Tag Archives: fraudulent transfer

June 21, 2016

Supreme Court Expands Creditors’ by Allowing Denial of a Discharge Under Sec. 523(a)(2)(A) if Debtor Transfers Assets in Violation of State Fraudulent Transfer Statute

Section 523(a)(2)(A) of the Bankruptcy Code allows a creditor to obtain a judgment denying its debtor a discharge of debts incurred by false pretenses or actual fraud. However, if the debt itself was not incurred by actual fraud, but the debtor subsequently transfers his assets with the intent prevent its creditors from obtaining payment, may the creditor still obtain a judgment denying the debtor’s discharge under § 523(a)(2)(A)? The United States Supreme Court answered that question in the affirmative in its recent decision in Husky International Electronics, Inc. v. Ritz, 2016 WL 2842452 (2016).

Chrysalis Manufacturing Corp. incurred a debt to Husky International arising from Chrysalis’s purchase from Husky of components used in electronic devices. Over a period of four years, Chrysalis incurred a debt to Husky totaling over $160,000. There was no contention that this debt was incurred as the result of false representations or actual fraud. However, during the latter part of this same period, Daniel Ritz, a director and owner of Chrysalis, caused Chrysalis to transfer virtually all its assets to other companies Ritz also controlled. Husky sued Ritz under a Texas statute which allows creditors to hold shareholders responsible for corporate debts under circumstances involving actual fraud. After Ritz filed a personal bankruptcy petition under chapter 7, Husky brought an adversary proceeding against him seeking denial of the dischargeability of its debt under § 523(a)(2)(A). The District Court concluded the Ritz was liable under the Texas statute but also concluded that the debt was not obtained by actual fraud could be discharged. The Fifth Circuit affirmed, agreeing the debt could be discharged since it was not incurred by actual fraud as required by § 523(a)(2)(A).

The Supreme Court reversed, holding the term “actual fraud” in § 523(a)(2)(A) “encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation.”

The Court commenced its analysis by first looking to the prior Bankruptcy Act, which prohibiting debtors from discharging debts obtained by false pretenses or false representations, but contained no provisions relating to situations which might constitute “actual fraud” but not fall within the meaning of false pretenses or false representations. Congress added the term “actual fraud” when it enacted the Bankruptcy Code in 1978. The addition of the words “actual fraud” were presumed by the Court to have “real and substantial effect.” The Court believed the words “actual fraud” were intended to mean something other than “false representation.” The Court then analyzed the historical meaning of the terms “actual fraud” and concluded the words have long included the type of fraudulent transfer scheme in which Ritz engaged. First, the Court noted the word “actual” has a simple meaning in the common law, and denotes any fraud that “involves moral turpitude or intentional wrong,” and stands in contrast to implied fraud or fraud in law. The Court stated “Thus, anything that counts as ‘fraud’ and is done with wrongful intent is ‘actual fraud.’”

The Court found analyzing the history of the word “fraud” to be more challenging, and although it “connotes deception or trickery generally,” was more difficult to precisely define. However, the Court noted the term “fraud” had long been used by courts to describe a debtor’s transfer of assets which impairs a creditor’s ability to collect a debt. The Court further noted that fraudulent conveyances at common law did not require a misrepresentation by a debtor to his creditor. The fraudulent conduct was not in inducing the creditor to extend credit but rather was in the act of concealment and hindrance. As a result, the Court determined the actual fraud need not be present at the inception of a credit transaction.

February 16, 2016

Seventh Circuit Finds Suspicion, Negligence and Ineptitude Sufficient to Defeat a Claim that a Transferee Received a Fraudulent Transfer in Good Faith, but Insufficient to Equitably Subordinate the Transferee’s Claim

Section 548(c) of the Bankruptcy Code entitles the recipient of a fraudulent transfer in certain circumstances to retain a lien on the property received through the debtor’s fraud if the transferee took the property in good faith and for value. The Seventh Circuit recently, In addressing a case where the bankruptcy trustee asserted the recipient of a fraudulent lien did not take in good faith and its claim should be equitably subordinated to unsecured claims, held suspicion, negligence and ineptitude on the part of the claimant to be sufficient to defeat the recipient’s claim that it acted in good faith but insufficient to equitably subordinate the claim. Grede v. Bank of New York Mellon Corp. (In re Sentinel Management Group, Inc.), 809 F.3d 958 (7th Cir. 2016).

In Sentinel, the debtor was a cash management firm which borrowed money from BNYM to funds its operations. Sentinel received money from its customers, which it used to purchase securities for its customers and which it was required by law to maintain in segregated accounts separate from the accts which Sentinel used for its own trading. Sentinel had a capitalization of less than $3 million, but also had securities it had purchased for its customers’ accounts which exceeded $300 million. When securities markets became shaky in the summer of 2007, Sentinel found itself unable to meet both its collateral levels with the bank and its customers’ requests to redeem their securities. Sentinel embarked on a scheme under which it borrowed on its line of credit with the bank to meet its customers’ redemption demands, and transferred its customers’ securities from their segregated accounts into Sentinel’s personal accounts on which the bank held a lien. By transferring customer securities to accounts on which the bank held a lien, Sentinel violated federal law. When Sentinel filed bankruptcy, a dispute arose between the bank and the trustee over whether the bank received its lien in good faith or whether the trustee could avoid the lien under § 548. The district court ruled in favor of the bank, finding the bank’s actual belief that Sentinel had not pledged the securities in question without its customers’ consent, was sufficient to establish it acted in good faith. The Seventh Circuit reversed.

The Seventh Circuit stated the district court’s conclusion was wrong. The court held that inquiry notice, which it defined as “awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing,” prevents the recipient of a fraudulent transfer from the protections afforded a good faith transferee. The court further stated “inquiry notice is not knowledge of fraud or other wrongdoing but merely knowledge that would lead a reasonable, law-abiding person to inquire further—would make him in other words suspicious enough to conduct a diligent search for possible dirt.” As a result, an actual belief that the transfer is not fraudulent is insufficient if the recipient has knowledge of facts which place him on notice that further investigation is warranted. In this instance, the fact that the debtor’s capital was less than $3 million yet it had the ability to post $300 million of collateral to secure its debt to the bank, were sufficient to place the bank on notice that the debtor was using someone else’s property to collateralize the loan. A memo from a bank employee who worked on the Sentinel account to the bank evidencing “puzzlement” at the source of the collateral and a suspicion that the collateral was owned by parties other than the debtor, was sufficient to require additional investigation on the bank’s part. As a result, the court held the bank did not qualify as a good faith transferee with respect to its lien on securities owned by the debtor’s customers.

The next question before the court was whether the bank’s conduct was sufficient to warrant equitable subordination of its unsecured claim to claims of general unsecured creditors. The trustee argued that the same conduct which prevented the bank from being considered a good faith transferee was sufficient to warrant equitable subordination of its claim. The court disagreed, stating that, while mere negligence or ineptitude may be sufficient to place a transferee on inquiry notice for purposes of a good faith defense, they are insufficient to warrant equitable subordination under § 510(c)(1). In order to warrant equitable subordination, the court held the transferee’s conduct must not only be inequitable but “seriously so,” using the words “egregious,” “tantamount to fraud” and “willful” as the type of conduct required. The bank should have suspected something was amiss, and that was sufficient to eliminate its good faith defense, but because the trustee did not establish the bank knew Sentinel had pledged its customers’ securities without their consent, the court found there was insufficient evidence to equitably subordinate the bank’s unsecured claim.

December 1, 2015

Non-Compete Agreements and Fraudulent Transfer Law–How Doing Nothing can be Reasonably Equivalent Value in the Tenth Circuit

How can a recipient of a transfer of money do nothing in return, and by such inaction provide reasonably equivalent value in exchange for the transfer? The Tenth Circuit in its decision in Weinman v. Walker (In re Adam Aircraft Industries, Inc.), 2015 WL 5973397 (10th Cir. 2015) held that a former employee’s compliance with a severance agreement containing a non-compete provision, provided reasonably equivalent value in exchange for the payments made to him under the agreement.

Joseph Walker served as president and a member of the board of directors of the debtor. Throughout his tenure, he never had an employment agreement, a non-compete agreement or a severance agreement, with the company. About one year before the company filed bankruptcy, its board concluded that it needed to replace Walker as president of the company and to remove him from the board. This conclusion was not known to Walker until after the board had hired his replacement. At the time, the company was in the final stages in its negotiations for a substantial debt financing with Morgan Stanley. In communicating the board’s decision to Walker, the Chairman and CEO told Walker that it was important to the company’s financing negotiations that Walker’s separation be treated as a resignation rather than a firing. Shortly after this discussion, Walker went to his office, retrieved his personal belongings and left the company’s premises never to return. The minutes of the board meeting for Feb. 7, 2007 reflected Walker had resigned effective Feb. 2, 2007. His replacement commenced his duties as president of the debtor on Feb. 2, 2007.

Over the next several days, Walker and the company negotiated a separation agreement that contained several essential elements: (1) the company retained Walker as a consultant for 18 months at a salary of $250,000 per year, contingent on his helping the debtor to maintain its sales backlog at a certain level, (2) Walker would not compete with the company during this time frame, (3) the company would refund Walker’s deposit he had placed for the purchase of an aircraft, and (4) the company would repurchase stock Walker owned in the company for the same price he paid for it several months earlier. The separation agreement, along with a subsequent modification of it, both stated that Walker’s employment with the company terminated March 1, 2007, about one month after Walker’s resignation.

The company’s bankruptcy trustee sued Walker seeking to recover, among other things, the severance payments made to him under the agreement as fraudulent under §548. The questions addressed by the Tenth Circuit included (1) whether Walker was a statutory insider for purposes of § 548, (2) whether Walker was a non-statutory insider, and (3) whether Walker gave reasonably equivalent value in exchange for the severance payments he received.

With regard to its determination whether Walker was a statutory insider, the court first looked to the definition of the term “insider” in the Bankruptcy Code. That definition states that an “insider” is an officer, director or a person in control of the debtor.   In this instance, although the two separation agreements stated that Walker’s employment terminated on March 1, the Tenth Circuit held that the bankruptcy court’s finding that his employment actually ended on February 1 was not clearly erroneous. Walker had submitted his resignation, emptied his office, had performed no duties, and his replacement took office, all on February 1 and 2. Finding these facts supported a conclusion that Walker had made a “clean break” with the company in early February, the Tenth Circuit affirmed the finding that Walker was not a statutory insider on the dates he received his severance payments. With regard to the question of whether Walker qualified as a non-statutory insider, the Tenth Circuit considered the only evidence produced by the trustee—that Walker had presented the initial terms for his separation—to be an insufficient basis for a finding of insider status.

In addressing the trustee’s arguments that Walker did not provide reasonably equivalent value in exchange for his severance payments, the Tenth Circuit noted the bankruptcy court’s findings of fact on the dispute. The bankruptcy court found that (1) Walker agreed to refrain from taking a position with a competing company, (2) Walker could have easily found a position with the competitor because of his high reputation in the industry, (3) Walker agreed to be supportive of the debtor in its efforts to obtain its financing package from Morgan Stanley, and (4) waived his potential claims for wrongful termination. In short, the company was willing to pay Walker money in exchange for his noncompetition, goodwill and waiver of claims. The members of the board were sophisticated business people, and the majority of them were outside directors who were more intent on making a profit than in reaching an agreement with Walker merely to placate him. The evidence established that several members of the board were concerned that firing Walker could imperil the company’s negotiations for financing, and reaching an agreement with Walker that paid him several hundred thousand dollars while at the same time preserving the company’s ability to receive $80,000,000 in financing, was a good deal for the company.

In reaching its conclusion, the Tenth Circuit refused to accept the trustee’s argument that non-compete agreements have no value as a matter of law. The court distinguished the holdings of two cases on which the trustee relied—In re Joy Recovery Tech. Corp., 286 B.R. 54 (Bankr. N.D. Ill. 2002) and In re Vadnais Lumber Supply, Inc.), 100 B.R. 127 (Bankr. D. Mass. 1989)—because the individuals involved in both cases already owed a fiduciary duty to their employers not to compete, a duty which Walker did not owe until after he entered into the separation agreements following his resignation as president.

May 26, 2015

Seventh Circuit Holds that the Religious Freedom Restoration Act does not Apply in Cases Where the Government is not a Party, and Further Holds a Creditors Committee is not “the Government”

In its recent opinion in Jerome Listecki, as Trustee of the Archdiocese of Milwaukee Catholic Cemetery Perpetual Care Trust v. Official Committee of Unsecured Creditors, 2015 WL 1010089 (7th Cir. 2015), the Seventh Circuit held that the Religious Freedom Restoration Act (“RFRA”) does not apply in cases where the government is not a party, and further held that the creditor the Creditors Committee in the case was not the equivalent of the government for purposes of the RFRA.  The facts of the case involved a claim by the Committee to avoid the transfer of a substantial sum of money by the Archdiocese of Milwaukee to a perpetual care trust as a fraudulent transfer.  In seeking declaratory relief, the Archbishop contended the transfer was protected by the RFRA.  Because the filing of the complaint created a conflict for the Archbishop, he and the Committee stipulated, and the bankruptcy court granted, the Committee derivative standing to pursue avoidance of the transfer.  The Committee then filed a counterclaim asserting the transfer was avoidable under the Bankruptcy Code.  The U.S. District Court for the Eastern District of Wisconsin held that RFRA is not applicable when the government is not a party to the suit based on the statute’s plain language, a ruling with the Seventh Circuit affirmed.  However, the U.S. District Court also found that the RFRA was applicable to the action because the Committee acted under “color of law” and was the “government” for RFRA purposes, rulings with the Seventh Circuit reversed. 

The Seventh Circuit noted that it had previously stated in dicta that the RFRA is applicable only to suits where the government is a party.  The court followed that dicta in its opinion, holding the statute’s plain language, its legislative history and the compelling reasons offered by its sister circuits justified a holding that RFRA is applicable only in suits where the government is a party.  The plain language of the statute provides that the “government shall not substantially burden a person’s exercise of religion even if the burden results from a rule of general applicability,” and that a private party cannot step into the shoes of the “government.”  The language of the statute indicated to the court that relief is “clearly and unequivocally” limited to that from the “government.”  The legislative history of the statute also was replete with references to protection of religious liberty from government incursion.  Thus, the court concluded that RFRA applies only to actions involving the government as a party.

With that conclusion, the court then turned to whether the Committee was the “government” such that RFRA would apply to the action, and concluded the Committee was not.  The Archdiocese argued that the Committee was the “government” because it acted under color of law as an arm of the U.S. Trustee, its creation by the U.S. Trustee pursuant to the Bankruptcy Code, and its performance of a traditional government function.  The court rejected these arguments.  First, the court noted that none of the members of the Committee was a governmental actor.  In addition, although appointed by a government entity pursuant to statute, the court found that, once appointed, a Committee “takes on a life of its own.”  Further, the court noted that a committee represents the larger interests of the unsecured creditors, “and it is to them, and not the Trustee, court or any governmental actor, that the committee owes a fiduciary duty,” with no requirement to act in accordance with the Trustee’s or the court’s wishes.  The court noted that a committee can, in fact, oppose a debtor’s or trustee’s conduct.  The fact that a committee enjoys a limited grant of immunity was not conclusive, as the court noted that such immunity is routinely given to private individuals.  The court rejected the argument that the Committee performed a “public function” because it did not perform its functions in connection with the reorganization in an impartial matter and, in fact, was far from impartial in representing the interests of its constituency.  The court held that, while determination of whether a committee is acting as the “government” must be determined on a case by case basis, the Committee in this case did not. 

July 20, 2012

Lenders Beware When Securing Debt With Assets of a Borrower’s Subsidiaries

By Risa Lynn Wolf-Smith and Clarissa M. Raney

Wolf_Smith_Risa_blogA recent Eleventh Circuit Court of Appeals decision, TOUSA, sends a warning about the dangers of securing the debt of a borrower with assets of its subsidiary.  The Court held that the TOUSA subsidiaries did not receive reasonably equivalent value for paying the loan obligation of their parent and that the lenders who received the payments were therefore liable for fraudulent conveyance recoveries.  The decision provides a strong reminder to lenders to carefully consider whether and how to accept asset pledges or guarantees from borrowers’ subsidiaries, often referred to as upstream guarantees.  Creditors and lenders alike should think twice before accepting payments from subsidiary transactions which may later be avoided.  Below is a summary of this important decision.

In Senior Transeastern Lenders v. Official Comm. of Unsecured Creditors (In re TOUSA, Inc.), 680 F.3d 1298, 2012 U.S. App. LEXIS 9796 (11th Cir. 2012), a corporation known as TOUSA, Inc. paid a settlement to its prior lenders with loan proceeds obtained from its new lenders.  The new loan was secured by the assets of several of TOUSA’s subsidiaries.  The subsidiaries were not obligors on the new loan; however, they guaranteed unsecured bonds and a separate revolving line of credit.  Subsequently, both TOUSA and the subsidiaries filed for bankruptcy.

The Unsecured Creditors’ Committee in the bankruptcy proceeding filed an adversary proceeding to avoid the liens on the subsidiaries’ assets claiming that the subsidiaries did not receive “reasonably equivalent value” and therefore, the transfers were fraudulent under Section 548 of the Bankruptcy Code.  The lenders argued that the subsidiaries received reasonably equivalent value through the economic benefit of avoiding default on the bonds and revolving line of credit.  The bankruptcy court disagreed and avoided the liens for lack of reasonably equivalent value, ordered the prior lenders to disgorge $403 million of loan proceeds and awarded damages to the subsidiaries.  The lenders appealed, and the district court reversed the judgment as to the prior lenders because it found that the subsidiaries received reasonably equivalent value through indirect benefits received from the loan, including the opportunity to avoid bankruptcy.  The Committee appealed the district court decision, and the Court of Appeals agreed with the bankruptcy court and reversed the district court decision.  The Court of Appeals held that the subsidiaries did not receive reasonably equivalent value.

Lessons of TOUSA

The lessons of TOUSA highlight the challenges and pitfalls for lenders to distressed companies.  Lenders must be wary when credit is secured by assets of an entity that that is not an obligor on their loans.  More specifically, lenders need to attempt to document that they are providing value to the non-obligor entity and that such value is reasonably equivalent to the assets securing the loan.  Moreover, a heightened level of due diligence may be required of lenders to a financially distressed borrower as to the source of funds used to satisfy the loan.  It is apparent from TOUSA that indirect benefits to the non-obligor entity may not be enough.