Establishing Intent: Steve Bartman, Lyondell, and Actual Fraudulent Transfer Law

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You are probably familiar with the Bankruptcy Code’s fraudulent transfer provisions, which allow a trustee to recover cash or assets that a debtor transferred away with actual intent to hinder, delay, or defraud its creditors. This can be a powerful tool in the hands of a trustee or creditors’ committee. See 11 U.S.C. Sec. 548(a)(1)(A).

But you may not have spent a lot of time thinking about how to prove intent when the debtor is a company. A company is a legal fiction; by itself, it can’t intend anything. And companies are typically made up of a lot of different people, including board members, officers, and employees. When it comes to fraudulent transfer litigation, who knew what, and who intended what, can be critical to creditor recoveries.

A recent decision by the New York district court provides a good example of how this works and how it can impact you.

In re Lyondell Chem. Co

Roughly one year before Lyondell Chemical Company (a Delaware corporation) collapsed into bankruptcy, its former shareholders had received $6.3 billion in distributions through a LBO. This included $100 million paid to its CEO through various stocks and options. The trustee alleged that Lyondell’s CEO had intended to defraud the company’s creditors by stripping it of assets to enrich himself and other shareholders, and that he accomplished this by knowingly presenting false financial projections to the company’s board of directors when the board considered approval of the LBO. The trustee asserted that the financials were inflated, unreasonable, and unachievable, and that consequently the LBO left the company inadequately capitalized and put creditors at great risk of a bankruptcy that could wipe out their claims.

The trustee’s lawsuit to avoid and recover these payments as actual fraudulent transfers hinged on whose intent would be imputed to the debtor. Would it be the scheming CEO? Or the duped board members?

Round One: The Bankruptcy Court Looks at the Board’s Intent

The bankruptcy court held that it was the intent of the board of directors that matters, and so it dismissed the trustee’s claim. Why? Under Delaware law, a corporation’s board of directors must approve a LBO. The court therefore felt that it was the intent of the company’s board, or a “critical mass” of the board members, which was essential to determining whether the company intended to defraud anyone.

Round Two: The District Court Imputes the CEO’s Intent to the Debtor

The New York district court disagreed and found that it was the CEO’s intent that mattered. Why? Because Delaware courts adhere to the “general rule of imputation.”

This means that Delaware corporations are held responsible for the acts and knowledge of their officers and directors acting within the scope of their authority… even when they act fraudulently.  (The rule may seem harsh, but it is designed to incentivize corporations to create strong information systems and controls).

Similarly, when an employee acts within the scope of employment or has a duty to disclose information to his employer, the law assumes that the employer was aware of that information… even if the employee failed to disclose it.

Based on these two legal principles, the district court found that the CEO’s knowledge and intent could be imputed to Lyondell even though the CEO did not control the board and it was the board, not the CEO, that approved the LBO and the resuling shareholder payments.

The court went on to find that there were enough facts to create a strong inference that the CEO acted with actual intent to hinder, delay, and defraud Lyondell’s creditors.  Because that intent could be imputed to the debtor, the court held that the trustee’s complaint would survive a motion to dismiss and that the litigation could continue.

Hey… What about Steve Bartman?

The district court also examined what “actual intent” means. The trustee had argued that debtors are presumed to intend the “natural consequences” of their actions, and that he would not need to prove the debtor actually wanted to, or believed it would, cause harm. The trustee lost this argument, and he could therefore have won the battle while ultimately loosing the war. The district court  held that the standard for finding “actual intent” to defraud is higher, and that the trustee would need to prove more. He would need to establish as an additional element, actual intent and an awareness of the consequences, not just an awareness of the facts from which the consequences would arise.

What does that mean, exactly? Let’s say you’re Steve Bartman. You’re sitting at Wrigley Field drinking a beer and watching the Cubs play. You reach to catch a foul ball. A natural consequence of reaching for that ball is that you could disrupt the game. But to establish that you actually intended to cause the Cubs to lose requires more. Chicagoans would have to prove that you weren’t just foolish, but you actually intended to cost the Cubs the National League pennant.

So the trustee was arguing that he would only need to show that, by inflating financials and paying out huge sums to himself and other shareholders, a natrual consequence would be the creditors would be hindered, delayed, or defrauded in their recoveries.  He may not have cared on whit about what happened to those creditors one way or another, as long as his actions, as a natural cosequence, hindered them.  The district court held that the trustee would need to prove more. He would need to prove that the CEO actually thought about the creditors and intended to harm them or was conscious that he was harming them.  (Legal geeks, you can curl up with the Yale Law Journal’s Intent to Defraud, published in 1915, to delve into these nuances.)

Weisfelner v. Hofmann (In re Lyondell Chem. Co.), 2016 WL 4030937 (S.D.N.Y. July 27, 2016) (motion for reconsideration denied).

Zombie Debt: The Ultimate Survival Guide

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Fall has returned. Maybe you’re making ghost costumes, stocking up on Halloween candy, or tuning in to Season 7 of The Walking Dead. If you’re the Supreme Court, your mind is on zombie debt.

What Is Zombie Debt

I first encountered zombie debt a few months ago when a co-worker asked me to look at a solicitation letter her daughter had received. The letter promised her daughter could get out of paying her student loans (for a fee) by defaulting and hiring the “servicer” to run the clock until the statute of limitations passed. Mom wanted to know if the offer was too good to be true.

First, if you have to ask whether something is a scam, it probably is. Moreover, although we all think of very old, time-barred debt as “uncollectable,” legally speaking, the debt is not necessarily dead; it is only nearly dead. In virtually all states, the statute of limitations does not actually extinguish the debt. Instead, it makes the debt much harder to collect by limiting the creditor’s actions or serving as an affirmative defense that may be asserted in a collection action.

This old, “uncollectable” zombie debt can come back after you. Debt scavengers know this and may purchase zombie debt portfolios for next to nothing and then look for ways to collect.

Fighting Zombie Debt under the Fair Debt Collection Practices Act

These debt collectors must take care to comply with the Fair Debt Collection Practices Act (FDCPA). Federal courts have issued decisions holding that suing, or even collecting, on time-barred debt may violate the FDCPA under a variety of theories. For example, such collection activity could be unconscionable; it may not be authorized or permitted by law; or it may be misleading in various ways.

Can Bankruptcy Stop Zombie Debt….?  The SCOTUS Weighs In.

But what happens to zombie debt when the debtor files a bankruptcy case is the subject of significant confusion, disagreement, and conflicting case law. Because of this, the Supreme Court bravely granted certiorari this month in Midland Funding, LLC v. Aleida Johnson, a decision of the Eleventh Circuit that held that filing a proof of claim in a bankruptcy case on a time-barred debt violates the FDCPA.

The Eleventh Circuit case is at odds with the majority view espoused by the Second, Eighth and Ninth Circuit Courts of Appeal, which hold that the filing of a proof of claim that is accurate but based on a time-barred debt does not violate the FDCPA. Or in any event, that such an application of the FDCPA is precluded by the Bankruptcy Code. (The Fourth Circuit arrives at the same result by a different route, holding that the filing of the time-barred claim is actionable under but does not violate the FDCPA).

There will undoubtedly be numerous scholarly articles written on the nuanced legal questions that the Supreme Court will be considering. When you parse through the issues, they center on two key questions.

The first question is what, precisely, is the definition of a bankruptcy claim? A claim is generally understood to be a right to payment recognized under state law. If time-barred debts are not “rights to payment” within the meaning of applicable state law, then filing a claim based on such debt could be an “abusive practice” that violates the FDCPA

The second question is whether the Bankruptcy Code precludes a FDCPA action based on the filing of a bankruptcy claim for a time-barred debt. In other words, is such a claim inherently at odds with and precluded or displaced by the Bankruptcy Code’s separate claims allowance and objection process?

I will be closely watching the Supreme Court’s decision on these questions and will be updating you on any new developments and their impact on the bankruptcy claims process.

Mette H. Kurth

Paying With Other People’s Money: A Close Look at Avoidance Actions

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Section 502(d) Typically Applies to Avoidance Actions By the Debtor

One of the weapons in a debtor’s arsenal is its ability to disallow a vendor’s claim until the vendor satisfies any fraudulent transfer or preference exposure it might have.

The court shall disallow any claim of an entity . . . that is a transferee of a transfer avoidable under section . . . 548 . . . unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section . . . 550 . . . of this title.”  –11 U.S.C. § 502(d).

Broadly speaking, Section 502(d) has two purposes. First, it is about fundamental fairness. It prevents certain creditors who owe money to the bankruptcy estate from sharing in distributions until their debt is paid. Second, it incentivizes parties to comply with court orders by allowing the debtor to withhold distributions until those debtTypical.PNGs are satisfied.

This makes a lot of sense in your typical situation, where a debtor seeks to recover prepetition payments that it made to one of its vendors. In practice, preference defendants threatened with disallowance of their entire claim often agree to offset amounts they owe the estate against distributions on their claims.

But when one of the debtor’s affiliates paid your bill, things get more complicated.

It May Not Apply to Avoidance Actions by Non-Debtors

Tthe-transactionhat was the situation in In re Hoku Solar. A vendor received payment on its invoice from the debtor’s parent, after which both companies filed separate bankruptcy cases. The trustee for the parent then sought to avoid and recover the payment that it made to the vendor as a fraudulent transfer. The vendor, in turn, asserted a contingent claim in the debtor’s case, seeking to assert a claim for any invoices that would be reinstated if it disgorged the payments.

The trustee’s next move was to look to the language of Section 502(d), which states only that the court shall disallow any claim of an entity that has received an avoidable transfer. It does not say that the avoidable transfer has to have been made by the debtor. Based on this literal reading of Section 502(d), the trustee argued that the creditor’s claim against the debtor’s estate should be disallowed.

The Idaho bankruptcy court rejected this approach, observing that even though the language of Section 502(d) arguably applied, the section’s purposes would not be served by disallowing the creditor’s claim. Disallowing the claim, it said, would be unfair to a vendor that could be left with no place to turn for payment on its underlying (and potentially unpaid) invoice. This would be exacerbated by the fact that the parent’s creditors—not the debtor’s—would be the ones to benefit from any disgorged payments. As for using Section 502(d) to incentivize the vendor to satisfy any fraudulent transfer claims, the court similarly felt that a creditor’s distributions in one case should not be used to impact claims in another case.

Change Up.PNGThe bankruptcy court therefore held that the creditor—an avoidance action defendant in a parent company’s bankruptcy case—could file a claim in the subsidiary’s case that is not subject to disallowance under Bankruptcy Code section 502(d).  (If the vendor had received its payment directly from the debtor, however, its claim would have been disallowed.)

The Bottom Line?

Avoidance actions are complex, and small details can make a big difference. S0 make sure you understand all of the nuances before bringing a claim or responding to a demand.

As a more esoteric point, the case also illustrates the tension that sometimes arises between strict construction and more liberal or equitable interpretations of the Bankruptcy Code. When the two collide, the results can be unpredictable.

See In re Hoku Solar, Inc., 2016 WL 563036 (Bankr. D. Idaho Feb. 12, 2016)

Mette H. Kurth

Reclamation Claims, Bankruptcy Financing, and You.

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Reclamation rights are an important, but often confusing, tool in a credit manager’s arsenal.  Adding to the confusion, New York and Delaware courts have recently diverged in their treatment of certain aspects of reclamation claims.

Reclamation Rights: The General Rule

In the bankruptcy context, reclamation rights are based on Bankruptcy Code section 546(c). This code section does not create new reclamation rights, but it does recognize otherwise valid state law reclamation claims.

Subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof . . . a seller of goods that has sold goods to the debtor in the ordinary course of such seller’s business [has the right] to reclaim such goods if the debtor has received [them] while insolvent within 45 days before the commencement of a case under this title. 11 U.S.C. § 546(c)

In plain English, the concept is straightforward enough.  Let’s say you manufacture fuzzy eggbeaters.  If you deliver your eggbeaters to a customer as usual but it turns out the company was insolvent, and this all happened in the 45 days before the customer goes bankrupt, you may be able to get your eggbeaters back or assert an administrative claim for the amounts you are owed.  (There are a quite a lot of legal nuances to this.)

Adding Some Complexity: The Pre-Existing Secured Lender

Your reclamation rights, however, are subject to prior rights of a senior secured lender, e.g., the bank that finances your customer’s fuzzy eggbeater and furry teacup retail business. Think about a typical scenario where a bank extends a credit line to a company and takes a security interest in all of its assets. That security interest typically extends to existing and future assets. So when the retailer then goes out and buys your fuzzy eggbeaters, they become part of the bank’s collateral.  When you try to get them back, you may find your reclamation rights trumped by the lender’s pre-existing security interests. If the bank is underwater—often the case in a bankruptcy—your reclamation rights may have no  real value.

More Complexity: Bankruptcy Financing

Still with me?  Now let’s introduce some typical bankruptcy financing terms. Companies are often financed with revolving credit lines. When a company seeks bankruptcy protection, it typically needs to establish new financing. Very often, its existing lender will provide that new financing on terms that include a rollup of pre-petition debt. In other words, as new post-petition credit is extended, payments are applied first to the old, pre-petition debt.  The result is that, over time, the old pre-petition loan is rolled up into a new post-petition loan. (Post-petition loans are treated more favorably in bankruptcy, so there are a lot of advantages to a lender in doing this.)

This is where things get interesting for reclamation claimants and where New York and Delaware bankruptcy courts recently parted ways.

New York’s “Integrated Transaction” Approach: The Lender Wins

In two New York cases decided in 2003 and 2007, the bankruptcy courts considered the relative rights of: (a) a post-petition lender where the post-petition loan proceeds had been used to rollup the debtor’s pre-petition loan; and (b) reclamation claimants.  The new post-petition loans were made after the reclamation rights arose. Since Section 546(c) states that reclamation rights are subject to prior rights of a secured lender, the reclamation claimants argued that their rights trumped those of the new post-petition lender. The bankruptcy courts disagreed, however.  They held that the security interests under the post-petition loans “related back” to the lender’s prepetition rights because of the rollup feature.  Viewing the two loans and resulting liens as an “integrated transaction,” the courts sided with the secured lenders.

You can view the New York opinions here: In re Dana Corp., 367 B.R. 409 (Bankr. S.D.N.Y. 2007); and In re Dairy Mart Convenience Stores, Inc., 302 B.R. 128 (Bankr. S.D.N.Y. 2003).

Delaware’s Approach: Questioning the Integrated Transaction

In a recent opinion, In re Reichhold Holdings US, Inc., Judge Mary Walrath parted ways with the New York decisions. She held that a post-petition lender’s security interest – perfected after the reclamation rights arose – does not trump those reclamation rights even if the loan proceeds were used to payoff a pre-petition loan that would have.

In this case, the debtor’s prepetition lender had a lien on all of the debtor’s inventory.  Shortly after the debtor filed for bankruptcy, the court approved post-petition financing from a new lender.  That new financing was used to payoff the debtor’s old, pre-petition loan. And the new loan was secured by a first priority lien on all of the debtor’s assets, subject to valid, non-avoidable liens in existence as of the petition date.

After the bankruptcy filing, a vendor delivered a reclamation demand to the debtor and filed an administrative claim based on its reclamation rights. The trustee objected, stating that the reclamation claim was rendered valueless when the pre-petition loan was repaid. The vendor fought back, arguing that the new lender had not assumed the old, pre-petition lender’s liens but rather had obtained entirely new, post-petition liens. Since only prior liens defeat a reclamation claim, the vendor asserted that its reclamation claims trumped those of the new, post-petition lender.

The Delaware bankruptcy court rejected the logic of the New York bankruptcy courts, following a Six Circuit case, In re Phar-Mor, instead. Finding that the two loans, which were made by different lenders at different times, were not an integrated transaction, the bankruptcy court overruled the trustee’s clam objection.

“[W]hen the Prepetition Loan was paid from the DIP Loan, the Prepetition Lender’s lien was satisfied but [the vendor’s] reclamation rights remained in force.  The fact that funds obtained from the DIP Loan were used to satisfy the Prepetition Loan, or that the Debtor granted the DIP Lenders a lien in inventory to obtain such funds, is irrelevant.  [The vendor’s] reclamation rights arose before the DIP Lenders’ security interest attached, and the DIP Lenders’ lien was expressly subject to reclamation rights under section 546. . . .  Nor can the Court find that the DIP Loan and the Prepetition Loan are an ‘integrated transaction.’  They were two different loans by two different lenders at two different times.  Because [the vendor’s] rights arose before the DIP Lenders had any rights in the goods, the Court concludes that the DIP Lenders do not have prior rights in the goods under section 546(c).”

You can view the Delaware opinion here: In re Reichhold Holdings US, Inc., 2016 WL 4479286 (Bankr. D. Del. Aug. 24, 2016); see also In re Phar–Mor, 301 B.R. 482 (Bankr. N.D. Ohio 2003), aff’d, 534 F.3d 502 (6th Cir. 2008).

Some Concluding Thoughts

This is certainly good news for vendors with reclamation claims.  It is worth noting, though, that most post-petition loans are made by existing, pre-petition lenders.  This loan was made by a new and different lender group, which was a factor that the court noted when it held that the two loans should not be viewed as an integrated transaction. The result could be different if the pre-petition and post-petition loans were made by the same lender.

Mette H. Kurth

Tired of Election Tweets? Follow the Delaware Bankruptcy Court Instead.

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The Delaware Bankruptcy Court is now on Twitter.  Follow the Court and receive updates @USCourtsDEB.

No political tweet-storms here. Instead, find out how you, too, can comment on the local rules this fall. Better yet, peruse the local rules in Word or PDF format. Be the first to receive exciting tweets about bankruptcy procedure and rules in the months to come.

Mette H. Kurth