Sixth Circuit Addresses Discovery Rule for Fraudulent Transfer Claims

June 29, 2017

Daniel M. Anderson
Ice Miller LLP; Columbus, Ohio

 

In a recent decision, the U.S. Court of Appeals for the Sixth Circuit found itself “obliged to explore some uncharted territory of Ohio substantive and procedural jurisprudence” arising out of fraudulent transfer and related claims from a Ponzi scheme.

In Bash v. Textron Financial Corp. (In re Fair Finance Co.), the court decided a number of issues arising under Ohio law. First, it ruled on whether the refinancing of a debt was a novation such that a transfer occurred for purposes of the Uniform Fraudulent Transfer Act (UFTA). Second, it determined whether the discovery rule created by § 9 of the UFTA, triggered by knowledge of the transfer or by knowledge of the circumstances, makes the transfer potentially fraudulent. Third, it decided whether the court should adopt the Second Circuit’s Wagoner rule, or whether wrongdoing by the debtor’s principals should be addressed under the affirmative defense of in pari delicto. Finally, in applying the in pari delicto defense, the court determined whether Ohio would recognize the “innocent insider” rule.

In Bash, the debtor had undergone a leveraged buyout in 2002 that was financed by Textron. By 2003, the new owners were running the company as a Ponzi scheme. In 2004, Textron refinanced the debt. In 2009, the FBI raided the debtor, and its principals were indicted and eventually convicted.

The trustee brought claims against Textron for aiding and abetting, conspiracy, avoidance of actual and constructive fraudulent transfers, equitable subordination, and disallowance of claims. The district court granted a Rule 12(b)(6) motion to dismiss, but the Sixth Circuit reversed.

The Fraudulent Transfer Claims

The court was confronted with two primary questions regarding the fraudulent transfer claims. First, the court had to determine whether the liens granted in connection with the 2004 refinancing were a mere continuation of those granted in 2002, such that there was no transfer in 2004, or whether they separate and distinct from the 2002 liens. Second, it had to decide whether the discovery rule saved the UFTA claim from the statute of limitations.

Was There a Transfer?

Textron first argued that there was no “transfer” because UFTA permits the avoidance of a “transfer” of an “asset,” but excludes from the definition of “asset” any property to the extent it is subject to a valid lien. This meant that the trustee, in order to survive dismissal, had to plausibly allege that the 2004 security interests were newly granted. Textron argued that the 2004 security interests were merely a refinancing of the 2002 loan, but the Sixth Circuit held that the complaint plausibly alleged that the 2004 agreement was a novation of the 2002 agreement such that the 2002 lien was cancelled and replaced by the 2004 lien, so that dismissal as a matter of law was inappropriate. The court found that the documents were ambiguous, and that the circumstances of the 2004 agreement meant that the trustee had plausibly alleged that the debtor had transferred a security interest in assets no longer encumbered by a valid lien, and therefore there was a “transfer” for purposes of the Ohio UFTA. The court further found that the trustee had plausibly alleged that Textron made the transfers in the course of an effort to perpetuate a Ponzi scheme that had started by the end of 2003 and therefore were made with the intent to hinder, delay or defraud creditors as a matter of law.

How to Apply UFTA § 9’s Discovery Rule

The court then considered whether the action was timely filed. Under § 9(a) of UFTA, a claim for an intentional fraudulent transfer must be brought within four years of the date of the transfer or, if later, within one year after the transfer “was or could reasonably have been discovered by the claimant.” Because the transfer itself was a matter of public record, although its fraudulent nature would not become apparent until the Ponzi scheme was uncovered, the court had to determine whether the requirement of reasonable discoverability applied only to the transfer itself, or to the fraudulent nature of the transfer.

The Sixth Circuit was confronted with the fact that no Ohio court had addressed whether or not the one-year period runs from when the transfer was (or reasonably could have been) discovered. The court thus had to make an “Erie guess” regarding how the Ohio Supreme Court would rule. Drawing from the principles underlying Ohio’s general discovery rule and UFTA decisions from other states, the court ruled that the one-year period did not start to run until the fraudulent nature of the transfer was or reasonably could have been discovered.

Rejection of the Wagoner Rule

With respect to the civil conspiracy claim, the court had to determine several issues arising out of the fact that the debtor’s principals were involved in the misconduct. Textron relied upon Shearson Lehman Hutton Inc. v. Wagoner, 944 F.2d 114, 120 (2d Cir. 1991), which holds that where a bankrupt corporation has joined with a third party in defrauding its creditors, its trustee cannot recover against the third party for damage done to the creditors. The court rejected Wagoner, holding that it conflates the in pari delicto defense with the standing inquiry.

In Pari Delicto

Having held that the debtor’s own involvement in the fraud should be addressed under the affirmative defense of in pari delicto, the court then considered that defense. The court noted that the imputation of knowledge and conduct of agents to the principal is governed by Ohio law, under which the agent’s knowledge and conduct will not be imputed if the agent “is engaged in committing an independent fraudulent act on his own account, and the facts to be imputed relate to this fraudulent act.” This is known as the “adverse interest” exception.

However, the adverse interest exception has an exception: the “sole actor” doctrine. Under this doctrine, if the agents responsible for the adverse conduct are the officers or directors of the principal and those officers or agents “so dominated and controlled the [principal] that the [principal] had no separate mind, will, or existence of its own,” then the officers and directors are deemed the “alter egos” of the principal, and “any malfeasance on their parts is directly attributable to the [principal].”

However (as if this were not sufficiently confusing already), the sole-actor exception has its own exception: the “innocent insider” corollary. If an innocent person inside the corporation had the power to stop the fraud, the agent and the company are not mere alter egos, so the sole-actor rule cannot apply. Since no Ohio court had addressed the “innocent insider” corollary, the Sixth Circuit was required to make another “Erie guess.” The court held that Ohio would adopt the “innocent insider” corollary because it further serves the logic underpinning the imputation rules lying at the heart of the in pari delicto doctrine.

 

This article was originally published in the May 2017 edition of the Commercial Fraud Committee Newsletter. Participation in ABI's committees is one of the many benefits of becoming a member.  Committees provide networking and leadership opportunities.  For additional information on how you could become involved in ABI and our Committees please visit membership.abi.org 

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