In its Jan. 11 opinion in In re DBSI Inc., the U.S. Bankruptcy Court for the District of Delaware held that a trustee's complaint seeking to recover actual and constructively fraudulent transfers satisfied the heightened pleading requirements set forth in Rule 9(b) and post-Twombly.
In Twombly, the U.S. Supreme Court heightened the pleading requirement, requiring that plaintiffs include enough facts in their complaint to make it plausible — not merely possible or conceivable — that they will be able to prove facts to support their claims. In this case, the defendants argued, among other things, that the trustee had neither satisfied the pleading requirements set forth in Twombly, nor those dictated by Federal Rule of Civil Procedure 9(b).
According to the opinion, DBSI Inc. and its affiliates were involved in: (a) the syndication and sale to investors of tenant-in-common interests in real estate; (b) the purchase of real estate; and (c) investments in technology companies. On Nov. 6, 2008, DBSI Inc. and certain of its affiliates filed petitions under Chapter 11 of the Bankruptcy Code. On June 29, 2010, the Chapter 11 trustee commenced adversary proceedings seeking to avoid, among other things, allegedly fraudulent transfers made by certain of the debtors to Walter E. Mott and John D. Foster, who were equity holders, general partners and directors and/or managing officers of the various debtors.
According to the complaints, in 2002 and 2006, Mott and Foster sold their equity and partnership interests in DBSI and certain of its affiliates through Stock Repurchase Agreements and Partnership Interest Redemption Agreements (the agreements) for payments to be made over several years totaling, in the aggregate, approximately $7 million, the opinion said. The trustee's complaint alleged that the agreements were actually and/or constructively fraudulent because: (i) Mott and Foster were insiders of the DBSI enterprise; (ii) the DBSI enterprise was insolvent at the time the agreements were signed; and (iii) due to the DBSI enterprise's insolvency, the equity and partnership interests of Mott and Foster were of no value. After commencement of the adversary proceeding, the bankruptcy court, in the main bankruptcy case, made findings of fact and conclusions of law that "DBSI ran its business and [affiliated] entities as a unified enterprise under common ownership and control" with a "small group of insiders [that] employed that control to raise cash, commingle it, and then distribute it as needs presented." Accordingly, the affairs of the debtors, along with those of certain non-debtor DBSI entities, were substantively consolidated nunc pro tunc to Nov. 10, 2008.
On Oct. 8, 2010, Mott and Foster filed motions to dismiss contending, inter alia: (1) that the allegations of actual fraudulent intent failed because the trustee's complaints: (a) provided no direct evidence of fraudulent intent; (b) did not sufficiently plead any badges of fraud; (c) failed to sufficiently plead that Mott and Foster were insiders; and (d) failed to sufficiently plead that the DBSI entities were insolvent; and (2) that the claims seeking to avoid and recover the constructively fraudulent transfers failed because: (a) DBSI received reasonably equivalent value for the transfers; (b) the complaint failed to adequately allege that Mott and Foster were insiders; and (c) the complaint failed to adequately allege that the DBSI entities were insolvent at the time of the transfers.
In raising these arguments, Mott and Foster generally argued that because the counts sounded in fraud, the trustee's complaint was required to meet the heightened pleading requirements imposed by Federal Rule of Civil Procedure 9(b) and that "the conclusory, one-size-fits-all facts alleged by the trustee do not amount to the plausibility — let alone probability — of culpability required by Twombly ." Specifically, Mott and Foster asserted that the trustee's complaint "contain[ed] what could charitably be described as a smattering of incomplete and misleading statements concerning [Mott and Foster's] status as ... alleged 'insider[s].'" In addition, Mott and Foster averred that the trustee's complaint "merely parroted the statutory requirements" for the pleading of fraudulent transfers and contained only a generalized, conclusory allegation that DBSI's liabilities exceeded its assets. Similarly, with regard to the constructive fraud counts of the complaint, Mott and Foster argued that the complaint merely recited the statutory requirements and, consequently, that the trustee had not alleged sufficient facts.
In response, the trustee first argued that Twombly "simply calls for enough facts to raise a reasonable expectation that discovery will reveal evidence of the necessary element[s]" of fraud. Secondly, the trustee argued that Rule 9(b) did not require fraud to be pleaded with particularity; instead, it required the trustee to plead the circumstances constituting the fraud with particularity. In addition, the trustee pointed out that when a trustee is the plaintiff, the requirements of Rule 9(b) are relaxed and liberally interpreted.
The trustee further asserted that sufficiently pleading fraud is typically accomplished through the pleading of various "badges of fraud" from which fraud could reasonably be inferred. Accordingly, the trustee argued that the complaint pleaded sufficient badges of fraud as it alleged that: (i) there was a close insider relationship consistent with the presence of fraud; (ii) the DBSI entities were insolvent; and (iii) the DBSI enterprise was a Ponzi scheme, the opinion said. Finally, the trustee argued that the counts seeking to avoid and recover constructively fraudulent transfers were not governed by Rule 9(b), but instead, were governed by the much more liberal pleading requirements set forth in Rule 8. Therefore, the trustee urged that the constructive fraud counts were properly pleaded as they specifically identified each of the transfers, pleaded the insolvency of each of the transferors (in addition to the fact that the DBSI enterprise as a whole was insolvent), and alleged that the transferors did not receive reasonably equivalent value for their transfers to Mott and Foster.
In addressing Mott and Foster's contention that the trustee's complaint did not adequately plead actual fraudulent intent, the bankruptcy court agreed with the trustee and stated that "because direct evidence of fraudulent intent is difficult to prove, [the trustee] could sufficiently plead fraudulent intent by alleging[,]" among other things, "(1) the relationship between the debtor and the transferee; (2) adequacy of consideration for the conveyance; (3) insolvency or indebtedness of the debtors; (4) how much of the debtor's estate was transferred; (5) reservation of benefits, control or dominion by the debtor over the property transferred; and (6) secrecy of concealment of the transaction."
Turning to the badges of fraud alleged by the trustee, the first dispute turned on the allegations regarding Mott and Foster's status as insiders. Mott and Foster argued that the relevant period of inquiry as to their status was when the transfers were made. In contrast, the trustee argued that the relevant inquiry was Mott and Foster's status when the agreements were executed. The court agreed with the trustee's position that it was Mott and Foster's status when the agreements were executed that was relevant in determining whether the agreements were fraudulent. Consequently, the bankruptcy court determined that the trustee's allegations that Mott and Foster were directors and/or officers of various DBSI entities at the time of execution of the agreements, and that Foster had a 5 percent stake in the DBSI entities at that time, were sufficient to support a finding that Mott and Foster were insiders.
Having resolved the first point of contention with regard to the badges of fraud, the bankruptcy court next turned to Mott and Foster's argument that the trustee had not properly pleaded the DBSI entities' insolvency. In his complaint, the trustee pleaded that the individual DBSI entities were insolvent, and that the overall DBSI enterprise was insolvent, at the time the agreements were executed. In support of those allegations, the trustee generally alleged that the DBSI entities never generated a profit, that liabilities for each of the DBSI entities exceeded assets, that each DBSI entity relied upon investment money being distributed among the entities on an as-needed basis, and that the DBSI entities failed to properly account for their assets and liabilities. Moreover, the trustee alleged that "the entire DBSI enterprise, being a Ponzi scheme, was by definition insolvent during that time, as it was dependent on constant infusions of cash from new investors to satisfy obligations owed to prior ones." In contrast, Mott and Foster argued, in reliance upon 11 U.S.C. § 101(32), that the trustee was required to provide a "precise calculation and allegation of the sum of the excess of the value of each general partner's nonpartnership property ... over such partner's nonpartnership debts."
The bankruptcy court found Mott and Foster's position unavailing and rejected it for two reasons. First, the bankruptcy court held that the trustee's allegations satisfied the general pleading requirements for insolvency with regard to the respective DBSI entities. Second, even had the trustee's allegations with regard to the respective DBSI entities been insufficient, the bankruptcy court (after noting that the DBSI enterprise had been substantively consolidated) concluded that "the trustee's allegations of the insolvency of the unified DBSI enterprise is sufficient to meet the insolvency criteria for fraudulent transfer analysis." Accordingly, the bankruptcy court found that the trustee had adequately pleaded insolvency.
Finally, the bankruptcy court turned to the adequacy of consideration provided by Mott and Foster under the agreements. In rather summary fashion, the bankruptcy court stated that "because [the] trustee has sufficiently alleged that the unified DBSI enterprise was insolvent, [the] trustee has necessarily alleged that Mott and Foster's interests in the DBSI enterprise were valueless." Accordingly, the bankruptcy court held that the agreements involved payments to Mott and Foster in return for nothing of value.
Having found that the trustee adequately alleged that Mott and Foster were insiders, that the individual DBSI entities were insolvent (as well as the DBSI enterprise), and that the consideration for the agreements was valueless, the bankruptcy court held that the trustee had adequately pleaded both actual fraudulent intent and sufficient facts to support a cause of action to avoid and recover constructively fraudulent transfers. Consequently, the bankruptcy court denied Mott and Foster's motions to dismiss with regard to the counts alleging actual and constructively fraudulent transfers.
While courts have imposed more stringent requirements on complaints seeking to recover preferential transfers pursuant to § 547 of the Bankruptcy Code post- Twombly, this case seems to indicate that complaints containing fraudulent transfer claims pursuant to §§ 544 and 548 of the Bankruptcy Code may not have been impacted to the same degree by the heightened pleading requirements espoused in Twombly.
Rudolph J. Di Massa, Jr., a partner at Duane Morris, is chairman of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.
Blake D. Roth is a 2009 graduate of the Earle Mack School of Law at Drexel University and an associate in the business reorganization and financial restructuring practice group at Duane Morris.
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