Section 548 of the United States Bankruptcy Code allows for the avoidance of transfers that are either intentionally or constructively fraudulent. Section 548 provides, in relevant part, as follows:
(a)(1) The trustee may avoid any transfer ... of an interest of the debtor in property, or any obligation ... incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily -- (A) made such transfer or incurred such obligation with actual intent to hinder, delay or defraud any entity to which the debtor was or become, on or after the date that such transfer was made or become, on or after the date that such transfer was made or such obligation was incurred, indebted; or (B)(i) received less than reasonably equivalent value in exchange for such transfer or obligation; and (ii)(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation; (II) was engaged in a business or a transaction ... for which any property remaining with the debtor was an unreasonably small capital; (III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor's ability to pay as such debtor's matured ...
At first glance, section 548 appears to cast a wide net that would classify many types of transactions as fraudulent transfers. However, a recent decision by Judge Brendan L. Shannon in the Elrod Holdings bankruptcy shows the evidentiary hurdles a plaintiff must overcome in order to establish a fraudulent transfer claim under section 548.
In 2006, Elrod Holdings (the "Debtor") filed for chapter 7 liquidation in the United States Bankruptcy Court for the District of Delaware. The Debtor began its business in 1965 designing, manufacturing and installing spectator seating for motor sport raceways. In 2005, the Elrod family sold 75% of their stock in the company to a company called Champlain for $35 million. Champlain paid the Elrods $26 million in cash and the remainder in notes.
Soon after the sale to Champlain, the Debtor's business quickly deteriorated. By June 2006, the Debtor, Elrods and certain lenders sought to restructure the company's debt. A few months after the restructuring, Safeco, the Debtor's bonding company, demanded that the Elrods provide personal guarantees before Safeco would issue further bonds on projects for which the Debtor was a contractor. When the Elrods refused to provide personal guarantees to Safeco, Safeco refused to issue construction bonds, resulting in the Debtor quickly running out of money.
Fraudulent Conveyance Claims
As part of the pre-bankruptcy restructuring, the Elrods agreed to purchase certain equipment from the Debtor and lease the same equipment back to the Debtor. After the commencement of the bankruptcy proceeding, George Miller, as the chapter 7 trustee, commenced an adversary action alleging that the Elrod's "participated and/or aided and abetted in the [sale leaseback], with the actual intent to hinder, delay, and/or defraud the Debtor's creditors." In addition to claiming that the sale leaseback was actually fraudulent, the trustee argued that the leaseback of the equipment was constructively fraudulent.
Looking first at whether there was "actual intent" for the fraudulent transfer claims, the Court noted (and the parties agreed) that it was the Debtor's intent that was key to determine whether a conveyance was fraudulent, not the intent of the party receiving the conveyance. The Elrods argued that there was no fraudulent intent on the part of the Debtor. The chapter 7 trustee, on the other hand, argued that the Elrod's intent to hinder, delay or defraud should be imputed to the Debtor because the Elrods dominated or controlled the Debtor.
In order to decide whether the intent of the Elrods would be imputed to the Debtor, the Court looked at the "intent imputation doctrine" recognized by the United States Bankruptcy Court for the Southern District of New York in Jackson v. Miskin (In re Adler, Coleman Clearing Corp.), 263 B.R. 406, 445 (S.D.N.Y. 2001)(finding that under "the domination and control rule, the requisite intent derives from a transferee who is in the position to dominate or control the debtor's disposition of his property, a circumstance that section 548(a)(1)(A) anticipates by its provision that the fraudulent conveyance by the debtor may be voluntary or involuntary.") Applying Adler, the intent of the transferees (the Elrods) can be imputed to the Debtor if (i) the Elrods possessed the requisite intent to hinder, delay or defraud the Debtor's creditors; (ii) the Elrods were in a position to dominate and control the Debtor; and (iii) the Elrod's domination and control related to the Debtor's disposition of its property.
In deciding whether the Elrods had the requisite fraudulent intent, the Court observed that fraudulent intent may be based on circumstantial evidence. Citing In re Vaniman Int'l Inc., the Court noted that "[a]s a general rule, fraudulent intent is found on the basis of circumstantial evidence because 'fraudulent intent is not susceptible to direct proof.'" In re Vaniman Int'l Inc., 22 B.R. 166 (Bankr. E.D.N.Y. 1982). Signs of fraud include evidence of a close relationship among the parties to a transaction, the transaction involves a "secret and hasty transfer" or contains inadequate consideration.
The Trustee argued that a close relationship did exist between the parties and that the Elrod's refusal to execute the bond agreement evidenced fraud. For purposes of summary judgment, the Court found that the Trustee had identified some of the "badges of fraud." Having made this determination, the Court next addressed whether the Elrods were in a position of control. Here, the Court noted that vicarious intent is an extreme situation that is dependent upon nearly total control of a debtor by the transferee. A typical case where transferee intent is imputed on the Debtor is one where the transferee is the sole shareholder of the Debtor and has complete control. The Trustee argued that although the Elrods comprise only a minority of the Debtor's board, they still exercised functional control of the Debtor. Even so, the Court found that functional control is not enough. To prevail, the Trustee must show that the Elrods had "formal, legal control as well as functional control."
After finding that actual intent did not exist, the Court next turned to the Trustee's allegations that the transfer of property was constructively fraudulent. Here the Court begin its analysis with the rule that whether a transfer conferred "realizable commercial value" was central to deciding whether the transfer at issue was constructively fraudulent. On this point, the Court found several examples of value provided by the Elrods in the sale leaseback transaction. First, the Elrods submitted an appraisal showing that the price at which the Elrods purchased the equipment from the Debtor was greater than the actual value of the equipment. Next, the Elrods introduced evidence that the rental payments from the Debtor to the Elrods were at a below market interest rate that was to the Debtor's benefit. The Trustee, on the other hand, offered no evidence to show the value provided by the Elrods was less than a reasonably equivalent value. Based on these findings, the Court granted summary judgment for the Elrods on the Trustee's fraudulent transfer claim.
Under most circumstances, claims alleging fraud must be pled with particularity. The decision in Elrod shows that a plaintiff alleging fraud must satisfy certain factual thresholds in order to overcome a motion for summary judgment. Further the decision shows the challenges for plaintiffs who seek to impute the allegedly fraudulent conduct of a third party on to a debtor.