Garcia v. Garcia (In re Garcia), 507 B.R. 434 (Bankr. E.D.N.Y. 2014) –

Limited liability company (LLC) membership interests owned by a debtor were transferred to other LLC members after they expelled him shortly before his Chapter 11 bankruptcy. The debtor sought to set aside these transfers as fraudulent conveyances or preferences. After the bankruptcy court dismissed both claims, the debtor sought reconsideration of the preference theory.

The debtor (Garcia) and two relatives held the membership interests in two limited liability companies. The other members caused Garcia to be expelled because he took excess distributions of ~$715,000 from the LLCs. Under the operating agreements, as a result of the expulsions Garcia’s membership interests were transferred to the other members, and they were required to pay him the market value of his interests. After an involuntary petition was filed against Garcia, he sought to avoid the transfers of his membership interests as either preferences or fraudulent transfers.

There was no allegation of actual fraud. For constructive fraud, the debtor was required to show that he did not receive “reasonably equivalent value” for the transfer in addition to showing insolvency, unreasonably small capital or intent to incur debts beyond the ability to pay. However, the court found that the obligation to pay market value for his LLC interests constituted reasonably equivalent value, and consequently dismissed the fraudulent transfer claims.

As for the preference claims, among other things the debtor was required to show that the transfers were “on account of an antecedent debt.” The defendants had claims against Garcia for return of the excess distributions. However, the court found that the membership transfers were not “on account of” the excess distributions debt because the transfers were not made in satisfaction of the debt.

Garcia argued that “on account of” is ambiguous because it could have an “accounting meaning” – referring to the transfer as payment of the antecedent debt, or it could have a “causative meaning” – referring to the transfer as “because of” the debt. Garcia argued that but for the excess distributions, he would not have been expelled and his membership interests would not have been transferred. So, the transfer was because of the excess distribution debt.

He supported his position by citing to a U.S. Supreme Court case under Title VII holding that “the ordinary meaning of ‘because of’ is ‘by reason of’ or ‘on account of.’” The bankruptcy court noted that this case was not an interpretation of “on account of,” and commented that the quoted statement was dicta and irrelevant in that Title VII claims are “demonstrably different” from preference claims.

The court added that there is a “well-established principle that intent of the parties is irrelevant when determining whether a transfer constituted a preference under §547(b).” The issue in a preference action is the effect of a transfer, not the intent of the parties. Interpreting Section 547 to mean that a transfer was “because of” the debt is inconsistent with this principle.

The debtor also argued that the grant of a security interest can be avoided, so there can be a transfer that does not reduce the debt. The court again found the argument to be irrelevant under the facts of this case.

The debtor pressed on to argue that the expulsions were just like perfection of a security interest and impermissibly improved the defendants’ position with respect to other creditors. First, the court noted that Garcia received reasonably equivalent value, so the other creditors were not deprived of an economic benefit. And even if the right to receive payment for his interest could be set off against the claims to recover excess distributions, if the defendants were able to establish the requirements for a setoff under Section 553 of the Bankruptcy Code, that was a permissible advantage.

Consequently, the court held that the transfers of the debtor’s LLC membership interests were not “on account of an antecedent debt.”

It is interesting to observe the debtor’s efforts to undo his expulsion. In this case the fraudulent transfer claim failed because he was entitled to receive payment of the market value of his interests. However, it is not unusual for an LLC operating agreement to provide for dilution or termination of a member’s interest as a remedy for failure to make required capital contributions or as a penalty for bad acts without providing for any compensation of the member. Consider whether taking action to dilute or terminate a member’s interest under these circumstances might be susceptible to avoidance as a fraudulent transfer.

Vicki R. Harding, Esq.