This decision highlights the importance of structuring transactions to ensure that the entity that receives contractual benefits from a transaction is the same entity that provides funds related thereto.
The United States District Court for the Southern District of New York recently addressed a transferee’s attempt to use corporate veil-piercing to defend against an avoidance action by a Chapter 7 trustee. The transferee-defendant argued that its potential liability for a challenged payment from the debtor could be offset by value that it had provided to the debtor’s nondebtor affiliate. The Bankruptcy Court for the Southern District of New York dismissed the trustee’s action and agreed with the transferee-defendant that a nondebtor special purpose vehicle formed to acquire and hold real estate for the debtor was the debtor’s alter ego. The District Court reversed on appeal and concluded that the transferee did not have a reasonable equivalent value defense based on consideration provided to the special purpose vehicle, nondebtor affiliate of the debtor in exchange for a downpayment from the debtor.
Background
The sole owner of a litigation financing business, consisting of several affiliated entities (Cash4Cases), created a special purpose vehicle, Liberty Bridge Properties LLC (LBP), to purchase a Manhattan brownstone to be used as an office space in Cash4Cases’s New York operations. Cash4Cases wired a $280,000 downpayment to Carob Bean Realty Corp. II, an entity that contracted to sell real estate to LBP. The real estate purchase agreement between LBP and Carob Bean contemplated that, as a condition to closing, Carob Bean would obtain a variance so that the property could be used as an office by Cash4Cases. LBP and Carob Bean never closed the real estate purchase agreement, and Carob Bean kept the downpayment from Cash4Cases and eventually sold the property to an unrelated third party.
In January 2020, Cash4Cases and several of its affiliates—but not LBP—commenced Chapter 7 bankruptcy cases. The Chapter 7 trustee commenced an adversary proceeding to recover the value of the downpayment from Carob Bean as a constructively and an actually fraudulent transfer. The Bankruptcy Court dismissed the trustee’s claims, granted Carob Bean’s motion for summary judgment and denied the Chapter 7 trustee’s competing motion for summary judgment. In reaching its decision, the Bankruptcy Court determined that LBP was the alter ego of Cash4Cases and that the zoning variance that Carob Bean provided to LBP constituted fair consideration to Cash4Cases in exchange for the downpayment that the Chapter 7 trustee sought to claw back.
The District Court’s Ruling
On appeal, the District Court analyzed the Bankruptcy Court’s conclusions that (i) LBP and Cash4Cases could be considered a single corporate entity for purposes of the real estate purchase transaction and (ii) the $228,000 that Carob Bean spent to obtain the zoning variance for LBP’s benefit constituted fair consideration and reasonably equivalent value for Cash4Cases’s $280,000 downpayment. Considering the Bankruptcy Court’s holding that LBP was the alter ego of Cash4Cases, the District Court addressed the Chapter 7 trustee’s argument that corporate veil piercing may never be used defensively. Although Carob Bean was a good faith third party doing business with the debtors and the debtors had apparently exercised total control over LBP, the District Court reversed the Bankruptcy Court’s holding that LBP was the alter ego of Cash4Cases. The District Court concluded that corporate veil-piercing is only available under New York law upon a showing of control exercised over an entity with an intent to defraud that causes an injury. The District Court observed that the Bankruptcy Court erred by completely failing to consider the intent to defraud and causation of injury prongs of its alter ego analysis and emphasized that a defendant would have to prove both elements in addition to showing control to use this defense. The court further reasoned that consolidating LBP with Cash4Cases for the purpose of the real estate agreement would benefit Carob Bean but would effectively facilitate an abuse of corporate entity structure by reducing the total amount available to creditors of the debtors’ bankruptcy estates.
The District Court also determined that the value of the zoning variance was not necessarily worth the $280,000 that Carob Bean received. The District Court acknowledged that the transferring debtor, Cash4Cases, may have indirectly benefited from the use of a new space, but that all of the contractual rights attendant to the purchase agreement for which the downpayment was made belonged to LPB. The District Court remanded those issues for the Bankruptcy Court to determine whether any value was received by Cash4Cases.
Conclusion
This decision highlights the importance of structuring transactions to ensure that the entity that receives contractual benefits from a transaction is the same entity that provides funds related thereto. Despite acting in good faith at all times, the transferee recipient of the downpayment in this case was ultimately disadvantaged by the nature of the transaction and left without defenses that it would have had if the deal had been designed differently. It is worth considering whether the District Court may have reached a different conclusion had Carob Bean required the downpayment to be made into an escrow account owned by LBP or if it had required LBP to submit the downpayment directly. The decision also highlights the importance of conducting thorough diligence on the corporate structure of your contract counterparties.
For More Information
If you have any questions about this Alert, please contact Catherine Beideman Heitzenrater, Nathan Yeary, any of the attorneys in our Business Reorganization and Financial Restructuring Practice Group or the attorney in the firm with whom you are regularly in contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.