Badges of Fraud and the Imputation of Actual Fraudulent Intent – Chief Judge Shannon (Bankr. D. Del.) Issues Latest Order in Long-Running Syntax-Brillian Fraudulent Transfer Action

  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.

Conclusion

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.

Is Denial of Receipt Enough to Contest Service Under 12(b)(5)? Must a Preference Complaint Allege More Than Recipient, Transfer Date, and Amount to Satisfy Twombly/Iqbal? Judge Sontchi Clarifies Delaware’s View

  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.

Conclusion

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.

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.

Background

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.