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Article: September 2017: Bankruptcy & Restructuring Litigation Update

Business Litigation Reports

Ninth Circuit Holds That a Shareholder Can Be Liable for an Actual Fraudulent Transfer When Its Wholly-Owned Corporation Transfers Assets Even Absent a Showing of Alter Ego. On July 11, 2017, the Ninth Circuit in DZ Bank AG Deutsche Zentral-Genossenschaft Bank v. Meyer, No. 15-35086, 2017 WL 2954611 (9th Cir. Jul. 11, 2017), issued a short but nonetheless important decision concerning shareholder liability for fraudulent transfers when wholly-owned subsidiaries transfer assets. The decision not only finds liability at the shareholder level, but also holds that a shareholder can be liable even without a showing of alter ego or the shareholder holding legal title to the assets. DZ Bank will likely embolden creditors and bankruptcy estates to challenge a wider array of fraudulent transfers and should give pause to companies (and their directors and officers) facing insolvency on structuring asset transfers at subsidiaries that they control.

In DZ Bank, two individuals (a husband and wife) owed a lender approximately $1.73 million evidenced by a promissory note. Prior to defaulting on the note, the individuals “executed an elaborate series of transfers and sales to place their assets beyond the reach of their creditors.” 2017 WL 2954611 at *1. These transfers and sales all were undertaken by subsidiaries wholly-owned by one of the individuals. Specifically, a wholly-owned insurance company transferred assets, valued at $123,000, to another company the individual owned. That second company, which then held $385,000 in assets, transferred all of its assets to a third company under the individual’s control, for no consideration. That third company then “agreed to pay the $385,000 back to Meyer, personally, over time.” Id. The opinion does not identify any facts regarding this third company, including whether it had the ability to perform on the agreement to pay the $385,000 to the individual.
The individuals then filed for personal bankruptcy. The lender asserted that the $385,000 transferred out of the second company to the third company was actually fraudulent pursuant to the State of Washington’s version of the Uniform Fraudulent Transfer Act and, as a result, the debt owed to the lender was not dischargeable under 11 U.S.C. § 523(a)(2)(A). Id.

The bankruptcy court found for the lender, but only to the extent of the $123,000 that was first transferred because that was the amount traceable to the lender’s security interests. The district court affirmed, but on different grounds: that the lender could only avoid transfers of assets titled in the individual’s name. Since the assets were legally titled in the second company’s name, and the lender had not alleged alter ego, the lender could not recover the full amount transferred.

The Ninth Circuit reversed on all grounds, concluding that the entire $385,000 was subject to avoidance as an actual fraudulent transfer. The court stated: “If [the second company] had retained the $385,000 in assets, DZ Bank would have been able to enforce any judgment against the Meyers, prior to their filing for bankruptcy protection, by executing against Louis Meyer’s 100% ownership interest in the [second company] to satisfy $385,000 of its claim.” Id. at *2. The court continued, “His shares [in the second company] became worthless as a result of his actions as [the second company’s] sole owner and shareholder, while, even after filing for bankruptcy, he continued to receive payments from [the third company].” Id.

DZ Bank stands for three important legal principles, at least one of which may go beyond any existing federal court precedent. First, a debtor makes a fraudulent transfer even if it does not transfer assets titled in the debtor’s name, as long as the debtor indirectly owns the asset. See id.

Second, DZ Bank extended its first principle to the circumstance where a debtor’s wholly-owned subsidiary is transferring the assets the subsidiary clearly owns, which may be the first circuit-level authority so holding. For support, the Ninth Circuit cited with favor three cases, Wiand v. Lee, 753 F.3d 1194 (11th Cir. 2014), Reilly v. Antonello, 852 N.W.2d 694 (Minn. App. Ct. 2014), and In re Nickerson, 2014 WL 6686524 (Bankr. D.S.D. Nov. 25, 2014). Wiand concerned a SEC receiver appointed for several corporations seeking to recover false profits an investor received in a Ponzi scheme; in Wiand the transfers were made by corporations to the Ponzi scheme orchestrator, who then made transfers to investors. The Eleventh Circuit held that the element of “a conveyance of property which could have been applicable to the payment of the debt due” was “established because the funds that Nadel controlled and transferred to investors could have been applied by him to pay the debt he owed to the receivership entities as a result of his use of funds to perpetrate a Ponzi scheme. With each transfer that Nadel made, Nadel became a debtor of the receivership entities because he diverted the funds from their lawful purpose in violation of his fiduciary duties and was thus obligated to return those same funds to the entities to be used for the benefit of the investors. Therefore, with each transfer, Nadel diverted property that he controlled and that could have been applicable to the debt due, namely, the very funds being transferred.” Wiand, 753 F.3d at 1203.

Reilly and Nickerson involved a slightly different fact pattern—in each case, the debtor caused its wholly-owned subsidiary to issue more stock so as to dilute its ownership, see DZ Bank, 2017 WL 2954611 at *2, which is more closely connected to the debtor because of the debtor’s clear ownership interest in the existing stock. Thus, the Ninth Circuit arguably went further than the precedent it favorably cited to a more expansive universe of transfers. Instead of dilution of stock owned by a debtor, or transfers involving a Ponzi scheme, a subsidiary’s transfers could be avoided as actually fraudulent solely because its sole shareholder directed it.

Third, though it did not provide any specific analysis, the DZ Bank opinion unambiguously holds that there was no requirement to prove alter ego in order to avoid as an actual fraudulent transfer a transfer that was not actually made by the debtor but rather was made “indirectly” by the debtor through a corporation wholly-owned by the debtor. DZ Bank, 2017 WL 2954611 at *1 (expressly disagreeing with the district court’s holding that the UFTA required the lender to obtain a ruling that the subsidiary was the alter ego of the debtor).

DZ Bank may ultimately have limited application by covering only actual fraudulent transfer cases involving transfers by wholly-owned subsidiaries. Actual fraudulent transfers are far more difficult to establish than constructive fraudulent transfers. But the court’s holdings arguably should apply with equal force to constructive fraudulent transfers, which are much more commonly pursued in bankruptcy cases. The UFTA does not treat differently what is a transfer solely because it is an actual fraudulent transfer. If DZ Bank does extend to constructive fraudulent transfer claims, such claims do not require a showing of intentional misconduct but a showing that the debtor (not the wholly-owned subsidiary) received less than reasonably equivalent value at a time that the debtor (not the wholly-owned subsidiary) was insolvent or had less than reasonable capital to operate. Even if DZ Bank is limited to actual fraudulent transfers, the elimination of a need to show alter ego will make it easier to challenge transfers by a wholly-owned subsidiary as actual fraudulent transfers. Finally, left unanswered is whether the rulings in DZ Bank apply in a circumstance where a debtor-shareholder controls the actions of a company, but is neither an alter ego nor its sole shareholder. No doubt this is fertile ground for additional litigation.