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From Across the Pond – Dissipation of Assets May be Tort Under English Law: Marex Financial Limited v. Garcia [2017] EWHC918

Editor’s Note from The Bankruptcy Cave:  Our good colleagues Robert Dougans and Tatyana Talyanskaya from BC’s London office published this earlier in the summer, and we could not wait to add it to your autumn reading list.  The lesson here is powerful – England, the birthplace of the common law, comes through again to right an injustice where traditional legal principles might otherwise fall short.  Many of you readers have often dealt with defendants playing a shell game with their assets.  The Marex decision provides a powerful response – an independent tort against the individuals who perpetrated the asset stripping, instead of a pursuing a daisy-chain of subsidiaries and affiliates, all bereft of assets.  We at The Bankruptcy Cave applaud this decision – for every right, there shall be a remedy! 

There is a joke that freezing injunctions are dangerous to heath.  They appear to be carcinogenic, as people subject to them often tell the Court they are too ill to engage with proceedings.  (Observation of such defendants may provide heartwarming evidence for miracle cures.)  They also appear to cause amnesia, as defendants somehow forget to disclose the existence of very substantial assets.

In a similar way adverse judgments can be a boon for corporate finance professionals.  A large judgment against a corporate defendant may well provoke a flurry of M&A activity as the unsuccessful corporate defendant’s asset are rapidly re-allocated to other group companies, or to the defendant’s beneficial owner

The background to the decision of Mr. Justice Knowles in Marex Financial Ltd v Garcia [2017] EWHC 918 (Comm) dealt with a familiar situation.  A claimant obtains a judgment against the company which (according to pre-litigation due diligence) has substantial assets.  When enforcement proceedings begin the claimant learns that the management/owners of the defendant company have immediately emptied the cupboard as soon as judgment was obtained, leaving them with a worthless decision.

What can be done? Insolvency law may provide remedies but a claimant is then in the hands to some extent of insolvency practitioners, and clawing back assets from some jurisdictions may be difficult in practice.  Mr. Justice Knowles’ decision suggests a claimant should explore making the persons responsible for the asset-stripping liable in tort.

The Marex case involved the claimant, a foreign exchange broker, obtaining judgment for $5m against two BVI companies (the “Companies) owned by Mr. Sevilleja.  As soon as the draft judgment was circulated, Mr. Sevilleja embarks upon a thorough asset-stripping of the Companies, transferring over $9m from the Companies to himself.  When they commenced enforcement proceedings Marex found that the Companies’ position had deteriorated and they had just over $4,500 between them.  Marex brought proceedings against Mr. Sevilleja, saying he had induced/caused the Companies to dissipate assets to frustrate the earlier judgment.  Marex relied upon the following causes of action.

  • knowingly inducing and procuring the Company’s to act in wrongful violation of the Claimants rights under the judgments;
  • committing the tort of intentionally causing loss by unlawful means; and/or unlawful interference with the Claimants economic interests (some of the so-called “economic torts”).

The defendant argued that no tort of unlawful violation of rights under a judgment existed. He accepted that the relevant “economic torts” did exist (they are well-established under English law), but argued that they did not cover frustrating the enforcement of a judgment in this way.

Mr. Justice Knowles found for the claimant on both points: He recognised the existence of a tort violation of rights under a judgment, and also recognised that doing so could count as an economic tort.

Of particular note is that the reasoning for his judgment was based on the well-known proposition that an award of damages by a court of competent jurisdiction (even a foreign court with whom there is no enforcement convention) is recognised in England as a debt which can be enforced at common law. This judgment does not, therefore, simply cover frustrating enforcement of an English court judgment.  Asset-stripping a company to frustrate enforcement of a foreign court judgment could also create an actionable wrong under English law.

There are powerful lessons to be learned from this case.  Defendants who try to avoid paying judgment debts must tread very carefully to avoid risking personal liability.  Claimants who are the victim of post-judgement assets stripping can, however, take heart – they may be able to pin the blame upon persons/entities with assets.

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No Trustee Left Behind – Another Bankruptcy Court Requires Colleges to Return Tuition to the Bankruptcy Estate

b09036864402bfedc690a2f80d6de804Another bankruptcy trustee catches another hapless college unaware.  In Roach v. Skidmore College (In re Dunston), Bankr. S.D. Ga. (Jan 31, 2017), a trustee appears to win the next battle of “bankruptcy estates v. child’s college,” ruling that an insolvent parent who paid the college tuition of an adult child made a fraudulent transfer to the college.  Thus, the unsuspecting college will likely have to return the tuition to the parent’s bankruptcy estate.

The theory is simple (albeit unsettling to some).  Under Section 548 of the Bankruptcy Code (and applicable state law, as a back-up), if any debtor makes a transfer to a third party while insolvent, and does not receive reasonably equivalent value in return, the debtor’s bankruptcy trustee may reclaim such transfer for the benefit of unsecured creditors (and for the benefit of the trustee’s fees, of course).  In plain English, the recipient got the money, and didn’t provide anything to the insolvent party which made the payment.  That’s unfair to the insolvent payor’s other creditors (who are left with crumbs, or nothing), and thus a “fraudulent transfer” can be reclaimed for all such other creditors.  Congress has excluded some charitable contributions and tithes from attack. 11 U.S.C. § 548(a)(2).  But Congress did not include tuition paid for an adult child in the list of exceptions, and so it is not the place of courts to graft a “adult child college tuition” exclusion to the statute.

We had a prior post on this, here.  In that post, we went over a contrary ruling from the District of Massachusetts, DeGiacomo, as Chapter 7 Trustee v. Sacred Heart Univ. (In re Palladino), Bankr. D. Mass. (Aug. 10, 2016).  In that case, the Bankruptcy Court ruled against the Chapter 7 trustee by holding that the future benefits an adult child may get from a college education can provide “reasonably equivalent value” such that the parent’s tuition payment to the college is not voidable.  As the Palladino Court held, “[a] parent can reasonably assume that paying for a child to obtain an undergraduate degree will enhance the financial well-being of the child which in turn will confer an economic benefit on the parent.  This, it seems to me, constitutes a quid pro quo that is reasonable and reasonable equivalence is all that is required.”  (Other coverage of Palladino and opinions like it, including this recent ruling from Georgia, can be found in the outstanding coverage of Katy Stech of the Wall Street Journal  here, here, and here (alas, WSJ subscriptions required)).

Now, in Roach v. Skidmore College (In re Dunston), the Bankruptcy Court for the Southern District of Georgia has ruled to the contrary.  In Dunston, the Court rejected the argument that an indirect economic benefit of having a well-educated and (hopefully) a gainfully employed adult child is “reasonably equivalent value.”  Instead, according to Dunston, paying an adult child’s tuition is simply honoring a “moral obligation,” and not any legal duty or actual, monetary obligation of the parent.  The college – in this case, the august institution Skidmore College, near beautiful Saratoga Springs and home to some seriously rockin’ a cappella – provided no value to the debtor parent.  Thus, the Dunston court allowed the fraudulent transfer action to go forward – and its will eventually be successful, in The Bankruptcy Cave’s view.

Our previous post on this issue criticized what we believed was a results-oriented decision in Palladino.  To be sure, few like the idea of our educational institutions having to fully refund tuition payments which they accepted innocently, without knowing of the parent’s insolvency.  But despite these misgivings, Palladino was incorrect under a plain reading of the statute – any time an insolvent debtor gives money to a third party, and receives nothing in return, that money should come back to the bankruptcy estate to benefit all other innocent creditors.  The Dunston decision is right.

This problem cries out for a legislative solution.  Until then, bankruptcy courts will honor the wording of the fraudulent transfer status and require colleges to return the tuition (Dunston) or find “future economic value” to the parent that is, in the view of The Bankruptcy Cave, entirely speculative (Palladino).  While there are many problems with our current bankruptcy statutes, this one really needs a solution.

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Defending A Preference Action – Can You Setoff Post-Petition Amounts Owed by the Debtor Against Your Preference Liability?

All bankruptcy lawyers (and most long-suffering trade creditors) know that creditors who receive payments from a debtor within the “preference period” – 90 days before a voluntary bankruptcy case was filed, or 1 year if the creditor is an “insider” of the debtor – are at risk of lawsuit to return those payments to the bankruptcy estate. Pre-petition claims the creditor hold are no automatic defense.  However, the Bankruptcy Court for the District of Delaware recently ruled, as a matter of first impression in that Court, that an allowed post-petition claim of the creditor can be used to set off the creditor’s preference liability. See Official Comm. of Unsecured Creditors of Quantum Foods, LLC v. Tyson Foods, Inc. (In re Quantum Foods, LLC), 2016 WL 4011727 (Bankr. D. Del. Jul. 25, 2016).  Here is a copy of the case.

The background of the case is simple. The Unsecured Creditors Committee filed various preference actions.  In the Quantum Foods preference case, the Committee sought to avoid and recover over $13 million in pre-petition transfers to two related Defendants.  The Defendants claimed, among other defenses, a right to set off a previously allowed administrative expense claim for $2.6 million in food products they had supplied to the Debtors post-petition.[1]

The Committee asserted that the Defendants’ setoff argument was a guise for a “post-petition new value defense.”  This would be improper, the Committee asserted, as a creditor’s new value defense is determined as of the bankruptcy petition date.  [The seminal decision on this is from Bankruptcy Judge Lundin, holding that “the preference window of § 547 close[s] on the date of the filing of the bankruptcy petition and post-petition payments [cannot] be used to deplete pre-petition ‘new value.'”  See here.]  However, while that is the rule in Delaware too under Friedman’s, the Court was not persuaded that this had anything to do with the new value defense.  It reasoned that a new value defense exclusively involves pre-petition activity, whereas the Defendants’ setoff claim was purely based on post-petition activity.  In short, post-petition activity (such as delivery of goods) will not give rise to a preference defense under the strict confines of the Bankruptcy Code, but may give rise to a plain old setoff defense under common law.

Thus, the question became not a matter of the new value defense under Section 547 of the Bankruptcy Code, but rather, the well-established doctrine of setoff.  In deciding whether the Defendants had valid setoff rights, the Court relied on the long-cited authority that, “setoff is only available in bankruptcy when the opposing obligations arise on the same side of the . . . bankruptcy petition date.”  Accordingly, setoff would only be permissible if the opposing obligation, i.e. the preference claim, also arose post-petition.  A “claim” in bankruptcy is defined as a “right to payment.”  Thus, the Court ruled, a preference claim is a “right to payment” which necessarily can only arise post-petition because a preference cause of action does not exist until after a bankruptcy case is initiated.

This is an important decision, from an important court.  It provides comfort to creditors that supply goods post-petition – non-payment for those goods, while a stinging result, can at least be used to reduce preference liability.

[1] The opinion did not address issues of mutuality of obligor and obligee.  That is, if Defendant A holds the $2.6 million post-petition claim, then it will be hard (actually, impossible) for that claim to be used as an offset against Defendant B’s liability.  So we will have to watch how this shakes out once the actual facts and mutuality of the claims among multiple parties are determined during discovery.

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Over Four Hundred Years of Law on Fraudulent Transfers, Flushed Down the Drain

In 1571, Parliament enacted a law, sometimes known as the Statute of 13 Elizabeth, creating one of the greatest means of creditor protection – the proscription of fraudulent transfers.  As Professors Baird and Jackson stated, the law prevents an “Elizabethan deadbeat [from selling] his sheep to his brother for a pittance.”[1]  The law has progressed, covering not just intentional acts to hinder, delay, or defraud creditors, but also “constructively fraudulent transfers” in which a third party who is not in on any con nonetheless gets something from an insolvent debtor for less than reasonably equivalent value.

These are simple, straightforward principles, with which no bankruptcy professional (or really, anyone) could quibble.  You got stuff and you didn’t pay for it, so you need to give it back.  There are some exceptions.  Voiding transfers in the securities industry, for instance, could up-end financial markets.  So Congress added Sections 548(d)(2)(B) – (E) of the Bankruptcy Code to protect various securities-related transfers from avoidance as constructively fraudulent transfers.  Likewise, Congress has excluded some charitable contributions and tithes from attack. 11 U.S.C. § 548(a)(2).

Now, a Bankruptcy Judge (which is not, the last time we checked, a Congressional body which can change the law), has grafted another exception to Section 548: transfers by a parent to help an adult child, where the adult child might (or might not, who knows) return the favor sometime in the future.  This is the law under DeGiacomo, as Chapter 7 Trustee v. Sacred Heart Univ. (In re Palladino), Case No. 15-01126, Bankr. D. Mass., Docket No. 76 (August 10, 2016) (Here’s a link to the opinion).  In Palladino, the Chapter 7 Trustee sued a university, which had received tuition money from the insolvent Debtors.  But the Debtors didn’t get anything for the payments – it went to pay the tuition of the Debtors’ adult child.  Thus the Chapter 7 Trustee sought to get the money back from the university, and distribute it to rightful creditors.

In Palladino, one of the parents / debtors defended the payments on moral grounds, stating “I am her mother and she shouldn’t have to come out of [Sacred Heart University] saddled with thousands of dollars in loans.”  Morality has nothing to do with constructively fraudulent transfers, and so we don’t know why this statement made it in the opinion.  Instead, the Bankruptcy Judge ruled against the Chapter 7 Trustee by holding that future, entirely speculative benefit can somehow provide “reasonably equivalent value” such that a transfer is not voidable.  As the Court held, “[a] parent can reasonably assume that paying for a child to obtain an undergraduate degree will enhance the financial well-being of the child which in turn will confer an economic benefit on the parent.  This, it seems to me, constitutes a quid pro quo that is reasonable and reasonable equivalence is all that is required.”  Wow.  No caselaw is cited by the Court for this proposition.  Indeed, none of us at the Bankruptcy Cave have ever heard of future, speculative benefits serving as a defense to a constructively fraudulent transfer action.  As to children taking care of parents, we suggest a review of King Lear (you know, “how sharper than a serpent’s tooth . . .”).

Future debtors, please take note of this remarkable opinion.  If you want to help a family member, then give them money before bankruptcy, for any plausible (or implausible reason).  Sick relative?  Down on their luck relative?  Relative that wants to invest in uranium stock, purchase the Brooklyn Bridge, or bail a Nigerian prince out of jail?  The Palladino ruling creates a debtor-friendly “it tugs on your heartstrings” / “blood is thicker than water” defense to fraudulent transfer actions.  And preferences too!  Why not?  Palladino is a safe haven for most or all of these wrongful actions.

Now, we understand the basis for the Palladino ruling.  Palladino was one of those “every possible ruling seems unfair” cases, in which a Chapter 7 Trustee was suing the child’s university, seeking to recover pre-petition tuition payments made by the insolvent parents for the benefit of the innocent child.  These cases are awful.  The child did nothing wrong.  The university did nothing wrong.  Indeed, the university really can’t police against this, unless it enacts a rule that every tuition payment must come from a check written on the student’s account.[2]  And even then, that would just make the innocent child / student the defendant.  That sticks in some people’s craw.[3]  On the other hand, creditors are unpaid – why should a kid get free or subsidized college when creditors have to lick their wounds? In any event, a bill is now kicking around Congress to exempt payments like these from fraudulent transfer attack under Section 548 of the Bankruptcy Code, as Lynne Xerras of Holland and Knight has written here.

So we understand the ruling.  But we still don’t like it.  Bankruptcy judges are not legislative bodies.  Bankruptcy judges can’t change the law, or create exceptions based on subjective principles of fairness.  If lawsuits like Palladino shouldn’t be allowed, it is up to Congress to make that decision, and not bankruptcy judges.  We are afraid that the Bankruptcy Code, the Statute of 13 Elizabeth, and creditor protections of all sort, all just got a little weaker through Palladino.

[1]           Baird & Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 Vand. L. Rev. 829, 852 (1985)); a full copy of this classic is located here.

[2]           And even then, would the school be automatically immune from attack as an immediate transferee under Section 550(a)(2)?  Ug.  More briefing on legal issues is not the solution to this problem.

[3]           The WSJ’s bankruptcy blog has covered this issue a lot.  See http://blogs.wsj.com/bankruptcy/2015/05/06/whats-behind-bankruptcy-lawsuits-over-college-tuition/; for Friday’s coverage of Palladino, if you have a WSJ subscription, you can click here.

 

 

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Golf Channel Finds the Fairway in Fraudulent Transfer Litigation – Good News for Vendors in Ponzi Scheme Cases

In some good news for commercial vendors, the Supreme Court of Texas recently ruled that payments for ordinary services provided to an insolvent customer are not recoverable as fraudulent transfers, even if the customer turns out to be a “Ponzi scheme” instead of a legitimate business.

In Janvey v. Golf Channel, Inc.,[1] the Court considered whether, under the Texas Uniform Fraudulent Transfer Act (“TUFTA”), a vendor should be required to return payments it received in good faith for services rendered simply because its customer turned out to be a Ponzi scheme and not a lawful business.[2]  Ultimately, the Court determined that the objective market value of services provided in the ordinary course of business serves as a defense to a fraudulent transfer claim, despite the illegitimate nature of the Ponzi scheme. In reaching that conclusion, the Court rejected the contention that the value provided must flow directly to the Ponzi scheme’s creditors.

A quick refresher on fraudulent transfers: The Uniform Fraudulent Transfer Act (and its bankruptcy counterpart, Section 548 of the Bankruptcy Code) prevents a debtor from improperly moving assets beyond the reach of creditors. As one example relevant to the Janvey case, an asset may be recovered for the benefit of creditors if the debtor transferred it “with actual intent to hinder, delay, or defraud” creditors, unless the transferee took the asset in good faith and for reasonably equivalent value. Factors indicating fraudulent intent include transfers to insiders, concealment of the transfer, or debtor-retained control of an asset after the transfer, all of which are questions of fact.

When a Ponzi scheme is involved, courts generally bypass analyzing such “badges of fraud” and conclusively presume that all transfers in furtherance of the scheme—even to legitimate creditors with no role in the fraud—are made with actual intent to defraud because the underlying business is inherently illegal and insolvent. In addition, the nature of the Ponzi scheme raises doubts about a vendor’s normal defense that it provided value, because the “value” the vendor provided does not necessarily improve the position of the scheme’s creditors – it actually unwittingly allows the illusion of the Ponzi scheme continue, keeping the scheme afloat to defraud other investors. Indeed, this was the position the United States Court of Appeals for the Fifth Circuit took in Janvey before vacating its initial opinion and certifying this state law question to the Supreme Court of Texas. 780 F.3d at 647.

In Janvey, The Golf Channel (“TGC”) had a media-advertising services contract with Stanford International Bank Limited (“Stanford”), receiving $5.9 million for its advertising services. When Stanford became exposed as running a Ponzi scheme, a court-appointed receiver sued TGC to recover the transfers as fraudulent, asserting that the $5.9 million TGC had received did nothing to benefit Stanford’s defrauded investors or creditors, even though the same services would be valuable to a legitimate business. The receiver contended that, under the statute, the meaning of “value” should be measured only by the actual utility of the services to the creditors, categorically rejecting the market value of the services as a relevant consideration. The Fifth Circuit initially agreed with the receiver (in a decision that shocked many), then vacated its opinion and asked the Supreme Court of Texas to interpret applicable Texas law under TUFTA.

Luckily for TGC and all other good-faith commercial vendors, the Supreme Court of Texas did not adopt the receiver’s position. Instead, the Court determined that incidental involvement in a Ponzi scheme is insufficient to negate the objective value of services provided, holding that a showing of “reasonably equivalent value” sufficient to defend the fraudulent transfer claim can be satisfied with evidence that the transferee (i) fully performed under a lawful, arm’s-length contract for fair market value, (ii) provided consideration that had objective value at the time of the transaction, and (iii) made the exchange in the ordinary course of the transferee’s business. The Court opined that an objective inquiry that considers the existence of “value” from a reasonable creditor’s perspective at the time of the transaction is consistent with the statutory language and strikes an appropriate balance between protecting creditors and protecting vendors who have given reasonably equivalent value in good faith.  (BTW, for another post on protecting vendors from avoidance actions where the vendor is not the least bit at fault, read this post from our fellow Bankruptcy Cave bloggers, here.)

A contrary holding would have required vendors to determine not only each customer’s creditworthiness at the outset of a relationship, but to monitor the legitimacy of the customer’s business at all times – impossible for any vendor to do, especially with investment schemes that appear for years to be legitimate businesses. For now, as long as vendors meet the standards outlined about regarding the objective value they provide, they should be safe from fraudulent transfer claims – at least in Texas.

[1]    2016 WL 1268188 (Tex. April 1, 2016, Case No. 15-0489).

[2]    The Supreme Court of Texas undertook this analysis on a certified question from the United States Court of Appeals for the Fifth Circuit. See Janvey v. Golf Channel, Inc., 792 F.3d 539 (5th Cir. 2015). In certifying the question to the Supreme Court of Texas, the Fifth Circuit, en banc, vacated its earlier panel decision that would have required The Golf Channel to return the payments at issue. See Janvey v. Golf Channel, Inc., 780 F.3d 641 (5th Cir. 2015).

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Preference Defendants, Rejoice! Services Billed in a Lump Sum Can Be Allocated Per Diem, for Your New Value Defense

Preference actions are, for the most part, insanity. We won’t go on a tirade here. But recently, a ruling brings common sense to the “new value” defense.

Specifically, all bankruptcy lawyers know that any “new value” must come after the allegedly preferential transfer. This can be problematic for service providers, especially services provided daily, or over time. The debtor may, for instance, pay a prior invoice on April 10, and then file for bankruptcy on April 20, or 30, before the service provider generates an invoice for all of April’s services. A crafty trustee may thus argue that there is no evidence of new value provided after April 10, and hence no new value defense.

The recent case of Levin v. Verizon Business Global, LLC (In re OneStar Long Distance, Inc.), 3:15-cv-00049 (S.D. Ind. March 28, 2016) is a perfect example of this. The defendant provided telecommunications services to the debtor, some at fixed monthly charges and some based on the debtor’s actual usage. The debtor made $300,000 in payments to the service provider in mid-December, and then filed for bankruptcy in late December, before a December bill could be rendered. The evidence was clear that the December bill would have been over $1.1 million, but the trustee alleged that the service provider had to go further, and break down this huge bill, covering millions of transactions, into what was actually provided each day. (We note as well that the transactions in question took place in 2003 – this case is still going on a baker’s dozen years later – pretty hard to nail down evidence of this type after such a delay.)

The court rejected this, wisely. It used a per diem approach, meaning the debtor had received about $35,000 of new value each and every day ($1.1 million divided by 31 days equals about $35,000). Thus, nine days after the $300,000 in payments at issue, over $315,000 of new value would be provided (that is, 9 multiplied by the per diem estimate of $35,000), resulting in a complete defense.

(The court did note that if the Trustee could show the services had been cut off, or some other evidence to show that the $1.1 million in December services were very front-loaded, and hence before the payments, and not after, the result might be different. There was no such evidence here.)

We applaud this logical approach. The burden of proof for any affirmative defense lies with the defendant, but to require a defendant providing regular, daily services to show the exact day and minute for every dollar of value over a given month is really too much. Let’s all sleep better tonight, until we come across the next preference opinion that makes our blood boil (like those cases holding that post-petition payment of a Section 503(b)(9) claim reduces the vendor’s new value defense, even though these were the very creditors providing goods on credit that were trying to help the debtor stay out of bankruptcy, and even though the tense of Section 547(c)(4)(B) makes it clear that post-petition payments don’t count at all in the new value analysis, and even though . . . ok, enough ranting, read this and this if want to ignore the good feelings of this blog post and get back to preference law insanity.)

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7th Circuit Disrupts Commercial Certainty in Lease Terminations; Landlords, We Hate That You Have to Read this Blog Post

There are many tenants that are, shall we say, “problem children.” They pay late, open late, breach, junk up your strip or building, threaten, the works. Sometimes, the landlord finds it easier just to reach a lease termination agreement with such a tenant, with the parties walking away with a mutual release. If the lease is below market, or the landlord is really motivated to move this tenant along, the landlord even provides some “keys money” to terminate the lease.

This normal practice may now be turned on its head. In a recent opinion, the Seventh Circuit ruled that a pre-bankruptcy lease termination was a “transfer” under the Bankruptcy Code. Because it was a “transfer,” if the tenant did not receive “reasonably equivalent value” for the value of the lease (such as where the tenant alleges it was a below market lease, which could have been assigned in bankruptcy for cash, or even for more cash than the tenant/debtor received), then the landlord can be sued. The damages? The difference between that which the ne’er-do-well tenant received (even if that amount is $0) and the amount that the tenant’s expert witness says could have been received had the lease not been terminated, and the debtor had instead assigned it to a third party during the bankruptcy in an open sale process.[1] In re Great Lakes Quick Lube LP, 2016 WL 930298 (7th Cir. March 11, 2016).

The Seventh’s Circuit’s opinion in Quick Lube is very problematic because it ignores:

First, Section 8(e)(1) of the Uniform Fraudulent Transfer Act, which states a transfer is not voidable if it “results from . . . termination of a lease upon default by the debtor when the termination is pursuant to the lease and applicable law.”  Indeed, the drafters of this uniform law, promulgated all the way back in 1984, noted in their commentary (see page 32 of this link) that Section 8(e)(i) of UFTA was intended to “reject[] the rule adopted in Darby v. Atkinson (In re Farris), 415 F.Supp. 33, 39-41 (W.D. Okla. 1976), that termination of a lease on default in accordance with its terms and applicable law may constitute a fraudulent transfer.”

Second, as Judge Markell once noted, the much wiser approach to transactions of this type is that “a noncollusive termination of a lease is not a transfer at all” and hence cannot be avoided by mischievous debtors and their hired guns experts. See here for the full opinion.

Third, Section 365(c)(3) of the Bankruptcy Code provides that the “trustee … may not assume or assign any … unexpired lease of the debtor … if … such lease . . . has been terminated under applicable nonbankrupty law prior to” the bankruptcy case. See 11 U.S.C. § 365(c)(3). That is, if a properly terminated lease cannot be assumed or assigned in bankruptcy by one very specific section of the Code, then how can its pre-bankruptcy termination be voided due to a generic separate section of the Code? The Seventh Circuit side-stepped this argument too in Quick Lube, by saying the debtor and its creditors simply wanted the value of the lease and not the actual lease itself. That’s a tautology – how can there be value in a lease that no longer exists?

Finally, and most importantly, this entire line of reasoning ignores the need for certainty in commercial transactions involving lease transactions.   So what do we do?

First, be aware of this decision, and make the client aware if it is ever negotiating over a lease termination with a tenant, especially a financially troubled tenant. There are no foolproof workarounds to this decision, and so the client needs to be fully aware of this risk. Maybe it is just easier to declare a default and go through a dispossessory, if weeks (months?) of careful negotiation over termination can be up-ended by a later litigation against the landlord to pay for the “actual value” of the lease?

Second, thoroughly document in the termination agreement the benefits the tenant is receiving. Bankruptcy trustees and creditors like easy cases, not hard ones. If they can see more benefit that the tenant received in the termination agreement, or clearly spelled out provisions showing the tenant’s ability to forego late fees, attorneys’ fees, ongoing rent, other charges, and the like through the lease termination, a litigious trustee may think twice.

Third, if a lease termination is accompanied by any “keys money,” make sure it is paid to the actual tenant, and not any affiliate. A sure-fire path to litigation begins with paying the wrong tenant or an affiliate, instead of the actual obligor on the lease. (This is fundamental, we know, but we have seen unsuspecting parties many times be persuaded to pay a parent company, or affiliate.)

The Seventh Circuit has long been a leading court on bankruptcy issues. We at The Bankruptcy Cave will continue to monitor this decision, which we think, unfortunately, is going to be used often in the upcoming downturn.

[1]           Recall that a lease’s anti-assignment provisions are worthless to a landlord in a tenant’s bankruptcy case. See 11 U.S.C. § 365(f) (“. . . notwithstanding a provision in an . . . unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such . . . lease . . .”). Of course, 1984’s “shopping center” amendments to the Bankruptcy Code prohibit an assignment that disrupts the tenant mix or balance in the shopping center, would substantially reduce percentage rent, or that violates any radius or use provision in the lease. See 11 U.S.C. § 365(b)(3).  (A great discussion of the “shopping center” amendments to the Bankruptcy Code in practice can be found here.)  But still, the nullification of anti-assignment clauses in bankruptcy make leases far more valuable in the bankruptcy case than they would be outside of bankruptcy.

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10th Circuit Holds That First Time Transactions Fall Within 11 U.S.C. 547(c)(2), Ordinary Course of Business Defense

In a decision that surprised many, the United Stated Circuit Court of Appeals for the Tenth Circuit (the “10th Circuit Court of Appeals”) affirmed decisions finding that a payment made on account of a first time transaction between a debtor and creditor can qualify for the ordinary course of business defense under 11 U.S.C. § 547(c)(2).

C.W. Mining Company (the “Debtor”) entered into an equipment agreement with a new contractor, SMC Electric Products, Inc. (“SMC”), in an attempt to increase the Debtor’s coal production. This agreement was reached several months before the filing of an involuntary bankruptcy petition. Within 90 days of the involuntary bankruptcy filing, the Debtor made the first payment under the agreement in the amount of $200,000 to SMC via wire transfer. The Trustee filed an adversary proceeding seeking to avoid and recover the $2000,000 payment under 11 U.S.C. §§ 547(b) and 550, as an alleged preferential transfer. The bankruptcy court ruled that the payment could not be avoided because it was made in the ordinary course of business of the Debtor and SMC and was therefore protected by 11 U.S.C. §§ 547(c)(2). The United States Bankruptcy Appellate Panel affirmed the bankruptcy courts decision.

In affirming the decision, the 10th Circuit Court of Appeals held that the fact that the Debtor and SMC had entered into the agreement for the first time and that the alleged preferential payment was the first payment under the agreement did not alter the applicability of 11 U.S.C. § 547(c)(2). Under § 547(c)(2), a trustee may not avoid a transfer “to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee” when “such transfer was….(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or (B) made according to ordinary business terms.” The incurrence of the debt and the payment must be in the ordinary course of business for both the debtor and the transferee. See 11 U.S.C. § 547(c)(2) (emphasis added). The 10th Circuit Court of Appeals held that the statute refers to the “ordinary course of business or financial affairs of the debtor and the transferee,” not between the debtor and transferee. C.W. Mining, U.S. App. LEXIS 13981, at 10 (emphasis added). Further, the 10th Circuit Court of Appeals agreed with the Sixth, Ninth and Seventh Circuits that have held that a first time transaction can be protected by 11 U.S.C. § 547(c)(2). Wood v. Stratos Prod. Dev., LLC (In re Ahaza Sys. Inc.), 482 F.3d 1118, 1126 (9th Cir. 2007). (“[A] first-time debt must be ordinary in relation to this debtor’s and this creditor’s past practices when dealing with other, similarly situated parties.”); Kleven v. Household Bank F.S.B., 334 F.3d 638, 643 (7th Cir. 2003)( “[T]he court can imagine little (short of the certain knowledge that its debt will not be paid) that would discourage a potential creditor from extending credit to a new customer in questionable financial circumstances more than the knowledge that it would not even be able to raise the ordinary course of business defense, if it is subsequently sued to recover an alleged preference.”) (quoting Warsco v. Household Bank F.S.B., 272 B.R. 246, 252 (Bankr. N.D. Ind. 2002); Gosch v. Burns (In re Finn), 909 F.2d 903, 908 (6th Cir. 1990)(“Obviously every borrower who does something in the ordinary course of her affairs must, at some point, have done it for the first time.”).

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Earth to Creditors: Triangular Payment Arrangements May Constitute “Reasonably Equivalent Value”

Satellite Orbiting Earth.

The Eleventh Circuit Court of Appeals recently clarified the meaning of “reasonably equivalent value” in a complex fraudulent transfer case.  Its decision in In re PSN USA, Inc., Case No. 14-15352 (11th Cir. Sept. 4, 2015), provides particular insight on fraudulent transfers in the context of parent-subsidiary and other triangular payment arrangements.  The Eleventh Circuit held that even though the debtor, a cable television channel, was not a party to the underlying satellite services contract at issue, payments made from the debtor to the satellite services company pursuant to its parent company’s contracts constituted “reasonably equivalent value” and could not be avoided as constructive fraudulent transfers.

PSN USA, Inc. (the “Debtor”) operated the PSN Channel, a cable television station that broadcasted live and recorded sporting events throughout Latin America.  Pan America Sports Network International (“PSNI”) was a holding company that wholly owned the Debtor.  PSNI contracted with cable and satellite operators, who, in turn, offered and distributed the PSN Channel to subscribers in South America and the Caribbean.  PSNI paid a fee to the Debtor to operate the PSN Channel.  Although the Debtor was not a party to these cable and satellite contracts, the network’s policy and practice required the Debtor to cover all production expenses, including paying PSNI’s contractual obligations to cable and satellite operators.

Consistent with this arrangement, PSNI entered into several contracts with Intelsat Corporation and Intelsat International Systems, LLC (collectively, “Intelsat”) to broadcast the PSN Channel.  Between 2000 and 2002, the Debtor made a total of $3 million in payments to Intelsat under these contracts.  During this period, the Debtor became insolvent and, in March 2002, filed a voluntary bankruptcy petition.

Six years later, the PSN Liquidating Trust (the “Trust”) filed an adversary complaint against Intelsat alleging that the payments from the Debtor were recoverable as constructive fraudulent transfers pursuant to section 548 of the Bankruptcy Code and the Florida Uniform Fraudulent Transfer Act.  See 11 U.S.C. § 518(a)(1)(B) & (ii)(I); Fla. Stat. § 726.105(1)(b).  The Trust argued that the payments were avoidable fraudulent transfers because the Debtor was not a party to the satellite contracts, did not own the satellite services, and did not benefit from them.  Essentially, the Trust took the position that the Debtor received less than reasonably equivalent value in exchange for the transfers at issue.  According to the Trust, payment or assumption of a third party’s debt by an insolvent entity is per se a fraudulent transfer because it necessarily lacks adequate consideration.

The Eleventh Circuit Court of Appeals, however, rejected a per se approach and concluded that payments made to fulfill contractual obligations of third parties may not be fraudulent transfers where an economic benefit is directly or indirectly conferred upon the transferor.  In this case, although the Debtor was not a party to the satellite contracts of its parent company, the Debtor derived a benefit from those contracts.  Specifically, the satellite services permitted the Debtor to operate the PSN Channel, and the Debtor earned a service fee from PSNI from that operation.  This indirect benefit to the Debtor through PSNI was sufficient to satisfy the “reasonably equivalent value” requirement, and the Eleventh Circuit affirmed the bankruptcy court’s order that the Trust could not avoid the transfers.

As parent-subsidiary and other affiliate relationships are increasingly common, the shrewd practitioner needs to be aware of the potential virtues and pitfalls of triangular payment relationships, which almost certainly will be called into question as fraudulent transfers in the event of an insolvency.

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