In re Lyondell Chemical Co. 2016 Update – Judge Gerber Finds Pre-Merger D&Os Did Not Possess Actual Intent to Hinder, Delay or Defraud Creditors in Prepetition Leveraged Buyout

  This blog’s post on the Shareholder Opinion provides the pertinent background on the bankruptcy and adversary cases and the defined terms therein apply here unless otherwise stated.

The additional background included here is limited solely to that which pertains to the allegations against the Defendants.  At bottom, the instant complaint (the “Complaint”) included a count charging that Merger-related payments to Lyondell’s Pre-Merger Directors and Officers were intentional fraudulent transfers.  The Court noted that although the sums sought against the shareholders differed, the allegations supporting the requisite scienter overlapped with those in the Complaint; likewise, the Court found the allegations equally deficient against the Pre-Merger Directors and Officers as they were against the shareholders.  As such, the fraudulent transfer count was dismissed.

The Pre-Merger Directors and Officers

Prior to the events at issue here, Lyondell’s Board of Directors (the “Pre-Merger Directors”) consisted of 10 elected outside directors (the Outside Directors”) and one additional director, Dan Smith (“Smith”), Lyondell’s CEO. Lyondell’s COO, Morris Gelb (“Gelb”), was not a director at the time of the Merger, but became one as of March 28, 2008, along with Edward Dineen (“Dineen”), who was Lyondell’s former Senior Vice President of the Chemicals and Polymers business segment.  Gelb and Dineen were among the 12 senior Lyondell executives, including Smith (collectively, the “Pre–Merger Officers”), who collectively received over $158 million in “Change of Control” payments and over $93 million in Merger consideration pursuant to the Merger, on account of stock options, restricted stock, performance units, severance/retirement plans and other benefits.  Similarly, Lyondell’s Outside Directors received, as a result of the Merger, a total of approximately $19 million in Change of Control payments and Merger consideration.

The Fraudulent Transfer Allegations

The fraudulent transfer count seeks to recover approximately $271 million that was transferred to the Pre-Merger Directors and Officers in the form of Change of Control payments and as Merger consideration for their Lyondell stock.  The allegations underlying this count essentially break down into two categories: (1) those speaking of Smith’s actions in bringing about Lyondell’s “refreshed” projections and the Merger, and (2) those speaking of Lyondell’s Outside Directors in approving it.

Analytical Framework

As discussed at some length in the related opinion preceding the Shareholder Opinion, the Court held that the Trustee had to establish a “critical mass” of the Lyondell (pre-Merger) Board members had the requisite fraudulent intent. In the Shareholder Opinion, the Court examined in great detail the nature of the intent required to establish claims for intentional fraudulent transfers. After doing so, the Court concluded that the Trustee had still failed to satisfactorily plead factual allegations demonstrating a strong inference of an actual intent to hinder, delay or defraud creditors by a critical mass of Lyondell’s board of directors.

In this case, the Court found that although the Trustee sought to recover Merger consideration and Change of Control payments received by the Pre–Merger Directors & Officers (as contrasted to Merger consideration received by Lyondell’s shareholders generally), the same facts underlie the claims of both types.  In both cases, the intentional fraudulent transfer claims rested on (i) alleged efforts by Smith and confederates to present fraudulent “refreshed” earnings projections; (ii) the presence of Pre–Merger Directors at Board meetings at which the “refreshed” projections were discussed; (iii) failures by Pre–Merger Directors to challenge Smith’s allegedly inflated projections, and (iv) to engage in basic due diligence to satisfy themselves that the projections had a reasonable basis; and Pre–Merger Directors’ acts to nevertheless approve the Merger and the terms of the LBO financing.

The Trustee, of course, alleged that the payments provided motivation for action and inaction by Pre-Merger Directors and Officers, even with respect to payments to shareholders for their stock.  Nevertheless, the Court found that the Trustee made no additional allegations with respect to control by Smith over other Pre-Merger Directors, or that a critical mass of them otherwise intended to hinder, delay, or defraud Lyondell creditors.  The Court noted that this result would not differ if the Pre-Merger Directors and Officers had the requisite intent as transferees, as the intent must be the intent of the transferor.

Ultimately, then, “just as the Court determined that the allegations supporting the fraudulent transfer claims were insufficient vis-a-vis payments to shareholder defendants, the Court comes to the same conclusion vis-a-vis payments to Pre–Merger Ds & Os.”  The Court found that while the allegations (again) raised “serious concerns over whether they breached fiduciary duties as directors and officers, those allegations are insufficient to demonstrate that a critical mass of the Lyondell Pre–Merger Directors (who were the ones in a position to control the transfer at issue) possessed an “actual intent to hinder, delay or defraud creditors” by their actions.”  As such, the fraudulent transfer count was dismissed.

A copy of the opinion can be found here or on Westlaw as Weisfelner v. Blavatnik (In re Lyondell Chemical Co.), Adv. Proc. No. 09-1375 (REG), 2016 WL 48155 (Bankr. S.D.N.Y. Jan. 4, 2016).

LBOs, BODs, and Fraudulent Transfers: Judge Gerber Clarifies When a Board Has Actual Intent to Hinder, Delay or Defraud Creditors in a Prepetition Leveraged Buyout in In re Lyondell Chemical Co.

  The actions were initiated for the purpose of avoiding, as intentional or constructive fraudulent transfers, payments made to the Debtors’ former shareholders in connection with a prepetition leveraged buyout.  In the course of the litigation and the underlying opinions (an opinion issued in 2014 dealt with an initial round of motions to dismiss), several interesting questions have been addressed for fraudulent transfer purposes, including: (i) whether the intent of a controlling person on a board of directors is the critical consideration rather than the board’s intent; (ii) which, if any, actual intent standard applied in the context of a board of directors; and (iii) if applicable, what kinds of allegations provided the predicate for a finding of a board’s actual intent.

In the instant opinion, the Court found that the plaintiff-trustee failed to satisfactorily plead factual allegations demonstrating an actual intent to hinder, delay or defraud creditors by a critical mass of Lyondell’s board of directors.  As such, the claims for intentional fraudulent transfers were dismissed.  While Judge Gerber permitted state law constructive fraudulent transfer claims to survive the motions to dismiss, this post will focus on the actual fraudulent transfer analysis, as the former claims largely pertained to standing and plan-related issues not germane to the blog’s central focus.

The LBO, the Bankruptcy, and the Genesis of the Adversary Proceedings

In December 2007, Basell AF S.C.A. (“Basell”) acquired Lyondell Chemical Company (“Lyondell”, or the “Debtor”) by means of a leveraged buyout (the “LBO”), forming a new company after a merger (“Merger”).  The LBO was 100% financed by debt secured by the assets of Lyondell.  Lyondell took on approximately $21 billion of secured indebtedness in the LBO, of which $12.5 billion was paid out to Lyondell stockholders.

In January 2009, Lyondell, along with 78 affiliates, filed a petition for Chapter 11 relief in the Southern District of New York.  Lyondell’s unsecured creditors then found themselves behind that $21 billion in secured debt, with Lyondell’s assets having been depleted by payments of $12.5 billion in loan payments to stockholders.  This led to the filing of three adversary complaints (the “Complaints”) by the trustee (the “Trustee”) of two trusts formed to pursue claims on behalf of Lyondell and its creditors, with each action brought against shareholder recipients (collectively, the “Defendants”) of the $12.5 billion.  The Trustee brought constructive fraudulent transfer claims in two of the actions, and intentional fraudulent transfer claims in all three.

In 2014, the Court dismissed the Complaints’ claims for intentional fraudulent transfers for failing to allege facts sufficient to support the requisite intent on the part of Lyondell’s board of directors (the “Board”), but with leave to replead (the “First 12(b)(6) Decision”).  This led to the revised Complaints (the “Revised Complaints”) at issue in the Court’s latest opinion.  The Defendants sought again to dismiss the intentional fraudulent transfer claims on the basis that the deficiencies identified in the First 12(b)(6) Decision were not cured; they likewise sought dismissal of the state law constructive fraudulent transfer claims.

The Board’s Governance and the First 12(b)(6) Decision

According to the Revised Complaints, the Board consisted of 10 elected outside directors – who served for periods of less than one year up to twelve years – and one additional director, Dan Smith (“Smith”), Lyondell’s CEO.  The Trustee alleged that the Smith utilized his longtime status as CEO and sole management member of the Board to regularly dominate Board decisions, although the Court dismissed this as conclusory; in any event, the Court found the duration of the outsiders’ tenure to be irrelevant.

Notwithstanding the Trustee’s contentions to the contrary, the First 12(b)(6) Decision had rejected his contention that the Court should rely on any intent of Smith alone for actual fraudulent transfer purposes, concluding that the appropriate standard was the First Circuit’s In re Roco Corp. – e.g., whether the individual whose intent is to be imputed “was in a position to control the disposition of [the transferor’s] property.”  Consistent with the Delaware law principle that corporations can merge only with the approval of their boards of directors, the LBO transaction was approved by the Board.  Thus, the Court found that it was the Board’s intent that was critical – meaning that the Trustee had to establish that enough Board members had the requisite intent on their own, or that Smith or another could cause that number of Board members to form the requisite intent.*

*The Court notes in an interesting footnote digression, that its rulings have been in the context of a corporation with a functioning board of directors, as contrasted to a closely held corporation with little or no board decision-making; in the latter case, the Court postulated that the requisite intent based on the intent of the company’s principals could be easier to find.

The Revised Complaint and the New Allegations

The Revised Complaints allege that the Board knew of the “dire” consequences of approving the LBO transaction, pointing to its (1) turning a blind eye to alleged gross overstatements of future earnings; (2) receiving a collective windfall of over $19 million in Merger-related consideration; (3) awareness of the direct relationship between the cyclicality of the industries in which the company operated and the need to limit leverage in order to ensure financial flexibility; (4) understanding that every dollar to the Lyondell shareholders would be funded with leveraged debt; and (5) knowledge that the transaction would leave Lyondell inadequately capitalized.  In sum, the Board allegedly knew that the projections were inflated and unreasonable and that they were putting Lyondell’s creditors at risk.

Furthermore, the Revised Complaints bolster allegations against Smith, specifically that (1) he dominated the Board’s decisions by manufacturing “bogus” projections; (2) he alone had pre-negotiated the price per share with Basell’s controller; and (3) that members of senior management collaborated with Smith in presenting the false projections.

Which Analytical Standard(s) Apply?

The Court first noted that the heightened pleading standards of Fed. R. Civ. P. Rule 9(b) apply in cases of intentional fraudulent transfers, thus meaning a plaintiff has to (i) plead, with particularity, the circumstances constituting fraud or mistake; and to (ii) establish the defendant’s mental state.  Taken further, the Court had to focus on the nature of the Board’s intent as a predicate to evaluating the allegations put forward to establish that intent.  For 11 U.S.C. § 548 (“Section 548”), the Uniform Fraudulent Conveyance Act (“UFCA”), and the Uniform Fraudulent Transfer Act (“UFTA”, and together with Section 548 and UFCA, the three statutes applicable in the instant case), “actual intent to hinder, delay, or defraud” must be shown.  The Court found that the requisite intent must be consistent with the overall theme of intentional fraudulent transfer law: proscribing intentional actions to injure creditors, by means of placing assets out of the reach of creditors’ reach or by other intentional steps to prevent creditors from collecting on their debts or placing obstacles in creditors’ way.

In terms of the types of allegations that would permit a finding of that intent, the Court analyzed the facts under four rubrics:

Restatement (and the “Natural Consequence” Standards?)

The Court first turned to the position advocated by the Restatement of Torts (and the Defendants), which contemplates something beyond simply a bad result after the fact, or results from mere negligence: “… the actor desires to cause consequences of his act, or believes that the consequences are substantially certain to result from it.”  In other words, the Trustee must put forward allegations establishing the requisite intent to achieve the consequences — impeding creditor recoveries — and not just to engage in an aggressive transaction that puts creditor recoveries at risk.  In so finding, the Court declined the Trustee’s suggestion that the Restatement Standard be limited to Ponzi Scheme cases, and rejected his advocacy for the “natural consequences” standard.  This latter standard stems from a 2013 Seventh Circuit decision (In re Sentinel Mgmt. Grp.), which the Court found to be too ambiguous to constitute a reliable standard, as it could be read to establish liability for consequences that are merely “foreseeable” or negligent.

Applied here, the Court can found no allegations supporting an inference that any of the Board members other than Smith and one other director had any wrongful intent of any type. Nor, for that matter, could the Court find allegations supporting the view that Smith’s satisfactorily pleaded dishonesty and greed was accompanied by an actual intent that creditors not be paid, or that they be otherwise hindered in their debt recovery efforts.  The individual allegations as to the Board members do not (i) say what he or she said or heard with respect to any creditors not being paid; (ii) allege that directors other than Smith knew the projections were fraudulent; (iii) allege that there were any decisions to take steps to cause creditors not to be paid.  In short, the Court found the allegations largely conclusory.

The allegations against Smith were sufficient to establish intent on his part to defraud Bassell’s controller, lenders, and others due to the merger price, but do not support an intent to hinder, delay or defraud creditors – let alone that he caused other Board members to join him in such a plan.  Merely voting in favor Smith’s recommendations was insufficient to support the conclusion that he controlled them.

In sum, the Court found plenty of evidence of negligence, but no intent to do creditors harm.

Badges of Fraud

The Court noted the use of “Badges of Fraud” as circumstantial evidence of actual intent and cited the enumerations in the Texas UFTA and Section 548 as examples.  According to the Court, in the typical Badges of Fraud situation, many or most of the Badges can be found, but in the instant case, nearly none of them can.  The only semblance of badges the Court could find was that (i) the transfer was of substantially all of the debtors’ assets (since a large proportion of Lyondell assets were subjected to liens); (ii) the transfer was arguably to an insider (since the directors are insiders, and they received cash payments); and (iii) the debtor became insolvent shortly after the transfer was made.  The Court found the silence as to the other badges of fraud to be deafening and to be determinative.

“Motive and Opportunity”

The Court found the “Motive and Opportunity” standard to require that “[g]enerally, in intentional fraudulent transfer cases as well as securities fraud cases, a strong inference of fraudulent intent may be established either (a) by alleging facts to show that defendants had both motive and opportunity to commit fraud, or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness.” Judge Gerber urged caution on that standard, however, as entities may not always act in accordance with motivation.  In this context, the Court noted that generalized motives of corporate officers and directors (e.g., motives to maximize the amount received on the sale of stock or to increase executive compensation) do not support the required “strong inference” of scienter; there must be a demonstration of something out of the ordinary, such as when motive and opportunity are coupled with “something else”.

Here, the Court found that the Board had nothing more than motive and opportunity.


While the Court was willing to assume that recklessness (a securities fraud doctrine) was a potential basis for finding intent, it construed the level of recklessness in a fraudulent transfer case to require allegations of facts that give rise to a strong inference of fraudulent intent – and not, by contrast, “fraud by hindsight.”  In other words, a state of mind approximating actual intent, and not merely a heightened form of negligence.

As discussed above, the Court again found evidence of negligence, but nothing beyond that; to the contrary, most of the allegations were merely conclusory, in that they fell short of alleging, for example, that the Board knew the financial projections were fraudulent.  The Revised Complaints alleged that the Board accepted the projections with insufficient scrutiny.

Having found none of the four tests conclusive as to actual fraud, the Court dismissed them in their entirety, this time without leave to amend.

Notwithstanding the underlying complexity of the Lyondell proceedings, the pair of 12(b)(6) decisions Judge Gerber issued in these adversary proceedings provide important and in many ways much-needed guidance on the parameters of actual fraudulent intent in merger/LBO contexts.  Most importantly, they establish who (or what) must be the source of the intent and their relation vis-à-vis the consequences of their action.  For proper context, the decisions should be read in conjunction with one another.

A copy of the opinion can be found here.

How Much Control Must a Bank Exert to be Considered an Initial Transferee Under 11 U.S.C. § 550? Can Substantive Consolidation be Applied Nunc Pro Tunc to Help ‘Create’ an Avoidance Action? Chief Judge Frank (Bankr. E.D. Pa.) Provides an Answer in In re Universal Marketing, Inc.

  The opinion also addresses the question of whether a substantive consolidation order can be applied nunc pro tunc to the petition date without violating Owens Corning’s prohibition against “offensive” use of the substantive consolidation doctrine.  The timing of the substantive consolidation order in this case – which provisionally carved out the defendant-bank from its application – is critical to one of the plaintiff-trustee’s avoidance causes of action.

Ultimately, the Court found that the defendant-bank’s actions were essentially administrative in nature and did not rise to the level of dominion or control over funds necessary to satisfy the statute and judicially created tests.  The Court did, however, find that in the circumstances here, applying substantive consolidation nunc pro tunc to the petition date would not be impermissibly offensive vis-à-vis the defendant, as the “carve-out” negotiated with the defendant was meant to be transitory, leaving the chapter 7 trustee free to seek application of the doctrine at a later date.


The facts of this case are extensive and warrant a full review by the reader, but pertinent to this post, they are as follows: the Debtor, Universal Marketing, Inc. (“UMI”), commenced its Chapter 11 case on July 23, 2009 (the “Petition Date”), but was quickly converted to a case under Chapter 7.  Prior to the Petition Date, Universal Delaware, Inc. (“UDI”) acted as the management company for UMI.  Operationally, UMI and UDI had separate banking relationships, the former with TD Bank and the latter with Wilmington Savings Fund Society (“WSFS”), although the cash needs of the various entities were met by numerous intercompany transfers on a daily basis.  In March 2009, UDI and WSFS entered into a line of credit loan transaction (the “Loan”), obligating WSFS to make available a $5 million line of credit.  By July 2009, however, the banking relationships with both UMI and UDI had soured, and within a few days of each other, TD Bank locked down UMI’s accounts and WSFS took similar action.  Specifically as to WSFS, the bank placed a “post no debits” (“PND”) restriction on the UDI accounts effective July 16, 2009, which had the effect of stopping automated debiting and allowing WSFS to review UDI’s account and ensure there were sufficient funds for outgoing transfers.  While the PND was in effect, UDI received over $11.6 million in transfers from UMI and a related entity (the “UMI Transfers”).  On July 20, following discussions among UDI and WSFS, WSFS removed the PND restriction, but offset $5 million to formally repay the Loan (the “Setoff”).  Three days later, UMI filed its bankruptcy petition.

Following conversion to Chapter 7, the Chapter 7 Trustee (the “Trustee”) sought substantive consolidation of the Debtor’s estate and extension of bankruptcy proceedings to certain non-Debtor entities, including UDI.  WSFS initially opposed substantive consolidation, but the parties later settled the issue as approved by an August 4, 2010 order (the “Order”).  This Order, while nunc pro tunc to the Petition Date, specifically provided that substantive consolidation would not impact WSFS’s rights, and that WSFS was excepted from the effects of the Order.  As to WSFS, the parties agreed that UDI would be deemed to have filed a bankruptcy as of August 4, 2010, and that the estates would be treated as jointly administered, not substantively consolidated.  Significantly, the parties agreed that the Trustee retained the right to extend the effect of the substantive consolidation to WSFS nunc pro tunc to the Petition Date, which WSFS could challenge.

On July 18, 2011, the Trustee initiated the adversary proceeding against WSFS based on a variety of legal theories, although this post will focus on the three counts brought under 11 U.S.C. §§ 544, 547, 548, 550, and/or 553.  The parties filed motions for summary judgment in May 2014, which the instant opinion addresses.

The First Counts

The first counts relevant here are based on 11 U.S.C. §§ 544 and 548, by which the Trustee asserted actual fraud allegations based on 6 Del. C. § 1304(a)(1) and 11 U.S.C. § 548(a)(1)(A), as well as constructive fraud.  The Court found no evidence in support of a claim for intentional fraud, so it limited its analysis to constructive fraud.  The pertinent transfers are the UMI Transfers and the Setoff (whereby UDI involuntarily transferred to WSFS an amount that paid off the Loan).  The Trustee argued that the UMI Transfers went directly to WSFS, and that WSFS was an initial transferee under 11 U.S.C. § 550 because it exercised dominion and control over UDI’s depository accounts by placing the PND restriction, then taking the funds for its own benefit to satisfy the Loan.  The Trustee alleged this was for no consideration to UMI, since UMI owed no money to WSFS.  Alternatively, the Trustee asserted that he could recover the Transfers from WSFS as a subsequent transferee, as UMI did not receive reasonably equivalent value for the transfers it made to UDI.  WSFS, of course, asserted that UDI was the initial transferee, and that the Transfers were made in satisfaction of UDI’s outstanding debt in good faith and without knowledge of their avoidability.

The Court noted that the most heavily litigated issue in section 548 actions is whether the debtor received reasonably equivalent value in the transaction.  In the Third Circuit, courts employ a two-step process in determining whether a debtor received reasonably equivalent value in the form of indirect economic benefits in a particular transaction: (1) whether any value is received, and (2) whether that value was reasonably equivalent to the transfer made. In re R.M.L., 92 F.3d 139, 152 (3d Cir. 1996).  I.e., what the debtor gave up and what it received that could benefit creditors, be it direct or indirect.  As to section 544, the Trustee invoked 6 Del. C. §§ 1304 and 1305 as his authority to step into the shoes of an actual creditor who existed at the beginning of the case and avoid the Transfers pursuant to state law.

Is WSFS an initial transferee?

The Court found that the Trustee’s theory hinged on the notion that WSFS was the initial transferee of the Transfers, but since that term is not defined in section 550, courts (although not the Third Circuit) have developed tests for determining whether a party is an initial transferee.  The first of these tests is referred to as the “dominion-and-control test”, as articulated in Bonded Fin. Servs. v. European Am. Bank., 838 F.2d 890 (7th Cir. 1988): “the minimum requirement of status as a “transferee” is dominion over the money or other asset, the right to put the money to one’s own purposes.” Id. at 893.  This is related to the “conduit theory” doctrine, that says if an entity receives a transfer, it may not be a transferee at all, but only a mere conduit if the transfer is for the limited purpose of allowing the entity to pass the asset through to another party.

The Ninth Circuit made a distinction between “dominion” and “control” in In re Incomnet, Inc., 463 F.3d 1064 (9th Cir. 2006), stating the “focus of the dominion standard is “whether an entity had legal authority over the money and the right to use the money however it wished.” Id. at 1070. The transferee has dominion if it has “the right to put the money to one’s own purposes.” Id.  In contrast, the “control” standard may involve a broader, more flexible approach, in which the courts look at the entire transaction as a whole to evaluate which party truly had control of the money”. Id.

The Trustee pushed the Court to employ the “dominion-and-control test”, and focus on the transferee’s relationship to the property; WSFS encouraged application of the “dominion test” as set forth by Incomnet, since it never exercised dominion over the UMI Transfers because it had no legal right to use those funds – the PND was just a temporary cautionary measure.  Moreover, WSFS argued that the Setoff was a subsequent transaction, performed only after UDI had taken title and dominion over the UMI Transfers.

The Court agreed with WSFS that it was only a subsequent transferee, not an initial transferee.  It found that the measures taken by WSFS at the time of the PND did not restrict all outgoing transfers from UDI’s account.  In addition, there was no evidence of any legal title change to the funds in UDI’s account, nor is there any indication that UDI was helpless and without access to funds.

As to the Trustee’s subsequent transferee argument, the Court found that the Trustee failed to prove that UMI did not receive reasonably equivalent value for the UMI Transfers.  Beyond the fact that the Trustee submitted no evidence to substantiate his supposition that UDI did not provide value to UMI, WSFS offered evidence that the Transfers were made in exchange for value in the form of receivables UMI owed to UDI and liquidity obtained through cash management services WSFS provide to UDI.

The Second Count

The Trustee also sought to avoid the Setoff under 11 U.S.C. §§ 550 and 553(b).  That section permits a trustee to avoid the amount by which a creditor improved its position by setoff during the 90 day period prior to the petition date.  In this case, 90 days before the Petition Date, there was an “insufficiency” (the amount by which a claim against a debtor exceeds a mutual debt owing to the debtor by the claimholder) of $5.75 million, and on the day of the Setoff, there was no insufficiency.  This depends, of course, on a finding that UDI’s estate was substantively consolidated with UMI’s as to WSFS, making the Petition Date July 23, 2009 – not August 4, 2010 as the Order provides.  If the latter, then the Trustee’s argument could not satisfy the 90 day requirement in section 553(b).

Can the Trustee seek substantive consolidation as to WSFS?

WSFS, relying on In re Owens Corning, 419 F.3d 195 (3d. Cir. 2005), argued that the Trustee could not wield substantive consolidation offensively, i.e., in a manner to single out and create a section 553(b) claim against WSFS.  The Trustee argued he was not singling out WSFS and that a major aspect of substantive consolidation is to allow the estate to bring actions on behalf of the consolidated estates; in his opinion, the issue was merely deferred as to WSFS, not waived.

The Court agreed with the Trustee.  Having walked through the seminal Owens Corning decision – and specifically WSFS’s favored tenet that while “substantive consolidation may be used defensively to remedy the identifiable harms caused by entangled affairs, it may not be used offensively (for example, having a primary purpose to disadvantage tactically a group of creditors in the plan process or to alter creditor rights)” Id. at 211 – the Court found that that tenet simply did not control here.  Rather, the Trustee was not seeking to isolate WSFS impermissibly, and the Order clearly stated the parties reserved their rights to seek or contest further substantive consolidation.  In effect, the Court found the agreement approved in the Order to be a “standstill agreement”, and to give effect thereto, the litigation should be treated as resuming the dispute when they declared a truce in August 2010.  The Order should not now be read to have essentially waived the parties’ rights.  As such, the Court found that the issue could be considered on its merits and refused to grant summary judgment in favor of WSFS, as neither party discussed whether the Trustee has evidence to support substantive consolidation or the elements of a setoff claim under section 553(b).

Can parties carve themselves out of a substantive consolidation order?

An interesting side note to this section of the opinion is the Chief Judge’s acknowledgement that Owens Corning left open the question whether a creditor may carve itself out of the effects of consolidation.  Nevertheless, the Court states that “right or wrong, that is what occurred in this case…”

A copy of the opinion is attached here.

Chief Judge Stark (D. Del.) Issues a Pair of Opinions Addressing New Value, Ordinary Course of Business, and Earmarking Defenses (Part II)

  The pertinent facts of that case are as follows: in May 2006, the Debtor engaged the defendant/appellant, Prudential Real Estate and Relocation Services, Inc. and Prudential Relocation, Inc. (“Prudential”), to perform various relocation services for the Debtor’s employees.  The agreement contemplated that the Debtor would pay Prudential for services within 30 days of receiving an invoice.  While the Debtor was timely with its payment of invoices during the first year and a half of the parties’ agreement, the Debtor began to fall behind.  As a result, Prudential placed the Debtor on “billing review,” which implemented the following conditions: (1) Prudential would not accept new employee transfers, (2) the Debtor would begin paying Prudential on a weekly, instead of monthly, basis, (3) the Debtor would pay a $900,000 lump sum to reduce the outstanding accounts receivable balance, and (4) Prudential would eventually terminate the agreement if the conditions were not satisfied.  By January 18, 2008, the Debtor had complied with these terms and Prudential removed the Debtor from the payment plan.

In August 2008, Prudential learned that the Debtor had terminated 650 of its employees in light of financial difficulties.  That same month, Prudential again placed the Debtor on billing review due to late payments.  This second payment plan implemented the same conditions as the first plan, except for varying payment amounts.  On November 25, 2008, the Debtor filed for chapter 7 bankruptcy relief in the United States Bankruptcy Court for the District of Delaware.

In the 90 days prior to the petition date, the Debtor had made 12 payments to Prudential totaling $781,702.61, which the Trustee sought to recover as preferential transfers under 11 U.S.C. §§ 547 and 550.  Following trial, the Bankruptcy Court awarded judgment in favor of the Trustee for $653,323.20, which represented $781,702.61 of preferential transfers, reduced by $128,379.40 of “new value” that Prudential had provided under 11 U.S.C. § 547(c)(4).  Both parties filed timely appeals to the District Court.

Prudential argued on appeal that the transfers were not preferential because they occurred in the “ordinary course of business” as defined by 11 U.S.C. § 547(c)(2).  The Trustee cross-appealed, alleging that Prudential’s “new value” defense impermissibly included amounts provided after the petition date, plus the Bankruptcy Court failed to provide prejudgment interest to his judgment.

The District Court first addressed the ordinary course of business defense under 11 U.S.C. § 547(c)(2).  This defense provides that: “The trustee may not avoid under this section a transfer— (2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was— (A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or (B) made according to ordinary business terms”.  Chief Judge Stark noted that courts have considered the following factors to assess if a transfer occurs in the ordinary course of business: (1) the length of time the parties engaged in the type of dealing at issue; (2) whether the subject transfers were in an amount more than usually paid; (3) whether the payments at issue were tendered in a manner different from previous payments; (4) whether there appears to be an unusual action by the debtor or creditor to collect on or pay the debt; and (5) whether the creditor did anything to gain an advantage (such as gain additional security) in light of the debtor’s deteriorating financial condition.

Prudential argued that the Bankruptcy Court erred by finding that the Debtor’s faster payments during the preference period (during which the average payment time dipped from 45.3 days historically to 28 days) meant that they were not in the ordinary course of business.  Citing In re Archway Cookies, 435 B.R. 234 (Bankr. D. Del. 2010), Chief Judge Stark found that the proper inquiry is whether the change in payment timing was significant, regardless of whether it was faster or slower, as “small deviations in the timing of payments may not be so significant as to defeat the ordinariness of such payments[,] [whereas] courts have held greater deviations . . . sufficiently significant to defeat the ordinariness of such payments.”  In this case, the District Court found that the Bankruptcy Court’s ruling that a 40% increase in payment timing was significant – especially when paired with the fact that Prudential insisted on the quicker payment schedule – was not clearly erroneous.

The District Court went on to reject Prudential’s arguments, based on In re Global Tissue L.L.C., 106 F. App’x 99 (3d Cir. 2004) and In re AE Liquidation, Inc., 2013 WL 5488476 (Bankr. D. Del. Oct. 2, 2013) respectively, that (i) 6 “extremely late” invoices out of 3,500 may have improperly skewed the average payment time and (ii) that the Bankruptcy Court was inconsistent in finding a 40% increase in payment time was significant whereas a 10-15% increase in payment  time (as found in the earlier, unrelated AE Liquidation case) was not.  To the former, the District Court found that the late payment pattern in Global Tissue was established consistently over two months, while in this case, it was comparatively minimal.  As to the earlier AE Liquidation case, Chief Judge Stark saw nothing inconsistent with finding a 40% deviation significant and 10-15% insignificant, given the subjective nature of these types of cases.

The District Court next found that Prudential had knowledge of the Debtor’s financially deteriorating condition and subsequently used this knowledge to extract better repayment terms.  Chief Judge Stark rejected the relevance of the parties’ past payment plans, a holding which he found to be congruent with In re Hechinger Inv. Co. of Delaware, Inc., 489 F.3d 568 (3d Cir. 2007).  He found that the payment plans were a deviation from the “baseline” relationship the parties had established; i.e., once the conditions that precipitated the payment plan went away, the parties returned to their baseline relationship.  Thus, they were not representative of the parties’ normal, ordinary arrangement.

Chief Judge Stark then turned to the Trustee’s appeal, specifically whether an improper amount of new value was allocated to Prudential.  For this position, the Trustee argued that approximately $71,000 of Prudential’s $128,000 new value was provided after the petition date, which violates the precedent issued by the Third Circuit in In re Friedman’s Inc., 738 F.3d 547 (3d. Cir. 2013); see also Evan T. Miller, “The Third Circuit Draws a Line in the Sand on New Value in Friedman’s,” ABI Unsecured Trade Creditors Committee Newsletter, Vol. 12, No. 1, April 2014.  Since the Bankruptcy Court did not distinguish between prepetition and postpetition payments for new value purposes, the District remanded the matter for a determination of the same.

The District Court likewise remanded the Trustee’s prejudgment interest claim to the Bankruptcy Court, so that the lower court could – as consistent with the Hechinger opinion – explain its reasoning for denying an award of prejudgment interest.

Copies of both opinions can be found here.  Stay tuned to Avoidance Action Update for any further developments in these cases.

Chief Judge Stark (D. Del.) Issues a Pair of Opinions Addressing New Value, Ordinary Course of Business, and Earmarking Defenses (Part I)

  The opinions, both penned by Chief Judge Leonard P. Stark, make clear that the arrangement of a “payment plan” between the debtors and defendant may not necessarily render transactions made pursuant thereto “ordinary” for purposes of § 547(c)(2); furthermore, they confirm that the “earmarking doctrine” will be strictly construed.  In both cases, the District Court held for the appellee/plaintiff on the substantive issues of the appeals.

“Earmarking” Strictly Construed

The earlier of the two opinions, Masiz v. Burtch (In re Vaso Active Pharmaceuticals, Inc.), 537 B.R. 182 (D. Del. 2015), involved an adversary proceeding brought by a plan-appointed trustee to recover $776,363 from the defendant, John Masiz (“Masiz”).  Masiz founded the Debtor approximately nine years prior.  Following a 2004 lawsuit by the Securities and Exchange Commission in connection with an initial public offering of the Debtor’s equity, Masiz agreed to resign as CEO and board member of the Debtor, but remained as a “strategic consultant”.  In 2006, the Debtor, as represented by Kelley Drye & Warren, LLP (“KDW”) filed a malpractice lawsuit against Robinson & Cole, LLP (“R&C”), the firm that had provided legal representation in connection with the IPO.  Concurrently, the Debtor arranged for Masiz to begin working on an unpaid basis, but if the Debtor succeeded in its malpractice suit, Masiz would be paid retroactively.  For these purposes, the Debtor agreed to compensate Masiz at $175,000 per annum.

R&C settled the malpractice suit for $2.5 million, although not before firing KDW.  Following disbursement of the settlement funds, KDW asserted an attorney’s lien in the same, which further prompted the Debtor to enter into a separate settlement with KDW, whereby KDW agreed to accept $595,000 in satisfaction of its fees.  The KDW settlement “acknowledged” that the Debtor intended to release $598,000 of the R&C settlement to Masiz in satisfaction of his accrued unpaid wages.  Subsequent to that transfer, but before the bankruptcy, the Debtor made an additional $178,363 payment to Masiz on account of his continued employment.

The Trustee alleged in his complaint that the two payments to Masiz were either preferential payments under 11 U.S.C. § 547 or fraudulent transfers under 11 U.S.C. § 548.  Ultimately, the Bankruptcy Court (Judge Sontchi) issued two opinions granting summary judgment in the Trustee’s favor with respect to the §§ 547 and 548 claims.  Masiz appealed both to the District Court, arguing the Trustee lacked standing; that the “earmarking doctrine” excluded the transfers from avoidance; that several issues of disputable fact were impermissibly decided at the summary judgment stage (including whether § 547(b)(5) had been established); and that while the Bankruptcy Court was correct in finding Masiz had established a new value defense, it erred in the calculating the amount of that new value.

The District Court quickly dismissed the contention that the Trustee had not yet acquired standing to bring the instant action, pointing to specific language in the confirmation order.  Moving on to Masiz’s “earmarking” argument and pertinent to this post, Chief Judge Stark noted that the doctrine targets one of the fundamental elements of a preference action under 547(b) – e.g., that a voidable preference first requires some interest of the debtor in property.  He cited the “earmarking” standard elucidated in past Third Circuit and Delaware Bankruptcy Court Opinions as follows: “[w]hen … funds are provided by [a] new creditor to or for the benefit of the debtor for the purpose of paying the obligation owed to [an existing] creditor, the funds are said to be ‘earmarked’ and the payment is held not to be a voidable preference.” In re Winstar Commc’ns, Inc., 554 F.3d 382, 400 (3d Cir. 2009).  The District Court went to say that in “order to invoke this doctrine, a party must demonstrate ‘(1) the existence of an agreement between the new lender and the debtor that the new funds will be used to pay a specified antecedent debt, (2) performance of that agreement according to its terms, and (3) the transaction viewed as a whole … does not result in any diminution of the [debtor’s] estate.’” Id. “The central inquiry is ‘whether the debtor had the right to disburse the funds to whomever it wished, or whether the disbursement was limited to a particular old creditor or creditors under the agreement with the new creditor.’” In re AmeriServe Food Distribution, Inc., 315 B.R. 24, 30 (Bankr.D.Del.2004) (quoting In re Superior Stamp and Coin Co., Inc., 223 F.3d 1004, 1009 (9th Cir.2000)).

The Bankruptcy Court found that the R&C settlement did not direct any funds to Masiz, nor did it mention the KDW settlement.  The District Court agreed, and rejected the contention that the KDW settlement should be the operative document for “earmarking” purposes.  Chief Judge Stark found that KDW did not have control over or disburse any funds, and pursuant to the AmeriServe decision, a party must both disburse funds and direct those funds for the “earmarking doctrine” to apply.  Thus, the District Court rejected Masiz’s argument.

The District Court subsequently dismissed Masiz’s argument that summary judgment was inappropriate since the Trustee had not established § 547(b)(5).  This element requires that the transfer in question: “enables such creditor to receive more than such creditor would receive if— (A) the case were a case under chapter 7 of this title; (B) the transfer had not been made; and (C) such creditor received payment of such debt to the extent provided by the provisions of this title.”  Chief Judge Stark found that § 547(b)(5), as measured from the time of the bankruptcy filing, simply requires that the creditor in question would have received less than a 100% payout of its claim in a Chapter 7 liquidation.  Given the substance of the plan and disclosure statement, the District Court found that circumstance was met.

Lastly, the District Court found that the Bankruptcy Court did not err in the calculation of Masiz’s “new value” defense.  This defense, as codified in § 547(c)(4), provides that a trustee may not avoid any transfer: “to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor—(A) not secured by an otherwise unavoidable security interest; and (B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor.”  Chief Judge Stark found that Masiz’s new value contribution was properly valued at 72 days of service, which translated to $34,520.55 when converted to a percentage of the annual $175,000 salary he agreed to.  The District Court found that Masiz pointed to no other method of calculation and that his claiming the new value amount to be disputed does not render it so for summary judgment purposes.

Note that on October 2, 2015, Masiz appealed Chief Judge Stark’s order and opinion to the Third Circuit Court of Appeals.  The appeal remains pending as of this writing.

Part II of this post will be up tomorrow.

Judge Sontchi Rules Preferential Transactions Were Made in the Ordinary Course of Business Notwithstanding Earlier Ruling Adverse to Defendant at Summary Judgment Stage

  The Court made this decision notwithstanding an earlier adverse ruling on Defendant’s summary judgment motion which sought dismissal, inter alia, on OCOB Defense grounds.

On August 29, 2008 (the “Petition Date”), Trevi Architectural Inc. along with its parent company, Sierra Concrete Design, Inc. (the “Debtors”), filed voluntary chapter 7 petitions for relief.  Prior to the Petition Date, Defendant provided plastic composites to the Debtors under a credit limit and on the following invoice terms: from February 2004 to April 2007, net 30 days, from April 2007 through August 2008, net 60 days, with variation in the time of payment a routine occurrence.  On August 19, 2010, the Chapter 7 Trustee (the “Trustee”) appointed in the Debtors’ cases filed a complaint (the “Complaint”) seeking to avoid and to recover 27 preferential transfers – totaling $612,879.94 – from Defendant.  In a January 2012 opinion, the Court granted, in part, and denied, in part, Defendant’s summary judgment motion on the basis that Defendant established a limitation of liability under Bankruptcy Code section 547(c)(4) but didnot establish the OCOB Defense.  On the latter issue, the Court found that the parties’ pre-preference relationship as presented to the Court – which consisted of 17 checks covering approximately 68 invoices over an 11 month period – was insufficient to establish the existence of an ordinary course of business; moreover, the Court found that Defendant’s behavior during the preference period was of the type that “the preference law is intended to thwart.”

In September 2014, the trial on the Complaint went forward on the question of whether seven transfers in the amount of $172,932.14 were protected by the OCOB Defense or the “contemporaneous exchange of new value” defense under Bankruptcy Code section 547(c)(1).  The Court first analyzed the OCOB Defense, noting that the defense was divided into subjective and objective components, with Defendant needing only to satisfy one of the two.  As to the former, the Court found that the parties’ relationship was established over a 4.5 year period, during which time there were approximately 610 transactions between them, and other than letting the Debtors know that they were at or near their credit limit, Defendant never pressured the Debtors to pay outstanding invoices at a faster rate than usual; the Court noted that the evidence submitted at trial was vastly more extensive than that put before the Court at the earlier summary judgment stage, and as such, easily established an ordinary course of dealing.  Compared to the preference period, the Court found no evidence that the amounts paid or method of payment were unusual, nor did Defendant take any steps to pressure the Debtors.

With respect to the days-to-pay comparison – 55.22 days during the historical period versus 27.3 in the preference period – the Court found that this facially significant deviation was distinguishable from cases like In re Archway Cookies for several reasons – one, the parties changed their payment terms during their relationship; two, the Debtors were engaged in a construction project during the Preference Period that required product and invoicing at a faster rate; and three, the parties operated under a credit limit which was not strictly enforced by Defendant during either the historical period or preference period.  The Court found that the Trustee offered no evidence to rebut these points.

In its analysis of the objective OCOB Defense prong, the Court found that the trial testimony of Defendant’s CEO was insufficient to establish the “industry” standard requirement under Bankruptcy Code section 547(c)(2)(B), notwithstanding his 40 years of experience and assertion that Defendant’s contracts were in line with the industry.  The Court agreed with the Trustee that Defendant’s CEO provided no objective data or reports on the “industry standard”.

In analyzing Defendant’s contemporaneous exchange of new value defense provided for in Bankruptcy Code section 547(c)(1), the Court found that there was no evidence in the record to indicate that the parties intended at any time during the Preference Period for the transfers to be contemporaneous.  To the contrary, the Court found that the Debtors routinely paid outstanding invoices within either net 30 or net 60 days, averaging 52.8 days to pay; checks sent by the Debtors often referenced old invoices; and finally, Defendant admittedly applied payments to old invoices, a hallmark of a party’s lack of intent to commit contemporaneous exchanges.

Notwithstanding Defendant’s failure under Bankruptcy Code sections 547(c)(2)(B) and 547(c)(1), the Court found that Defendant established a complete defense under section 547(c)(2)(A), and thus entered judgment in Defendant’s favor under Federal Rule of Bankruptcy Procedure 7058.

A copy of the opinion can be found here.