While savvy debtors rarely make intentionally fraudulent transfers right before they file for bankruptcy, they may seek to effect constructively fraudulent transfers far in advance when they see the possibility of bankruptcy as a plausible alternative in the longer-term A transfer is constructively fraudulent, and thus can be voided by a bankruptcy trustee, 11 U.S.C. § 550, if the debtor made the transfer on or within two years before the date of filing the bankruptcy petition and the debtor “received less than a reasonably equivalent value in exchange for such transfer or obligation,” § 548(a)(1)(B)(i). A recent decision by the United States Ninth Circuit Court of Appeals provides guidance for bankruptcy courts seeking to assess if a purported loan advanced during such a period actually constitutes an equity investment intended to unfairly enrich a shareholder of the debtor corporation before that corporation goes in to bankruptcy.
In the Matter of Fitness Holdings Intern., Inc., 714 F. 3d 1141 ( Court of Appeals, 9th Circuit 2013), the Court looked at how Fitness Holdings International, Inc. (“Fitness Holdings”) had received, prior to its bankruptcy, substantial funding from two sources: the Pacific Western Bank and its sole shareholder, Hancock Park. Previously Hancock Park had guaranteed all of the loans the bank issued to Fitness Holdings and had lent the company funds all secured by promissory notes to be paid back by Fitness Holdings. Then in June 2007 Fitness Holdings struck what totaled a $25 million restructuring agreement with the bank wherein, upon closing, almost $12 million dollars would be issued to Hancock Park as payment on those notes. In addition, Hancock Park would at the same time be released from its guarantee of any further Fitness Holdings’ obligations to the bank. Fourteen months later the company filed for Chapter 11 bankruptcy protection.
Bypassing a discussion of the procedural developments in the case, eventually the bankruptcy trustee who is responsible for administering the debtor’s estate in bankruptcy, sought to recover payments made to Hancock Park, the bank and two other individuals, both members of the board of directors, on the grounds that the payments made to them under the restructuring deal were constructively fraudulent transfers.
The Ninth Circuit decided that the lower court should look to the state law – in this case California common law – to determine if the loans in question were actually payments in satisfaction of an equity interest. If so, the bankruptcy court could then rule that the trustee may seek to recover those payments. The decision is significant as cases from other federal circuits have applied federal law or rules to determine if a loan payment is actually some form of ad hoc equity distribution. This case settles that legal issue for all courts within the Ninth Circuit’s jurisdiction.
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