Creditors cannot recover punitive damages to remedy a fraudulent transfer if Delaware law applies, according to the teaching of Bankruptcy Judge Kevin Gross of Delaware.
Five days earlier in the same lawsuit, Judge Gross had ruled in favor of creditors by holding that their damages in a fraudulent transfer suit are not capped by the amount of their claims. His new decision on Nov. 6 shows that Judge Gross doesn’t always rule in favor of creditors pursuing damages resulting from a leveraged buyout that quickly turned sour and ended up in bankruptcy.
The new opinion stemmed from post-confirmation fraudulent transfer litigation involving the LBO of Physiotherapy Holdings Inc. About one year after the LBO, the company defaulted on $210 million in senior unsecured notes that had been sold to finance the acquisition. For the noteholders’ claims, the confirmed chapter 11 plan gave them an allowed unsecured claim of $210 million, for which they received new common stock plus half of recoveries by a litigation trust.
The trust created for creditors under the plan filed suit after confirmation against the selling shareholders in the LBO, seeking to recover about $250 million they received and alleging that the transaction was a fraudulent transfer “with actual intent” or was constructively fraudulent.
Assuming the selling shareholders had fraudulent transfer liability, Judge Gross ruled in his Nov. 1 opinion that the noteholders theoretically could recover the $250 million that the shareholders were paid in the LBO, even though the noteholders had already sold their stock and recovered more than their allowed claims. To read ABI’s discussion of the Nov. 1 opinion, click here.
The trust also had a motion pending for permission to amend the complaint by making a claim for punitive damages. That issue was the topic of Judge Gross’ Nov. 6 opinion.
To decide whether the proposed amendment was futile, Judge Gross was required to determine whether the Delaware or Pennsylvania versions of the Uniform Fraudulent Transfer Act applied to the LBO. The creditors would win if Pennsylvania law applied, but they would lose if Delaware law governed.
Deciding that Delaware law applied, Judge Gross denied the motion to amend the complaint.
Making an educated guess, the Third Circuit had concluded in Klein v. Weidner, 729 F.3d 280 (3d Cir. 2013), that the Pennsylvania Supreme Court would allow punitive damages under that state’s version of the UFTA.
Not so in Delaware, Judge Gross said, even though Delaware’s highest court has not decided whether a fraudulent transfer suit under its law permits punitive damages.
To determine how Delaware courts would rule, Judge Gross cited the Delaware Court of Chancery’s ruling that Delaware’s equity courts do not award punitive damages.
Because the bankruptcy court is a court of equity, Judge Gross concluded that a bankruptcy court applying Delaware law could not award punitive damages, just like the Delaware Chancery Court does not award “punies.”
Observing that the two states’ laws were polar opposites, Judge Gross therefore had to decide whether the suit was governed by Delaware or Pennsylvania law. Strong facts supported either state.
Ultimately, Judge Gross decided that Delaware had “the most significant relationship to the claim and the parties” because the entities created in the LBO and the creditors’ trust were formed in Delaware.
Ruling in favor of the defendants and barring a claim for punitive damages, Judge Gross decided a significant question regarding federal practice. The creditors’ trust had argued that the defendants waived the choice of law because they did not raise the issue in a prior motion to dismiss.
Judge Gross said that choice of law is not an affirmative defense that can be waived. In addition, choice of law is typically fact-intensive and inappropriate for basing a decision on a motion to dismiss.
Furthermore, choice of law made no difference on the prior motion to dismiss because the law in the two states was “nearly” identical on the issues underpinning the motion to dismiss.