Cooper v Centar Investments LTD, et al. (In re Trigem America Corporation), 431 B.R. 855 (C.D. Cal. 2010)
In an attempt to avoid an inevitable put on its convertible bonds (which would have capsized Korean company TriGem Computer, Inc. (TGI) and caused it to be de-listed from the Korean Stock Exchange), TGI used its American subsidiary, TriGem America Corporation (TGA), as a conduit to transfer about $17 million cash from TGI to its bondholders as part of a purported swap agreement. TGI and TGA characterized their internal cash transfer as a payment of accounts receivable owed by TGI to TGA. The “too clever” plan failed, as did both companies, and TGA filed a chapter 11 petition months after the transfer. The bankruptcy trustee sought to avoid the conduit-transfer from TGA to the bondholders as a fraudulent conveyance. The Bankruptcy Court held that the earmarking doctrine – i.e., the funds were earmarked for another purpose and thus were never actually property of TGA’s estate – prohibited the bankruptcy trustee from recovering the funds.
The Korean parent company, TGI, had issued zero-coupon convertible bonds to several investors in 2004. These bonds matured April 14, 2008, and had a put option, whereby the holders could present the bonds to TGI for redemption at ascending percentages of par on scheduled dates. Relevant to this case, the holders could present the bonds April 14, 2005, and receive 104.5 percent of par from TGI.
Within weeks of the imminent April 14, 2005 put, TGI’s financial condition had deteriorated so substantially that the Korean Stock Exchange warned it would place TGI’s stock under special supervision, and perhaps de-list the stock. Given looming deadlines by the stock exchange and the impending bond put date, TGI convinced bondholders to convert their original bonds to mandatory convertible bonds without a put option. As part of the “confirmation agreements,” which were designated as “swap agreements,” TGI agreed to pay the bondholders $17.85 million in immediate cash as security, in case stock prices did not climb. However, to avoid alerting the Korean Stock Exchange to its scheme and triggering mandatory waiting periods in Korea that would push the deal past critical deadlines, TGI arranged to transfer cash through its American subsidiary, TGA, which contributed a nominal $250,000 of its own cash to the deal.
TGI wired $15.6 million to TGA, and the remaining cash transfer amounts were paid to bondholders by TGA out of its own funds and from borrowing through a sister company. The $15.6 million transfer was characterized as an intercompany payment on TGA’s accounts receivable (although, notably, TGA owed considerably more to TGI than vice-versa).
The swap delay tactic did not work, and within months, TGI filed for receivership protections in Korea and TGA filed a chapter 11 petition in California. The bankruptcy trustee sought to recover the $17.85 million transferred from TGA to the bondholders as fraudulent transfers, in a motion for summary judgment. The debtor and bondholders filed counter-motions for summary judgment. As to the $15.6 million inter-company transfer, the court ruled in favor of TGA and the bondholders and did not avoid that portion of the transfer.
At the heart of the court’s analysis was whether “‘an interest of the debtor in property’ . . . was transferred.” The bondholders’ principal defense was that the $15.6 million was not property of TGA, since it was “earmarked” by TGI for direct transfer to the bondholders. In other words, the money was never TGA’s, and TGA was merely a conduit for the transfer.
First, the court indicated that neither TGI nor TGA appeared to have clean hands (particularly since TGI was seeking to hide transactions from Korean regulatory authorities). As the court noted, it “was tempted to simply disregard entirely the earmarking defense under the ancient precept that one seeking the protection of equity must come to court with clean hands.” Nevertheless, the court resisted this “temptation,” since it could identify no law in America or Korea that had been violated.
More importantly, the court determined that TGA’s creditors had no interest or expectancy in the $15.6 million that quickly passed through TGA’s bank accounts. The money clearly belonged to TGI. The mere fact that TGA accounted for the transfer as an inter-company payment of its accounts receivable was not enough to make it property of TGA, since an objective observation of the facts revealed that TGA owed far more money to TGI than vice-versa, and but for the swap transaction, TGA would never have received the money. The court looked beyond the characterization of the transfer to determine its true nature (although, again, the court noted that it is “always satisfying to see too clever actors hoisted upon their own petard”).
The trustee argued that the funds were not earmarked because TGA could have done anything it wanted with the $15.6 million, but the court rejected this contention on the basis that it could apply to virtually all earmarking cases. The issue is whether there was a written or oral understanding or instruction that the funds were earmarked. Here, there was such an understanding. The court also rejected the trustee’s arguments that the earmarking defense did not apply to fraudulent transfer actions in the 9th Circuit. The court ruled that earmarking went to the central issue in both fraudulent transfer and preference actions, whether the transferred property was actually property of the debtor’s estate.
As to the $250,000 TGA transferred to the bondholders out of TGA’s own cash accounts, the court easily determined that transfer was a fraudulent transfer, irrespective of the Section 546(g) “safe harbor” provisions for swap agreements. The court ruled that the transaction was not actually a “swap” at all, since it was clearly outside the norms commonly used in the securities trade (i.e., it was used as a device to evade Korean regulators). Here, the property was clearly that of TGA’s estate, and thus within the scope of section 548 (unlike the earmarked funds). Moreover, because TGA did not receive “reasonably equivalent value” for this transfer, it was avoidable as a fraudulent transfer.
Therefore, the Bankruptcy Court found that there was no triable issue of material fact. With respect to the TGI funds, the court determined they were earmarked and thus not the property of the debtor, and not avoidable as fraudulent transfers. With respect to the $250,000 owned by TGA, the court permitted the trustee to recover the funds as an avoidable fraudulent transfer.
Although courts will often punish parties that have appeared to act inequitably or unfairly, they will not do so when it creates an unfair windfall for creditors. Where funds are earmarked and pass through a debtor’s accounts merely as a conduit, a trustee or creditors will not likely be able to benefit from the cash transfer merely because it was part of a grander, perhaps less-than-savory scheme --at least not so long as the scheme was not designed to defraud the debtor’s own creditors.