Imputation of Fraudulent Intent to Legal Entities: Can One Bad Apple Spoil the Barrel?

How do you show that a legal entity acted with intent to defraud its creditors for purposes of an avoidance action asserted under Bankruptcy Code § 548(a)(1)(A)? After all, legal entities themselves cannot form an intent; they can only act through their officers, directors or agents. In an action to avoid a fraudulent transfer, courts determine the transferring legal entity’s intent by imputing the intent of its agents to the legal entity.

Recently, Judge Craig T. Goldblatt examined whether it would be appropriate to impute the fraudulent intent of one officer, the bad apple, to an entity where the entire board, the barrel, authorized a tender offer and all other officers acted innocently in casting their votes. [1] Ultimately, the court held that the fraudulent intent of the chief executive officer (CEO) would be imputed to the legal entity notwithstanding the innocence of the majority of board members who voted to approve the transaction. [2]

Transaction Background

In June 2020, a cyber-fraud prevention company used $72 million in new investor funds to purchase outstanding stock from existing shareholders. [3] As part of raising these funds, the founder and CEO fabricated business records and drastically inflated revenue to defraud investors. [4] The board of directors for the company voted to approve the tender offer, as they too were deceived by the CEO’s falsified inflated financial statements. [5]

Procedural Background

After discovering the CEO’s fraud, in October 2020, the company filed a voluntary chapter 11 petition. [6] Eventually a litigation trustee was appointed and initiated an avoidance action to recover the $72 million the company paid in exchange for the outstanding stock and argued that the purpose of the transaction was to defraud the investors. [7] In pertinent part, the defendants argued that the CEO’s fraudulent intent could not be imputed to the company because a majority of the board of directors lacked any fraudulent intent when they voted to approve the transaction. [8]

Analysis

Within the Third Circuit, federal courts look to the law of the state of incorporation when deciding whether to impute the intent of an individual to a corporation. [9] Under Delaware law, the intent of a transaction that requires board approval turns on the intent of a majority of the company’s board. [10] Here, Judge Goldblatt canvassed recent opinions on Delaware law and neatly summarized the key takeaway: when “asked to determine whether an individual’s intent should be imputed to a legal entity for the purpose of deciding whether someone’s improper motive infected a corporate action, the touchstone of the analysis is ultimately a question of causation. [11]

One person’s control over an entire board can justify attributing that person’s intent to the rest of the board. [12] Although deception can be a means of exercising control, if it is too remote then it cannot permit the imputation of fraudulent intent from one bad actor to other board members. [13]

In some instances, an intervening event will cut off a bad actor’s malintent from imputation to innocent board members. [14] For example, where a sole member relies on a law firm’s opinion such that the bad faith of a different law firm’s opinion cannot be causally connected to the challenged decision, the causation element is lacking, because the connection between the bad faith and the decision is too attenuated. [15] This is because the second law firm’s opinion severed the causal connection between bad faith and the sole member’s decision. [16]

Here, the ultimate question facing the court was whether the cause of the debtor’s decision was the CEO’s fraud, or the independent decision reached by the innocent board members. [17] The court concluded that the board’s decision to approve the tender offer was the direct and intended outcome of the CEO’s fraud and even went so far as to label the CEO’s fraud as the “sine qua non of the tender offer” before holding that the CEO’s intent to hinder, delay or defraud creditors would be imputed to the debtor. [18]

In explaining its reasoning, the court emphasized that the CEO had sole access to the debtor’s accounts, which showed that the debtor was deeply insolvent (in sharp contrast to the falsified financial information the CEO shared with other board members and investors), and that the line between the CEO’s intent to defraud creditors and the debtor’s decision to purchase its shares in the tender offer was “as straight as an arrow. [19] The CEO used deceit to exercise control over the majority of board members, therefore the CEO’s intent to defraud creditors could be imputed to the company. [20]

The CEO’s fraud was the direct cause of the company’s tender offer, and the innocent board members’ involvement in approving the tender offer did not sever the causal nexus between the CEO’s fraud and company’s action. [21] After imputing the CEO’s fraudulent intent to the debtor, the court granted summary judgment in favor of the litigation trustee. [22] On these facts, the fraudulent intent of the bad apple spoiled the barrel and justified the imputation of the CEO’s intent to the company, notwithstanding the innocence of other board members who voted to approve the tender offer.