The Thomas Petters Ponzi scheme produced a trilogy of decisions in the last four weeks dealing with fraudulent transfers and substantive consolidation. Last month, we reported a split decision handed down on May 16 by the Eighth Circuit where the majority held that defendants in a fraudulent transfer suit were not “aggrieved persons” and thus lacked standing to appeal an order granting substantive consolidation.
The dissenter argued that the loss of affirmative defenses resulting from substantive consolidation conferred standing to appeal. Today, we report a May 19 decision by Bankruptcy Judge Gregory F. Kishel of St. Paul, Minn., holding that a pivotal affirmative defense was not lost as a consequence of substantive consolidation of the Petters companies.
Tomorrow, we will report a landmark decision on May 31 by Judge Kishel dealing with other defenses to fraudulent transfer suits brought in the wake of the Petters Ponzi scheme.
The Petters Fraud
The Petters bankruptcy that unfolded in 2008 was second only to Bernard Madoff’s Ponzi scheme in the hierarchy of egregious frauds. Petters obtained loans ostensibly to finance inventory purchasing, when in fact the proceeds of new loans were used exclusively to pay principal and interest on prior loans.
In his opinion on May 19, Judge Kishel dealt with the Petters trustee’s contention that substantive consolidation, upheld in the circuit court three days earlier, obliterated the defendants’ defense that the transferor-debtors had no actual creditors whose existence is required to sustain a suit by the trustee under Section 544(b). That section demands the existence of an actual creditor who could mount a fraudulent transfer claim.
The Bankruptcy-Remote Structure of the Petters Loans
Petters’ lenders, not alleged to have been aware there was fraud, structured the loans using so-called bankruptcy-remote entities. The Petters companies that obtained the loans had no other creditors, thus minimizing the likelihood that they, as borrowers, would become debtors in bankruptcy. Even if there were bankruptcies, the borrowers would have had no other creditors enabling a trustee to sue under Section 544(b), which allows a trustee to mount a lawsuit that could have been brought by an actual creditor with an allowed claim.
Judge Kishel had authorized substantive consolidation of the main Petters company with most of its affiliates, including the bankruptcy-remote borrowers that ended up in bankruptcy anyway. He found that Petters never respected corporate formalities and transferred funds willy-nilly among his companies.
The circuit court in substance upheld substantive consolidation in May by holding that the fraudulent transfer defendants lacked standing to appeal because they were not “aggrieved persons.” To read ABI’s discussion of the Eighth Circuit opinion, click here.
The Trustee’s Complaints
The trustee had filed hundreds of fraudulent transfer suits, alleging generally that there were actual creditors who could be plaintiffs absent bankruptcy. The lenders argued that there were in fact no actual creditors of the borrowers, thus precluding the trustee from suing.
In the adversary proceeding that ended up being the test case, the trustee amended his complaint by alleging that the actual-creditor requirement was satisfied by substantive consolidation since the Petters companies had abundant creditors. The defendant in the test case filed a motion to dismiss, contending that substantive consolidation could not provide the required actual creditor when the transferor-debtor in reality had no other creditors.
The trustee inveighed against dismissal, contending that the post-petition grant of substantive consolidation should be given retroactive effect to supply the actual creditor required by Section 544(b).
Judge Kishel’s Opinion
The predicate creditor could not be supplied by the Bankruptcy Code itself given the principles of statutory construction, the judge said. There was no actual creditor in compliance with the definitions in the Code, he said, because no one had a right to payment enforceable under a pre-petition agreement or nonbankruptcy law.
Saying that the case presented an issue of first impression, Judge Kishel next examined the purpose of substantive consolidation. As a remedy authorized by the Supreme Court in 1941, he said that it was created “entirely on considerations of equity” and has been “used exclusively to support the administrative function in bankruptcy” — that is, to simplify the distribution of assets when debtors have ignored corporate formalities, comingled assets, and kept inadequate records.
Judge Kishel said that the trustee’s argument ignored the separate corporate existence of the special-purpose entities before bankruptcy. He said that consolidation did not alter the status of the companies “as separate persons under nonbankruptcy law.” Consolidation, he ruled, “was limited in its effect to constructs under bankruptcy law.” Even today, he said, the special-purpose entities retain their separate “pre-petition legal personalities.”
No reported case, according to the judge, has said that substantive consolidation effects a merger or dissolution of debtor companies themselves. Rather, he said, consolidation “only alters the allocation of assets among creditors.”
“If the debtor-transferor had no such creditors, the gap is not retroactively filled by a substantive consolidation,” Judge Kishel held in the process of ruling that the trustee did not have an actual creditor as required by Section 544(b).
Implications of the Decision
The opinion might be interpreted as drawing a roadmap for fraudsters intent on insulating their investors from some types of fraudulent transfer suits. The opinion does not consider whether the traditional power of a court of equity to recharacterize transactions would avail a trustee. Indeed, the opinion several times talks about simple corporate existence as controlling the outcome even though the judge elsewhere in the opinion says that corporate formalities were uniformly ignored.
The decision could be viewed as meaning that a fraudster can set up a bankruptcy-remote entity and immediately violate every rule about corporate separateness, while still availing investors of defenses as though the businesses of the companies had been conducted with respect for corporate formalities. The decision does not place any onus on investors, even sophisticated investors, to police their debtors by ensuring that corporate formalities are respected. In short, investors in a doubtful scheme can insist on lending to a bankruptcy remote entity and then turn their backs to the actual conduct of the business.
The decision does not deal with the notion that the creation of the bankruptcy-remote entities was a fraud on creditors ab initio. A theory of fraud at the inception might preclude special-purpose vehicles from providing protection to recipients of fraudulent transfers.
In fairness, however, it may not be appropriate to read the opinion so broadly. It dealt with only one issue among a plethora of defenses by the investors and claims by the trustee. Although substantive consolidation may not supply the actual creditor required by Section 544(b), the trustee may have other theories to impose liability on those who made profits by receiving money stolen from other investors.
No Quick Appeal
Judge Kishel’s opinion was not an order from which the trustee can appeal. It was only a ruling on a discrete issue among many defenses raised in the defendants’ motion to dismiss. An appeal presumably will await a final order dismissing that trustee’s suit, if indeed that is to be the outcome.
Judge Kishel wrote another important Petters opinion on May 31 interpreting a decision from the Minnesota Supreme Court that, on the surface, seemed to provide the defendants with several other ironclad defenses to constructive fraudulent transfer suits emanating from Ponzi schemes.
The discussion of the May 31 opinion will appear in this column tomorrow. Without giving away the import of tomorrow’s story, suffice it to say that Judge Kishel understands the state’s highest court as modifying the pleading requirements in a fraudulent transfer suit arising from a Ponzi scheme, not insulating investors from liability for disgorging the receipt of fictitious profits.