S.D. Ohio 1979) (court found that the parties had treated the debtors as a consolidated unit during the period in question, and thus examined the insolvency of the debtors on a consolidated basis)).
For another case utilizing the “dominion” test, see the Blog post relating to Goldstein v. Wilmington Savings Fund Society (In re Universal Marketing, Inc.), 541 B.R. 259 (Bankr. E.D. Pa. 2015) as summarized here.
A copy of the Empire Memorandum Decision can be found here.
The matter was remanded from the United States District Court for the District of Delaware (the “District Court”) on appeal of the Court’s July 17, 2013 Order (the “Order”) granting judgment in favor of the Trustee’s Complaint to avoid and recover preferential transfers against Prudential.
On November 25, 2008, AE Liquidation, Inc., EIRB Liquidation, Inc., and Eclipse Aviation Corporation filed for voluntary relief under chapter 11 of the Bankruptcy Code. On March 5, 2009, the case was converted to chapter 7 and the Trustee was appointed. On November 23, 2010, the Trustee filed a Complaint against Prudential asserting that certain pre-petition transfers were preferential and avoidable under § 547(b) of the Bankruptcy Code. On July 17, 2013, the Court entered the Order finding: (i) $781,702.61 of pre-petition transfers to Prudential were preferential; (ii) Prudential had a new value defense totaling $128,379.40; and (iii) the Trustee was not entitled to prejudgment interest. On appeal, the District Court remanded the matter for the Court to reconsider: (i) the amount of Prudential’s new value defense; and (ii) whether the Trustee was entitled to prejudgment interest.*
*A blog post on this earlier opinion was published on December 1, 2015, available here.
The Trustee argued that $71,808.83 of the new value defense was not eligible for new value credit because it related to post-petition services. Prudential responded that the post-petition invoices were prepared solely to support its proof of claim and did not reflect the actual date the underlying services were performed. Prudential also claimed the Trustee waived the argument by failing to raise it until post-trial briefing. The Court found that the testimony of Prudential’s Director of Accounting was contrary to Prudential’s assertions and that the District Court already rejected Prudential’s waiver argument. Accordingly, the Court reduced Prudential’s new value defense to $56,571.37, to reflect only services provided pre-petition.
With regard to prejudgment interest, the Trustee argued that the estate should be able to recover prejudgment interest beginning on the date the last preferential transfer was made. Prudential contended that the Court reasonably exercised its discretion in denying prejudgment interest in the Order. In granting prejudgment interest, the Court relied on the decision in Peltz v. Worldnet Corp. (In re USN Communications., Inc.), 280 B.R. 573, 602 (Bankr. D. Del. 2002), for the proposition that prejudgment interest is routinely granted in avoidance actions. The Court disagreed, however, with the amount of prejudgment interest sought by the Trustee. Relying again on USN Communications, the Court held that the prejudgment interest should be calculated from the date the action was commenced, not the date of the last avoidable transfer; further, the Court found that the appropriate rate for prejudgment interest is the federal judgment interest rate, for the calendar week preceding the filing date of the Complaint. Therefore, the Court awarded the Trustee $5,186.97 in prejudgment interest.
A copy of the Court’s opinion is available here.
In Forman v. Moran Towing Corp. (In re AES Thames, LLC, et al.), Adv. No. 13-50394 (KJC) (Bankr. D. Del. Mar. 3, 2016), the Court found that a holistic view of the parties’ relationship mitigated the apparent lateness of the subject Transfers (as defined below), such that they were in fact made in the ordinary course of business. This represents one of Judge Carey’s first opinions regarding 547(c)(2) since his 2010 In re Pillowtex decision.
Given the frequency with which ordinary course issues arise in preference litigation and the ever nuanced application of the doctrine, this is a unique and useful decision for those representing defendants.
The Bankruptcy Case, the Parties’ Background, and the Transfers
The facts of this adversary proceeding were stipulated to in a joint pretrial memorandum. Prior to the Petition Date (February 1, 2011), the Debtor at issue here had operated a coal-fired power plant. In 2004, the Debtor entered into a Transportation Agreement (the “Agreement’) with Moran Towing Corporation (“Defendant”), under which Defendant agreed to provide marine services to transport coal by vessel or barge to the Debtor’s facility.
During the period between July 16, 2007 and September 22, 2010 (the “Historical Period”), Defendant invoiced the Debtor; between October 5, 2010 and November 16, 2010, Defendant sent eight invoices (the “Invoices”) to the Debtor, five of which were due on November 26, 2010, and three were due on December 26, 2010. Notwithstanding, the Debtor paid the former batch on December 15, 2010 (19 days late) and the latter batch on January 6, 2011 (10 days late); it was these two batches of transfers (collectively, the “Transfers”) which the Plaintiff-Trustee later sought to claw back through the instant action.
Traits of the Transfers vs. Historical Practice
The Court recited the following comparison between the Parties’ practices during the Historical and Preference Periods:
|Lateness: -28 days (i.e. 28 days early) to 35 days after Agreement Due Date, or 2.45 avg days late||Lateness: 10-19 days after Agreement Due Date, or 15.63 avg days late|
|Payment Amounts: ~$42K to ~$138K||Payment Amounts: ~$69K to ~ $123K|
|Number of invoices paid by one payment: one to eight||Number of invoices paid by one payment: three to five|
|Payment Method: wire||Payment Method: wire|
The Court’s Analytical Framework
Citing to Judge Sontchi’s (Bankr. D. Del.) Burtch v. Texstars, Inc. (In re AE Liquidation, Inc.), Adv. No. 10-55502, 2013 WL 5488476 (Bankr. D. Del. Oct. 2, 2013) (which in turn cites the Third Circuit’s 1999 SEC v. First Jersey Sec., Inc., 180 F.3d 504 decision), the Court referenced the following factors in analyzing 547(c)(2) defenses:
(i) The length of time the parties engaged in the type of dealing at issue;
(ii) Whether the subject transfers were in an amount more than usually paid;
(iii) Whether the payments at issue were tendered in a manner different from previous payments;
(iv) Whether there appears to be an unusual action by the creditor or debtor to collect on or pay the debt; and
(v) Whether the creditor did anything to gain an advantage (such as obtain additional security) in light of the debtor’s deteriorating financial condition
Judge Carey further notes (and the present opinion underscores) that “no one factor is determinative [and] the Court should consider the parties’ relationship in its entirety.” Indeed, he cites (i) Judge Robinson’s (D. Del.) Forklift Liquidating Trust v. Clark-Hurth (In re Forklift LP Corp.), Case No. 02-1073, 2006 WL 2042979 (D. Del. Jul. 20, 2006), (ii) Judge Sontchi’s Burtch v. Prudential Real Estate and Relocation Services, Inc. (In re AE Liquidation, Inc.), Adv. No. 10-55543, 2013 WL 3778141 (Bankr. D. Del. Jul. 17, 2013), and (iii) Judge Walsh’s Radnor Holdings Corp. v. PPT Consulting, LLC (In re Radnor), Adv. No. 08-51184, 2009 WL 2004226 (Bankr. D. Del. Jul. 9, 2009), for the position that “[c]ourts have determined that the timing of payments along with some other factor prevent application of ordinary course of business defense.”
The Parties’ Positions
The Parties disagreed on how to compute the timing of the payments. The Trustee argued that it was appropriate to analyze only whether the Debtor consistently paid Defendant on the Due Date specified in the Agreement, or the degree of lateness thereafter; Defendant’s preferred approach – i.e., measuring from cargo load date to payment, or from invoice date to payment – would not reflect whether the payments were timely or whether there was a consistency to the payments.
The Trustee further argued that the average days late in the Historical Period (2.45 days after the Due Date) clearly contrasted with that in the Preference Period (15.63 days after the Due Date), and that only 4 of 164 invoices (2.44%) in the Historical Period were paid 10 days or later after the Due Date. Thus, the Transfers did not conform to more than 97% of Historical Period payments, although Defendant responds that the Preference Period lateness range (10-19 days) is actually well within the Historical Period lateness range (-28-35 days).
The Court’s Holding – Does lateness alone take a payment out of the ordinary course?
Initially, the Court found that the Historical Period’s three years were sufficient to establish an ordinary course of dealings. Moreover, the Parties stipulated that Defendant took no unusual action to collect on the Invoices. Thus, before the Court was strictly a matter of determining whether the Transfers were similar to those made during the Historical Period – i.e., pitting Trustee’s average payment reliance against Defendant’s range of payment statistics.
Judge Carey held that notwithstanding timing’s importance, it “does not portray the complete picture”, quoting from Judge Sontchi’s Sass v. Vector Consulting, Inc. (In re American Home Mortgage Holdings, Inc.), 476 B.R. 124, 138 (Bankr. D. Del. 2012). As such, the Court found that a late payment of 10 or 19 days was not unprecedented in the parties’ relationship. Moreover, the Court found that the Transfer amounts fell within the Historical Period amount range; the Transfers paid multiple invoices together, just as the Debtor had done historically; payments were always made by wire; and there was no attempt by Defendant to gain an advantage over other creditors during the Preference Period. Ergo, the difference in payment timing, “without more, . . . should [not] preclude application of the ordinary course of business defense.”
While the Court stressed that the instant opinion was specific to these “unique circumstances”, it is nonetheless noteworthy that an otherwise “ordinary” relationship can potentially trump a relatively large deviation in average days to pay. One wonders what difference it would have made had the Transfers in this case been made substantially earlier in the Preference Period, as opposed to later, which some courts have noted is a pertinent distinction. It is also questionable whether the Court will always look for another factor to pair with average lateness, or if it would have been determinative had the deviation been twice or three times as large.
A copy of the memorandum order can be found here.
The Complaint, predicated on the fraudulent transfer provisions of 11 U.S.C. § 548 and Delaware’s own fraudulent transfer provision in 6 Del. C. § 1304, contained sufficient “badges of fraud” for the Court to draw the “reasonable inference [that] the Debtors incurred the subject obligations (the “Obligations”) with the actual intent to delay, hinder, or defraud” within the meaning of either statute.
In varying degrees, the Court touches upon the “collapsing doctrine”, the good faith exception under 11 U.S.C. § 548(c), and the imputation of the Debtors’ officers, directors, and shareholders’ fraudulent intent to the Debtors. It is notable that, with respect to the last point, several of the subject officers, directors, and shareholders were also officers, directors, and/or shareholders of Taiwan Kolin Co., Ltd. (“Kolin”, the overlapping individuals referred to as the “Kolin Faction”), a company with whom the Debtors orchestrated their purportedly fraudulent scheme.
History of the Debtors, Management Structure, and the Alleged Fraudulent Scheme
The instant memorandum order does not delve into the facts in explicit detail, as they have been detailed in three prior opinions: (i) SB Liquidation Trust v. Preferred Bank (In re Syntax-Brillian Corp.), Case No. 08-11407 (BLS), 2011 WL 3101809 (Bankr. D. Del. July 25, 2011) (“Bankruptcy Opinion I”); (ii) SB Liquidation Trust v. Preferred Bank (In re Syntax-Brillian Corp.), Case No. 08-11407 (BLS), 2013 WL 153831 (Bankr. D. Del. Jan. 15, 2013) (“Bankruptcy Opinion II”); and (iii) SB Liquidation Trust v. Preferred Bank (In re Syntax-Brillian Corp.), 573 F. App’x 154 (3d Cir. 2014) (the “Third Circuit Opinion”, and together with Bankruptcy Opinions I and II, the “Prior Opinions”). As such, a bit of context from those earlier cases is helpful for understanding the latest one; the following facts are taken from the Third Circuit Opinion.
Syntax Groups Corporation (“Syntax”) was a California corporation that distributed electronic products to United States consumers. Several Syntax officers and directors were also officers, directors, and/or shareholders of Kolin – aka the Kolin Faction. In 2004, Syntax entered into a manufacturing agreement with Kolin, which provided that Syntax would import HD TVs manufactured by Kolin. The Plaintiff-Trust (“Plaintiff”) avers that this agreement was intended to enhance Kolin’s financing options and artificially inflate its sales revenue, thereby improving its creditworthiness; moreover, Plaintiff alleges that Syntax simultaneously entered into incentive agreements with Kolin, which allowed Kolin to systematically over-charge Syntax, while periodically providing Syntax with price protection’ rebates to lessen the impact on Syntax’s financial statements.
Syntax and Defendant commenced a business relationship in November 2004, when they entered into a $3.75 million loan agreement, which was guaranteed by members of the Kolin Faction. Defendant also provided letters of credit and “trust receipt” loans to Syntax, which Syntax used to acquire inventory from Kolin. Plaintiff contends that, over time, as Kolin continued to overcharge Syntax, the proceeds of Syntax’s sales were insufficient to repay the debt owed to Defendant. Syntax’s debt to Defendant thus grew, and, as a result, the loan agreement between Syntax and Defendant was amended to increase the principal loan and credit maximums several times.
Syntax and Brillian Corporation (“Brillian”) merged in November of 2005. Pursuant to this merger, Syntax became a wholly owned subsidiary of Brillian, and Brillian changed its name to Syntax-Brillian Corporation (“Debtor”, or together with its affiliated debtors, the “Debtors”). Plaintiff maintains that the Kolin Faction devised this merger in order to raise additional funds for Kolin by expanding Syntax’s access to U.S. markets.
The Bankruptcy Case, the Adversary Proceeding, and the Prior Opinions
Ultimately, the Debtor filed for relief under Chapter 11 of the Bankruptcy Code in July 2008. The instant adversary suit was filed in July 2010, by which Plaintiff contended that, by providing financing to Syntax and the Debtor, Defendant enabled the Kolin Faction’s fraud and delayed the Debtor’s ultimate demise, thus allowing the Kolin Faction to divert millions of dollars away from the Debtor’s creditors. In its original complaint, Plaintiff asserted four causes of action against Defendant, including ones for actual and constructive fraud under 11 U.S.C. §§ 548(a)(1)(A), (B) and 544(b), and 6 Del. C. §§ 1304(a)(1), (2) and 1305. Defendant moved to dismiss.
In Bankruptcy Opinion I, Chief Judge Shannon dismissed the complaint, finding that Plaintiff did not allege sufficient facts to show that Defendant actually or constructively knew of the ongoing fraud. The Court found that such failure was fatal because Plaintiff’s fraudulent transfer claims hinged on the “collapsing doctrine” – an equitable tool whereby a court can collapse multiple transactions and consider the overall financial consequences of the transactions, but which also requires a showing of the transferee’s knowledge of the fraudulent scheme. Plaintiff sought reconsideration of Bankruptcy Opinion I based on newly discovered evidence, but the Court denied the motion for the reasons promulgated in Bankruptcy Opinion II – primarily that Plaintiff failed to show that the new evidence (which stemmed from a concurrently filed United States Securities and Exchange Commission complaint) would have changed the Court’s disposition.
Plaintiff appealed both Bankruptcy Opinions directly to the Third Circuit, which affirmed in part and vacated in part Bankruptcy Opinion I, and affirmed Bankruptcy Opinion II. As detailed in the Third Circuit Opinion, the court concluded that the relevant statutes only require Plaintiff to allege the intent of the Debtors – i.e., Plaintiff did not have to aver knowledge of the Debtor’s fraudulent intent on the part of Defendant. On remand, the Third Circuit tasked the Bankruptcy Court with determining whether Plaintiff sufficiently alleged actual fraud under the heightened pleading standard of Rule 9(b) of the Federal Rules of Civil Procedure (“FRCP”).
The Complaint and its Amended Allegations
Following the Third Circuit Opinion, Plaintiff filed the Complaint, which asserts three counts against Defendant: (i) avoidance of the Kolin Secured Line Obligations, the Note 204615 Obligations, the December 2006 Line 202359 Obligation, and the September 2007 Line 202359 Obligations (collectively, the “Obligations”), on the basis that they were incurred with the actual intent to delay, hinder, or defraud under 11 U.S.C. §§ 548(a)(1)(A) and 544(b), and applicable state law; (ii) avoidance of the Kolin Secured Line Principal Transfer and the Line 202359 Payoff Transfer (collectively, the “Transfers”); and (iii) recovery of the Transfers under 11 U.S.C. 550.
The Third Circuit Opinion provides pertinent detail about the alleged Obligations to Defendant incurred by Syntax or the Debtor, and concomitant payments made by the same to Defendant:
- Kolin Secured Line: alleged to have been used by the Debtor to borrow money from Defendant and funnel the money to Kolin through Loan 204159 and/or Line 192882341 which were secured by a series of bank accounts that Kolin maintained at Defendant. These obligations total $38,800,000, and interest and principal repayments on that line of credit amounted to $29,106,962.42.
- Note 204615: Syntax and the Debtor allegedly funneled $4 million to Kolin as part of the Kolin Faction’s scheme. These obligations total $4 million plus the interest payments of $274,444.40.
- Line 202359: The Debtor allegedly used this line of credit to transfer to Kolin $31 million in December 2006; Plaintiff asserts that the Debtor purported to justify this transfer as payment on invoices issued by Kolin to SBC for phony “tooling” expenses and fictitious sales of television sets. Plaintiff alleges that the Debtor again used Line 202359 in September 2007 to transfer to Kolin an additional $15 million. These transfers were also purportedly justified by fraudulent payables by the Debtor to Kolin. Plaintiff asserts that both the obligations under Line 202359 as well as interest payments on the line totaling over $3.5 million should be set aside.
As summarized by the Third Circuit, the “gist of [Plaintiff’s] claims is that [the Debtor] entered into financing with [Defendant] to siphon money to Kolin.”
The Motion to Dismiss (“MTD”) and the Parties’ Arguments
Defendant sought to dismiss the Complaint under FRCP 12(b)(6), pointing to the lack of direct evidence of fraud or the presence of any badges of fraud. Moreover, Defendant argues that the Obligations could not be fraudulent conveyances because they could not, in and of themselves, cause damage to the Debtors’ creditors, as they were payments towards fully secured obligations. Defendant also asserts that it gave value in good faith within the meaning of 11 U.S.C. § 548(c).
In response, Plaintiff again sought to use the “collapsing doctrine”, and collapse the Obligations into one transaction so that the Court could consider the outgoing transfers to Kolin. Plaintiff further alleged that the Debtors knew to a substantial certainty that incurring the Obligations would have the consequence of hindering, delaying, or defrauding its creditors, and that the Kolin Faction’s knowledge of said harm should be imputed to the Debtors because of the members of the Kolin Faction serving as directors and officers of the Debtors. This is so because, inter alia, the Kolin Faction had the power to cause the Debtors to enter into the Obligations, generate fake “credit memos” that purported to represent various credits Kolin gave the Debtors, and significantly benefit from the Debtors’ under-cost selling.
The Court’s Memorandum Order
The Collapsing Doctrine Foreclosed by the Law of the Case; Good Faith Irrelevant
The Court began by disposing of certain arguments proffered by the parties in support of their respective frameworks. As an initial matter, the Court found that Plaintiff’s use of the “collapsing doctrine” was foreclosed by Bankruptcy Opinion I as a result of another doctrine – the law of the case. That doctrine prohibits a plaintiff from re-litigating the same issue in the same case. The Court stated that the Third Circuit, because it agreed with Plaintiff’s argument that fraudulent transfer claims only require evidence of the Debtors’ intent, did not consider or disturb the Court’s conclusion that the Collapsing Doctrine could not apply.
As to Defendant’s section 548(c) “good faith” defense, the Court declined to consider it on the basis that it is an affirmative defense. As such, Plaintiff does not have to allege that Defendant lacked good faith; rather, Defendant must plead and establish facts to prove the defense, but only after Plaintiff meets its evidentiary burden of proving a prima facie case. Thus, it was inappropriate to consider section 548(c) at the motion to dismiss stage.
Delaware’s Fraudulent Intent Framework: Badges of Fraud and the Natural Consequences Standard
Moving to the merits, the Court analyzed the MTD under the Third Circuit’s Fowler v. UPMC Shadyside, 578 F.3d 203 (3d Cir. 2009) opinion (a case also discussed in this blog’s previous post on Judge Sontchi’s (Bankr. D. Del.) opinion in In re MCG Limited Partnership, available here). Chief Judge Shannon also cited to one of his prior opinions in Official Comm. of Unsecured Creditors of Fedders N. Am., Inc. v. Goldman Sachs Credit Partners (In re Fedders N. Am., Inc.), 405 B.R. 527 (Bankr. D. Del. 2009), for the proposition that “[in] bankruptcy, the heightened pleading standard under Rule 9(b) is relaxed and interpreted liberally where a trustee, or a trust formed for the benefit of creditors is asserting the fraudulent transfer claims.”
With respect to 11 U.S.C. § 548(a)(1)(A) and 6 Del. C. § 1304(a)(1), the Court noted the actual intent requirement in both statutes required a showing of at least one of the three requisite states of mind – intent to hinder, intent to delay, or intent to defraud. He then again referred to his Fedders opinion to state that the requisite intent may be demonstrated circumstantially with “badges of fraud”. As provided in the District of Delaware’s In re Hechinger Inv. Co. of Del, Inc., 327 B.R. 537 (D. Del. 2005) opinion, the Court enumerated a non-exclusive list of “badges”: (1) the relationship between the debtor and the transferee; (2) consideration for conveyance; (3) insolvency or indebtedness of the debtors; (4) how much of the debtor’s estate was transferred; (5) reservation of benefits, control or dominion by the debtor; and (6) secrecy or concealment of the transaction. The Court noted that the “badges” analysis is not a “check-the-box” inquiry and provides only a basic rubric, requiring courts to examine the totality of the circumstances to determine whether fraudulent intent exists.
Applied here, the Court could “reasonably infer based on the relative positions of the Kolin Faction members within the Debtors’ organization that they had the power to cause the Debtors to incur the Obligations”, and as a result, would impute the intent of those individuals to the Debtors. The Court found that the Obligations were incurred while the Debtors not only had negative income and gross margins, but also will the Kolin Faction was in the midst of generating fake credit memos and sales. The Court also noted Seventh Circuit’s “Natural Consequences” standard, in which the “Debtors are presumed to intend the natural consequences of their acts”, and the natural consequence of incurring the Obligations would, at a minimum, delay or hinder distributions to the creditor body. Combined with the badge of fraud that the Debtors were insolvent at the time the Obligations were incurred, the Court found both the bankruptcy and Delaware statutes satisfied for purposed of defeating a motion to dismiss.
Note: for a comparison on the “Natural Consequences” standard, see the blog’s Lyondell post here for the Southern District of New York’s discussion.
Given that Count II (avoidance of the Transfers) is predicated on the avoidance of the Obligations in Count I, the Court found that if Plaintiff was successful as to Count I, then by operation of law, any security interests held by Defendant are retroactively nullified; conversely, if the Court found the Obligations were not fraudulently incurred, then their repayment does not harm creditors. As such, Count II could not be dismissed while Count I survived. For similar reasons, the MTD as to Count III (recovery of the transfers) was also denied.
Like the three prior opinions that this case has spawned, the instant memorandum order provides sound guidance for attorneys handling fraudulent transfer actions. It offers good examples of the allegations and level of detail necessary for an actual fraud claim to survive a motion to dismiss (here, one “badge of fraud” to go with the totality of circumstances at the time). This order is also useful for its discussion of the law of the case doctrine, the collapsing doctrine, the timing of good faith/548(c) at the motion to dismiss stage, and the imputation of officers/directors’ intent to a debtor entity. To the last point, and as noted above, it is worth the reader’s time to compare the conclusions reached here regarding fraudulent intent with those in the Southern District of New York’s Lyondell progeny of cases, posts about which are available here and here.
A copy of the memorandum order can be found here.
In Giuliano v. Haskett (In re MCG Limited Partnership), Adv. Pro. No. 14-50536 (CSS), 2016 WL 362990, at *1 (Bankr. D. Del. Jan. 28, 2016), the Court found that (1) the Defendant’s mere denial – even when presented by sworn declaration – of proper service by the Plaintiff-Trustee (“Plaintiff” or “Trustee”) was insufficient for purposes of a motion to dismiss under 12(b)(5); and (2) Twombly, Iqbal, and the Third Circuit’s subsequent Fowler decision all require that the Plaintiff-Trustee allege more than just whom the transfer was made to, the dates of the transfer, and the amount. Given the volume of avoidance actions the District of Delaware continues to see, it is an opinion practitioners in that jurisdiction need to be aware of.
The Bankruptcy and Adversary Cases
MCG Limited Partnership, et al. (the “Debtors”), a global consulting firm at one time, filed their cases under Chapter 11 in November 2012, but by August 2013 had converted to Chapter 7. Thereafter, the appointed Chapter 7 Trustee sought and obtained entry of a procedures order (the “Order”) governing the mechanics of various preference actions that he was pursuing on behalf of the estate, including the instant proceeding.
In August 2014, the Trustee filed the complaint (“Complaint”) against Defendant, seeking to avoid and recover a single payment to Defendant (the “Transfer”) pursuant to 11 U.S.C. §§ 547 and 550, and disallow claims under 11 U.S.C. § 502(d). Trustee served Defendant by mailing the Defendant at the same address at which he allegedly received the Transfer, and the same address the Trustee would later use to serve the procedures motion and corresponding Order. Defendant responded with a Motion to Dismiss (“MTD”) on grounds of deficient process, insufficiency of service of process, and failure to state a claim upon which relief can be granted, pursuant to Federal Rules of Civil Procedure (“FRCP”) 12(b)(4), (5), and (6) respectively.
FRCP 12(b)(4) and 12(b)(5) – Sworn Denial is Not Enough
Defendant argued that under FRCP 12(b)(5), the Trustee needed and failed to allege the “location of Defendant’s dwelling house, his usual place of abode, or the physical address where Defendant regularly conducts business”; in support, Defendant submitted a sworn declaration stating that the address on the Summons and Complaint was none of these places and as such, did not receive a copy of the pleadings. Further, Defendant argued that FRCP 12(b)(4) isn’t met, given that the summons fails to state the date, time, and place for the pre-trial conference.
The Trustee argued in response that the Order permitted the abrogation of the pre-trial requirements, and that the MTD showed that Defendant received actual notice of the Complaint and timely filed a response. The Trustee also pointed out that Defendant had knowledge of the instant proceedings for at least six months, as his prior counsel had previously contacted Trustee’s counsel in an attempt to resolve the matter.
The Court found in the Trustee’s favor on this point. First, the Court noted that a plaintiff has the burden of proof to show proper service by a preponderance of evidence; a defendant may then rebut a plaintiff’s prima facie case as to adequacy of service of process by providing “sufficient evidence”, at which time the burden shifts back to plaintiff. Citing and using the rationale provided in Garcia v. Cantu, 363 B.R. 503 (Barnkr. W.D. Tex. 2006), the Court found that “mere denial that the address is incorrect, even in a sworn affidavit, is generally insufficient for challenging service.” The Court found it important that the Complaint was sent to the same address to which the Transfer was sent – a check that was ultimately negotiated. Further, the Court agreed that the MTD and the parties’ pre-Complaint negotiations evidenced Defendant’s awareness and actual notice of the Complaint.
As to Defendant’s FRCP 12(b)(4) argument, the Court found that the Order governed the necessity (or lack thereof) of providing pre-trial conference details.
Thus, the MTD’s 12(b)(4) and (5) grounds were rejected.
What does Twombly, Iqbal, and Fowler require for a Preference Complaint?
Defendant also argued that FRCP 12(b)(6) warranted dismissal of the Complaint. Specifically, he argued that the Complaint fails to describe with particularity the business relationship between the Debtors and Defendant, as well as what gave rise to the antecedent debt. Defendant argued that the Trustee alleged “prior contractual obligations” as the basis of the debt, and no contract was attached. The Trustee responded and described that the elements of 11 U.S.C. § 547 were met.
The Court found for Defendant. After citing Ashcroft v. Iqbal, 556 U.S. 662 (2009) and Bell Atlantic v. Twombly, 550 U.S. 544, 570 (2007) for the proposition that threadbare recitals of the elements of a cause of action and conclusory statements were insufficient to meet the heightened pleadings standard, Judge Sontchi found that Fowler v. UPMC Shadyside, 578 F.3d 203 (3d Cir. 2009) governed the analysis here. Under Fowler, a two-part test must be applied in evaluating a complaint. – first, the court “must accept all of the complaint’s well-pleaded facts as true, but may disregard any legal conclusions”; second, the court must determine “whether the facts alleged in the complaint are sufficient to show that the plaintiff has a ‘plausible claim for relief”.
For preferential transfer complaints in particular, the Court referred back to the mandates of Valley Media, Inc., v. Borders, Inc. (In re Valley Media, Inc.), 288 B.R. 189 (Bankr. D. Del. 2007) and Miller v. Mitsubishi Digital Elecs. Am. Inc. (In re Tweeter Opco), 452 B.R. 150 (Bankr. D. Del. 2011). The Valley Media decision, issued by former Judge Walsh, provides that preference complaints should include the following: (a) an identification of the nature and amount of each antecedent debt and; (b) an identification of each alleged preference transfer by (i) date, (ii) name of debtor/transferor, (iii) name of transferee and (iv) the amount of the transfer. The later Tweeter decision, issued by Judge Walrath, endorsed Valley Media, adding the complaint must plead particularized facts alleging the nature of the contractual or other business relationship between the preference defendant and debtor which give rise to the antecedent debt.
Applying that framework here, the Court found that the Complaint “merely parrots the language of section 547 and offers no particularized facts giving context to the [Transfer]…” This fell short of Twombly/Iqbal as well as Fowler’s two-part test. To the latter point, the Court ruled that the Complaint blended facts and legal conclusions, instead of keeping them separate; moreover, the Complaint did not allege any facts that gave context or a description of the Transfer beyond whom the check was sent to, the dates the check were sent and received, and the amount of the Transfer. The Court held that such detail was insufficient.
Can the Complaint’s Defects Be Cured by Amendment?
Notwithstanding the Court’s 12(b)(6) ruling, it allowed the Trustee to amend the Complaint. In so finding, the Court noted that there was no evidence of bad faith or intentional undue delay on the Trustee’s part; nor did it see any evidence that Defendant would suffer undue delay “because this is the first attempt at seeking approval to amend”; lastly, there was no evidence of repeated failures on the part of the Trustee to cure the deficiencies. Accordingly, the Court dismissed Defendant’s argument that the amended complaint draft had to be submitted with a motion for leave to amend, finding no support for such a requirement in FRCP 15.
Although the avoidance complaint at issue here was fairly typical in its scope – as were the 12(b) defenses to the same – this opinion highlights the nuances that make or break a case for a preference defendant. The amount of pre-complaint communications between the parties, the existence of an address used to receive a preference, the absence of any proof supplemental to Defendant’s sworn declaration, and the very fact that Defendant filed the MTD, all factored into the Court’s rejection of Defendant’s 12(b)(5) defense and adoption of the Garcia framework.
Plaintiffs should also take note of this case. Though the Trustee ultimately received leave to amend the Complaint, thereby potentially limiting the value Defendant’s 12(b)(6) success, the Court made clear that merely stating the preference recipient, the amount of the transfer and date thereof does not comply with Delaware’s bankruptcy jurisprudence.
A copy of the opinion can be found here.
The principal adversary proceeding among those ruled upon, Wiscovitch–Rentas v. Villa Blanca VB Plaza LLC (In re PMC Marketing Corp.), 2016 WL 234963 (B.A.P. 1st Cir. Jan. 19, 2016), provided a helpful survey of the First Circuit’s preference action jurisprudence, including the different analytical frameworks for assessing the “ordinariness” of a given transaction. In so doing, the Panel provided a cautionary tale to preference defendants as to the level of proof they must offer in utilizing the defenses of 11 U.S.C. § 547(c).
The Bankruptcy and Adversary Cases
The Debtor’s case began under Chapter 11 in March 2009, but by May 2010, it had been converted to Chapter 7. In March 2012, the appointed Chapter 7 trustee (the “Trustee”) filed a complaint against Villa Blanca VB Plaza LLC (“Defendant”) seeking “turnover of preferential transfers pursuant to § 547.” The transfers at issue (the “Transfers” or “Transfer”) were two rent payments from the Debtor to Defendant on December 16, 2008 and January 13, 2009; rent was typically due on the first day of each month per the terms of the operative lease agreement.
In the subsequent summary judgment motions that were filed in the Bankruptcy Court, Defendant argued, inter alia, that the Transfers were made in the ordinary course of business “by a tenant to the landlord” pursuant to section 547(c)(2)(A) and (B). Defendant further argued that the Transfer* (*Defendant alleged only one of the Transfers was actually within the preference period, which the Trustee ultimately conceded) was late, and as such could be considered ordinary because it was within the pattern of payments between the parties. In support of this contention, Defendant attached a payment ledger covering the period from May 1997 through July 2011.
The Trustee filed a cross-motion for summary judgment, by which she challenged Defendant’s 547(c)(2)(B) defense on the basis that Defendant neither alleged nor demonstrated that the Transfer was made in accordance with the ordinary business terms of the industry. As to section 547(c)(2)(A), the Trustee alleged that the Transfer was inconsistent with the contract terms, and therefore did not satisfy the ordinary course of business exception. Further, the Trustee argued that reviewing the pre-preference period history showed no set payment pattern – in some months, the Debtor made no payments, while in others it made two, etc. The Trustee later amended these arguments (by way of an amended cross-motion for summary judgment, the “Amended Cross-Motion”) by striking the objective argument while bolstering the subjective argument by supplying an analysis of the degree of lateness of the Debtor’s payments pre-preference period and during the preference period. The latter analysis showed that the “average lateness during the pre-preference period was 64.3 days and the median was 59 days, while the preference period the average lateness and the median were both 105 days.”
The Bankruptcy Court entered an order striking the Amended Cross-Motion for being filed without leave of court and timeliness reasons. As to the merits of Defendant’s 547(c) defense, the Bankruptcy Court found that the ledger “revealed an inconsistent payment date and thus demonstrated that the lessor/lessee payment relationship . . . seemed to be a rather flexible one. . . [Defendant] has met the burden for both § 547(c)(2) and § 547(c)(2)(A).” In so finding, the Bankruptcy Court found no genuine issue of material fact and granted summary judgment in favor of Defendant.
The Trustee immediately filed a motion for reconsideration, arguing that “allowing late payments to be considered ordinary where there is no established pattern of payment would be tantamount to allowing the exception to swallow the rule.” This motion too was denied, prompting the instant appeal.
The Parties’ Arguments on Appeal
The Trustee’s contentions on appeal were largely the same as those contained in his summary judgment arguments, while adding that the Amended Cross-Motion shouldn’t have been struck, as it simply provided the analysis that Defendant should have furnished. In response, Defendant relied upon its assertion that the Transfer was late, thus fitting within the pattern of payments the Debtor and Defendant had established; Defendant did not, however, provide an analysis of that pattern, choosing to rely instead on the Bankruptcy Court’s characterization of the relationship as “a flexible one”. In fact, Defendant rejected the notion that it was required to establish a baseline of dealings at all, arguing that the Debtor’s ledgers and the lease agreement were sufficient.
The BAP’s Analytical Framework
The Panel began by noting that there is “no precise legal test to determine whether a preferential transfer was made in the ordinary course of business between the debtor and the creditor”, and as such, it noted that ordinary course of business defenses can rarely be determined at the summary judgment stage. Referring repeatedly to the seminal First Circuit decision in In re Healthco Int’l, Inc., 132 F.3d 104 (1st Cir. 1997), the Panel stated that “[w]here there were virtually no significant similarities between the challenged payment and the antecedent course of dealings between the parties,” courts should refuse to apply the § 547(c)(2) defense. This “consistency analysis” requires the preference defendant to establish a “baseline of dealing” between the parties during the historical period. Per Healthco, the First Circuit instructs that the factors that “bear upon whether a particular transfer warrants protection under [§] 547(c)(2) … include the amount transferred, the timing of the payment, the historic course of dealings between the debtor and the transferee, and the circumstances under which the transfer was effected.”
The Panel then considered the importance of the “lateness factor”. Citing to, among other cases, the Delaware Bankruptcy Court’s In re Archway Cookies opinion, the Panel found that “[l]ate payments do not preclude a finding that the payment occurred during the ordinary course of business . . . [and that] a pattern of late payments can establish an ordinary course between the parties.”
The Panel next discussed several theories courts have employed in determining whether a given late payment is “ordinary”:
- One approach courts have taken is by utilizing the “average lateness” theory – this involves consideration of the average time of payment after the issuance of the invoice during the pre-preference and post-preference periods.
- Another approach is to consider the “range of lateness”. This method “considers a transfer during the preference period to be ordinary if it is paid within the minimum and maximum days in the range of all payments during the historical period.”
- Yet another approach is to consider the “median lateness” in addition to the average, as the Fifth Circuit has done.
- Finally, the Panel noted the decision reached in In re ACP Ameri-Tech Acquisition, LLC, 2012 WL 481582 (Bankr. E.D. Tex. Feb. 14, 2012), which it characterized as rejecting “any mathematical analysis whatsoever”; the Panel found no other case law support for such an approach.
While finding that the First Circuit has yet to weigh in on the appropriate methodology for analyzing data concerning the lateness of the debtor’s payments during the preference and pre-preference period, the Panel found that the weight of authority suggests that some level of analysis concerning the timing of the preferential payment compared to the historical timing of payments prior to the preference period is warranted.
Applying the Standard
In applying the foregoing framework to the instant case, the Panel first found that the Bankruptcy Court’s decision to be “devoid of legal authority and unaccompanied by any analysis of the data concerning the Debtor’s payment pattern, it is at odds with the weight of authority, which favors a more elaborate, multi-factor analysis to assess whether a challenged transaction is consistent with the parties’ course of dealing.”
Next, the Panel found that “nothing in the record suggests that [Defendant] addressed, or that the bankruptcy court even considered, the issue of the appropriate look-back period for this case, nor does the record otherwise disclose sufficient information from which the Panel might discern when the Debtor was financially sound for purposes of that determination.” As such, Defendant failed to establish a baseline period for comparison, and also neglected to point to and analyze evidence demonstrating that the timing of the Transfer was consistent with, or ordinary in relation to, payment practices during that period. Although it relied on a “lateness” theory, Defendant never disclosed the degree of lateness of the challenged payment. Instead, “[i]t simply furnished the bankruptcy court with a copy of a 32–page payment ledger, without any analysis” from which the Panel could determine that: the Transfer was consistent with past payments in form, deviated from usual collection or payment activities, or did not take advantage of the Debtor’s deteriorating financial condition.
The Panel ultimately found that under no theory is the conclusory incantation “late payments are ordinary course,” standing alone, sufficient to satisfy § 547(c)(2)(A). Rather, the consistency determination requires a “fine-grained analysis.” Ergo, the Panel found in favor the Trustee.
The opinion crystallizes the potential dangers in not completing some sort of analysis when making a 547(c)(2) defense, even in a circuit where uncertainty remains as to the precise standard to apply. Although the data arguably was there to offer an analysis in opposition to the Trustee’s, Defendant here did not do so. The extent to which a contrary analysis in this case would have helped Defendant is unclear, although the Panel noted in dicta that the Trustee’s calculations showed a “meaningful change in the degree of lateness of payments during the pre- and post-preference period.”
Note that the foregoing opinion (available here) was cited in the Panel’s similar and concurrently issued opinions for its analysis of 547(c)(2)(A). See Wiscovitch–Rentas v. Sur CSM Plaza Inc. (In re PMC Mktg. Corp.), 2016 WL 319515 (B.A.P. 1st Cir. Jan. 19, 2016), and Wiscovitch–Rentas v. Santa Rosa Mall LLC (In re PMC Mktg. Corp.), 2016 WL 319528 (B.A.P. 1st Cir. Jan. 19, 2016).