Badges of Fraud and the Imputation of Actual Fraudulent Intent – Chief Judge Shannon (Bankr. D. Del.) Issues Latest Order in Long-Running Syntax-Brillian Fraudulent Transfer Action

By Evan T. Miller, Esq.

In the latest memorandum order from SB Liquidation Trust v. Preferred Bank (In re Syntax-Brillian Corp.), Case No. 08-11407 (BLS), Adv. No. 10-51389 (BLS) (Bankr. D. Del.), an adversary proceeding that has already spawned three opinions (including one from the Third Circuit), Chief Judge Shannon denied the defendant-bank’s (“Defendant”) motion to dismiss the complaint (as amended, the “Complaint”).  The Complaint, predicated on the fraudulent transfer provisions of 11 U.S.C. § 548 and Delaware’s own fraudulent transfer provision in 6 Del. C. § 1304, contained sufficient “badges of fraud” for the Court to draw the “reasonable inference [that] the Debtors incurred the subject obligations (the “Obligations”) with the actual intent to delay, hinder, or defraud” within the meaning of either statute.

In varying degrees, the Court touches upon the “collapsing doctrine”, the good faith exception under 11 U.S.C. § 548(c), and the imputation of the Debtors’ officers, directors, and shareholders’ fraudulent intent to the Debtors.  It is notable that, with respect to the last point, several of the subject officers, directors, and shareholders were also officers, directors, and/or shareholders of Taiwan Kolin Co., Ltd. (“Kolin”, the overlapping individuals referred to as the “Kolin Faction”), a company with whom the Debtors orchestrated their purportedly fraudulent scheme.

History of the Debtors, Management Structure, and the Alleged Fraudulent Scheme

The instant memorandum order does not delve into the facts in explicit detail, as they have been detailed in three prior opinions: (i) SB Liquidation Trust v. Preferred Bank (In re Syntax-Brillian Corp.), Case No. 08-11407 (BLS), 2011 WL 3101809 (Bankr. D. Del. July 25, 2011) (“Bankruptcy Opinion I”); (ii) SB Liquidation Trust v. Preferred Bank (In re Syntax-Brillian Corp.), Case No. 08-11407 (BLS), 2013 WL 153831 (Bankr. D. Del. Jan. 15, 2013) (“Bankruptcy Opinion II”); and (iii) SB Liquidation Trust v. Preferred Bank (In re Syntax-Brillian Corp.), 573 F. App’x 154 (3d Cir. 2014) (the “Third Circuit Opinion”, and together with Bankruptcy Opinions I and II, the “Prior Opinions”).  As such, a bit of context from those earlier cases is helpful for understanding the latest one; the following facts are taken from the Third Circuit Opinion.

Syntax Groups Corporation (“Syntax”) was a California corporation that distributed electronic products to United States consumers.  Several Syntax officers and directors were also officers, directors, and/or shareholders of Kolin – aka the Kolin Faction.  In 2004, Syntax entered into a manufacturing agreement with Kolin, which provided that Syntax would import HD TVs manufactured by Kolin.  The Plaintiff-Trust (“Plaintiff”) avers that this agreement was intended to enhance Kolin’s financing options and artificially inflate its sales revenue, thereby improving its creditworthiness; moreover, Plaintiff alleges that Syntax simultaneously entered into incentive agreements with Kolin, which allowed Kolin to systematically over-charge Syntax, while periodically providing Syntax with price protection’ rebates to lessen the impact on Syntax’s financial statements.

Syntax and Defendant commenced a business relationship in November 2004, when they entered into a $3.75 million loan agreement, which was guaranteed by members of the Kolin Faction. Defendant also provided letters of credit and “trust receipt” loans to Syntax, which Syntax used to acquire inventory from Kolin.  Plaintiff contends that, over time, as Kolin continued to overcharge Syntax, the proceeds of Syntax’s sales were insufficient to repay the debt owed to Defendant. Syntax’s debt to Defendant thus grew, and, as a result, the loan agreement between Syntax and Defendant was amended to increase the principal loan and credit maximums several times.

Syntax and Brillian Corporation (“Brillian”) merged in November of 2005. Pursuant to this merger, Syntax became a wholly owned subsidiary of Brillian, and Brillian changed its name to Syntax-Brillian Corporation (“Debtor”, or together with its affiliated debtors, the “Debtors”). Plaintiff maintains that the Kolin Faction devised this merger in order to raise additional funds for Kolin by expanding Syntax’s access to U.S. markets.

The Bankruptcy Case, the Adversary Proceeding, and the Prior Opinions

Ultimately, the Debtor filed for relief under Chapter 11 of the Bankruptcy Code in July 2008.  The instant adversary suit was filed in July 2010, by which Plaintiff contended that, by providing financing to Syntax and the Debtor, Defendant enabled the Kolin Faction’s fraud and delayed the Debtor’s ultimate demise, thus allowing the Kolin Faction to divert millions of dollars away from the Debtor’s creditors.  In its original complaint, Plaintiff asserted four causes of action against Defendant, including ones for actual and constructive fraud under 11 U.S.C. §§ 548(a)(1)(A), (B) and 544(b), and 6 Del. C. §§ 1304(a)(1), (2) and 1305.  Defendant moved to dismiss.

In Bankruptcy Opinion I, Chief Judge Shannon dismissed the complaint, finding that Plaintiff did not allege sufficient facts to show that Defendant actually or constructively knew of the ongoing fraud.  The Court found that such failure was fatal because Plaintiff’s fraudulent transfer claims hinged on the “collapsing doctrine” – an equitable tool whereby a court can collapse multiple transactions and consider the overall financial consequences of the transactions, but which also requires a showing of the transferee’s knowledge of the fraudulent scheme.  Plaintiff sought reconsideration of Bankruptcy Opinion I based on newly discovered evidence, but the Court denied the motion for the reasons promulgated in Bankruptcy Opinion II – primarily that Plaintiff failed to show that the new evidence (which stemmed from a concurrently filed United States Securities and Exchange Commission complaint) would have changed the Court’s disposition.

Plaintiff appealed both Bankruptcy Opinions directly to the Third Circuit, which affirmed in part and vacated in part Bankruptcy Opinion I, and affirmed Bankruptcy Opinion II.  As detailed in the Third Circuit Opinion, the court concluded that the relevant statutes only require Plaintiff to allege the intent of the Debtors – i.e., Plaintiff did not have to aver knowledge of the Debtor’s fraudulent intent on the part of Defendant.  On remand, the Third Circuit tasked the Bankruptcy Court with determining whether Plaintiff sufficiently alleged actual fraud under the heightened pleading standard of Rule 9(b) of the Federal Rules of Civil Procedure (“FRCP”).

The Complaint and its Amended Allegations

Following the Third Circuit Opinion, Plaintiff filed the Complaint, which asserts three counts against Defendant: (i) avoidance of the Kolin Secured Line Obligations, the Note 204615 Obligations, the December 2006 Line 202359 Obligation, and the September 2007 Line 202359 Obligations (collectively, the “Obligations”), on the basis that they were incurred with the actual intent to delay, hinder, or defraud under 11 U.S.C. §§ 548(a)(1)(A) and 544(b), and applicable state law; (ii) avoidance of the Kolin Secured Line Principal Transfer and the Line 202359 Payoff Transfer (collectively, the “Transfers”); and (iii) recovery of the Transfers under 11 U.S.C. 550.

The Third Circuit Opinion provides pertinent detail about the alleged Obligations to Defendant incurred by Syntax or the Debtor, and concomitant payments made by the same to Defendant:

  • Kolin Secured Line: alleged to have been used by the Debtor to borrow money from Defendant and funnel the money to Kolin through Loan 204159 and/or Line 192882341 which were secured by a series of bank accounts that Kolin maintained at Defendant. These obligations total $38,800,000, and interest and principal repayments on that line of credit amounted to $29,106,962.42.
  • Note 204615: Syntax and the Debtor allegedly funneled $4 million to Kolin as part of the Kolin Faction’s scheme. These obligations total $4 million plus the interest payments of $274,444.40.
  • Line 202359: The Debtor allegedly used this line of credit to transfer to Kolin $31 million in December 2006; Plaintiff asserts that the Debtor purported to justify this transfer as payment on invoices issued by Kolin to SBC for phony “tooling” expenses and fictitious sales of television sets. Plaintiff alleges that the Debtor again used Line 202359 in September 2007 to transfer to Kolin an additional $15 million. These transfers were also purportedly justified by fraudulent payables by the Debtor to Kolin. Plaintiff asserts that both the obligations under Line 202359 as well as interest payments on the line totaling over $3.5 million should be set aside.

As summarized by the Third Circuit, the “gist of [Plaintiff’s] claims is that [the Debtor] entered into financing with [Defendant] to siphon money to Kolin.”

The Motion to Dismiss (“MTD”) and the Parties’ Arguments

Defendant sought to dismiss the Complaint under FRCP 12(b)(6), pointing to the lack of direct evidence of fraud or the presence of any badges of fraud.  Moreover, Defendant argues that the Obligations could not be fraudulent conveyances because they could not, in and of themselves, cause damage to the Debtors’ creditors, as they were payments towards fully secured obligations.  Defendant also asserts that it gave value in good faith within the meaning of 11 U.S.C. § 548(c).

In response, Plaintiff again sought to use the “collapsing doctrine”, and collapse the Obligations into one transaction so that the Court could consider the outgoing transfers to Kolin.  Plaintiff further alleged that the Debtors knew to a substantial certainty that incurring the Obligations would have the consequence of hindering, delaying, or defrauding its creditors, and that the Kolin Faction’s knowledge of said harm should be imputed to the Debtors because of the members of the Kolin Faction serving as directors and officers of the Debtors.  This is so because, inter alia, the Kolin Faction had the power to cause the Debtors to enter into the Obligations, generate fake “credit memos” that purported to represent various credits Kolin gave the Debtors, and significantly benefit from the Debtors’ under-cost selling.

The Court’s Memorandum Order

The Collapsing Doctrine Foreclosed by the Law of the Case; Good Faith Irrelevant

The Court began by disposing of certain arguments proffered by the parties in support of their respective frameworks.  As an initial matter, the Court found that Plaintiff’s use of the “collapsing doctrine” was foreclosed by Bankruptcy Opinion I as a result of another doctrine – the law of the case.  That doctrine prohibits a plaintiff from re-litigating the same issue in the same case.  The Court stated that the Third Circuit, because it agreed with Plaintiff’s argument that fraudulent transfer claims only require evidence of the Debtors’ intent, did not consider or disturb the Court’s conclusion that the Collapsing Doctrine could not apply.

As to Defendant’s section 548(c) “good faith” defense, the Court declined to consider it on the basis that it is an affirmative defense.  As such, Plaintiff does not have to allege that Defendant lacked good faith; rather, Defendant must plead and establish facts to prove the defense, but only after Plaintiff meets its evidentiary burden of proving a prima facie case.  Thus, it was inappropriate to consider section 548(c) at the motion to dismiss stage.

Delaware’s Fraudulent Intent Framework: Badges of Fraud and the Natural Consequences Standard

Moving to the merits, the Court analyzed the MTD under the Third Circuit’s Fowler v. UPMC Shadyside, 578 F.3d 203 (3d Cir. 2009) opinion (a case also discussed in this blog’s previous post on Judge Sontchi’s (Bankr. D. Del.) opinion in In re MCG Limited Partnership, available here).  Chief Judge Shannon also cited to one of his prior opinions in Official Comm. of Unsecured Creditors of Fedders N. Am., Inc. v. Goldman Sachs Credit Partners (In re Fedders N. Am., Inc.), 405 B.R. 527 (Bankr. D. Del. 2009), for the proposition that “[in] bankruptcy, the heightened pleading standard under Rule 9(b) is relaxed and interpreted liberally where a trustee, or a trust formed for the benefit of creditors is asserting the fraudulent transfer claims.”

With respect to 11 U.S.C. § 548(a)(1)(A) and 6 Del. C. § 1304(a)(1), the Court noted the actual intent requirement in both statutes required a showing of at least one of the three requisite states of mind – intent to hinder, intent to delay, or intent to defraud.  He then again referred to his Fedders opinion to state that the requisite intent may be demonstrated circumstantially with “badges of fraud”.  As provided in the District of Delaware’s In re Hechinger Inv. Co. of Del, Inc., 327 B.R. 537 (D. Del. 2005) opinion, the Court enumerated a non-exclusive list of “badges”: (1) the relationship between the debtor and the transferee; (2) consideration for conveyance; (3) insolvency or indebtedness of the debtors; (4) how much of the debtor’s estate was transferred; (5) reservation of benefits, control or dominion by the debtor; and (6) secrecy or concealment of the transaction.  The Court noted that the “badges” analysis is not a “check-the-box” inquiry and provides only a basic rubric, requiring courts to examine the totality of the circumstances to determine whether fraudulent intent exists.

Applied here, the Court could “reasonably infer based on the relative positions of the Kolin Faction members within the Debtors’ organization that they had the power to cause the Debtors to incur the Obligations”, and as a result, would impute the intent of those individuals to the Debtors.  The Court found that the Obligations were incurred while the Debtors not only had negative income and gross margins, but also will the Kolin Faction was in the midst of generating fake credit memos and sales.  The Court also noted Seventh Circuit’s “Natural Consequences” standard, in which the “Debtors are presumed to intend the natural consequences of their acts”, and the natural consequence of incurring the Obligations would, at a minimum, delay or hinder distributions to the creditor body.  Combined with the badge of fraud that the Debtors were insolvent at the time the Obligations were incurred, the Court found both the bankruptcy and Delaware statutes satisfied for purposed of defeating a motion to dismiss.

Note: for a comparison on the “Natural Consequences” standard, see the blog’s Lyondell post here for the Southern District of New York’s discussion.

Given that Count II (avoidance of the Transfers) is predicated on the avoidance of the Obligations in Count I, the Court found that if Plaintiff was successful as to Count I, then by operation of law, any security interests held by Defendant are retroactively nullified; conversely, if the Court found the Obligations were not fraudulently incurred, then their repayment does not harm creditors.  As such, Count II could not be dismissed while Count I survived.  For similar reasons, the MTD as to Count III (recovery of the transfers) was also denied.

Conclusion

Like the three prior opinions that this case has spawned, the instant memorandum order provides sound guidance for attorneys handling fraudulent transfer actions.  It offers good examples of the allegations and level of detail necessary for an actual fraud claim to survive a motion to dismiss (here, one “badge of fraud” to go with the totality of circumstances at the time).  This order is also useful for its discussion of the law of the case doctrine, the collapsing doctrine, the timing of good faith/548(c) at the motion to dismiss stage, and the imputation of officers/directors’ intent to a debtor entity.  To the last point, and as noted above, it is worth the reader’s time to compare the conclusions reached here regarding fraudulent intent with those in the Southern District of New York’s Lyondell progeny of cases, posts about which are available here and here.

A copy of the memorandum order can be found here.

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