A Fraudulent Transfer may be the Result of a Breach of Fiduciary Duties

John Hayes

St. John’s University School of Law

American Bankruptcy Law Review Staff

            Under section 548 of title 11 of the United States Code (the “Bankruptcy Code”), a trustee may avoid any transfer or obligation incurred if the debtor had actual intent to hinder, delay, or defraud creditors.[1]  A fraudulent transfer may be the result of self-dealing and a breach of fiduciary duties.[2]  In In re TransCare Corporation, the United States Court of Appeals for the Second Circuit affirmed the bankruptcy and district courts’ findings that Lynn Tilton—the sole director and indirect owner of TransCare Corp.— engaged in an actual fraudulent transfer and breached her fiduciary duties under Delaware law.[3]  TransCare is a Delaware corporation headquartered in New York that provides hospitals with ambulance and paratransit services.[4]  Tilton owned 61% of TransCare and maintained control over its significant financial and operational decisions.[5]  After experiencing financial difficulties, a major creditor of TransCare issued a notice of non-renewal and pressured TransCare to liquidate.[6]  Despite receiving several offers to sell certain assets and contracts, that Tilton never pursued, Tilton devised the “Tilton Plan,” pursuant to which TransCare would be split into two entities: “NewCo'' and “OldCo.”[7]  To create NewCo, Tilton directed Patriarch Partners Agency Services (“PPAS”)—a company that acted as an agent for certain TransCare creditors and under Tilton’s control—to foreclose on TransCare’s most profitable sectors.[8]  PPAS would then sell those assets to Tilton affiliates.[9]  Following the sale, OldCo would retain the remaining TransCare assets and file for relief under Chapter 7 of the Bankruptcy Code.[10]  Not long after TransCare filed for bankruptcy, the Trustee of the TransCare estate discovered that NewCo had foreclosed on all of TransCare’s physical assets and TransCare could not meet its payroll obligations.[11]  After the Trustee refused to provide NewCo with TransCare’s computer server, Tilton transferred the assets back to the TransCare Estate where they were liquidated by TransCare’s Trustee.[12]  The Trustee filed a complaint in the Bankruptcy Court for the Southern District of New York alleging that Tilton breached her fiduciary duty to TransCare by engaging in a self-interested transaction and the foreclosure on TransCare’s assets was an actual fraudulent conveyance.[13]  The bankruptcy court held that Tilton engaged in an actual fraudulent conveyance and recommended that the district court find Tilton breached her fiduciary duties.[14]  On Tilton’s appeal, the Southern District of New York affirmed the bankruptcy court’s ruling that Tilton was liable for a fraudulent transfer and adopted the bankruptcy court’s recommendation that Tilton breached her fiduciary duties.[15]

            On a subsequent appeal by Tilton, the United States Court of Appeals for the Second Circuit affirmed the district court’s finding that Tilton breached her fiduciary duty under Delaware law, which was applicable because TransCare was incorporated in Delaware.[16]  Under Delaware law, Tilton owed a duty of loyalty to TransCare.[17]  According to the Circuit Court, Tilton violated that duty because the Tilton Plan was a self-interested transaction that failed to demonstrate fair dealing or fair price.[18]  In terms of fair dealing, the Second Circuit affirmed the district court’s finding that Tilton “presented no evidence of true arm's-length bargaining designed to protect the interests of the company and/or the minority shareholders.”[19]  Furthermore, Tilton did not present evidence that she considered alternatives other than selling the profitable TransCare assets to herself.[20]  Regarding fair price, the Second Circuit found Tilton’s valuation method of NewCo neglected the “highest value reasonably available under the circumstances.”[21]  Although Tilton’s $10 million purchase price was based on the book value of TransCare’s assets, this methodology failed to account for the value of the business as a going concern and its liquidation value had TransCare not been severed into OldCo and NewCo.[22]

            In addition, the Second Circuit affirmed the ruling that Tilton engaged in an actual fraudulent conveyance.[23]  Because Tilton’s transfer of TransCare’s assets to NewCo was undisputed, the key issue was whether the Trustee satisfied his burden to prove Tilton’s actual intent to hinder, delay, or defraud creditors.[24]  In making this determination, courts analyze “badges of fraud,” which are factors that typically evidence an intent to hinder, delay, or defraud.[25]  In this instance, the Second Circuit agreed with the lower courts’ conclusion that the transaction bore all of the badges of fraud, including a close relationship between the parties in the transaction, lack of consideration, and the retention of possession.[26]

            Under Delaware law, directors and majority shareholders owe a duty of loyalty to their corporation.[27]  When a fiduciary violates that duty by selling certain parts of the corporation to themselves and having the remainder file for bankruptcy, it may also constitute an actual fraudulent conveyance under bankruptcy law.[28]  For an actual fraudulent conveyance claim, a court will generally consider the badges of fraud to ascertain the fiduciary’s intent to hinder, delay, or defraud creditors because a “transferor rarely admits her own fraudulent intent.”[29]  Importantly, the Second Circuit joins the Fourth, Fifth, Eighth, and Ninth circuit in holding that review of fraudulent transfer decisions apply the clear error standard of review unless the finding is based on legal error.[30]