Section 363(b) of the Bankruptcy Code affords debtors flexibility to sell assets outside of the ordinary course of business after notice and a hearing.  This right is supported by sections 363(f) and 363(m), which allow debtors to sell property free and clear of all liens and interests, subject to certain requirements, and limit a party’s right to reverse or modify a sale pursuant to section 363 where the purchaser acted in good faith and the party seeking the appeal did not seek to stay the sale pending the appeal.  Although the Bankruptcy Code affords debtors significant flexibility with respect to asset sales, we are reminded by a recent decision by the United States Bankruptcy Court for the Central District of California, Enrenberg v. Roussos et al. (In re Roussos), that the Bankruptcy Code does not promote or protect sales of assets that are tainted by collusion or fraud.  While the facts of this case are particularly egregious, the decision reinforces for all practitioners the importance of full and complete disclosure to the bankruptcy court in connection with a bankruptcy sale, particularly where the prospective purchaser is an insider of the debtor, as defined in section 101(31) of the Bankruptcy Code

The Facts

In the early 1980s, two brothers, Theodosios Roussos and Harry Roussos, partnered with a third party to purchase two apartment buildings.  From the outset, the Roussos brothers sought, fraudulently, to extinguish the third party’s ownership interest in the properties by excluding the third party on title to the properties.  The third party was unaware of this exclusion and it was not until ten years later that the deficient title registration was discovered.  Upon discovery of the deficient title registration, the third party’s widow commenced a state court action and successfully obtained a judgment against the Roussos brothers awarding the third party its rightful title to the property, in addition to compensatory and punitive damages.

Subsequently, and in an ongoing effort to extinguish the third party’s interest in the properties, the Roussos brothers filed for chapter 11 in the summer of 1993.  As part of the chapter 11 cases, the Roussos brothers filed a motion seeking an order authorizing the sale of the properties to two corporate entities free and clear of the third party’s interest in the properties.  The bankruptcy court issued the requested sale order, which included a provision granting the corporate entities protection under section 363(m) of the Bankruptcy Code.  In so doing, the bankruptcy court relied on the declarations by the Roussos brothers which falsely stated that the sale was an arms-length transaction, that neither one of the Roussos brothers held any interest in the two corporate entities that would serve as the purchasers, and that the properties were over-encumbered.  Once title to the property was conveyed to the two corporate entities, the Roussos brothers’ chapter 11 cases were converted to chapter 7 cases and each of the Roussos brothers received a discharge, although the state court judgment was excepted from discharge.

Unbeknownst to the bankruptcy court, the Roussos brothers secretly controlled the two corporate entities, the properties were not over-encumbered, and the sale motion was part of the Roussos brothers’ conspiracy to dispossess the third party of its interest in the properties.  Fortunately, after the sale order was entered, the third party’s widow continued to pursue her late husband’s ownership rights in the properties and discovered (albeit more than ten years after the commencement of the chapter 11 cases) that the Roussos brothers intentionally withheld from the court the fact that they controlled the corporate entities that purchased the properties.  As a result, the chapter 7 cases were reopened and a chapter 7 trustee was appointed.  Upon completing its own due diligence, the chapter 7 trustee filed a complaint in the bankruptcy court seeking, among other things, (i) to vacate the sale order for fraud on the court pursuant to Rule 60(d)(3) of the Federal Rules of Civil Procedure, (ii) to vacate the deeds transferring the ownership of the properties to the corporate entities, (iii) turnover of the properties pursuant to section 542 of the Bankruptcy Code, and (iv) compensatory and punitive damages against the Roussos brothers for fraud and breach of fiduciary duty.

The defendants moved to dismiss the chapter 7 trustee’s complaint arguing, among other things, that: (i) the statute of limitations for all allegations asserted in the complaint had expired, (ii) the complaint failed to allege that the sale price of the properties had been reduced by the conspiracy, (iii) an action for turnover under section 542 must fail because the properties were no longer property of the estate, and (iv) that any claim for damages against the Roussos brothers violated the discharge injunction.

Decision

The bankruptcy court’s decision focused primarily on the claim for fraud on the court under Rule 60(d)(3) of the Federal Rules of Civil Procedure, which codifies the court’s inherent power to investigate whether a judgment was obtained by fraud.  As the bankruptcy court explained, fraud on the court embraces “only that species of fraud which does or attempts to, defile the court itself, or is fraud perpetrated by officers of the court so that the judicial machinery can not perform in the usual manner its impartial task of adjudging cases that are presented for adjudication.”  Fraud on the court usually involves a scheme by one party to hide a key fact from the court and the opposing party, or perjury or nondisclosure of evidence so significant that it undermines the workings of the adversary process itself.  Notably, there is no statute of limitations for fraud on the court.

The bankruptcy court found that the trustee’s complaint alleged facts sufficient to state a claim for fraud on the court.  Although nothing in the Bankruptcy Code prohibits a sale to insiders, such sales are subject to “heightened scrutiny to the fairness of the value provided by the sale and the good faith of the parties in executing the transaction” because a sale to insiders is “fundamentally different from a sale at arms-length” where the exposure to the marketplace ensures that the sale price is reasonable.  As a result of the Roussos brothers’ false declarations, the court did not apply the heightened scrutiny necessary to ensure that the insider sale yielded optimal value for the estate and, accordingly, the Roussos brothers’ perjury undermined the workings of the adversarial process itself and amounted to fraud on the court.

The bankruptcy court was not persuaded by the defendants’ assertion that the complaint failed to demonstrate that the sale price was materially lower as a result of the fraud, finding that a decreased sale price “inevitably” results when debtors sell assets to entities that are under their secret control because debtors in such schemes have no incentive to market the assets aggressively.

The bankruptcy court made the following observations with respect to certain of the remaining claims asserted in the trustee’s complaint:

  • The claims seeking compensatory and punitive damages against the Roussos brothers were not likely to succeed, as the Roussos brothers’ personal liability was discharged as part of the chapter 7 cases and the period of time to revoke such discharge had expired. The chapter 7 trustee sought to have the bankruptcy court modify the order for relief under section 348 of the Bankruptcy Code such that liability for conduct associated with the sale (e., post-filing, but pre-conversion conduct) would not be discharged.  The bankruptcy court found that cause did not exist to modify the date of the order for relief to prevent the debtors from receiving discharge of debts that accrued post-filing, but pre-conversion as such debts were discharged nineteen years ago, and such retroactive modification of the date would (i) be inconsistent with the finality of the discharge exemplified in the Bankruptcy Code and (ii) would affect numerous parties who were not before the bankruptcy court.
  • The bankruptcy court found that the trustee failed to plead sufficiently that the claims for fraud and breach of fiduciary duty had not been barred by the statute of limitations. The statute of limitations on claims for fraud or breach of fiduciary duty were postponed until the plaintiff discovers, or has reason to discover, the cause of action.  To benefit from such postponed accrual, the plaintiff must show (i) the time and manner of discovery and (ii) the inability to have made earlier discovery despite reasonable diligence.  Although the complaint contained extensive allegations regarding the third party’s widow’s attempts to uncover the fraud and breach of fiduciary duty, the complaint did not contain sufficient allegations showing the trustee’s diligence and the court found no basis for imputing the widow’s actions to the trustee.
  • The bankruptcy court found sufficient facts to support a claim for turnover under section 542 of the Bankruptcy Code, finding that if the sale order was procured by fraud on the court, it would be void ab initioand, as a result, the properties would still constitute property of the estate and be eligible for turnover.

Conclusion

As previously noted, the facts of this case are particularly egregious.  We are certain that none of our readers would undertake or advise their clients to undertake actions similar to the mischievous actions taken by the Roussos brothers (in fact, the attorney who had advised the Roussos brothers in connection with the transfer of the property to the two corporate entities later resigned from the California State Bar with charges pending related to the attorney’s formation of sham corporations on behalf of his clients).  Nevertheless, this decision reminds us of the importance of full disclosure to the court of any connection between a purchaser and a debtor that would render the purchaser an insider of the debtor.  Such disclosure will assist in ensuring that the purchaser and the debtor retain the full benefit of sections 363(f) and 363(m) of the Bankruptcy Code.