With apologies to our readers, we are once again obliged to report on a decision by Bankruptcy Judge Craig T. Goldblatt of Delaware, this time because he has written an important decision about the imputation of actual fraud to a corporation.
On a motion for summary judgment, Judge Goldblatt imputed fraudulent intent to the corporation, even though a majority of the board were unaware of the fraud and indeed were themselves victims of the fraud.
Judge Goldblatt based his reading of Delaware law in part on a recent decision from the Delaware Chancery Court, where the chancellor said that “the actual fraudulent intent of an entity exercising control over a transferor may be imputed to the transferor.” Cleveland-Cliffs Burns Harbor LLC v. Boomerang Tube, LLC, No. 2022-0378-LWW, 2023 WL 5688392 at *12 (Del. Ch. Sept. 5, 2023).
Thoroughgoing Fraud from Inception
The debtor corporation was founded in 2016 and controlled by an individual who had exclusive access to the company’s bank accounts and exclusive control over financial statements issued by the debtor.
In the four years of the debtor’s existence, Judge Goldblatt said in his October 19 opinion that the revenues generated by the debtor were “only trivial.” In one year, for instance, the debtor reported $270,000 in revenue, when actual revenue was less than $25,000. In the four years before bankruptcy, total revenues were less than $500,000, while operating expenses were $13 million.
Using altogether fictional financial statements, the founder was successful in raising $143 million from sophisticated investors in several financings. As part of the later financings, the hoodwinked investors were given three seats on the board of five. The founder occupied one of the non-investor seats.
The lawsuit before Judge Goldblatt involved a tender offer just a few months before the fraud blew up.
To enable the tender offer, the debtor completed a $73 million preferred stock financing. The financing permitted but did not require that proceeds from the financing be used in a tender offer for outstanding stock.
The independent board members knew that the Securities and Exchange Commission had been sniffing around. The board engaged an accounting firm, a forensic investigator and a law firm to investigate claims by the whistleblower.
Judge Goldblatt said that the outside professionals were “apparently all deceived by [the founder’s] fabrications [and] reported no instances of fraud or wrongdoing.” The board then approved the oversubscribed tender offer where the debtor paid $72 million to repurchase stock.
The founder received $17 million from selling some of his stock in the tender offer.
After the tender offer, the fraud unraveled when the company’s new president obtained access to bank accounts. Three months after the tender offer, the founder was arrested. Four months after the tender offer, the debtor was in chapter 11. The founder pled guilty and is now in prison.
The debtor confirmed a liquidating plan that created a litigation trust to pursue lawsuits.
The Lawsuit
The litigation trust sued some of the shareholders who sold stock in the tender offer. The complaint alleged actual and constructive fraudulent transfers along with unjust enrichment. The defendants conceded that the stock they sold was worthless.
The trust and the defendants filed cross motions for summary judgment. Primarily, the defendants raised an earmarking defense and contended that the innocence of the board majority meant there was no fraudulent intent by the corporation to underpin an actually fraudulent transfer.
The defendants had all filed proofs of claim, allowing Judge Goldblatt to issue final orders.
Earmarking
The defendants contended there was no fraudulent transfer claim because the money paid out in the tender offer was not the debtor’s property, but rather was property of hoodwinked investors.
For earmarking to apply, Judge Goldblatt said that the “debtor must have been legally obligated to use the funds in [the tender offer], rather than having the discretion to use them for other purposes.” [Emphasis in original.] “If the debtor retains discretion to use the funds however it sees fit, then the funds are not earmarked.”
Perusing the tender offer documents, Judge Goldblatt determined that the debtor could use the proceeds “however it wanted.” He therefore dismissed the earmarking defense.
Fraudulent Intent
On a fraudulent transfer claim, Judge Goldblatt said that “[t]he intent that matters for fraudulent conveyance law is that of the transferor.” When a corporation is the transferor, it’s the intent of the corporation that matters.
For a corporation, it’s ordinarily the intent of the board that matters, and a majority of the debtor’s board were not only ignorant of the fraud but had been defrauded by purchasing some of the preferred stock in the financing.
When deciding whether to impute the intent of an individual to a corporation, Judge Goldblatt said that courts in the Third Circuit “should look to the law of imputation of the state under whose laws the entity is organized.”
In the case at hand, Judge Goldblatt said that the outside professionals who had ok’d the tender offer “had themselves been tricked by [the founder’s] fraud.” For guidance, he studied an opinion by retired Bankruptcy Judge Robert E. Gerber, In re Lyondell Chem. Co., 541 B.R. 172, 177-178 (Bankr. S.D.N.Y. 2015).
In Lyondell, Judge Gerber interpreted Delaware law to mean that the intent of an individual may be imputed to the board if the individual can “control” the board. Id. at 177-178. Judge Goldblatt noted that the Third Circuit had “adopted” Lyondell’s “reading of Third Circuit law.”
Similarly, Judge Goldblatt paraphrased the holding in the Delaware Chancery Court’s recent Boomerang opinion to mean “that one party’s control over another may provide a basis for imputing the intent of the controlling party to the one who was controlled.”
“In this case,” Judge Goldblatt said, “the argument for control by means of deception, and thus imputation, is exceptionally strong.” He said it was “undisputed” that the board was “controlled” by the founder “in the sense that he deceived them into believing, by virtue of his fraud, that the transaction was fair to the debtor.”
Judge Goldblatt granted summary judgment for the litigation trust on the claim for actual fraudulent transfer. It was therefore unnecessary for him to rule on the additional claims for constructive fraudulent transfer and unjust enrichment.
With apologies to our readers, we are once again obliged to report on a decision by Bankruptcy Judge Craig T. Goldblatt of Delaware, this time because he has written an important decision about the imputation of actual fraud to a corporation.
On a motion for summary judgment, Judge Goldblatt imputed fraudulent intent to the corporation, even though a majority of the board were unaware of the fraud and indeed were themselves victims of the fraud.