Lessons to be Learned: Motions to Dismiss When a Chapter 7 Trustee Asserts Claims Against Insiders and Corporate Affiliates of a Chapter 7 Debtor

The following is a case summary written by Kathleen A. Cashman-Kramer regarding the recent U.S. Bankruptcy Court decision in In re HVI Cat Canyon, Inc., 658 B.R. 558 (Bankr. C.D. Cal. 2024). To view the published opinion, click here:

SUMMARY

The Bankruptcy Court recently ruled on a motion to dismiss a trustee’s adversary proceeding brought against several insiders and corporate affiliates of the debtor HVI Cat Canyon, Inc. (“HVI”) on multiple grounds. The following chart illustrates the claims, parties and facts addressed in the motion to dismiss:

Nature of the claim	Against Which Defendant(s)	Summary of some of the facts alleged
Breach of fiduciary duty	Debtor’s CEO, sole director and beneficial owner Randeep Grewal	Grewal, over many years, caused the Debtor to incur millions of dollars in debt, then he siphoned the Debtor’s assets to himself or his affiliated companies for no consideration
Aiding and abetting the breach of fiduciary duty	CFO of the Debtor, and also CFO of affiliate of the Debtor GIT (also a defendant) Ernesto Olivares	Olivares assisted Grewal in his beaches, including cancelling a $79 million note owed to the Debtor by GIT, a Grewal affiliate, as well as other post-petition (chapter 11 period) transfers including payments made that violated cash collateral orders
Fraudulent transfers under Section 544(b)	Randeep Grewal	Same as above
Preferential transfers under Section 547(b)	Randeep Grewal and Susan Whalen	Same as above
Legal malpractice	Susan Whalen (Debtor’s senior VP, secretary and general counsel)	Among other things she represented interests adverse to the Debtor when she counseled the Debtor to cancel the $79 million note that GIT owed the Debtor for no consideration
Unjust enrichment	Olivares, Whalen and Grewal	Same facts

FACTUAL BACKGROUND

On July 25, 2019, the debtor filed a voluntary chapter 11 petition.  On October 16, 2019, a chapter 11 trustee was appointed.  On December 17, 2020, the bankruptcy court granted the Chapter 11 trustee’s motion to convert the case to Chapter 7.[1]  On July 23, 2021, the trustee filed his original complaint, asserting 12 causes of action against three individuals – Grewal, Olivas, and Whalen – and eight entities that were owned and/or controlled by Grewal and considered affiliates of the Debtor.

On October 22, 2022, after many months of negotiating extensions, the trustee filed an amended complaint.  Thereafter, on January 27, 2023, all eleven defendants filed motions to dismiss, and the three individuals filed a joint motion.

This article addresses only the opinion regarding the joint motion filed by the three individuals – Grewal, Olivares, and Whalen.  However, the bankruptcy court also issued opinions on the same date granting in part and denying in part the other eight defendants’ motions to dismiss.   

RESULT AND REASONING

The bankruptcy court’s February 29, 2024 order specifically found that: (1) the bankruptcy court had subject matter jurisdiction over claims alleged in the adversary proceeding; (2) the trustee’s fraudulent transfer claims could not be dismissed as time-barred at the pleading stage; (3) the trustee had ten-year look-back period under California law for fraudulent transfer claims; (4) the trustee stated preferential transfer claim against debtor’s CEO (Grewal), its general counsel (Whalen), and its affiliate; (5) the legal malpractice action against Whalen, Debtor’s general counsel, was not property of Chapter 7 estate; (6) the trustee’s unjust enrichment claim could be based on general counsel’s receipt of fraudulent transfers and preferential transfers; and (7) officers and attorney for debtor could violate automatic stay by causing an affiliate (GIT) to exercise offsets that reduced funds coming into estate.

A. Breach of Fiduciary Duty Cause of Action Against Grewal

Grewal argued that Colorado law applied because the debtor is a Colorado corporation. The Trustee contended that California law applied because California has a more significant relationship to the Debtor and the acts alleged in the amended complaint.  Id., at *573-575.  The bankruptcy court conducted a detailed analysis regarding this primary and fundamental claim.

Specifically, the court looked at the issue of Grewal as sole equity interest holder versus the Trust Fund Doctrine.  Grewal argued that in his capacity as shareholder, he approved the conduct on which the breach of fiduciary duty claims rely, and therefore, that conduct did not give rise to a claim for breach of fiduciary duty, citing Pueblo Foundry & Mach. Co. v. Lannon, 68 Colo. 131, 135 (1920) (“A corporation has no such separate entity as will permit it to act counter to the unanimous desire of its stockholders.”); Mackey v. Burns, 16 Colo. App. 6, 21 (1901). As Grewal acknowledged, California law provides an exception to the rule – namely, officers and directors of an insolvent corporation owe fiduciary duties to creditors under the “trust fund doctrine.”  See Berg & Berg Enters., LLC v. Boyle, 178 Cal. App. 4th 1020 (2009). In contrast, the Trustee argued that Colorado law — and resolution of whether it recognizes the trust fund doctrine — is not relevant to his breach of fiduciary duty claim because it was governed by California law. Id., at 574-575. 

The court summarized the issues as follows : (1) the applicable statute of limitations and whether the adverse domination doctrine tolls the running of the applicable limitations period; (2) the viability of the exculpation clause in the Debtor’s Articles of Incorporation (which would arguably be barred if California law applied); and (3) choice of law rules (the court found that it must apply federal choice of law rules which follow the Restatement (Second) of Conflict of Laws section 306 and PNC Bank v. Sterba (In re Sterba), 852 F.3d 1175, 1179 (9th Cir. 2017).)  Id., at *575-576.

The bankruptcy court concluded that a more “fulsome factual record” was required to conduct a meaningful choice of law analysis. The bankruptcy court ultimately denied Grewal’s motion to dismiss, subject to Grewal’s ability to later renew his arguments if the court found that Colorado law – not California law – applied. 

B. Aiding and Abetting Breach of Fiduciary Duty Against Olivares

Olivares argued that the aiding and abetting breach of fiduciary duty claim against him should be dismissed because it failed to allege facts that satisfy the elements of such a claim under Colorado law and is time-barred under Colorado law. Olivares also argued that the aiding and abetting claim fails based on the in pari delicto doctrine, because (since Grewal is the sole shareholder of the Debtor), Olivares’ conduct as agent is imputed to Grewal as principal, that the Debtor and Olivares are deemed “in pari delicto” and therefore the trustee cannot assert the Debtor’s claims against Olivares.

The trustee contended California law applied and that the FAC was adequately pled. The trustee further argued that pursuant to the “trust fund doctrine,” Grewal breached duties owed to the Debtor’s creditors once the Debtor became insolvent.  California law permits receivers to assert claims which would be barred by the in pari delicto doctrine if they were asserted by the insolvent debtor.

The bankruptcy court first considered the trustee’s in pari delicto argument., The bankruptcy court stated that whether in pari delicto applies depends on whether it is available under the law of the state that governs the breach of fiduciary duty claim and whether that state recognizes a “trust fund doctrine” allowing creditors of an insolvent corporation to sue for breaches of fiduciary duty.  Id., at *10.

Turning to the third issue and whether the in pari delicto doctrine prevents the Trustee from bringing her common law fraudulent transfer claims, the Court again disagrees with the Bankruptcy Court…. 11 U.S.C. § 544(b)(1) states that a “trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim.” (emphasis added) Section 544 plainly permits a bankruptcy trustee to brings claims under applicable state law that an unsecured creditor may bring. The Trustee is not attempting to bring a claim for the benefit of the Debtors but in favor of the unsecured creditor Mazakoda. The Court therefore finds that the doctrine of in pari delicto is inapplicable for claims brought under Section 544, as here.

In re HVI Cat Canyon, Inc., 2024 WL 863297, at *11, citing In re Melamed, 2022 WL 20727998, at *5 (C.D. Cal. Mar. 23, 2022), adopted 2023 WL 6476170 (C.D. Cal. Feb. 2, 2023) (reversing and remanding).

The court denied the motion to dismiss without prejudice to Olivares renewing his arguments regarding the in pari delicto doctrine. The court concluded that to the extent California law applies, the trust fund doctrine and section 544(b) would permit the Trustee to assert breach of fiduciary duty claims which could have been brought by an unsecured creditor, and the in pari delicto doctrine would be inapplicable. Alternatively, if Colorado law applies, the in pari delicto doctrine may bar the aiding and abetting claim against Olivares.

C. Fraudulent Transfer Causes of Action Against Grewal

The amended complaint alleged that various transfers by the Debtor to GRL, CAP and GIT are avoidable as fraudulent transfers under either bankruptcy law or non-bankruptcy law and sought avoidance and recovery of those transfers from them; claims under Bankruptcy Code section 550 against Grevino and CDG seeking to recover the value of assets transferred by the Debtor to a third party to fund the purchase of the Vineyard; recovery from Grewal on the fraudulent transfer claims based on allegations that GRL, CAP and GIT are alter egos of Grewal; and sought to hold Grewal personally liable for the claims against Grevino and CDG under an alter ego or single business enterprise theory of liability.

Grewal’s primary arguments against these claims were: (1) the trustee could not use the IRS as the “triggering creditor” under section 544(b) of the Bankruptcy Code to avoid transfers ten years prepetition, and, even if he could, the FAC failed to allege that the IRS held a claim against the Debtor at the time of each transfer and that the IRS’ claim remained unsatisfied on the Petition Date; (2) the claims based on section 548(a) failed because no transfers are alleged to have occurred within two years of the Petition Date; and (3) the claims alleging fraudulent transfers failed to comply with Rule 9(b) of the Federal Rules of Civil Procedure.   

After concluding that there was no requirement that the trustee anticipate and plead around the statute of limitation defense, the bankruptcy court found that state law may permit the Trustee to avoid transfers made after July 25, 2012 [citing Cal. Civ. Code § 3439.09(a) and (c)], thus creating a 7-year lookback period. If an actual unsecured creditor could avoid a transfer of a debtor’s asset outside of bankruptcy, a trustee can use section 544(b), combined with section 6502 of the Internal Revenue Code, to avoid fraudulent transfers within ten years of the petition date if the IRS is the triggering creditor.  The amended complaint alleged that the IRS was an unsecured creditor on the Petition Date and filed a proof of claim against the estate.  It specifically noted that the majority of courts deciding the issue held that trustee may step into the shoes of the IRS and may rely on section 6502 of the Internal Revenue Code to the same extent that the IRS could do so outside of bankruptcy.  As a consequence, the bankruptcy court found that the amended complaint allegations were adequate to establish that the Trustee had standing under section 544(b) to seek avoidance of alleged fraudulent transfers within the asserted the ten-year period, standing in the shoes of the IRS. Id., at 14-15. 

Finally, the bankruptcy court concluded that the amended complaint expressly alleged specific transfers made within two years of the Petition Date under section 548(a). Section 548(a)(1) allows a trustee to avoid fraudulent transfers or obligations made (or incurred) within two years before the petition date. 11 U.S.C. § 548(a)(1). The bankruptcy court granted the motion as to any transfers made or incurred prior to July 25, 2017 (two years prior to the Petition Date), but denied the motion as to all transfers made after July 25, 2017.  It also specifically found that the fraud claims were sufficiently plead under Rule 9(b) and denied Grewal’s motion on this point. 

D.        Preference Cause of Action Against Grewal and Whalen. 

In denying their motion to dismiss the Section 547(b) preference claims, the bankruptcy court specifically noted that the amended complaint in fact alleged that the Debtor paid Whalen during the one-year period prior to the petition date for legal services. The complaint also alleged that the Debtor transferred $330,346 in Overriding Royalty payments to GRL during the year preceding the Petition Date, pursuant to the antecedent Grewal Employment Contract obligating the Debtor to make such payments and pursuant to Grewal designating GRL to receive the royalty payments as his designee.  The court found that those facts were “sufficient to put both Grewal and Whalen on notice of what transfers form the basis of the preference claim, and that the antecedent debt as to Whalen is based on the legal services she rendered to the Debtor and, as to Grewal, is the Grewal Employment Contract.”  Id., at *16.  Because both Grewal and Whalen were insiders, and the complaint alleged that the payments were made while the Debtor was insolvent and allowed Whalen and Grewal to receive more than they would have received in a hypothetical chapter 7 case, the allegations were adequate, and the bankruptcy court denied the motion to dismiss these claims.

E.        Negligence/Legal Malpractice Claims Against Whalen.

The bankruptcy court considered and granted Whalen’s motion to dismiss with leave to amend when it found that Whalen may have a similar in pari delicto argument (as discussed above) which was also dependent upon which state law – California or Colorado – applied.  Whalen asserted that California legal malpractice law may prevent the trustee from pursuing her for malpractice due to Grewal’s participation and his wrongful conduct on behalf of the Debtor.  The court also noted that the Trustee failed to cite any authority holding that a creditor of a debtor has standing to sue the debtor’s lawyer for malpractice, and the claim plead was a direct cause of action under section 541(a)(1) by the Trustee on behalf of the debtor against the debtor’s former lawyer, Whalen.

F.        Unjust Enrichment Claims against Grewal, Olivares and Whalen.

The bankruptcy court found that the unjust enrichment claim against Olivares was subject to dismissal, because it did not allege that Olivares had actually received anything.  As to Whalen, its prior discussion about preferential transfers alleged against her was sufficient to deny the motion to dismiss as to her. Finally, as to Grewal, the bankruptcy court similarly found as it did with Olivares, and also granted the motion with leave to amend.  Id., at *19-20.

G.        Declaratory Relief – Grewal as the Alter Ego of the Debtor and other affiliates.

The bankruptcy court determined that the trustee had adequately plead that Grewal could be the alter ego of the Debtor and of the other affiliated defendants and granted the motion to dismiss as to the Debtor but denied the motion to dismiss as to the other corporate defendants.  It found that the trustee had standing to assert such claims.

H.        Civil Contempt for violation of the automatic stay (Grewal, Olivares and Whalen) and violation of cash collateral orders (Grewal and Whalen).

Finally, the bankruptcy court considered and denied the motion to dismiss on these two causes of action finding, that the Trustee alleged sufficient facts regarding both the existence and violation of the orders, and the fact that these individual defendants took actions that negatively impacted the estate.

AUTHOR’S COMMENTARY

If you represent trustees in avoidance actions (or parties who are defendants in avoidance actions), this case acts as a primer on pleading requirements.  Although this article did not delve in detail into the specific causes of action, anyone who is involved in cases with similar claims should review Judge Barash’s detailed discussion and analysis on each specific claim, especially as to what types of facts are sufficient (or insufficient).  A review of the docket in the bankruptcy court in this adversary reveals that the amended complaint (following the order granting in part and denying in party the motions to dismiss) was deemed filed March 22, 2024.  Between April 12-15, 2024, a total of eight answers were filed on behalf of all defendants.

These materials were authored by Kathleen A. Cashman-Kramer, Of Counsel at Fennemore LLP (KCashman-Kramer@Fennemorelaw.com), with editorial contributions from ILC member Maggie E. Schroedter (maggie@theRSfirm.com).

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[1] Mr. Krasnoff was appointed successor trustee on March 16, 2023, when the original trustee resigned.