The question “Where’s the Beef?” is typically associated with the famous Wendy’s television commercial from 1984 and its lovable actress, Clara Peller. But the recent decision in the chapter 7 case of a national meat processor had an avoidance action defendant asking, “Where’s the Beef … (with me)?” after the debtor’s chapter 7 trustee attempted to avoid over $5 million in transfers made by the debtor to the defendant prepetition. This is the first of two posts on Saracheck v. Crown Heights House of Glatt, Inc., a recent decision from the Bankruptcy Court for the Northern District of Iowa that provides insight into fraudulent transfer and preference defenses. Today’s post focuses on the court’s fraudulent transfer analysis, and the next post will focus on its preference analysis.

Background

The debtor, Agriprocessors Inc., operated a slaughterhouse and meat-packing factory in Postville, Iowa. Agriprocessors was one of the nation’s largest producers of kosher meat and poultry. Aaron Rubashkin, a Hasidic butcher from Brooklyn, and his family founded, owned, and ran the business. The Rubashkins were part of a tight-knit Lubavitch community. Prepetition, certain members of the community lent money to Agriprocessors on an unsecured basis.

In May 2008, U.S. Immigrations and Customs Enforcement staged a raid of the Postville facilities that led to numerous federal criminal charges, including charges against the debtor’s president, Shlomo Rubashkin. (Several books have been written about Postville and the Postville raid).

Following the Postville raid and the related financial difficulties that befell Agriprocessors, on November 4, 2008, Agriprocessors commenced a chapter 11 case in the Bankruptcy Court for the Eastern District of New York. The court concluded that appointing a chapter 11 trustee was necessary under 11 U.S.C. § 1104(a)(1) “for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management.” The New York bankruptcy court transferred the case to the Bankruptcy Court for the Northern District of Iowa on December 15, 2008. The Iowa bankruptcy court subsequently converted the case to a chapter 7 bankruptcy. The U.S. Trustee for the region retained the chapter 11 trustee as the chapter 7 Trustee.

The trustee filed a number of adversary complaints against creditors alleging they received fraudulent or preferential transfers. Among those defendants was Crown Heights House of Glatt, Inc. Crown Heights was in the business of selling kosher food products in Brooklyn. Its sole shareholder was Gutel Tzivin, a niece of Agriprocessors’ owner. The Tzivin family appeared to be part of the same tight-knit community as the Rubashkin family. Crown Heights had never purchased any products from the debtor but had been involved in hundreds of financial transactions with the debtor that resulted in huge sums of money flowing back and forth between it and the debtor.

Crown Heights asserted that the financial transactions at issue in the adversary proceeding were oral, short term loans that Crown Heights had made to the debtor. Crown Heights had not charged interest to Agriprocessors, and there were no written loan documents governing the lending relationship. Crown Height’s vice president testified that lending money in this fashion was common practice in their Orthodox Jewish community and tied to religious duty.

The majority of the funds that flowed from Crown Heights to the debtor came from the debtor’s “window check” writing practice in which Crown Heights would give Agriprocessors “window checks” printed with Crown Height’s name and allowed Agriprocessor’s president to write checks directly from Crown Heights’ bank account without any additional approval from Crown Heights’ representatives. The window check agreement gave Agriprocessors control over when a loan was made and repaid; in effect, the debtor had a credit line on Crown Heights’ bank account. In addition, Agriprocessor’s president used some of the window checks to make loans to third parties – in particular, to Best Value, a separate company owned or controlled by the Rubashkins.

The evidence showed that Crown Heights “failed to provide any meaningful oversight of the lending relationship.” Crown Heights’ representatives did not typically know why Agriprocessors needed the loans, when most of the loans were made, the amount of each loan, or even that the funds were “loaned” to parties other than Agriprocessors.  The court also found that the loan relationship contributed to the fraud Agriprocessors perpetrated on its creditors. The Agriprocessor’s president created false invoices showing it sold product to Crown Heights even though the sales never occurred. He used the false invoices and loan checks to obtain additional credit from Agriprocessors’ primary creditor, First Bank Business Credit. As part of the terms with First Bank, Agriprocessors’ trade invoices were required to be paid in full within 60 days following receipt; the window check arrangement made it easy for Agriprocessors to use Crown Heights’ own money to do so. The court found that, as a result of the lending relationship with Crown Heights, Agriprocessors was able to amass a significantly greater debt to First Bank than it otherwise could have, to the detriment of other creditors of the estate.

All in all, the debtor wrote 111 checks to Crown Heights totaling $5,364,090.33 in the two years prior to the bankruptcy filing. The trustee sought to recover the transfers as actual fraudulent transfers or constructive fraudulent transfers under 11 U.S.C. § 548 or as preferential transfers under 11 U.S.C. § 547.

Actual Fraud

Section 548(a)(1)(A) provides that a trustee:

may avoid a transfer of an interest of the debtor in property . . . 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 became, on or after the date that such transfer was made or such obligation was incurred, indebted[.]

At trial, the trustee argued that Crown Heights was so lax in its financial dealings with Agriprocessors that Crown Heights’ conduct amounted to actual fraud. The court rejected this theory because it was raised for the first time at trial, and also because the trustee provided no evidence of Crown Heights’ knowing involvement (or any involvement) in the debtor’s fraud. Further, the court explained that Crown Heights’ inattentiveness to its dealings with the debtor was irrelevant to the alleged actual fraud. Rather, it appeared on the record that Crown Heights’ involvement grew out of religious duty, shared community, a desire to help the Rubashkins, and trust (which, the court found, the debtor had abused).

It is unclear from the decision, but in asserting that Crown Heights had “unclean hands,” the trustee may have intended that Crown Heights should not be able to assert as a defense that it received the transfers in good faith and for value. The bankruptcy court noted briefly that “a transferee’s clear involvement in fraud can prevent the transferee from asserting certain defenses,” but the court did not analyze any of those defenses (although it seemed to acknowledge that there was evidence of actual fraud by the debtor).

As an aside, it’s worth noting that recent decisions such as Picard v. Katz, which comes out of the Madoff liquidation proceedings, illustrate that it is the fraudulent intent of the transferor, and not the transferee, that is relevant under section 548(a)(1)(A). (We have previously blogged about that decision here.) In that case, the court-appointed trustee, Irving Picard, brought suit against certain of Madoff’s customers, alleging, among other theories, actual fraud. It was “patent” that all the transfers made by Madoff’s firm during the two-year period prior to its bankruptcy were made with actual intent to defraud present and future creditors. In analyzing the extent to which the transfers at issue could be avoided, the district court looked at the application of the good-faith transferee defense under section 548(c) of the Bankruptcy Code. In pleading the customers’ bad faith, Picard had argued that either the customers were “willfully blind” to the underlying fraudulent scheme or, in the alternative, they were on “inquiry notice” of the fraud and failed to investigate. The court reasoned the subjective “willful blindness” test was more appropriate, and that if the trustee could show the customers lacked good faith based on their willful blindness, then the trustee could recover the customers’ return of principal.

Perhaps if the trustee in Agriprocessors had pled its allegations differently in the first instance, the court’s analysis of whether the transfers constituted actual fraud under section 548(a) would have been clearer.

Constructive Fraud

Turning to the trustee’s constructive fraud allegations, the court noted that the only disputed element under section 548(a)(1)(B) of the Bankruptcy Code was whether the payments the debtor made to Crown Heights within the two years before the bankruptcy were in exchange for reasonably equivalent value.

As far as Crown Heights knew, the only money it paid out were loans that correlated with what it received in loan payments. Thus, Crown Heights argued that all payments it received were loan payments and were for reasonably equivalent value. It also urged the court to adopt a “totality of the transfers” analysis of reasonably equivalent value. Crown Heights asserted that aggregating all the transfers it made to the debtor (approximately $6.4 million) and comparing that to the transfers the debtor made to Crown Heights (approximately $5.3 million) showed that, during the relevant two-year period, the debtor had actually borrowed more than it repaid.

The trustee claimed some payments may have been for reasonably equivalent value, but a larger number were not. Further, the trustee argued that, even if some of the transfers from the debtor to Crown Heights paid down preexisting debt, none of the loans added real value to the estate because they were used to further debtor’s fraudulent scheme and their net effect was to increase the amount of debt that the debtor could not repay.

The court found that the “totality of the transfers” argument advanced by Crown Heights was not supported by the case law and insufficient to show reasonably equivalent value. The proper focus was on the specific transaction sought to be avoided. Similarly, the court rejected the trustee’s argument, finding that the collateral effect on the welfare of the debtor’s business (here, exacerbating the harm to creditors and diminishing the estate overall) did not supplant an analysis of whether the debtor received less than reasonably equivalent value with respect to each individual transaction. Thus, the court analyzed each check from the debtor to Crown Heights during the relevant time period to determine whether it was given for reasonably equivalent value.

In many instances, the loans from Crown Heights correlated to repayment amounts from the debtor, but some checks from the debtor to Crown Heights predated any debt that had to be paid down. The court found two other types of transfers did not appear to pay down a preexisting debt: (i) transfers that paid off loans made to Best Value (and which did not benefit the debtor) and (ii) transfers that overpaid loan amounts due or owing. In those instances, the court held the transfers were not for reasonably equivalent value.

Conclusion

The court found the trustee was entitled to avoid transfers of $1,297,150.68 as constructively fraudulent. The atypical lending relationship and unique facts made for a complicated fraudulent transfer analysis in this case. In our next post, we will discuss the court’s analysis of the trustee’s efforts to avoid the transfers to Crown Heights as preferences.