Restructuring

Contributed by Laura Napoli
It is not often we report on a case from North Dakota, but this one caught our eye.  In PW Enterprises, Inc. v. North Dakota (In re Racing Services, Inc.), No. 06-7020, 2012 WL 5193775 (Bankr. D.N.D. Oct. 19, 2012), the United States Bankruptcy Court for the District of North Dakota examined whether a debtor’s payment of taxes owed by a third party could be challenged as a fraudulent transfer on the ground that the debtor did not receive reasonably equivalent value for the transfer because it was not the responsible taxpayer.   
Background
Debtor RSI provided simulcasting services to Team Makers, the operator of an off-track pari-mutuel wagering pool.  Pari-mutuel wagering is a type of betting where betters wager against other betters rather than the house.  The payoff odds are determined by the amount wagered on each participant in the race.  The operator of a pari-mutuel wagering system profits by retaining a percentage commission of the total amount wagered.  Team Makers, with RSI’s assistance, offered telephone and online horse betting.  The State of North Dakota collected tax revenue derived from all pari-mutuel racing authorized by the State.  Under North Dakota law, simulcast service providers, such as debtor RSI, were required to be separate entities from simulcast operators, such as Team Makers, but only simulcast operators were responsible for paying taxes to the North Dakota Racing Commission.
Notwithstanding Team Makers’ obligation to pay the taxes, RSI and Team Makers entered into an agreement where RSI assumed the responsibility for making the designated disbursements to the State and regulatory agencies.  Although the legal responsibility for paying the taxes remained with Team Makers, no prohibition existed against RSI actually making the payments.  In each of RSI’s annual license renewal applications to the State, RSI explicitly stated that it was contractually responsible for payment of taxes and fees.
In 1999, PW Enterprises began using RSI’s services to place daily wagers.  The relationship was a good one at first, until the events of September 11, 2001 caused a slowdown in the racing industry.  Shortly thereafter, RSI began asking the State for 30-day extensions for its payments.  The State’s Racing Commission continuously voted to approve these late payments until it learned that RSI had been operating an unlicensed wagering site.  Upon learning about this site, the Racing Commission threatened to take action on RSI’s license unless RSI immediately paid what it owed.  PWE also became concerned about RSI’s financial condition and stopped wagering through RSI.  In July of 2003, PWE demanded approximately $2 million of its money from RSI.
PWE initially worked with the State to get RSI back on its feet so that it could recover its money.  With PWE’s approval, however, the State appointed a receiver for RSI.  Further, without PWE’s knowledge, the State began to extract payments from RSI, even going so far as to draw on a letter of credit from PWE to RSI.  When RSI filed for bankruptcy in 2004, the State had collected over $5 million from RSI in the year prior to its filing, but PWE had collected nothing.  Both PWE and the State filed proofs of claim in RSI’s bankruptcy case.
PWE’s Preference Claims
PWE claimed that RSI’s payments to the State in the year leading up to the bankruptcy were recoverable as preferential transfers.  Pointing to the level of control the State had exerted over RSI in extracting funds, PWE argued that the State should be considered an “insider” of RSI under section 547(b) of the Bankruptcy Code.  Although the State did not fit into any of the nonexclusive categories of an “insider” laid out in section 101(31)(B), the court turned to case law to determine whether the State could fit under any other definition of an “insider.” 
An overview of the cases led the court to conclude that an insider is one who does not deal at arm’s length with the debtor and who exerts control over the debtor.  PWE argued that the State, as a regulator, controlled every aspect of RSI’s operations.  The State could inspect and audit RSI and could revoke RSI’s license in the event of a violation.  Yet, the court found that this sort of control was too general to render the State an insider of RSI.  Instead, the court focused on whether the State had more ability to assert control than other creditors.  Here, although the State had asserted some control over RSI, there was no evidence that the State had made RSI’s management decisions, directed its work performance, or directed payments of RSI’s expenses.  Although the State had demanded payments from RSI, the court noted that those demands related to transactions in which the State was directly involved.  Thus, they were not a reflection of day-to-day control.  For these reasons, the court concluded that the State did not wield enough control over RSI to render it an insider.
The court also found that the State’s transactions with RSI were at arm’s length.  Applying a test articulated by the Third Circuit in Schubert v. Lucent Tech., Inc. (In re Winstar Commc’ns, Inc.), 554 F.3d 382 (3d Cir. 2009), the court asked whether the State had the ability to coerce RSI into transactions that were not in RSI’s best interest.  Contrary to PWE’s arguments, the court found that the State wanted to keep RSI operating so that both it and PWE could get paid.  Further, during the receivership, only the receiver had control of RSI.  Because PWE had not shown that the State had the requisite control over RSI or that it had engaged in less than arm’s length transactions, the court concluded that the State was not an insider.
Because the State was not an insider, the court looked back only 90 days prior to the bankruptcy to determine whether RSI’s payments to the State were preferential transfers.  As to the 90-day period, a debtor’s payment to a creditor with a priority claim is not a preference if the creditor would have received the same distribution in a chapter 7 liquidation.  The court concluded that PWE had not shown that the State would not be entitled to payment of the amount of the contested transfers as a priority claim in a liquidation, so the court concluded that no preference was recoverable.
PWE’s Fraudulent Transfer Claims
Turning next to PWE’s fraudulent transfer claims under section 548(a)(1)(B) of the Bankruptcy Code, the court focused on whether RSI had received reasonably equivalent value for the transfers to the State.  To make this determination, the court applied a three part test, considering whether: (1) value was given; (2) in exchange for the transfer; and (3) what was transferred was reasonably equivalent to what was received.  PWE argued that RSI did not receive reasonably equivalent value for the taxes it had paid to the State because Team Makers, not RSI, was actually responsible for those taxes under North Dakota law.  Because RSI did not owe the taxes itself, PWE argued that the transfers could not be in satisfaction of RSI’s debt.
Notwithstanding PWE’s argument, the court concluded that RSI did receive value for the transfers.  Because they allowed RSI to continue operating, RSI’s payments to the State resulted in an economic benefit to RSI even though it was not legally responsible for the taxes.  The court further concluded that RSI’s payment of the taxes was an essential term and condition of its simulcast service provider license, which RSI submitted to the State every year and which the State had the power to revoke.  Because RSI’s payments to the State reduced the tax liability dollar-for-dollar, the court concluded that they did constitute reasonably equivalent value.
The District of North Dakota’s flexible approach to “reasonably equivalent value” resulted in the State retaining the tax payments.