Restructuring

Contributed by Andrea Saavedra
In the civil fraud context, Rule 9 of the Federal Rules of Civil Procedures requires a complaint to set forth with sufficient particularity facts regarding the alleged fraud so as to apprise a defendant fairly of the charges asserted.  Outside of the fraud context, the pleading standards of the FRCP historically have been fairly liberal, permitting a court, when faced with a motion to dismiss, to draw all factual inferences in favor of the plaintiff.  In Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007), however, the Supreme Court heightened the pleading requirement for ordinary civil claims, requiring plaintiffs to include factual allegations in their complaint to make it plausible – not merely possible or conceivable – for the court to find liability.  As a result, Twombly narrowed the gap between the standards for pleading both fraud and non-fraud causes of action.  Two recent bankruptcy court decisions highlight a paradox in pleading avoidance actions in a chapter 11 case under these standards.  In the first, the bankruptcy judge declined to dismiss a fraudulent transfer claim pleading actual fraud in a Ponzi scheme case, reasoning that the complaint sufficiently plead elements of that cause of action.  In the second, the bankruptcy judge granted a motion to dismiss a fraudulent transfer claim pleading constructive fraud, finding plaintiffs’ allegations relating to value implausible in light of the record developed previously in the main bankruptcy case.  Because the trier of fact – the bankruptcy judge – already is very familiar with the financial circumstances of the debtor and will have a keen sense of which factual allegations are “plausible” and which are not, in some cases alleging the elements of a constructive fraudulent transfer may be more challenging than alleging an actual fraud.
The first case on point is In re DBSI, Inc., et al. (Zazzali v. Swenson, et al.) (Case No. 09-12687) (Adv. Proc. No. 10-54649) (PJW) (May 5, 2011) (“Zazzali”).  In Zazzali, Judge Walsh in Delaware denied a defendant’s motion to dismiss avoidance claims based on actual fraud.  Specifically, the defendant argued that the complaint was deficient because it failed to allege that the specific transfers at issue were made by the debtor with actual intent to defraud creditors.  The trustee responded that, in the actually fraudulent transfer context, the complaint was sufficiently particular because he alleged that six commonly accepted “badges of fraud” surrounded the contested transfers at issue and the debtor’s business was a Ponzi scheme.  Indeed, the trustee asserted that fraudulent intent could be presumed as a matter of law given the mere allegation of a Ponzi scheme.  The defendant countered that there had to be an actual finding of a Ponzi scheme by the court in order for the complaint to meet the particularity standard.  The court disagreed, noting that Rule 9’s requirements “are relaxed in the bankruptcy context,” particularly in cases like Zazalli where a chapter 11 trustee had been appointed.  Because the complaint painted a full picture of the defendant’s alleged “broad and sweeping” fraudulent scheme (including reliance on the report of the court-appointed examiner), the court concluded that the defendant was fully apprised of the allegations asserted against him.
Contrast Zazzali with Liquidation Trust v. Daimler AG (In re: Old Carco LLC (f/k/a Chrysler LLC), Chapter 11 Case No. 09-50002, Adv. No. 09-00505 (AJG) (May 12, 2011) , a case involving claims alleging constructive fraudulent transfers.  In Old CarCo, Judge Gonzalez of the Southern District of New York dismissed, for the second time (and this time with prejudice), the Chrysler liquidating trust’s complaint to recover purportedly constructively fraudulent transfers made by the debtor to its former owner, Daimler in connection with Daimler’s sale of its controlling interest in the Chrysler entities to Cerberus Capital Management LP on the grounds that Chrysler did not receive reasonably equivalent value in exchange for the assets that it contributed to the sale.  Specifically, as part of the sale, Chrysler transferred its interest in the financial services business to Daimler.  At the time of the sale, Daimler received a valuation opinion from Houlihan Lokey Howard & Zukin Financial Advisors, Inc. as to the value of the consideration given to Chrysler in exchange for the financial services business.  Houlihan Lokey valued that business at $7.95 billion.  On the other side of the ledger, Houlihan valued the stock given to Chrysler in another affiliate, which managed the distribution and sales of Chrysler’s cars (“Motors”), at $5.5 billion, plus a $1.225 billion note from the financial services company for a total asset value of $6.725 million.  At the conclusion of Daimler’s sale marketing efforts, Cerberus emerged as the winning bidder.  As part of its purchase agreement, Cerberus made an equity contribution to the Chrysler companies of $7.2 billion, of which $3.45 billion was contributed to Chrysler as equity.  In addition, Cerberus obtained $12 billion of new debt financing for the Chrysler companies.  Chrysler also received a litany of other benefits noted by the court, which were equal to another $4 billion in value.
Despite this record showing far more value going into Chrysler than coming out, the trust asserted that Chrysler received $1.695 billion less than the value of the assets that it gave in the transaction.  The crux of the trust’s argument was that a sales and distribution agreement between Chrysler and Motors, which was Motors’ most valuable contract, could have been terminated by Chrysler on six months’ notice.  As a result, the liquidating trust alleged that the value of the Motors’ stock that Chrysler received in the transaction was not $5.5 billion, but merely just $450 million.
The facts regarding the sale were of particular significance to the court in assessing whether the complaint plead, as required under Twombly, a “plausible” theory of recovery.  The court not only considered the allegations in the complaint, but also the exhibits attached thereto or incorporated by reference; “matters subject to judicial notice” (i.e., essentially everything that was of public record in the chapter 11); and also any document upon which the plaintiff had notice of and relied upon in bringing the claim.
Reviewing the factual record and the allegations in the complaint, the court found the trust’s argument to be completely implausible as a theory of recovery.  First, the court dismissed as implausible the theory that Motors should be valued at only $450 million because (i) the trust completely failed to take into account the billions of dollars of value, including a large vehicle and parts inventory, as well as property, plant and equipment, and operating leases and (ii) its theory of an immediate termination of the supply and distribution agreement was highly unlikely.  The court also dismissed as absurd the trust’s argument that Chrysler could easily have terminated its relationship with Motors without major disruptive effect on the enterprise. Second, the court reasoned that the liquidating trust failed to take into account the substantial benefits accrued to Chrysler as a result of (i) access to the additional credit facilities secured by Cerberus and (ii) the substantial equity infusion provided by Cerberus.  The court further noted that Chrysler had received substantial tax benefits through the transaction and that Daimler and Chrysler entered into forty-nine ancillary agreements – most of which were established to have value in the bankruptcy case as they were assumed by the reorganized debtor.  The court further noted that the trust completely failed to consider other elements of value, including (i) a $920 million intercompany debt that was repaid to Chrysler, (ii) transfer of national sales companies and their related $1 billion in inventory to Chrysler, and (iii) Daimler’s guarantee of $1 billion of Chrysler’s pension obligations.  The court also disagreed that Chrysler did not receive market value for the sale of its headquarters property to a Cerberus subsidiary as part of the sale where the contemporaneous valuations of the property were commensurate with the price paid.  Finding that the allegations in the trust’s complaint were “implausible as a general matter”, the court dismissed it with prejudice.
Practitioners can cull two rules of conduct from these decisions.  First, when litigating a case in front of the same court that has presided over the debtor’s bankruptcy case, be cautious to not assert claims that are simply implausible in light of the public record.  While the wave of failures in the past few years have left a number of creditor constituencies out of the money, avoidance actions must be carefully considered before being prosecuted as a bankruptcy court – acting as both judge and jury – may not allow any far flung (even if creative) theory to get to trial, let alone survive a motion to dismiss, when its “judicial experience and common sense” tells it otherwise.  Second, when pleading actual fraud and fraud is already at issue in the debtor’s bankruptcy case, you may not have to belabor its existence to survive a motion to dismiss.  After all, the judge knows the story all too well.