Non-Dischargeability: Shuffling Assets Among Entities May Lead To Non-Dischargeability No Matter How Indirect and Difficult to Follow

Dz Bank Ag Deutsche Zentral-Genossenschaft Bank v. Meyer, 869 F.3d 939 (9th Cir. 2017)

The debtors caused assets to be transferred out of a closely-held corporation. A bank creditor alleged that the indirect transfer constituted a fraudulent transfer, and as a result the creditor’s debt was non-dischargeable. The bankruptcy court agreed but limited the amount of non-dischargeable debt to the value of assets attributable to the creditor’s security interest. The district court took a different approach that precluded consideration of assets titled in the corporation absent a showing that the corporation was an alter ego of the debtors. The creditor appealed to the 9th Circuit.

As a result of a convoluted sequence of events, the bank held a loan to an entity (Corp 1) secured by a blanket lien on all of its assets. A debtor was the sole member and manager of Corp 1, and the debtor and his wife guaranteed the loan to Corp 1.

Over a two-year period, Corp 1 and the bank entered into several forbearance agreements while the debtor repeatedly asked for loan modifications. In the meantime, the debtors took steps to place assets beyond the reach of their creditors.

Among other things, the debtor caused Corp 1 to transfer assets valued at $123,200 to another 100% owned corporation (Corp 2). He also purchased a third entity (Corp 3) for $200, caused Corp 2 to transfer its assets to Corp 3 for no consideration, and arranged for a family trust to buy 100% of the Corp 3 stock.

At that point Corp 3’s assets had a value of $385,000, of which $123,200 was attributable to the assets that originated with Corp 1. Corp 3 agreed to pay $385,000 back to the debtor personally, ostensibly as repayment of a shareholder loan. There were some further shenanigans that left all three entities (Corp 1, Corp 2 and Corp 3) insolvent.

After a default on the loan and personal guarantees, the bank sued Corp 1 and the debtors. Although the action against the debtors was stayed once they filed bankruptcy, the bank obtained a final judgment against Corp 1 for ~$1.7 million.

Corp 1 was not collectible, so the bank filed an adversary proceeding in the bankruptcy against the debtors, claiming that the transfer of assets out of Corp 2 was a fraudulent transfer. One of the exceptions from dischargeability under section 523(a) is for debts obtained by “actual fraud.” As the Supreme Court explained, this can include a fraudulent transfer.

Under the state fraudulent transfer act, “transfer” is defined as “every mode, direct or indirect” of disposing of an asset. “Asset” is defined as “property of a debtor.” And “property” is “anything that may be the subject of ownership.”

Against this background the bankruptcy court ruled in favor of the bank but limited the judgment to the part of $385,000 that could be traced to the bank’s collateral – namely $123,200. The district court concluded that the bank could recover only property of the debtor, and thus it concluded that the bank would have to obtain a ruling that Corp 2 was the alter ego of the debtors in order to have non-dischargeability based on Corp 2’s assets.

The 9th Circuit disagreed with both lower courts. As a preliminary matter, the court noted that the courts have used “actual fraud” to “describe the debtor’s transfer of assets that… impaired a creditor’s ability to collect the debt.” So, a fraudulent transfer based on actual intent (as opposed to constructive fraud) can be the grounds for non-chargeability of a debt.

Since a goal of the Uniform Fraudulent Transfer Act is to promote uniformity among states, the court found it instructive to consider decisions from other jurisdictions:

  • The 11th Circuit rejected an argument that the debtor must have legal title to the transferred assets. Rather it was sufficient if the assets could have been applied to payment of a debt due from the debtor.
  • In the context of a corporation where an officer’s ownership went from 100% to 2%, a Minnesota court rejected an argument that the corporation, not the officer, diluted stock ownership position. This in turn meant that the officer could be characterized as fraudulently transferring assets.
  • In another case the sole shareholder and director of a corporation caused dilution of his ownership from 100% to 20%. A South Dakota bankruptcy court rejected the argument that it was the corporation that diluted its own shares.

Turning to this case, the 9th Circuit reasoned that if Corp 2 had retained the $385,000 in assets, the bank would have been able to enforce a judgment against the debtor prior to the bankruptcy filing by executing against the debtor’s 100% ownership interest in Corp 2 to satisfy $385,000 of its claim. By indirectly transferring Corp 2’s assets to another entity the debtor depleted the value of his assets to the detriment of his creditors – similar to the stock dilution cases. His shares in Corp 2 became worthless, all while he continued to receive payments from Corp 3. Thus, the indirect transfers blocked the bank from collecting $385,000 of the debt owed.

Accordingly, the court held that based on the indirect transfers caused by the debtor the bank established that the debtor had an intent to hinder, delay or defeat creditors that constituted actual fraud to the bank’s detriment. Further the nondischargeability judgment should have been for the full $385,000: The bank could have recovered this amount by executing against the debtor’s stock in Corp 2.

Note that a key element in the court’s reasoning was that the bank could have executed against the debtor’s stock in a corporation, giving the bank access to the corporation’s assets. If the entity had been a limited liability company located in a jurisdiction that restricted a creditor’s remedies to a charging order as opposed to being able to foreclose on the debtor’s equity, the court’s analysis would not work. Because of this result, it has been suggested that merely converting an entity for a Corporation to a more protected form such as the limited liability company in a state with limited remedies could constitute a fraudulent transfer.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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