Judge Owens (Bankr. D. Del.) Issues First Avoidance Opinion in Rejecting Defendant’s Argument That Complaint Was Time-barred

In Judge Owens’s UMB Bank, N.A. v. Sun Capital Partners V, LP (In re LSC Wind Down, LLC), 2020 WL 377015 (Bankr. D. Del. Jan. 23, 2020) opinion, the Court denied Defendants’ 12(b)(6) motion to dismiss Plaintiff-Trustee’s attempt under section 544 to avoid and recover an alleged $42 million fraudulent transfer (the “Transfer”) made to Defendants more than five years prior to the Petition Date. The opinion is the first one issued by Judge Owens that pertains to avoidance actions; substantively, she found that because the Complaint alleged specific unsecured creditors of the applicable Debtor who could have avoided the Transfer as of the Petition Date, the motion to dismiss must be denied.

The Parties’ Positions
The Transfer at issue in the Complaint occurred on December 20, 2011, with the Debtors filing for bankruptcy relief on January 17, 2017. The Complaint was then filed on January 17, 2019 (referred to as the “Commencement Date” in the Opinion), two years after the Petition Date and a little over seven years after the date of the Transfer.

The issues largely revolved around the timing of the Complaint and the state law applicable to the same, given that it was brought pursuant to 11 U.S.C. § 544. Defendants argued that the Complaint was filed “well beyond the prescribed time period set forth by [the applicable] Florida state law, asserting Florida’s fraudulent transfer statute required such claims to be brought “within 4 years after the transfer was made or the obligation was incurred or, if later, within 1 year after the transfer or obligation was or could reasonably have been discovered by the claimant[.]” Since the Complaint was indisputably filed beyond the four year statute of limitations, only the one year savings clause could render it timely; Defendants argued that the savings clause could not apply, given that (i) Plaintiff had notice of the Transfer more than one year prior to the Commencement Date through its access to the Debtors’ books and records and public news reports, and (ii) the savings clause was not otherwise tolled.

In response, Plaintiff argued that the Complaint’s timeliness under the savings clause was not reliant on Plaintiff’s knowledge but rather that of the Debtors’ creditors. Because Plaintiff stepped into the shoes of the Debtors’ creditors to avoid the Transfer under section 544(b)(1), it argued that so long as one such creditor (a “Predicate Creditor”) was entitled as of the Petition Date to assert a claim against the Defendants under the Uniform Fraudulent Transfer Act (“UFTA”), then it may do so on or before two years after the Petition Date pursuant to section 546(a)(1)(A). As such, Plaintiff asserted the Complaint was timely, alleged the existence of sufficient Predicate Creditors under the savings clause, and the Complaint did not establish that every Predicate Creditor of the Debtors was time barred from bringing a state law avoidance claim against the Defendants as of the Petition Date.

The Court’s Findings
The Court began by noting the statute of limitations provided by the Bankruptcy Code under section 546(a) for causes of action brought via section 544. Judge Owens then found that despite “the Defendants’ contrary assertions, so long as an underlying state law avoidance claim is not time-barred as of the commencement of a bankruptcy case, a section 544(b)(1) claim may be brought provided that it is commenced within the time periods prescribed by section 546(a).” This approach made sense to the Court, “because it provides time for investigation and encourages value maximization.”

Against that backdrop, the Court found that Plaintiff complied with section 546(a), as the Commencement Date of the adversary proceeding was two years after the Petition Date. While it was Plaintiff’s burden to ultimately prove that a Predicate Creditor existed as of the Petition Date for 544(b) purposes, the Court found it premature to make such a ruling in addressing a timeliness defense contained in a motion to dismiss (an issue more typically raised in an answer).

Analyzing the Complaint, Judge Owens found that Plaintiff alleged that there was at least one unsecured creditor of the applicable Debtor who could have sought to avoid the Transfer as of the Petition Date, “and more specifically identifies by name over 100 of such creditors.” The Plaintiff “also alleges that these creditors did not know of and could not have reasonably known of the Transfer or its fraudulent nature prior to the Petition Date, thereby capturing the one-year savings clause under UFTA as applied by both Florida and Ohio law.” The Court highlighted the distinction between this specific naming of creditors and the case that Defendants primarily relied upon (In re Petters Co., Inc. 495 B.R. 887 (Bankr. D. Minn. 2013)), noting the latter plaintiff simply included a generalized statement with no identified creditors. Specific allegations are critical, as they “allow the Defendants ‘[t]o structure and pursue their opposition to’ the Plaintiff’s standing, a concern of the court [upon whose opinion Defendants’ relied].” Ultimately, then, the Court found Defendants’ arguments and supporting documentation more suitable for summary judgment than a motion to dismiss; accordingly, their relief was denied.

Conclusion
In addition to being Judge Owens’s first foray into avoidance litigation, her opinion is important for providing guidance to parties embroiled in a section 544 dispute, especially one involving a savings clause component. The Court found the specific naming of the creditors whose standing a plaintiff purports to use was a pivotal distinction between the instant case and the decision upon which Defendants relied. Also helpful is the Court’s overview of section 546(a)’s parameters as they apply to section 544.

A copy of the Opinion can be found here.

Are Customer Funds Held by Debtor Logistics Company Property of the Debtor’s Estate? Chief Judge Ferguson (D.N.J.) Addresses Multiple Avoidance Issues in TransVantage Solutions

  Chief Judge Ferguson (Bankr. D.N.J.) recently tackled some of these issues at the motion to dismiss stage in her opinion for Giuliano v. Delta Air Lines, Inc. (In re TransVantage Solutions, Inc.), Adv. No. 15-1882, 2016 WL 5854197 (Bankr. D.N.J. Oct. 6, 2016).  In denying the motion to dismiss (hereafter, the “Motion”), the Court provides a detailed analysis of the 547(b) preference elements that may prove influential as these cases arise in the future, notwithstanding the non-binding nature of the opinion.

Background

The TransVantage cases were initiated under Chapter 7 of the Bankruptcy Code on May 3, 2013 (“Petition Date”), following which Alfred Giuliano was appointed Chapter 7 Trustee (“Trustee”).  In April 2015, the Trustee filed hundreds of preference and fraudulent transfer complaints against various defendants.  Per one of the complaints (which may differ from defendant to defendant), the Debtors were

in the business of providing freight audit and payment services on behalf of its customers (the “Customers”) to help ensure that the auditing and payment of freight invoices were done accurately and timely. TransVantage Solutions would receive freight invoices from the Customers’ common carriers/shippers . . . and then audit and determine whether those invoices were accurate and in compliance with the Customers’ agreements with the carriers/shippers, tariffs and/or regulations.  TransVantage Solutions would then remit the funds received from the Customers to the applicable carriers/shippers. The transfers that are the subject of this Complaint are the transfers described in the preceding sentence that were received by the [Carrier].

Many defendants in the case settled, but ten did not (those ten hereafter referred to as the “Defendants”) and sought to go forward with the Motion.

The Preference Counts

The Defendants based their Motion upon, inter alia, an assertion that the Trustee failed to sufficiently plead the predicate elements of section 547(b) of the Bankruptcy Code.  These points are summarized as follows:

  1. “Interest of the debtor in property”

The Defendants first contended that because the Trustee referred to the funds advanced to the Debtors by the Customers as being held in trust, there could be no property of the estate involved.  The Court, however, would not dismiss the Complaint solely because of the Trustee’s use of the word “trust”; to contrary, the Court found the usage to be conclusory at best, as “[d]etermining whether something is a true trust for bankruptcy purposes is a legal determination for the court to make, it should not be done on a motion to dismiss.” The Court found this especially true considering the early stage of the proceedings, which warrants freely permitting amendment to cure pleading deficiencies.

Having dismissed the Defendants’ “trust” language argument, the Court found that the Debtors at least had a possessory interest in the funds in its own account, which account received the transferred funds from its Customers.

  1. “To or for the benefit of a creditor”

The Court next determined that payments made to the Carriers were for the benefit of the Customers who owed the freight bills.  Customers, in the Court’s view, met the definition of “creditors” under the Bankruptcy Code, as they would have had a claim against the Debtors by virtue of the Customers advancing funds to the Debtors for payment to the Carriers.

  1. “For or on account of an antecedent debt owed by the debtor”

One of the Defendants argued that the Trustee’s failure to allege an antecedent debt owed by the Debtors to the Defendant was dispositive because its business relationship was with the Debtors’ Customers, not the Debtors.  Nevertheless, the Court found that section 547(b)(2) “does not state that the antecedent debt must be owed by the debtor to the defendant, it merely states that it must be ‘owed by the debtor’”; as such, a payment to the Defendant would have been for the benefit of a Customer (a creditor).

  1. “Made while the debtor was insolvent”

The Court found this element met by virtue of the presumption of insolvency under section 547(f) as well as the allegation of a $40 million shortfall as of the Petition Date.

  1. “Made on or within 90 days before the date of the filing of the petition”

The Court found the Complaint clearly pled that pertinent transfers were made within 90 days of the Petition Date.

  1. “Transfer enabled the creditor to receive more than it would have in a Chapter 7 but for the transfer”

The Trustee argued that the Debtors’ liabilities exceeded their assets such that all of the Debtors’ unsecured creditors would not receive full payment – i.e., the Customers whose freight carriers received either full or partial payment made out much better than those Customers whose Carriers received no payment.  The Court appeared to find this allegation sufficient.

In light of the foregoing, the Court concluded the predicate preference elements were sufficiently pled to survive dismissal.  Interestingly, one of the Defendants also raised an ordinary course of business defense under section 547(c)(2), which the Court questioned both on procedural and substantive grounds.  To the latter, “[t]aking the factual allegations in the complaint as true . . . the payments were neither made in the ordinary course of business nor made according to ordinary business terms.”  Further, “the method of payment deviated from the ordinary course of business which was supposed to have been that the funds paid by the Customers were held specifically to pay the freight bills of that Customer and only that Customer.”

The Fraudulent Transfer Counts Under State and Federal Law

The Complaint also contains fraudulent transfer allegations under sections 544 (using New Jersey law) and 548.  The Defendants attacked these counts on multiple fronts, arguing that the Trustee failed to identify “an actual creditor holding an allowed unsecured claim who could avoid the challenged transfers.”  Nevertheless, the Court found that “[w]hen analyzing the sufficiency of a complaint for purposes of Rule 12(b)(6), courts do not generally require a trustee to plead the existence of an unsecured creditor by name, although the trustee must ultimately prove such a creditor exists.”

The Court next rejected the Defendants’ argument that the Complaint is deficient with respect to Federal Rule of Civil Procedure 9(b); the Defendants asserted that the Debtors’ intent to hinder, delay or defraud creditors did not meet the rule’s heightened pleading standards. The Court, however, found that Rule 9(b) permits fraudulent intent to be alleged generally.  As such, the Court found sufficient the Complaint’s allegations that the Debtors’ insiders “were not segregating the funds in the Freight Payment Plan Account, but instead using them to pay personal and business expenses, the complaint adequately pleads actual intent to hinder, delay or defraud.”

The Defendants also argued that the Complaint fails to allege a cause of action for constructive fraud under section 548(a)(1)(B) and N.J.S.A. 25:2-27 because the Debtors received reasonably equivalent value in exchange for each alleged transfer.  In other words, each transfer “was a ‘wash’ because each payment made to the Carriers reduced a corresponding liability owed to them by [the Debtors] (on behalf of the Customers) on a dollar for dollar basis.”  While not rejecting this contention, the Court found that it was inappropriate to find as much at the motion to dismiss stage, noting how highly fact-sensitive such a determination would be.

The Court likewise found that, despite the Defendants’ assertions to the contrary, the Complaint did sufficiently allege insolvency based upon statements that the Debtors’ debts were greater than their assets and that they could operate only in reliance upon new Customer funds.

Is the Bankruptcy Code Preempted by the Federal Aviation Administration Authorization Act?

The Defendants’ last argument relied upon the Federal Aviation Administration Authorization Act, which they averred should limit any remaining fraudulent transfer claims to 18 months prior to the bankruptcy filing.  The FAAAA is designed to preempt any law “related to a price, route or service of any motor carrier, … broker, or freight forwarder with respect to the transportation of property.”  Nevertheless, the Court rejected this argument for multiple reasons: (1) the Defendants cite no supporting case law in which the Bankruptcy Code or New Jersey’s fraudulent transfer statutes were preempted by the FAAAA; (2) the state law claims are derivative of the Trustee’s federal powers in any event, making it not a purely state law issue; and (3) two federal statutes should be harmonized instead of preempting one in favor of another.  To the last point, the Court found that the statutes could be so harmonized, as “the Bankruptcy Code’s goal of equality of distribution through allowing avoidance actions in no meaningful way interferes with the goal of increased competition in interstate transportation.”  Even if it did, however, the Court found that the FAAAA should yield to Bankruptcy Code, citing to a 1994 bankruptcy decision from the Northern District of California (In re Medicar Ambulance Co.).

Conclusion

It bears repeating that the Court has designated the instant opinion as “Not for Publication”.  Nevertheless, given the relative dearth of opinions in the logistics debtors space, parties representing any party in the affected trifecta (customer, debtor/trustee, carrier) should take note of this opinion.  The issues and questions in such cases are invariably quite similar – chief among them being the determination of the trifecta’s rights as to any alleged asset of the estate.

Moreover, it obviously remains to be seen what the final outcome will be in these cases once the parties have had an opportunity to flesh their arguments out with discovery.  Until then, this will be a docket to keep an eye on, barring settlement.

A copy of the Opinion can be found here.

Judge Houle (Bankr. C.D. Cal.) Addresses the Impact of Substantive Consolidation On Fraudulent Transfer Defenses in In re Empire Land, LLC

  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

The Transfers allegedly at issue can be summarized as follows:

(1) 9.6M Transfer: Empire Land transferred $9.6M to Defendant.
a. Defendant alleges:
i. that the transfer was part of a series of transactions where Empire Land was repaying an inter-company loan to Prestige:
1. Prestige deposited all but $3.5M of that amount into Aviat’s bank account, which immediately deposited it into Defendant’s bank account, which immediately deposited it into Empire Land’s bank account.
2. The $3.5M was deposited by Prestige directly into Empire Land’s bank account.
3. Empire Land transferred $9.6M to Defendant’s bank account, which immediately transferred the funds to Aviat’s bank account, and finally to Prestige’s bank account.
ii. That Plaintiff improperly isolates the one transfer (bolded above) from Empire Land to Defendant (implying that Defendant was a mere conduit).
b. Plaintiff counters that the $9.6M transfer was not a short term loan, but a capital distribution to Defendant.
(2) 4.0M Transfer:
a. Plaintiff alleges that Empire Land transferred $4M to Defendant as a capital contribution.
b. Defendant alleges that no transfer actually took place but a series of journal entries were made and reversed.
(3) $1.4M Transfer: Empire Global transferred its interest in a promissory note of approximately $1.4M to Defendant.
a. Defendant alleges the transfer was part of a four-step process to convert the balance of a prior loan from Previti to Empire Land into a capital contribution, such that Empire Land was no longer required to repay the Note. The $1.4M Transfer sequence moved from Previti, to the Family Trust, to Empire Global, to Defendant, and then to Empire Land.
b. Plaintiff alleges that the transfers were part of a scheme so it would appear that Empire Land could meet a $10,000,000 liquidity covenant required by a loan involving Empire Land.

 

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.

  1. 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.

4. Insolvency

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.

Conclusion

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.

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.

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.