Judge Houle (Bankr. C.D. Cal.) Addresses the Impact of Substantive Consolidation On Fraudulent Transfer Defenses in In re Empire Land, LLC

By Evan T. Miller, Esq.

*Update as of 7/19/2016: Since the post below on 4/18/2016, this decision has been appealed to the United States District Court for the Central District of California, and remains pending.*

Judge Houle (Bankr. C.D. Cal.) recently applied the “dominion test” to a series of transfers in the In re Empire Land, LLC bankruptcy cases, finding a material issue of fact existed as to whether the fraudulent transfer defendant could use the funds as it saw fit – hence, whether it could be a transferee of the funds.  The Court noted this approach was consistent with Ninth Circuit law, rejecting the Defendant’s purported use of the “control test” and its reliance on the estates’ substantive consolidation for purposes of analyzing the transactions.  The Defendant’s substantive consolidation argument makes this case an especially unique and interesting read.

The Bankruptcy Case and the Parties

The Debtors consist of several entities: Empire Land, LLC (“Empire Land”), Aviat Homes, L.P. (“Aviat”), Empire Construction, L.P. (“Empire Construction”), Empire Global Holdings, L.P. (“Empire Global”), Empire Residential Construction, L.P. (“ERC”), Empire Residential Sales, L.P. (“ERS”), Prestige Homes, L.P. (“Prestige”), and Wheeler Land, L.P. (“Wheeler”, and collectively, the “Debtors”).  The cases began in chapter 11 in April 2008, converted to chapter 7 in December 2008, and were substantively consolidated in September 2009.

In May 2009, the Chapter 7 Trustee (“Plaintiff”) filed a complaint (as amended, the “Complaint”) under 11 U.S.C. § 548 and Cal. Civ. Code § 3439.04, against Empire Partners, Inc. (“Defendant”), who served as either the general partner or managing member for Empire Global, Aviat, Empire Construction and Empire Land.  Until the chapter 7 conversion, James Previti (“Previti”) served as a director of Defendant and directly or indirectly controlled all of the legal and equitable interests of each of Empire Global, Empire Land, Aviat, Wheeler, ERC, ERS, Prestige, and Empire Construction.  In pertinent part, the complaint alleged four fraudulent transfers under federal and state law in the amounts of (1) $9,667,000 (“$9.6M Transfer”), (2) $4,000,000 (“$4M Transfer”), (3) $2,500,000, and (4) $1,415,032.14 (“$1.4M Transfer”, and together with the $9.6M and $4M Transfers, the “Transfers”).

The Transfers

The Transfers allegedly at issue can be summarized as follows:

(1) 9.6M Transfer: Empire Land transferred $9.6M to Defendant.
a. Defendant alleges:
i. that the transfer was part of a series of transactions where Empire Land was repaying an inter-company loan to Prestige:
1. Prestige deposited all but $3.5M of that amount into Aviat’s bank account, which immediately deposited it into Defendant’s bank account, which immediately deposited it into Empire Land’s bank account.
2. The $3.5M was deposited by Prestige directly into Empire Land’s bank account.
3. Empire Land transferred $9.6M to Defendant’s bank account, which immediately transferred the funds to Aviat’s bank account, and finally to Prestige’s bank account.
ii. That Plaintiff improperly isolates the one transfer (bolded above) from Empire Land to Defendant (implying that Defendant was a mere conduit).
b. Plaintiff counters that the $9.6M transfer was not a short term loan, but a capital distribution to Defendant.
(2) 4.0M Transfer:
a. Plaintiff alleges that Empire Land transferred $4M to Defendant as a capital contribution.
b. Defendant alleges that no transfer actually took place but a series of journal entries were made and reversed.
(3) $1.4M Transfer: Empire Global transferred its interest in a promissory note of approximately $1.4M to Defendant.
a. Defendant alleges the transfer was part of a four-step process to convert the balance of a prior loan from Previti to Empire Land into a capital contribution, such that Empire Land was no longer required to repay the Note. The $1.4M Transfer sequence moved from Previti, to the Family Trust, to Empire Global, to Defendant, and then to Empire Land.
b. Plaintiff alleges that the transfers were part of a scheme so it would appear that Empire Land could meet a $10,000,000 liquidity covenant required by a loan involving Empire Land.

 

The Issues and Arguments  – Does it matter if the estates were substantively consolidated?

Four issues were put before the Court by way of Defendant’s summary judgment pleadings, including whether: (1) Defendant was merely an initial transferee as to the Transfers; (2) Defendant had the intent to hinder, delay or defraud, as required by federal and state fraudulent transfer laws; (3) Defendant provided reasonably equivalent value to the Debtors in exchange for the Transfers; and (4) the Debtors were insolvent.

  1. Initial Transferee

The Court first addressed Defendant’s contention that it was not an initial transferee of the Transfers.  As noted in prior Blog posts (see here), the Ninth Circuit “uses the dominion test to determine whether a party is an initial transferee or a mere conduit,” as detailed in Universal Serv. Admin. Co. v. Post–Confirmation Comm. (In re Incomnet, Inc.), 463 F.3d 1064, 1069 (9th Cir. 2006).  Per Incomnet, the dominion test focuses on whether the recipient of funds has legal title to them and the ability to use them as he sees fit.  In determining whether an entity has dominion over funds, courts have focused on whether the entity has a legal obligation with respect to the funds and whether it received the funds without any restrictions.  The Court contrasted this with the “control” test used in other circuits, “where the entire transaction is viewed as a whole to determine who truly had control of the money.”

Applied here, the Court found that Plaintiff presented evidence that Empire Land and Empire Global made the $9.6M and $1.4M Transfers to Defendant – the former’s bank accounts and tax statements showed equivalent withdrawals and distributions, while Defendant’s accounts reflected the same in deposits.  Noting that Defendant may have been the entity behind the transfers, there was a material issue of fact as to whether Defendant could use the funds as it saw fit.

Furthermore, the Court found Defendant’s argument that no transfers (as to the $9.6M and $4.0M Transfers) actually occurred to be unavailing at this stage.  The Court found that there was evidence that $4M was recorded as a distribution from Empire Land to Defendant, while acknowledging Defendant’s evidence that the $4M was a recharacterization of a journal entry.

As to the $9.6M Transfer, Defendant argued that it was not a transfer because Defendant was only a conduit and the funds transferred were not diverted from being available to pay the Debtors other creditors, “as every dime that Defendant received ultimately went back to Debtors.”  Defendant argued, on the basis of In re Parkway Calabasas, Ltd., 89 B.R. 832 (Bankr. C.D. Cal. 1988), that because the cases were substantively consolidated, the series of transactions should be examined at as a unit.  The Court rejected that for several reasons: first, Calabasas dealt with an alleged fraudulent conveyance in a substantively consolidated case where one debtor paid the defendant for a another debtor’s debt – in the present case, the very nature of the transfer is disputed and neither party alleged the transfer was a debt payment; second, because the transfers were allegedly capital distributions, and not repayment of a debt, the Court reasoned multiple Debtors’ creditor bases may have been harmed; lastly, the Court found that Defendant was seeking to utilize the “control” test by viewing the series of transaction as a whole, which the Ninth Circuit does not follow.

2. Intent to Hinder, Delay or Defraud

Defendant further contested that there was any sign of an actual fraudulent transfer.  In analyzing the Transfers, the Court relied on the “badges of fraud” identified by the Ninth Circuit and statutory law as indicia of fraudulent intent at the time of a transfer.  Those include “(1) actual or threatened litigation against the debtor; (2) a purported transfer of all or substantially all of the debtor’s property; (3) insolvency or other unmanageable indebtedness on the part of the debtor; (4) a special relationship between the debtor and the transferee; and, after the transfer, (5) retention by the debtor of the property involved in the putative transfer.”

Here, the Court found no evidence of actual or threatened litigation against Empire Land or that Empire Land retained possession or control of the funds, but did note Plaintiff’s evidence of Empire Land’s insolvency at the time of the Transfers; a special relationship between Empire Land and Defendant; and that the Transfers occurred shortly before substantial debt was incurred.  This was sufficient to raise a disputed fact that warranted denial of summary judgment.

3. Reasonably Equivalent Value

Again relying on the substantive consolidation of the estates, Defendant argued that Plaintiff could not prove that the Debtors did not receive reasonably equivalent value for the transfers, as Defendant immediately gave the $9.6M Transfer to Aviat (Empire Land’s substantively consolidated co-debtor), which Defendant alleges was part of a series of inter-company loans. With respect to the $4M Transfer, Defendant argued that the ledger entries were reversed at the same instant, so that whatever theoretical “value” was transferred went first in one direction and then the next instant reversed and immediately flowed back, resulting in, if anything, an exchange of identical value. As to the $1.4M Transfer, the Note received by Defendant was ultimately given to Empire Land (Empire Global’s substantively consolidated co-debtor).

The Court found that without conclusively determining the proper characterization of the Transfers (inter-company loans or distributions), a disputed fact existed as to whether reasonably equivalent value was exchanged.

4. Insolvency

Defendant also contested the methodology of Plaintiff’s experts with respect to insolvency.  Specifically, Defendant objected because the expert examined the insolvency of certain Debtors on an individual basis instead of all Debtors on a consolidated basis (again referring back to the substantive consolidation order).  The Court was “unpersuaded by Defendant’s argument that Plaintiff must establish the insolvency of the Debtors on a substantively consolidated basis versus an entity by entity basis”, and in any event, “Defendant has not provided any legal authority in its papers to support this position.”  Plaintiff cited to Total Technical Servs., Inc. v. Whitworth, 150 B.R. 893 (Bankr. D. Del. 1993) for the proposition that the Court should only examine the insolvency of the debtor who made the alleged transfers.  As such, the Court again found an issue of triable fact that warranted denial of summary judgment.

Conclusion

Defendant’s heavy reliance on the issue of substantively consolidated estates and its inherent conflict with the Ninth Circuit’s “dominion” test make this a case to keep an eye on.  Arguably, the argument could be better received in a “control” jurisdiction, where a more comprehensive picture of a fraudulent transfer is encouraged.  Ultimately, the substance of the subject consolidation order would prove critical to any analysis, specifically whether there are findings that the debtors “were treated on a consolidated basis during the period in question (i.e. the time in which the transfers at issue were made).” Empire, 2016 WL 1391297 at *10 (citing Total, 150 B.R. at 900); see Cissell v. First Nat’l Bank, 476 F.Supp. 474, 479 (S.D. Ohio 1979) (court found that the parties had treated the debtors as a consolidated unit during the period in question, and thus examined the insolvency of the debtors on a consolidated basis)).

For another case utilizing the “dominion” test, see the Blog post relating to Goldstein v. Wilmington Savings Fund Society (In re Universal Marketing, Inc.), 541 B.R. 259 (Bankr. E.D. Pa. 2015) as summarized here.

A copy of the Empire Memorandum Decision can be found here.

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