Recent Developments Affecting Insolvency and Commercial Finance in California and the Ninth Circuit
| Publication year | 2018 |
| Author | Dan Schechter |
Dan Schechter1
Dan Schechter has taught at Loyola Law School, Los Angeles, since 1980. He is a co-author of California Real Estate Finance (5th Ed.) and writes the weekly Westlaw Commercial Finance Newsletter. He also serves as a consultant and as an expert witness in cases involving finance, insolvency, and real property.
This article briefly summarizes key features of decisions affecting insolvency and commercial finance rendered by state and federal courts within the Ninth Circuit. It also provides the author's editorial comments related to these decisions.2
• Even though a corporate looter first diverted his company's rebate checks into a secret account nominally opened in the company's name and then used those funds solely for his benefit, the innocent recipients of those funds were deemed the "initial transferees" of the company's money and were strictly liable as fraudulent transferees. [In re Walldesign, Inc., 872 F.3d 954 (9th Cir. 2017).]
Comment: The company's rebate checks were physically taken by the insider and then transferred by him into the secret account that he created for his own benefit. If that is not "dominion," what is? Yet the court held that the fact that the fake account was superficially in the company's name meant that the transfer from that account to the defendants was the "initial" transfer of the firm's funds, not when he took the rebate checks and stuffed them into the fake account.
This elevates form over substance.
• The waiver of sovereign immunity contained in the Bankruptcy Code enabled a bankruptcy trustee to assert state law fraudulent transfer claims against the Internal Revenue Service. [In re DBSI, Inc., 869 F.3d 1004 (9th Cir. 2017).]
Comment: The use of a puppet corporation to pay the equity holders' taxes is a common fact pattern. And because those same insiders are often able to delay the company's bankruptcy filing, the longer statute of limitations available under state law is vital to a trustee seeking to recover those fraudulent tax payments. The conflict between the Seventh and Ninth circuits on this key issue sets up the potential for Supreme Court review. My money is on the Ninth Circuit's position.
• A guarantor's disclaimer of his share of an inheritance was avoidable by the SBA as a fraudulent transfer, despite a state statute declaring that disclaimers are not fraudulent transfers. [United States Small Business Administration v. Bensal, 853 F.3d 992 (9th Cir. 2017).]
Comment: It is hard to argue with an express statutory preemption; this has to be the correct result. But does this decision cast doubt on In re Costas, 555 F.3d 790 (9th Cir. 2009)?
• A law firm's fraudulent transfer of its assets in an effort to hinder its former corporate client's recovery of a void contingent fee payment justified a trial court's trebling of the client's damages under the state's Unfair Trade Practices Act. [Merdes & Merdes, P. C. v. Leisnoi, Inc., 2017 Westlaw 5181610 (Alaska).]
Comment: I think this is the first reported decision in which a fraudulent transfer occurring in the context of a commercial creditor/debtor dispute has given rise to a damage award under a state's Unfair Trade Practices Act. If this precedent were to be widely followed elsewhere, many commercial creditors might be able to avail themselves of treble damages awards against judgment debtors (and perhaps their confederates) who engineer fraudulent transfers in an effort to defeat collection.
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• A transfer of a phony deed of trust to a nonexistent corporation triggered a "statute of repose," thus absolutely insulating a fraudulent transfer from attack. [PGA West Residential Assoc., Inc., v. Hulven International, Inc., 221 Cal. Rptr. 3d 353 (Cal. Ct. App. 2017).].
Comment: How can a non-event be an event that triggers the statute? The alleged corporate transferee did not even exist when the deed of trust was executed. Nothing happened. There can be no transfer without a transferee. Otherwise, a debtor could just whisper "I am transferring the property from my right hand to my left hand," and that would start the running of the statute of repose.
• The two-year statutory limitation governing the estate's avoidance claims is equitably tolled as a result of the bankrupt's misbehavior, even though the estate learned of the fraudulent transfers just before the two-year period had ended. [In re Milby, 875 F.3d 1229 (9th Cir. 2017).]
Comment: Bankrupts often misbehave and then conceal it during their bankruptcies, hoping to run out the two-year clock. This decision gives the estate a little bit of breathing room in order to sort out the facts before filing. But should post-discovery diligence be at all relevant to whether equitable tolling applies? The estate should be allowed plenty of time to investigate the facts carefully to determine whether the claim is valid and whether the defendants are solvent enough to warrant prosecution.
• A county tax lien encumbering a Chapter 11 debtor's personal property was avoidable by the estate because the lien was invalid under state law against a hypothetical subsequent bona fide purchaser of the debtor's assets. [In re Mainline Equipment, Inc., 865 F.3d 1179 (9th Cir. 2017).]
Comment: In the wake of this decision, it would not be surprising if the counties were to seek amendments to Revenue and Taxation Code section 2191.4 and Code of Civil Procedure (CCP) section 697.510, in order to expand their rights vis-a-vis bona fide purchasers of defaulting taxpayers' personal property. The easiest solution would be to permit counties to file with the Secretary of State's office, in order to provide the broadest possible notice to potential asset purchasers. Lenders should continue to search for local tax lien filings prior to releasing any funds, unless and until the tax lien system is folded into the existing state-wide judgment lien filing regime.
• A debt repayment was preferential because, under the statutory "hypothetical liquidation" rule, other funds deposited by the debtor could have been avoided as hypothetically preferential. [In re Tenderloin Health, 849 F.3d 1231 (9th Cir. 2017).]
Comment: It is unfortunate that the "hypothetical liquidation" standard is so fuzzy; the opportunities for litigation are endless. For example, what if there are potential but unresolved avoidance or tort claims asserted by the estate against unrelated third parties? Must the trustee take those claims into account when evaluating what a preference defendant would have received as a dividend in the bankruptcy case? What if some of those claims were determined, postpetition, to be worthless (or to be worth less than they appeared to be worth at the petition date)? Can the hypothetical liquidation standard employ hindsight as well as foresight?
B. Chapter 11.• When a vendor's nonrecourse junior purchase money lien was extinguished by a senior creditor's postpetition nonjudicial foreclosure sale, the vendor could not assert a deficiency claim under § 1111(b), even though the lien was in existence on the day the bankruptcy petition was filed. [In re Salamon, 854 F.3d 632 (9th Cir. 2017).]
Comment: There is little authority for the notion that any date other than the petition date determines the nature of a claim. § 1111(b) itself defines the circumstances under which the statute does not apply, and there are only two exceptions to the general rule: either a sale under § 363, or a sale under the plan. Congress was obviously aware of post-petition foreclosure sales, yet foreclosure sales were excluded from that exception. And haven't sold-out commercial junior vendors suffered enough, without also depriving them of the ability to invoke § 1111(b)? If the property is a success, the purchaser enjoys the upside. If the property is a failure, the vendor loses its junior lien and now loses all hope of recourse when the debtor files a Chapter 11 petition.
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• Even though affordable housing covenants encumbering a debtor's property were subordinated to a senior lien, the valuation of the collateral for purposes of a Chapter 11 cramdown plan did not have to account for the potential extinguishment of those covenants in the event of foreclosure. [In re Sunnyslope Housing Ltd. Partnership, 859 F.3d 637 (9th Cir.).]
Comment: This case is about lien priority, not valuation. There were two relevant encumbrances (i.e., property interests) attached to the debtor's property: the senior lien of the secured creditor, and the contractually subordinate right of the housing authority to enforce its covenants. Under § 510(a), that subordination agreement is per se enforceable. Yet the court simply reversed the priorities of those two encumbrances, stripping the senior lien of its senior status. That is an unauthorized taking of property. I am also troubled by the court's holding that when an assignee buys a claim at a discount, the assignee "consciously undertook" the risk that its senior position would be destroyed. That punishes parties who purchase debt, discouraging the secondary market. A petition for certiorari was denied on January 8, 2018.
C. Other Bankruptcy Issues.• Although the underlying bankruptcy case had been dismissed, a creditor that took an assignment of the estate's avoidance claims still had standing to prosecute them. [In re Know Weigh, LLC, 576 B.R. 189 (Bankr. C.D. Cal.).]
Comment: The most interesting aspect of this case is what happened to a hapless commercial real estate vendor who was defrauded by an unscrupulous buyer. (The vendor was the party seeking to assert the estate's claims, in an effort to get repaid.) If a subordinated vendor is asked to defer the purchaser's obligation to pay interest, that is a red flag: a project that cannot generate enough cash to service the mortgage debt is one that does not "pencil out."...
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