In the case of Forman v. Kelly Capital LLC (In re National Service Industries), Adversary No. 14-50377, U.S. Bankruptcy Judge Mary F. Walrath of the District of Delaware issued a memorandum opinion concerning various motions to dismiss filed in an action brought by a Chapter 7 trustee. In the complaint, the trustee: (1) sought to avoid certain fraudulent transfers and (2) asserted claims of breach of fiduciary duty against the debtor's former principals. In their motions to dismiss, the defendants asserted that the trustee's claims were either insufficiently pleaded or barred by the statute of limitations. While Walrath rejected most of these defenses, she did hold that certain portions of the fraudulent transfer claims were, in fact, barred by the applicable statute of limitations.
The procedural history of this case is relatively straightforward. On July 12, 2012, the debtor filed a voluntary petition for relief under Chapter 7 of the U.S. Code. Charles Forman was appointed the Chapter 7 trustee and on June 4, 2014, the trustee filed a complaint against the debtor's former officers and directors, Michael R. Kelly and David N. Spriggs II, along with various entities that were owned and/or controlled by these individuals. In the complaint, the trustee alleged Kelly, through one of his corporate affiliates, caused the debtor to sell the assets of its subsidiaries with the consideration of these sales flowing not to the debtor but, rather, to entities owned or controlled by Kelly. In addition, the trustee alleged that between 2004 and 2011, the debtor made approximately $120 million in loans and $70 million in transfers to the defendants and that, between 2007 and 2011, the debtor also forgave approximately $120 million in loans that were made to the defendants. Following the filing of the complaint, the defendants filed three motions to dismiss, claiming that the complaint was either insufficiently pleaded or barred by the statute of limitations.
In deciding the motions to dismiss, Walrath analyzed the standard of review for determining whether a complaint can withstand a Rule 12(b)(6) motion. According to the court, in order to survive a motion to dismiss, a complaint must contain "enough facts to state a claim to relief that is plausible on its face," citing Bell Atlantic v. Twombly, 550 U.S. 554, 570 (2007). A claim is "facially plausible 'when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged,'" quoting Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009). Furthermore, a complaint must set forth "more than labels and conclusions, and a formulaic recitation of the elements of a cause of action will not do," quoting Twombly. In order to determine whether a complaint is facially plausible, Walrath noted that courts must conduct a two-part analysis. "'First, the factual and legal elements of a claim should be separated' with the reviewing court accepting 'all of the complaints with pleaded facts as true, but ... disregard[ing] any legal conclusions,'" quoting Fowler v. UPMC Shadyside, 578 F.3d 203, 210-11 (3d Cir. 2009). Second, a court must "determine whether the facts alleged in the complaint are sufficient to show that the plaintiff has a 'plausible claim to relief.'"
With that backdrop in mind, the court turned to the actual claims asserted in the complaint. In this case, the trustee sought to avoid various transfers made to the defendants both under the Bankruptcy Code and under Delaware's Uniform Fraudulent Transfer Act. The trustee sought to avoid these transfers both on an actual fraud basis as well as on a constructive fraud basis.
In determining whether the actual fraudulent transfer claims could withstand a Rule 12(b)(6) motion to dismiss, Walrath first noted that "actual fraudulent transfer claims must meet the elevated pleading standards of Rule 9(b) of the Federal Rules of Civil Procedure, made applicable by Rule 7009 of the Federal Rules of Bankruptcy Procedure," citing Official Committee of Unsecured Creditors of Verestar v. American Tower (In re Verestar), 343 B.R. 444, 468 (Bankr. S.D.N.Y. 2006). The purpose of Rule 9(b)'s particularity requirement is to place the "defendants on notice of the precise misconduct with which they are charged and to safeguard defendants against spurious charges of immoral and fraudulent behavior," quoting Seville Industrial Machinery v. Southmost Machinery, 742 F.2d 786, 791 (3d Cir. 1984). Notwithstanding Rule 9(b)'s particularity requirement, Walrath noted that "badges of fraud have historically been used to show fraudulent intent," which, according to Walrath, may be pleaded generally under Rule 9(b), quoting Charys Liquidating Trust v. Growth Management LLC (In re Charys Holding Co.), Adv. No. 10-50204 (Bankr. D. Del. July 14, 2010). "Badges of fraud include, but are not limited to: (i) the relationship between the debtor and the transferee; (ii) consideration for the conveyance; (iii) insolvency or indebtedness of the debtors; (iv) how much of the debtor's estate was transferred; (v) reservation of benefits, control or dominion by the debtor over the property transferred; and (vi) secrecy or concealment of the transaction," quoting Official Committee of Unsecured Creditors of Fedders North America v. Goldman Sachs Credit Partners L.P. (In re Fedders North America), 405 B.R. 527, 545 (Bankr. D. Del. 2009). However, Rule 9(b)'s particularity requirements are "relaxed and interpreted liberally where a trustee or a trust formed for the benefit of creditors ... is asserting the fraudulent transfer claims."
Utilizing this standard, the court then analyzed the allegations set forth in the complaint and found that the trustee had, indeed, pleaded sufficient facts to "support several badges of fraud from which actual fraudulent intent could be inferred for Rule 9(b) purposes." First, the court noted the trustee alleged that the transfers at issue were made by the debtor to various insiders and their related entities. Second, the trustee alleged the debtor was subject to "thousands of asbestos-related claims" at the time of these transfers and thus, the debtor was "insolvent at the time of the transactions." Third, the court noted the trustee alleged that for each transaction the debtor received no value, let alone reasonably equivalent value. In light of this, the court found that the trustee had "adequately stated a claim for avoidance of actual fraudulent transfers under Rule 9(b)" and that the defendants were adequately put on notice of the specific transfers alleged in the complaint as the transfers were also identified by the date and amount of each transfer.
In the complaint, the trustee also sought to avoid the transfers and forgiveness of debt under both the Bankruptcy Code and Delaware's Uniform Fraudulent Transfer Act as constructive fraudulent transfers. In addressing the motions to dismiss these claims, the court first noted that unlike actual fraud, constructive fraudulent transfer claims do not need to meet the requirements of Rule 9(b) but rather need to meet the requirements of Rule 8(a)(2). Unlike Rule 9(b), Rule 8 of the Federal Rules of Civil Procedure only requires that a complaint contain "a short and plain statement of the claim showing that the pleader is entitled to relief." In this case, the court found that the trustee's constructive fraudulent transfer claims were sufficiently pleaded as the trustee alleged that for each transfer or forgiveness of debt, the debtor received nothing, "which is less than reasonably equivalent value." In addition, the trustee also pleaded that the debtor was insolvent as a result of the asbestos-related claims that were pending against it while these transfers/forgiveness of debt were made and thus the defendants were on sufficient notice of the type of claims being asserted by the trustee against them.
However, the court did dismiss certain of the constructive fraudulent transfer claims on the basis that these claims were barred by the statute of limitations. Under Delaware law, "there is a strict four-year statute of limitations for constructively fraudulent transfers." In analyzing the complaint, however, the court noted that there were various causes of action that occurred prior to July 12, 2008, which was four years prior to the petition date. As such, claims to recover these transfers were barred on their face by the statute of limitations and the court dismissed those claims from the complaint. The court further denied the trustee's request to amend the complaint with respect to these transfers as "the constructively fraudulent [transfer] counts cannot be amended to satisfy [the] statute of limitations requirements."
While the court dismissed the constructive fraudulent transfer claims that were barred by the applicable statutes of limitations, the court did not dismiss the actual fraudulent transfer claims for these same transfers. While acknowledging that there is also a four-year statute of limitations for actual fraudulent transfer claims, the court noted that "if the fraud is hidden, however, the statute of limitations is extended to one year after the fraud was or could reasonably have been discovered by the creditor." In moving to dismiss the actual fraudulent transfer claims as being barred by the statute of limitations, the defendants claimed that there were "no facts alleged in the complaint specifically addressing when the fraudulent transfers could have been reasonably discovered by a claimant." In rejecting this argument, the court found to the contrary and held that the complaint did contain facts that suggested the difficulty of reasonable discovery by a creditor of the fraud committed by the defendants. In particular, the complaint alleged that Spriggs and Kelly were the only shareholders and board members of the privately held debtor. The complaint further alleged that they secretly looted the debtor. The complaint also alleged that the debtor was not a public company and therefore its board resolutions and financial records were not available to the creditors. Accordingly, the court opined that from the face of the complaint, it was not inconceivable that equitable tolling would apply and, thus, it would be inappropriate to dismiss these claims at this point.
The court also addressed the defendants' motions to dismiss the breach of fiduciary duty claims alleged in the complaint. In particular, the trustee alleged that the individual defendants, Kelly and Spriggs, breached their fiduciary duties to the debtor by engaging in "self-interested transactions, namely directing the debtor to transfer funds to them and their related entities for no legitimate business reason and with no expectation that they would be repaid." Because the court must accept these allegations as true, for purposes of the motions to dismiss, the court found the trustee alleged sufficient facts to state a claim against Kelly and Spriggs for breach of fiduciary duty.
The court also rejected the defendants' claims that these claims were barred by the applicable statute of limitations. First, the court noted that Delaware has a three-year statute of limitations for breach of fiduciary duty but that the "statute of limitations will be tolled under the doctrine of fraudulent concealment if the plaintiff can prove: 'an affirmative act of concealment by the defendant—an "actual artifice" that prevents a plaintiff from gaining knowledge of the facts or some misrepresentation that is intended to put the plaintiff off the trial inquiry,'" quoting End of the Road Trust v. Terex (In re Fruehauf Trailer), 260 B.R. 168, 184 (D. Del. 2000). While the court acknowledged that most of the actions complained of by the trustee against the individual defendants occurred prior to July 12, 2009, a date that was three years prior to the petition date, the court found that the trustee's claims would permit a finding of equitable tolling for the same reasons why the actual fraudulent transfer claims would be viable: (1) the individual defendants were the only shareholders and board members of the privately held debtor; (2) that they secretly looted the debtor; and (3) that the debtor was not a public company and, as such, its board resolutions and financial records were not available to creditors until the bankruptcy. In light of this, the court denied the defendants' motions to dismiss the breach of fiduciary claims.
As fraudulent transfer and breach of fiduciary duty claims are commonly asserted by trustees or debtors-in-possession following the commencement of a bankruptcy case, this decision is helpful to both plaintiffs counsel and counsel for various defendants in terms of knowing what allegations, if any, meet the heightened pleading requirements promulgated by the U.S. Supreme Court in both Twombly and Iqbal, as well as what facts and circumstances constitute equitable tolling under Delaware law.`
Lawrence J. Kotler is a partner at Duane Morris who practices in the area of reorganization and finance, representing Chapter 11 debtors-in-possession, Chapter 11 trustees, Chapter 7 trustees, liquidating trustees, creditors committees, secured creditors and large institutional unsecured creditors in all facets of bankruptcy.
Reprinted with permission from Delaware Business Court Insider, © ALM Media Properties LLC. All rights reserved.