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

Fraud Claims: Don’t Throw Good Money After Bad

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Nobody likes wasting money, especially on legal fees.  Clients don’t like it.  And courts don’t like it.  As Judge Shannon admonished in a recent opinion:

The Court has previously expressed and now reiterates its profound concerns with respect to the dissipation of monies otherwise available for distribution to stakeholders being burned up in litigation of dubious merit and questionable collectability.

The best outcome for everyone, of course, is to avoid pursuing questionable litigation in the first place.

My colleague, John Bird, has written two articles illustrating some of the challenges and considerations that lawyers and clients should take into account when pursuing fraud claims.

Motion to Dismiss Second Amended Complaint – Another AgFeed Opinion

Opinion in AgFeed USA – Another (Mostly) Successful Motion to Dismiss

Simply put, the Delaware Bankruptcy Court, like other courts across the country, takes a hard look at fraud allegations and requires them to comply with elevated pleading standards under the Federal Rules of Civil Procedure.

To avoid spending money litigating claims that may be dismissed, it is important to take a hard, objective look at the fraud allegations in your complaint to make sure that they are based on particular, specific factual allegations (e.g., the who, what, when, where and how of the fraud, including the time, place, and content of alleged misrepresentations) and not just conclusory statements.  For example:

Very Bad: The defendant induced plaintiffs to invest in his business.

Bad: Throughout 2007, the defendant strongly encouraged Larry, Curley and Moe to continue investing by making statements such as “stay with the business.”

Better: On July 4, 2007, Larry, Curley and Moe received a letter signed by defendant and delivered to their offices in Miami, Florida soliciting a $1 million investment in defendant’s spray-on hair business and stating that the business had been valued at $10 billion by New York Investment Bank, LLP.

This requires that you conduct a pre-complaint investigation in sufficient depth to make sure that your allegations of fraud are supported by facts rather than being merely defamatory and extortionate.  (To make sure your analysis is completely objective, it may be a good idea to have a fresh set of eyes review the complaint before it is finalized.)

Without the necessary preparation, you may just find yourself throwing good money after bad.

Mette H. Kurth

When is a Settlement Not a Settlement? When It Is an Asset Sale.

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For business people, whether you are settling a dispute or selling an asset may seem obvious. But for lawyers, the distinction can be surprisingly tricky, and it has serious ramification for our clients.

The confusion arises because the Bankruptcy Code allows you to either sell or settle a claim that a debtor has against someone else. What happens if the trustee settles a claim against a defendant in exchange for a cash payment, and a creditor objects because it believes the claim is worth more than is being paid? What if a trustee wants to sell claims that the debtor has against third parties? Whether these transactions are treated as settlements or sales matters quite a bit.

When selling an asset under Bankruptcy Code section 363, you must demonstrate that you have maximized the asset’s value. To settle a claim, the bar is much lower. Bankruptcy Rule 9019 requires that you show that the settlement is fair and equitable, which generally means that it does not fall below the “lowest point in the range of reasonableness.” Moreover, you cannot appeal a bankruptcy sale to a good faith purchaser unless you obtain a stay. (This is meant to encourage bidding in bankruptcy sales by protecting good faith purchasers). A settlement, in contrast, can be appealed without a stay.

The Ninth Circuit Court of Appeals recently adopted the BAP’s earlier reasoning in Mickey Thompson (decided in 2003) and the reasoning of the Fifth and Third Circuits, holding that a bankruptcy court has the discretion to apply the more stringent standards and procedures for sales to a settlement agreement in order to maximize value.

In Adeli v. Barclay, the bankruptcy trustee had entered into a settlement agreement with a creditor under which the creditor would purchase the estate’s claims against it in exchange for both cash and a waiver of the creditor’s claims against the estate. The trustee filed a motion to approve the settlement under Rule 9019 and presented evidence regarding the settlement’s reasonableness. It also noticed the matter as a sale subject to overbidding under Section 363. Nobody submitted an overbid. The debtor then appealed the settlement to the district court—but without seeking a stay pending appeal. The Ninth Circuit concluded that, because the bankruptcy court determined that the creditor/buyer was a good faith purchaser of the potential claims, and the debtor did not seek a stay pending appeal, the appeal was moot under Bankruptcy Code section 363(m) and was properly dismissed.

While the Ninth Circuit’s decision adopted Mickey Thompson’s reasoning and does not appear to significantly change current practice, it does serve as a stark reminder of the very real differences between sale and settlement procedures. Meanwhile, its time for the lawyers to update their form files to replace references to Mickey Thompson with a citation to Adeli v. Barclay.

Adeli v. Barclay (In re Berkeley Delaware Court, LLC), No. 14-55854 *10 (9th Cir. August 23, 2016). Download in PDF

Mette H. Kurth