A recurring theme—one that enrages creditors—is that of a business owner who secretly transfers assets from a failing business to friendly affiliates and then files bankruptcy, leaving creditors holding the bag.
The Bankruptcy Code tries to address this by requiring that debtors open their books to the court and creditors. Where there is fraud or dishonesty, a creditor can ask the Court to appoint a trustee. Procedurally, however, debtors have a home court advantage.
The following case illustrates just how hard it can be… and the importance of creating a strong evidentiary record, including expert testimony, even if you think you’ve caught the debtor red handed.
“Vehemence,” the court said, “is no substitute for evidence.”
What Happened Was….
Pedro Lopez-Munoz owned and operated gas stations in Puerto Rico, both individually and through a corporation that he owned. When the business fell on hard times, he sold his interests in the gas stations to his corporation and then transferred ownership of the corporation to a trust. And guess what? Pedro was the trust’s principal beneficiary.
Seven months later, Pedro filed a Chapter 11 bankruptcy case. He didn’t mention his financial interests in the gas stations. Although he did disclose that he had transferred ownership of the gas stations to his trust, the statements he made were incomplete and misleading. Significantly, he claimed (incorrectly) that the trust beneficiaries were his children, not himself.
One of Pedro’s creditors learned about the transfers through legal discovery. It responded by asserting that Pedro had been trying to defraud his creditors, and it sought appointment of a Chapter 11 trustee. The U.S. Trustee’s Office supported the motion. That’s important because the U.S. Trustee’s Office serves as a watchdog for bankruptcy fraud. Having their support can send a strong signal that there are real issues.
In response, Pedro rescinded the transfers and corrected his disclosures. As for why he made the transfers? Pedro said he was really just trying to help all of his creditors out by shielding his assets from one particularly aggressive creditor. He also submitted expert testimony from his CPA stating that the transfers had no material effect on his bankruptcy estate because all proceeds were paid over to his secured creditors.
What Did the Court Do?
The appointment of a trustee is an extraordinary act, and the moving party (i.e., the creditor) has the burden of proving the appointment is justified. This is the debtor’s home court advantage.
After a two day hearing, the Bankruptcy Court said that the bonding company had not proven that a trustee should be appointed. The bonding company disagreed, appealed, and lost. Why?
The appellate court believed that Pedro’s explanation for the transfers (e.g., I was trying to help my creditors!) was credible enough to overcome a presumption of fraud.
Surprised? So was I at first. But the appellate court pointed out that the bonding company didn’t get an expert squarely in front of the trial court. Pedro’s expert, on the other hand, testified that there was no fraud and the transfers didn’t harm creditors. Since Pedro’s expert was largely unchallenged, Pedro won.
The Legal Underpinnings
Here’s a closer look at the court’s reasoning. The case was heard by the Bankruptcy Appellate Court in the First Circuit. Bankruptcy Code section 1104(a)(1) states that if a creditor requests appointment of a trustee, the court shall approve the request:
- For cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case . . . ; or
- If such appointment is in the interests of creditors, any equity security holders, and other interests of the estate . . . .
The appellate courts agree that there is a strong presumption against appointing a trustee. However, they don’t agree about what a creditor must do to overcome this presumption. Most state that the creditor must present “clear and convincing evidence.” Some are satisfied with a preponderance of evidence. The First Circuit hasn’t yet decided which standard to apply.
Both the bankruptcy and appellate courts hedged their answer on this issue. On one hand, the bankruptcy court decided that the majority’s approach (“clear and convincing evidence”) was correct. On the other hand, it stated that the standard to be applied didn’t matter because, under Puerto Rico’s fraud statute, a trustee wasn’t justified under either standard. The Bankruptcy Appellate Court—remarking on the lack of expert testimony to support the creditor’s motion—agreed. It held that, under either standard, the creditor had not shown a benefit to appointing a trustee that would outweigh its cost.
So Pedro avoided a trustee and it seems that the First Circuit could be falling into line with the majority rule, requiring clear and convincing evidence to justify appointment of a trustee.
United Surety & Indemnity Co. v. Pedro Lopez-Munoz (In Re Pedro Lopez-Munoz), 1st Cir. BAP No. PR16-011, Bankr. Case No. 13-08171-EAG (July 28, 2016).