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


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).

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


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

How to Appoint a Trustee. Be Clear. And Be Convincing.


 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).

View the Opinion in PDF

Mette H. Kurth