The following is a case update written by Corey R. Weber (firstname.lastname@example.org), a partner at BG Law LLP, analyzing a recent decision of interest:
The United States Bankruptcy Court for the Southern District of New York held in In re Wansdown Properties Corp. N.V., 647 B.R. 23 (Bankr. S.D.N.Y. 2022), that genuine issues of material fact precluded summary judgment on the defendant’s summary judgment motion on constructive fraudulent transfer claims but granted the debtor’s motion for partial summary judgment because the defendant’s affirmative defenses of unclean hands and fraud were inapplicable to avoidance action claims as a matter of law.
To view the opinion, click here.
The purpose of debtor Wansdown Properties Corporation N.V. (the “Debtor”) was to manage and invest the assets of Princess Achraf Pahlavi (the “Princess”), the twin sister of the Shah of Iran. The Debtor’s principal asset was a seven-story townhome in Manhattan. Azadeh Nasser Azari (“Azari”) worked for the Debtor and served the Princess for approximately 37 years. Following the Princess’ death in 2016, Azari received a signed confession of judgment from the Debtor in the lump sum of $2.7 million or the option of an open-ended monthly $9,000 payment. The confession of judgment was based on Azari’s loyalty and work for the Princess and was signed by a director of the Debtor. Azari filed the confession of judgment in New York in April 2016, creating a lien on the Debtor’s townhome. After a sheriff’s sale was scheduled for the townhome in October 2019, the Debtor filed a chapter 11 bankruptcy case and the sheriff’s sale was stayed. The Debtor thereafter filed an adversary proceeding to avoid and recover the confession of judgment as a constructively fraudulent transfer pursuant to 11 U.S.C. § 544(b) and N.Y. Debt. & Cred. Law (“DCL”) §§ 274 and 275. The townhome was sold for $11.5 million while the bankruptcy case was pending.
After discovery in the adversary proceeding, the parties filed cross motions for summary judgment/partial summary judgment. Azari’s motion focused on the assertion that there was no creditor holding an unsecured claim allowable under 11 U.S.C. § 502 and that the confession of judgment was not avoidable. The Debtor’s motion for partial summary judgment argued that Azari’s affirmative defenses of unclean hands and fraud were not applicable defenses to fraudulent transfer claims.
The bankruptcy court denied Azari’s summary judgment motion and granted the Debtor’s motion for partial summary adjudication as to the Debtor’s affirmative defenses.
The court determined that there was at least one creditor holding an unsecured claim allowable under 11 U.S.C. § 502 at the time of the bankruptcy filing, citing to the claims register and the Debtor’s plan of reorganization. With regard to Azari’s arguments that there could not be a creditor at the time of the bankruptcy filing because the Debtor made representations, including under oath, that it had funds on hand to pay all creditors in full and that some claims are disputed, the court again cited to the claims register, which included claims of the Internal Revenue Service and the New York State Department of Tax and Finance. The court stated that “[s]ince it is undisputed that eligible creditors have not been paid yet under the confirmed plan and at least some of those claims are impaired, the Debtor has the right to pursue its cause of action under sections 544(b) and 550(a).”
The Debtor’s first constructive fraudulent transfer claim brought pursuant to § 544(b) was under N.Y. Debt. & Cred. Law (“DCL”) § 274 (the version of § 274 that existed at the time the claim was filed), which requires that a transfer take place without fair consideration and made while the debtor is engaging or about to engage in a business or transaction for which the property remaining with the Debtor after the transfer is an unreasonably small amount of capital. The court cited to case law including In re Manshul Constr. Corp., 2000 WL 1228866, *54 (S.D.N.Y. August 30, 2000) for the standard that “[t]o determine whether the Debtor was left with unreasonably small capital, relevant factors include the transferor’s debt-to-equity ratio, historical capital cushion, and the need for working capital in the transferor’s industry.” In weighing whether the Debtor was left with unreasonably small capital after the transfer (providing the signed confession of judgment), the court turned to an analysis of different valuations of the Debtor’s principal asset, the townhome. Given that the valuations of the townhome ranged from $10.3 million to $37 million, the court determined that there was a genuine issue of material fact. As to working capital requirements, the court stated that the amount of working capital needed was unclear and determined that there was again a genuine issue of material fact. Therefore, the court denied summary judgment on Azari’s motion as to the § 274 claim.
The Debtor’s second claim brought was under DCL § 275, which requires that a transfer be made or obligation incurred without fair consideration when the debtor intends or believes that it will incur debts beyond its ability to pay the debts as they mature. This alternate constructive fraudulent transfer provision applies to both present and future creditors. Citing to MFS/Sun Life Trust-High Yield Series v. Van Dusen Airport Services Co., 910 F. Supp. 913, 943 (S.D.N.Y. 1995), the court stated that “Section 275 requires proof of the debtor’s subjective intent or belief that it will incur debts beyond its ability to pay as they mature.” Although the Debtor presented evidence supporting an inference that the director of the Debtor that signed the confession of judgment knew that doing so would cause the Debtor to incur debts beyond the ability to pay, the court noted that in reviewing a summary judgment motion, it had to view facts in the light most favorable to the non-moving party and therefore denied summary judgment for Azari on the § 275 claim.
As to the Debtor’s motion for partial summary judgment on Azari’s affirmative defenses of unclean hands and fraud, the court stated that “Wansdown points to extensive case law holding that defenses of unclean hands do not lie against claims brought by trustees on behalf of creditors pursuant to section 544(b), on the theory that innocent creditors should not be victimized by the bad acts of the debtor. Azari points to no persuasive authority distinguishing or contravening that authority.” The court cited to a series of cases holding that the doctrines of unclean hands and in pari delicto do not apply to avoidance action claims, including In re Wedtech Corp., 88 B.R. 619, 622 (Bankr. S.D.N.Y. 1988), In re Cornerstone Homes, Inc., 567 B.R. 37, 53 (Bankr. W.D.N.Y. 2017) and In re Davis, 785 F.2d 926, 927 (11th Cir. 1986). As stated by the court, “[t]he dispositive point is that in a section 544(b) avoidance action, the debtor is not suing on behalf of itself, but rather acts as a trustee or debtor in possession who is suing on behalf of other creditors.” The court granted the Debtor’s motion for partial summary judgment motion on this pure issue of law.
Unclean hands and in pari delicto are often asserted as defenses to fraudulent transfer actions along with other equitable affirmative defenses. The bankruptcy court correctly held that, based on well-settled case law, the doctrines of unclean hands and in pari delicto cannot be affirmative defenses to avoidance action claims because the debtor (or trustee) stands in the shoes of creditors rather than the debtor in pursuing avoidance action claims.
Contrast this result with when the debtor (or trustee) pursues common law claims such as breach of fiduciary duty and aiding and abetting breach of fiduciary duty (claims brought pursuant to 11 U.S.C. § 541 instead of § 544). Many courts have held that as to such common law claims, the doctrines of in pari delicto and unclean hands apply because “the underlying misconduct can be imputed to the corporate entity, and therefore to the trustee.” See, e.g., In re Mortgage Fund ’08 LLC, 527 B.R. 351, 366 (N.D. Cal. 2015) (citing to Peregrine Funding, Inc. v. Sheppard Mullin Richter & Hampton, LLP, 133 Cal. App. 4th 658, 677-79 (2005)). The district court in Mortgage Fund ’08 noted that “[a]lthough the Ninth Circuit has not directly addressed the issue, every circuit to have considered the question has held that a defendant ‘sued by a trustee in bankruptcy may assert the defense of in pari delicto, if the jurisdiction whose law creates the claim permits such a defense outside of bankruptcy.’” However, if a trustee is appointed in a bankruptcy case, the trustee is an independent fiduciary that represents the bankruptcy estate and is responsible for marshaling assets to pay creditors. From a practical standpoint it does not make sense for a bankruptcy trustee to be tainted by the debtor’s fraud or unclean hands that took place before the trustee was appointed. The Ninth Circuit has previously held that the unclean hands defenses do not apply to a receiver and, in dicta, applied the same rationale to a trustee. See F.D.I.C. v. O’Melveny & Myers, 61 F.3d 17, 19 (9th Cir. 1995) (“While a party may itself be denied a right or defense on account of its misdeeds, there is little reason to impose the same punishment on a trustee, receiver or similar innocent entity that steps into the party’s shoes pursuant to court order or operation of law.”) This is an issue that deserves consideration and precedent from the Ninth Circuit.
[The Commercial Finance Newsletter is written by an ad hoc group of the California Lawyers Association (CLA) Business Law Section. These materials were written by Corey R. Weber (email@example.com), a partner at BG Law LLP, a member of the ad hoc group and a past chair of the CLA Business Law Section, with editorial contributions by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal., Ret.), also a member of the ad hoc group. The opinions expressed herein are solely those of the author.]
This review was written by Corey R. Weber (firstname.lastname@example.org), a partner at BG Law LLP, a member of the ad hoc group and a past chair of the CLA Business Law Section, with editorial contributions by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal., Ret.), also a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.