The opinion of the court was delivered by: Paul G. Gardephe, U.S.D.J.
MEMORANDUM OPINION AND ORDER
These eight appeals arise from adversary proceedings Bayou Hedge Funds (the "Funds," "Bayou," or "Debtors") brought under §§ 548(a) and 544 of the Bankruptcy Code and §§ 273-76 of the New York Debtor and Creditor Law ("DCL") to recover -- as fraudulent conveyances -- redemption payments the Funds made to Appellants within two years of the Funds' collapse in August 2005.*fn1 (Am. Cmplt. ¶ 3 (CBHSE Ex. 1)) Appellants*fn2 appeal from a decision and orders of the United States Bankruptcy Court for the Southern District of New York, dated October 16, 2008, and January 28, 2009, respectively, granting Debtors summary judgment on their claims to avoid and recover payments made to Appellants in redemption of their principal investments and fictitious profits, and denying Appellants' cross-motions for summary judgment on their good faith defense under 11 U.S.C. § 548(c).*fn3 In granting Debtors summary judgment, the Bankruptcy Court held that $24.7 million in pre-petition redemption payments made to Appellants -- reflecting both return of investment principal and fictitious profits -- could be avoided under Section 548.
Critical to the Bankruptcy Court's determination that the redemption payments could be avoided as actual fraudulent conveyances was its ruling, as a matter of law, that Appellants could not prevail on their good faith affirmative defense. That finding is premised on a novel interpretation of the test for good faith under Section 548(c) of the Bankruptcy Code, which the lower court conceded "may be thought to differ in some respects from the case law." Bayou III, 396 B.R. at 847. In contrast to the vast weight of authority holding that a transferee is put on "inquiry notice" only upon receiving information indicating that the transferor is insolvent or that the transfer is being made for a fraudulent purpose, the Bankruptcy Court broadly held that information suggesting "some potential infirmity in the investment" or "some infirmity [in the] integrity of its management" is a sufficient trigger. Id. at 848. The Bankruptcy Court's expansion of the scope of information sufficient to trigger inquiry notice is not supported by the case law and requires reversal of its decision granting Bayou summary judgment.
The factual background of these appeals is discussed in detail in three prior decisions issued by the Bankruptcy Court, with which this Court presumes familiarity. See In re Bayou Group, LLC, 362 B.R. 624 (Bankr. S.D.N.Y. 2007) ("Bayou I"); Bayou II, 372 B.R. 661; Bayou III, 396 B.R. 810. The essential facts concerning the rise and fall of the Bayou Funds are not in dispute.
In 1996, Sam Israel, Daniel Marino, and James Marquez organized the Bayou Fund, a hedge fund that served large, primarily institutional investors. Bayou III, 396 B.R. at 822. In 2003, the original Bayou Fund was liquidated and was replaced by four on-shore hedge funds, all of which were limited liability companies. Id. Three of these funds -- Bayou No Leverage Fund, Bayou Accredited Fund, and Bayou Superfund -- are Appellees in this action.*fn4 (Am. Cmplt. ¶ 17)
Throughout their existence, all the Bayou funds were managed by Bayou Management LLC, which was owned by Israel, and all related trading activity was conducted through Bayou Securities, a broker-dealer owned by Bayou Group, LLC. Bayou III, 396 B.R. at 822. Until Bayou's collapse in 2005, Israel and Marino controlled the operation of all the Bayou entities, serving respectively as chief executive officer and chief financial officer of Bayou Management. Id.
The Bayou Fund began losing money soon after it began trading, and neither it nor its successor funds was ever profitable. Id. In addition to the trading losses they incurred, Israel and Marino plundered the Funds for their personal financial gain, generating millions of dollars in excessive trading commissions and awarding themselves millions in incentive bonuses based on non-existent profits. Id. at 823. In order to conceal their trading losses and self-dealing, and to attract additional investment, the Funds misrepresented their performance through false and fraudulent reports, releases, and financial statements. Id.; (see also Am. Cmplt. ¶ 12). For example, false performance returns were reported to investors in weekly, monthly, quarterly and annual financial reports, in individual account statements, and in Bayou's marketing materials. Bayou III, 396 B.R. at 823.
In 1998, in furtherance of their fraudulent scheme, Israel and Marino fired Bayou's independent auditor and replaced that firm with Richmond-Fairfield Associates, CPA, PLLC, a fictional accounting firm created by Marino to pose as an independent auditor. Id.; (see also Sonn. Ex. 1, ¶¶ 21-22). The Bayou Funds' subsequent annual financial statements contained a certification from Richmond-Fairfield stating that it was an independent firm of certified public accountants, that it had audited the financial statements of the applicable Bayou fund, that the audit had been conducted in accordance with generally accepted accounting standards, and that the Fund's financial statements "present fairly, in all material respects, the financial position of [the fund] and the results of its operations." Bayou III, 396 B.R. at 823. All of these representations were false. Id.
Another critical component of the fraud scheme was the Bayou Funds' consistent execution of investors' redemption requests in accordance with the Funds' operating agreements:
To avoid detection of the fraud, to retain existing investors and to lure new investors, the Bayou Hedge Funds invariably honored requests by investors who sought to exercise their contractual right to redeem their investments as falsely reported in the fraudulent financials, both as to impaired or non-existent principal and fictitious profits. These redemption payments thus constituted an integral and essential element of the alleged fraud, necessary to validate the false financials and to avoid disclosure.
Bayou II, 372 B.R. at 663.
Although one investor learned from New York Department of State records in July 2004 that the registered agent for Richmond-Fairfield was Dan Marino, Bayou III, 396 B.R. at 865 -- indicating that Bayou's representation of Richmond-Fairfield as an independent auditing firm was a fiction -- the Bayou Funds' fraudulent scheme was apparently never detected by investors or by regulators prior to the Funds' collapse. The end came in July 2005, when the Bayou Funds notified investors that they were voluntarily liquidating, and that all investors would receive a 100% redemption of their investments upon completion of a final audit. (CBHSE Ex. 1, ¶ 22) Bayou's investors received no further distributions from the funds, however. Bayou III, 396 B.R. at 823.
Over their lifespan, the Bayou Funds attracted more than $450 million from investors. Id. at 829. When the funds collapsed in the summer of 2005, investors sustained losses of approximately $250 million in invested principal. Id. at 823.
On September 29, 2005,Israel and Marino pleaded guilty in the United States District Court for the Southern District of New York to criminal informations charging them with, inter alia, conspiring to commit, and with the commission of, investment adviser fraud and mail fraud. (Sonn. Ex. 3) The informations charged that Israel and Marino had provided newsletters, reports, and financial statements setting forth inflated rates of return for the Bayou Funds, and had falsely represented to investors that Bayou's financial statements had been audited by an independent certified public accounting firm, when in fact Israel and Marino had created a sham accounting firm that conducted no audits. (Id.) The informations further alleged that between July 1996 and August 2005, Israel and Marino had, through this fraudulent scheme, "induced investors to contribute in excess of $450,000,000 to the Bayou Hedge Funds." (Id. at 4)
During his plea allocution, Israel admitted that he had "caused Bayou to send various kinds of documents containing false financial information about Bayou's performance to current and prospective clients of Bayou which made it appear that Bayou was performing better than it truly was. My purpose was to induce these people to invest in Bayou or continue to keep their money in Bayou." (Pltf. Ex. 3 at 24 (Israel Plea Tr.)); see Bayou III, 396 B.R. at 830. Marino similarly admitted that while serving as chief financial officer of Bayou he and others had intentionally sent false information to investors concerning "the true status of their investment," and that he had "set up an accounting firm that would give the appearance of an independent auditor to further the conspiracy to deceive Bayou investors." (Pltf. Ex. 4 at 27-28 (Marino Plea Tr.))
On December 14, 2006, James Marquez, a principal at Bayou until 1999 and the portfolio manager for the Bayou Fund, also pleaded guilty to charges of conspiracy to commit investment adviser fraud and mail fraud, among other crimes. (See Pltf. Ex. 5 at 20-22 (Marquez Plea Tr.)) Marquez admitted that he was aware of the trading losses that the Bayou Fund was suffering and that he caused inaccurate financial statements to be sent to investors "that made it appear that the fund was more successful than it actually was." (Id. at 20) Marquez further admitted that he was aware of the creation of Richmond-Fairfield and knew that it had been "formed to handle the audits for the Fund with the intent that the true financial status of the Fund not be disclosed to investors." (Id. at 10); see Bayou III, 396 B.R. at 830.
C. The Pre-Dissolution Redemptions
Appellants are investors in the Bayou Funds who redeemed their investments within two years of the Funds' collapse in the summer of 2005.*fn5 The Operating Agreement for each Fund governed the terms of these redemptions (Sonn. Exs. 26, 27), and permitted investors to redeem at the end of any calendar month by providing 15 days written notice. (Id. at § 10.1) Under the Operating Agreements, after a notice of redemption was received, the fund would pay "90% of the amount [in the particular investor's] Capital Account . . . within thirty (30) days of the effective date of the withdrawal." (Id. § 10.4) "[T]he balance of the amount due [would be paid] within thirty-one (31) days after the Company ha[d] received financial statements for the year ending as of the withdrawal date." (Id.)
Each of the Appellants redeemed the principal amount of their investments in the Bayou Funds -- along with the fictional profits reflected on their account statements -- within two years of the initiation of bankruptcy proceedings. See 11 U.S.C. § 548(a)(1) ("The trustee may avoid any transfer . . . of an interest of the debtor . . . incurred by the debtor, that was made or incurred on or within 2 years before the date of filing of the petition. . . .").
D. Bankruptcy Court Proceedings
On March 27, 2006, a group of unsecured, non-redeeming investors referred to as the Unofficial On-Shore Creditors Committee filed a civil complaint in this district against Israel, Marino, the Bayou Hedge Funds, and their affiliate entities.*fn6 (Sonn. Ex. 6)
The complaint alleged violations of Section 10(b) of the Securities Act of 1934 and Rule 10b-5 as well as state law causes of action for fraud and breach of fiduciary duty. (Id.) The complaint sought appointment of a receiver to prosecute claims on behalf of Bayou Group and to develop a plan of distribution for creditors. (Id.) On April 28, 2006, the District Court appointed Jeff Marwil to serve as receiver of Bayou Group, LLC and a number of related Bayou entities, including all of the Bayou funds named in this litigation. (Sonn. App., Ex. 7 at 2)
On May 30, 2006, the Bayou Funds and related entities each filed petitions for relief under Chapter 11 of the Bankruptcy Code. (Sonn. Ex. 9 ¶ 1) The Debtors subsequently initiated approximately 120 actions (Bayou Br. 2-3), including those now on appeal, seeking to recover as fraudulent transfers "the principal and fictitious investment gains fraudulently transferred to redeeming investors so that the funds can be equitably redistributed pro-rata to all of the Bayou Entities' creditors."*fn7 (Am. Cmplt. ¶ 2)*fn8
Debtors allege that the Bayou Funds were operated as a Ponzi scheme, in which "capital from new investors [was used] to pay redemption proceeds to investor creditors seeking to exit the Bayou Hedge Funds." (Id.) Debtors further allege that the redeeming investors "knew or should have known that the Bayou Entities were fraudulent and insolvent, and that the redemption payments were made in furtherance of a fraud." (Id. ¶ 27) In this regard, Debtors claim that the redeeming investors were "tipped" by their investment advisors to redeem, and that there were "a number of red flags that did or should have put [them] on actual or inquiry notice of the . . . fraud or insolvency" of the Bayou Funds. (Id.)
1. The Bankruptcy Court's Denial of Appellants' Motions to Dismiss
Appellants moved to dismiss the amended complaints, arguing that Debtors had failed to allege (1) actual intent to defraud with sufficient particularity; and (2) the absence of good faith on Appellants' part in redeeming their Bayou investments. Bayou I, 362 B.R. at 624. As to the latter argument, the Bankruptcy Court held that Debtors need not plead the absence of good faith, because it is an affirmative defense under Section 548(c). Id. at 638-39. As to actual intent to defraud, the court held that the allegations in the amended complaints had been pleaded with sufficient particularity.
Under Section 548(a)(1)(A), transfers can be avoided as fraudulent conveyances where the transferor made the transfers with actual intent to "hinder, delay, and defraud" creditors. In a Ponzi scheme scenario, a presumption of actual intent to "hinder, delay, and defraud" exists. The Bankruptcy Court found that the amended complaints' allegations concerning the Bayou Funds -- i.e., "that redemption payments of wholly-or partially-non-existent investment account balances and wholly-fictitious profits, as reflected on fraudulent financial statements, were made to earlier investors requesting redemption using funds invested by subsequent investors" -- fell well within the case law's description of a Ponzi scheme. Id. at 633-34. Accordingly, the Bankruptcy Court found that Debtors had adequately pleaded "actual intent" to hinder, delay and defraud.
In denying the motions to dismiss, the Bankruptcy Court also rejected Appellants' argument that the Second Circuit's decision in Sharp Int'l Corp. v. State Street Bank & Trust Co., 403 F.3d 43 (2d Cir. 2005), precluded Debtors' intentional fraudulent conveyance claims. The Bankruptcy Court found Sharp -- which involved Sharp's repayment of a legitimate loan from State Street, when Sharp's management was looting the company and State Street suspected fraud -- inapposite:
In contrast to the lawful and disclosed payment of a valid contractual antecedent debt in Sharp, the redemption payments at issue here of nonexistent investor account balances as misrepresented in the fraudulent financial statements were themselves inherently fraudulent and constituted an integral and essential component of the fraudulent Ponzi scheme alleged in the amended complaints. The payments alleged here of fictitious account balances and profits were inherently deceitful and unlawful and were necessarily made with intent to "hinder, delay or defraud" present and future creditors. No such allegation was made in Sharp, which involved only a disclosed repayment of a valid antecedent debt actually owed to State Street.
Id. at 638. The District Court denied leave to appeal on July 11, 2007. (Pltf. Ex. 1)
2. The Bankruptcy Court's Denial of Appellants' Motions for Summary Judgment on Standing Grounds
Appellants subsequently moved for summary judgment on Debtors' fraudulent conveyance claims, arguing that the non-redeeming investors lacked standing to bring these actions. Appellants argued that the non-redeeming investors were not creditors but merely equity holders under the Bankruptcy Code, and that their claims were, in any case, disallowed under Section 510(b) of the Bankruptcy Code. Bayou II, 372 B.R. at 664.
The Bankruptcy Court denied Appellants' motions on August 9, 2007, holding that the non-redeeming investors were not mere equity holders but were creditors by virtue of their tort claims against the Bayou Funds for rescission and damages. Id. at 665. The court further held that Section 510(b) speaks only of priority in distribution and "does not deal with allowance or disallowance of claims." Id. at 666. Accordingly, while non-redeemers' claims would be "subordinated to any creditor interest which has a higher priority under the Bankruptcy Code than that of the underlying stock or equity interest," such claims are not disallowed under Section 510(b). Id.
3. The Bankruptcy Court's October 16, 2008 Decision Granting Summary Judgment to Bayou
On January 18, 2008, Debtors moved for summary judgment arguing, inter alia, that Appellants' affirmative defense of good faith to Debtors' actual fraudulent conveyance claim failed as a matter of law. Appellants filed cross-motions for summary judgment. On October 16, 2008, the Bankruptcy Court issued an opinion holding, inter alia, that: (1) Debtors had established a prima facie case of actual fraudulent conveyance under Section 548(a)(1)(A) of the Bankruptcy Code by offering proof that each redemption payment was made by the Debtors with "actual intent to hinder, delay or defraud" the Bayou Funds' investors, Bayou III, 396 B.R. at 842-43; (2) an expert report offered by Debtors (the "Lenhart Report") was admissible and established that the Bayou Hedge Funds were insolvent when the redemption payments to Appellants were made, id. at 834, 836; and (3) Debtors had established a prima facie case of constructive fraudulent conveyance under Section 548(a)(1)(B) of the Bankruptcy Code, because the Bayou Funds were insolvent at the time the redemption payments were made and Appellants -- having received fictitious profits in addition to their invested principal -- had not given "reasonably equivalent value" for their redemptions; and (4) Appellants' affirmative defense of good faith to Debtors' actual fraudulent conveyance claim failed as a matter of law, because Appellants were on inquiry notice as a result of information suggesting "some potential infirmity in the investment" or "some infirmity [in the] integrity of its management," and they had not diligently investigated these issues. Id. at 865-79. Accordingly, the Bankruptcy Court granted Debtors summary judgment on their claims for actual and constructive fraudulent conveyance.
In nearly 250 pages of briefing, Appellants argue that the Bankruptcy Court committed a host of errors. As an initial matter, Appellants repeat their arguments that Debtors may not bring fraudulent conveyance claims on behalf of non-redeeming investors, because these investors are equity holders and not creditors under the Bankruptcy Code. (Sonn. Br. 47-60)Appellants also contend that the Bankruptcy Court should have dismissed Debtors' claims for actual fraudulent conveyance under Sharp Int'l Corp. v. State Street Bank and Trust Co., 403 F.3d 43 (2d Cir. 2005), because they were bona fide creditors who took their redemption payments in satisfaction of a pre-existing debt, just as the defendant in Sharp took payment to satisfy a legitimate pre-existing loan. (CBHSE Br. 24; Sonn. Br. 32)
Appellants further argue that the Bankruptcy Court misapplied the law applicable to their good faith defense under Section 548(c) by (1) broadening the test for when a transferee is put on inquiry notice, and (2) ruling as a matter of law that Appellants had been put on inquiry notice and had not conducted a diligent investigation under Section 548(c). (Sonn. Br. 39-40)
Appellants also contend that the Bankruptcy Court erred in admitting and in relying on the Lenhart Report to establish the insolvency of the Bayou Funds for purposes of Debtors' constructive fraudulent conveyance claim under Section 548(a)(1)(B) of the Bankruptcy Code.*fn9 (Sonn. Br. 61-66; Freestone Br. 40)
Under Rule 8013 of the Federal Rules of Bankruptcy Procedure, this Court "may affirm, modify, or reverse [the] bankruptcy judge's judgment, order, or decree or remand with instructions for further proceedings." Fed. R. Bankr. P. 8013. District courts review Bankruptcy Court summary judgment decisions de novo. Bear, Stearns Secs. Corp. v. Gredd (In re Manhattan Inv. Fund Ltd.), 397 B.R. 1, 7 (S.D.N.Y. 2007) ("In re Manhattan Inv. Fund III")(citing cases). In conducting such a review, the Court "decide[s] the issue[s] as if no decision had previously been rendered." H&C Dev. Group, Inc. v. Miner (In re Miner), 229 B.R. 561, 565 (2d Cir. 1999). "A bankruptcy judge's findings of fact[, however,] stand unless found by the district court to be clearly erroneous." Shimer v. Fugazy Express (In re Fugazy Express), 124 B.R. 426, 430 (S.D.N.Y. 1991) (citing In re Skinner, 917 F.2d 444 (10th Cir. 1990)). Moreover, this Court will review only those facts and legal arguments presented to the Bankruptcy Court. See Official Comm. of the Unsecured Creditors of Color Tile, Inc. v. Coopers & Lybrand, LLP, 322 F.3d 147, 166 (2d Cir. 2003); Authentic Fitness Corp. v. Dobbs Temp. Help Servs., Inc. (In re Warnaco Group, Inc.), No. 03 Civ. 4201 (DAB), 2006 U.S. Dist. LEXIS 4263, at *16 (S.D.N.Y. Feb. 2, 2006) (citing Invex, Ltd. v. Cassirer (In re Schick), No. 97 Civ. 9300 (JGK), 1998 WL 397849, at * 7 (S.D.N.Y. July 16, 1998); In re REA Holding Corp., 2 B.R. 733, 737 (S.D.N.Y. 1980)(argument not raised in bankruptcy court not properly before the district court on appeal)).
Federal Rule of Civil Procedure 56 is applicable to these proceedings pursuant to Federal Rule of Bankruptcy Procedure 7056. Under Rule 56, summary judgment is appropriate only when the "pleadings, the discovery and disclosure materials on file, and any affidavits show that there is no genuine issue as to any material fact and that the movant is entitled to judgment as a matter of law." Fed. R. Civ. P. 56(c). Whether facts are material is a determination made by looking to substantive law. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986). "The movant's burden will be satisfied if he can point to an absence of evidence to support an essential element of the nonmoving party's claim." Goenaga v. March of Dimes Birth Defects Found., 51 F.3d 14, 18 (2d Cir. 1995). "A dispute about a 'genuine issue' exists for summary judgment purposes where the evidence is such that a reasonable jury could decide in the non-movant's favor." Beyer v. County of Nassau, 524 F.3d 160, 163 (2d Cir. 2008). In deciding a summary judgment motion, the Court "resolve[s] all ambiguities, and credit[s] all factual inferences that could rationally be drawn, in favor of the party opposing summary judgment." Cifra v. Gen. Elec. Co., 252 F.3d 205, 216 (2d Cir. 2001). However, "a party may not 'rely on mere speculation or conjecture as to the true nature of the facts to overcome a motion for summary judgment.'" Lipton v. Nature Co., 71 F.3d 464, 469 (2d Cir. 1995) (quoting Knight v. U.S. Fire Ins. Co., 804 F.2d 9, 12 (2d Cir. 1986)).
II. DEBTORS HAVE STANDING TO CHALLENGE THE PRE-PETITION TRANSFERS
The Sonnenschein Appellants argue that the Bankruptcy Court erred in holding that Debtors have standing to avoid and recover the Bayou Funds' pre-petition transfers to Appellants. (Sonn. Br. 47-60) Under Section 550 of the Bankruptcy Code, "to the extent that a transfer is avoided under section . . . 548 . . . the trustee may recover, for the benefit of the estate, the property transferred. . . ." 11 U.S.C. § 550. The Debtors' standing is derived from that of non-redeeming investors by way of their creditor status, see 11 U.S.C. §§ 544, 548,but Appellants argue that the non-redeeming investors' "status primarily as equity holders deprived the Debtors of standing and the authority to sue on their behalf." (Sonn. Br. 47) This argument has no merit.
The non-redeeming investors on whose behalf these actions were commenced are creditors by virtue of their tort claims for fraudulent inducement, rescission and damages against the Bayou Funds. Because the non-redeeming investors were "fraudulently induced to purchase their investments in the Funds by the fraudulent financial statements certified by the non-existent accounting firm," there is no dispute that the non-redeeming investors "'had the right prior to the filing of the petition to pursue claims for damages or rescission against the Bayou Hedge Funds.'" Bayou II, 372 B.R. at 665 (quoting defendants' brief below (citing cases holding that defrauded investors are tort creditors)). Ample case law demonstrates that valid tort claims create creditor status at the moment the tort claims accrue. For example, in Drenis v. Haligiannis, 452 F. Supp. 2d 418, 428 (S.D.N.Y. 2006), the court found that limited partners with equity interests in a partnership were also creditors under the New York DCL because "of their [tort] claims against the defrauding defendants": "Under New York's broad definition of 'creditor,' one who has a right to maintain a tort action but has not recovered judgment at the time of the transfer is a creditor and 'it is now accepted that the relationship of debtor and creditor [in tort cases] arises the moment the cause of action accrues.'"*fn10 Drenis, 452 F. Supp. 2d at 428 (internal citations omitted)
Appellants concede that the non-redeemers have legitimate tort claims against the Funds (Sonn. Br. 37 ("each defrauded investor was a creditor to the extent the investor was entitled to rescind his or her investments and demand return of all invested monies or seek damages"); id. at 47 ("as everyone concedes, [non-redeeming investors] had the right prior to the filing of the petitions to pursue claims for damages or rescission"); id. at 58 ("It is undisputed that the investors had the right to pursue legal remedies, including for fraudulent misrepresentation, inducement and/or retention against the Bayou Hedge Funds.")), but contend that under the Bankruptcy Code, the non-redeemers cannot be both equity holders and creditors. The fact that an investor holds an equity interest, however, does not mean that that investor is not also a creditor. IDS Holding Co., LLC v. Madsen (In re IDS Holding Co., LLC), 292 B.R. 233, 238 (Bankr. D. Conn. 2003) (cases "providing that shareholders are equity security holders, not claim holders. . . . do not imply that a shareholder cannot also have a claim against the company in addition to being an equity security holder. 'There is no provision in the Bankruptcy Code that a limited partner with an equity security interest cannot also have an independent claim within the definition of 101(4) arising out of the same instrument.'") (quoting In re St. Charles Pres. Investors, Ltd., 112 B.R. 469, 474 (D.D.C. 1990) (stating that "the definitions of 'creditor' and 'equity security holder' are [not] mutually exclusive")). Appellants cite no law to the contrary.*fn11
Appellants argue, however, that the non-redeemers' tort claims will be subordinated under Section 510(b) of the Bankruptcy Code, and that as a result, the non-redeemers will be stripped of their status as creditors. Section 510(b) provides:
For the purpose of distribution under this title, a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 [11 USCS § 502] on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock.
11 U.S.C. § 510(b) (emphasis added).
Appellants argue that "[t]he first clear, direct effect of subordination to the level of equity holder in an insolvent estate is disallowance of the claim -- not distribution or recovery." (Sonn. Br. 58) As the Bankruptcy Court noted in rejecting this "sweeping" argument, however, it is "utterly without foundation." Bayou II, 372 B.R. at 666. The initial clause of Section 510(b) -- "for the purpose of distribution" -- betrays this provision's meaning and application. While Appellants cite cases (Sonn. Br. 58-60) that generally discuss priority in asset distribution -- and make the unremarkable point that equity holders frequently receive no distribution from an insolvent estate -- none of these cases suggest that subordination under Section 510(b) affects the standing of a creditor to assert claims in the first place.*fn12 Neither Section 510(b) nor the case law applying it suggests that subordination of a creditor's claim converts that claim to an equity interest or results in automatic disallowance of that claim. Section 510(b) "does not operate to reduce or eliminate [claims], but only to ensure that [claimants] receive compensation for their claim on the same basis as the claimants who are on the level to which their claim is subordinated." Kaiser Group Int'l, Inc. v. Pippin (In re Kaiser Group Int'l, Inc.), 326 B.R. 265, 268 (D. Del. 2005); see also 5 Collier on Bankruptcy ¶ 510.02 (15th ed. 2008) ("A creditor whose claim has been subordinated does not cease to be a creditor under the Code [and] continues to enjoy all of the rights of a creditor except to share in the distribution of the estate on parity with the other creditors.").*fn13
While, as the Bankruptcy Court noted, "subordination of a tort claim under Section 510(b) to the level of equity may be said to have the same practical effect as disallowance . . . where there is no value left over [after more senior claims have been paid under the debtor's reorganization or liquidation plan],"*fn14 Bayou II, 372 B.R. at 667, that result does not mean that tort creditors do not have standing to assert a claim. Priority in distribution is irrelevant to standing. Appellants are creditors regardless of how low on the totem pole their claims fall.
III. IN RE SHARP DOES NOT CONTROL THE INSTANT APPEALS
Appellants contend that in Sharp Int'l Corp. v. State Street Bank & Trust Co. (In re Sharp Int'l Corp.), 403 F.3d 43 (2d Cir. 2005), the Second Circuit "stated unequivocally that the fraudulent conveyance laws . . . are inapplicable to those conveyances which constitute 'the repayment of an antecedent debt.'" (CBHSE Br. 24 (quoting In re Sharp Int'l Corp., 403 F.3d at 54); see also Sonn. Br. 32) Appellants further contend that the redemption payments they obtained satisfied a legitimate, pre-existing debt the Bayou Funds owed to them as creditors, and that accordingly "the transfers here are outside the purview of the fraudulent conveyance laws." (CBHSE Br. 29; see also Sonn. Br. 31-39) Because an understanding of the facts and the legal issues presented in Sharp is critical in considering its applicability here, they are discussed in detail below.
In Sharp, debtor Sharp International brought intentional and constructive fraudulent conveyance claims under New York's DCL against its lender, State Street Bank. Sharp's controlling shareholders -- the Spitz brothers -- had falsified sales, inventory and accounts receivable data in order to report fictitious revenue in Sharp's financial records. They then used these fraudulent records to obtain loans from banks and other lenders, including a $20 million line of credit from State Street. Between 1997 and October 1999, the Spitzes looted the fraudulently raised funds as well as Sharp's corporate profits. In re Sharp Int'l Corp., 403 F.3d at 46.
In the summer of 1998, State Street began to suspect fraud, based in large part on Sharp's refusal to comply with certain accounting obligations required by the Sharp/State Street loan agreement, Sharp's purportedly rapid growth, and its "voracious consumption of cash." In October 1998, State Street sought information from Sharp about its largest customers and requested the 1998 work papers of Sharp's outside auditor. The following month, State Street requested a detailed statement listing accounts receivable and cash receipts, and asked Sharp for formal confirmations of the company's accounts receivable (both of which the Spitzes refused to provide). State Street also reviewed activity in Sharp's "demand and deposit" account at State Street "to see if any substantial payments had been made to the Spitzes." On November 18, 1998, State Street received Dun & Bradstreet reports concerning eighteen of Sharp's purported customers. The reports indicated that a number of these alleged customers were not doing business with Sharp. Id. at 47.
Based on this investigation, State Street demanded that Sharp, by March 31, 1999, obtain new financing and use these funds to pay off the amount Sharp had drawn down on its State Street line of credit. Sharp agreed, raised $25 million from unsuspecting investors, and used $12.25 million to pay off the State Street debt. During this period, State Street did not share its concerns about Sharp with anyone, ignored calls from Sharp's noteholders, chose not to exercise its right to foreclose on Sharp's line of credit, and consented to the Company's new indebtedness. Id. at 48.
In July 1999, Sharp's auditor refused to issue a 1999 audit opinion on Sharp and withdrew its 1997 and 1998 audit opinions. In September, Sharp was forced into bankruptcy, and in November 2000, the bankruptcy court entered a $44 million judgment against the Spitzes, who later pleaded guilty to fraud. The judgment remained unsatisfied. Id. at 48.
On May 30, 2001, Sharp brought an adversary proceeding against State Street in bankruptcy court, seeking as damages the amount the Spitzes stole after State Street's alleged discovery of the fraud, as well as the $12.25 million payment State Street received following the new financing. State Street moved to dismiss, arguing, inter alia, that Sharp had failed to state a claim for intentional or constructive fraudulent conveyance. The bankruptcy court dismissed Sharp's complaint, and the district court and the Second Circuit affirmed. Id.
As to intentional (or actual) fraudulent conveyance, Sharp sheds little light on the issues raised in this case. In particular, Sharp does not address the Section 548(c) good faith affirmative defense raised by Appellants. Sharp deals exclusively with provisions of New York's DCL; Section 548(c) was not at issue. Moreover, in affirming the dismissal of the actual fraudulent conveyance claim under DCL § 276, the Circuit acknowledged that where "'actual intent to defraud creditors is proven, the conveyance will be set aside regardless of the adequacy of consideration given.'" Id. at 56 (quoting United States v. McCombs, 30 F.3d 310, 328 (2d Cir. 1994)). Sharp works no change in the law as to actual fraudulent conveyance, and turns on a straightforward pleading issue.
The Second Circuit affirmed the dismissal of Sharp's actual fraudulent conveyance claim because "Sharp inadequately alleges fraud with respect to the transaction that Sharp seeks to void, i.e., Sharp's $12.25 million payment to State Street." Id. at 56. The Circuit noted that the fraud Sharp pleaded in the complaint relates to the manner in which Sharp obtained new funding from Noteholders, not Sharp's subsequent payment of part of the proceeds to State Street. The $12.25 million payment was at most a preference between creditors and did not "hinder, delay, or defraud either present or future creditors." DCL § 276. . . .
Here, the circumstances of Debtors' actual fraudulent conveyance claim could not be more different. The Amended Complaint pleaded, and the Bankruptcy Court found as a matter of law, that the redemption payments at issue were made "[t]o avoid detection of the fraud, to retain existing investors and to lure new investors," and constituted "an integral and essential element of the alleged fraud, necessary to validate the false financials and to avoid disclosure." Bayou II, 372 B.R. at 663;(see also Am Cmplt. ¶¶ 13-14)Because Sharp's complaint failed to plead that the loan repayment was made to "hinder, delay or defraud" Sharp's creditors -- and instead focused on "the manner in which Sharp obtained new funding" -- Sharp failed to make out a prima facie case of actual fraudulent conveyance.*fn15 In re Sharp Int'l Corp., 403 F.3d at 56. The Debtors here, however, specifically pled and demonstrated that the redemption payments hindered, delayed, and defrauded Bayou's creditors, by inter alia, forestalling disclosure of the fraudulent scheme.*fn16 Accordingly, Sharp provides no basis for dismissing Debtors' actual fraudulent conveyance claim.
As to Sharp's constructive fraudulent conveyance claim under DCL §§ 272-75, the Second Circuit's decision focuses on whether Sharp had adequately alleged a lack of "fair consideration" and "good faith" under New York law. In rejecting Sharp's argument that its constructive fraudulent conveyance claim should survive -- because State Street knew of the Spitzes' fraud and Sharp was insolvent when it repaid the loan -- the Second Circuit stated that "bad faith does not appear to be an articulable exception to the broad principle that the 'satisfaction of a pre-existing debt qualifies as fair consideration for a transfer of property.'" Id. at 54 (quoting Pashaian v. Eccelston Props., 88 F.3d 77, 85 (2d Cir. 1996) (interpreting New York law)). Appellants improperly cite language from this section of Sharp -- which has nothing to do with actual fraudulent conveyance under the Bankruptcy Code or with Appellants' good faith affirmative defense under Section 548(c) -- to support their argument that "payments to creditors which satisfy pre-existing debt are outside the purview of the fraudulent conveyance laws even if 'inherently fraudulent.'" (CBHSE Br. 28) Nothing in the Sharp decision indicates that the Court made any such pronouncement as to actual fraudulent conveyance under Section 548. Sharp addresses only the debtor's claims under the New York DCL.
DCL § 272 -- the central provision at issue in Sharp -- provides that [f]air consideration is given for property . . . [w]hen in exchange for such property . . . as a fair equivalent therefor, and in good faith, property is conveyed or an antecedent debt is satisfied. . . .
DCL § 272. The Second Circuit concluded that Sharp had "fail[ed] adequately to allege a lack of 'fair consideration,'" because it had not pleaded facts demonstrating that State Street had acted in bad faith. More specifically, the Second Circuit held that "State Street's knowledge of the Spitzes' fraud, without more, does not allow an inference that State Street received the $12.25 million payment in bad faith." Sharp, 403 F.3d at 53, 56.
While there are similarities between Section 548 of the Bankruptcy Code -- the statute at issue here -- and the New York State fraudulent conveyance statutes at issue in Sharp, there are, as the Second Circuit has recognized, important differences:
Unlike the Bankruptcy Code, [New York's Uniform Fraudulent Conveyance Act, DCL, §§ 270-281] is a set of legal rather than equitable doctrines, whose purpose is not to provide equal distribution of a debtor's estate among creditors, but to aid specific creditors who have been defrauded by the transfer of a debtor's property. Thus, [DCL §§ 270-281] does not bestow a broad power to reorder creditor claims or to invalidate transfers that were made for fair consideration, at least where no actual intent to hinder, delay, or defraud creditors has been shown.
HBE Leasing Corp. v. Frank, 48 F.3d 623, 643 (2d Cir. 1995) (citing Boston Trading Group v. Bunnazos, 835 F.2d 1504, 1508 (1st Cir. 1988)).
Perhaps in recognition of their somewhat different purposes -- protecting creditors versus distributing a bankrupt estate equitably -- the two statutes differ as to pleading and burdens of proof:
Under New York law, the party seeking to have the transfer set aside has the burden of proof on the element of fair consideration and, since it is essential to a finding of fair consideration, good faith. United States v. McCombs, 30 F.3d 310, 326 & n.1 (2d Cir. 1994). The Bankruptcy Code also provides that good faith is relevant in a constructive fraud case, but unlike New York law, § 548(c) of the Bankruptcy Code "designates the transferee's good faith as an affirmative defense which may be raised and proved by the transferee at trial," and the plaintiff need not plead lack of good faith as an element of the claim itself. Gredd v. Bear, Stearns Secs. Corp. (In re Manhattan Inv. Fund, Ltd.), 310 B.R. 500, 508 (Bankr. S.D.N.Y. 2002) [("In re Manhattan Inv. Fund I")].
Silverman v. Actrade Capital, Inc. (In re Actrade Fin. Techs., Ltd.), 337 B.R. 791, 802 (Bankr. S.D.N.Y. 2005).
Accordingly, in Sharp, the debtor -- in order to establish a claim for constructive fraudulent conveyance under New York law -- had the burden of pleading and proving that State Street had received the loan repayment in bad faith. Here, Bayou was not obligated to plead and prove that Appellants had received their redemption payments in bad faith. Instead, Appellants had the ...