In re SGK, a recent case out of the Bankruptcy Court for the Northern District of Illinois, touches upon a number of frequent and favorite topics here at the Weil Bankruptcy Blog, including fraudulent transfer, recharacterization and equitable subordination. In this, the first of a two-part post on In re SGK, we will examine the court’s treatment of the alleged fraudulent transfer claims.
Before its chapter 11 filing in 2013 and before changing its name to SGK Ventures, Keywell, LLC was a metal scrap processing and recycling business focusing on stainless steel, titanium and high temperature metal alloys. The profitability of Keywell’s primary business – stainless steel – was highly dependent on the commodity price of nickel and monthly sales volumes. Keywell chose not to hedge its exposure to the price of nickel and instead focused on rapid inventory turnover. When nickel prices were rising, Keywell was very profitable. Keywell struggled, though, when nickel prices experienced rapid or prolonged decline.
From 2006 through 2013, Keywell experienced both boom and bust. During the boom, Keywell made large distributions to its equity owners, including approximately $40 million in 2007 and an additional $29 million in 2008. During the bust, which started shortly after the 2008 distribution, Keywell took out loans from those same equity owners to support the business (more on these to come in part two). To increase recoveries to creditors in Keywell’s bankruptcy case, Keywell’s liquidating trustee filed suit against, among others, Keywell’s equity owners in connection with these transactions. Among other causes of action, the liquidating trustee for Keywell sought to (1) avoid the 2007 and 2008 distributions to Keywell’s equity owners as actual and constructive fraudulent transfers under state law, (2) recharacterize the loans from Keywell’s equity owners as equity instead of debt, and (3) equitably subordinate the loan claims to those of Keywell’s unsecured creditors.
Applicable Law for Fraudulent Transfer
In addition to section 548 of the Bankruptcy Code, debtors, or their liquidating trusts, have another avenue through which to bring fraudulent transfer causes of action. Section 544(b)(1) of the Bankruptcy Code allows the debtor to avoid prepetition transfers that would be avoidable by an unsecured creditor under applicable state law, which, in this case, means the Uniform Fraudulent Transfer Act (“UFTA”) as adopted and codified by Illinois.
Like section 548 of the Bankruptcy Code, the UFTA includes causes of action for both actual and constructive fraudulent transfer. The UFTA, unlike section 548, includes two separate actions for constructive fraudulent transfer – one that can be brought by existing or future creditors and one that can only be brought by creditors who existed at the time of the transfer in question. The difficulty with relying upon a statutory provision that requires a creditor to have existed at the time of the transfer is that the bankruptcy trustee also must demonstrate that the same creditor existed as of the petition date.
The SGK liquidating trustee, therefore, sought to rely upon state remedy that allows future creditors to attack transfers. Under the UFTA, that remedy requires a showing that the debtor made the transfer without receiving reasonably equivalent value and that, at the time of the transfer, the debtor either (1) was “engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction” or (2) “intended to incur, or believed or reasonably should have believed that [it] would incur, debts beyond [its] ability to pay as they became due.”
Notably, insolvency is not a factor under the formulation of constructive fraudulent transfer under which the liquidating trustee was proceeding. Proof of insolvency also is not necessary in dealing with a claim of actual fraudulent transfer “made with actual intent to hinder, delay or defraud any creditor of the debtor,” although insolvency before or shortly after a transfer is one of the eleven enumerated “badges of fraud” under the UFTA that may indicate actual intent.
Noting that a constructive fraudulent transfer only requires a showing based upon the preponderance of the evidence, the court found that the liquidating trustee nevertheless failed to establish that Keywell had unreasonably small capital to conduct its business. The liquidating trustee’s expert witness, the court concluded, did nothing more than offer a conclusory opinion that the equity cushion at the time of the 2008 distribution was insufficient – leaving the court with more questions for, than answers from, the liquidating trustee’s expert.
With respect to actual fraudulent transfer, the liquidating trustee was required to prove the claim by clear and convincing evidence. For its actual fraudulent transfer claims, the liquidating trustee relied upon insolvency as the key “badge of fraud.” Here, too, though, the court found the evidence lacking. The court concluded that not only had the liquidating trustee’s expert failed to establish insolvency, but the expert instead proved that Keywell was solvent following the 2008 distribution.
Accordingly, the failure to establish either unreasonably small capital or insolvency was fatal to the liquidating trustee’s claims for constructive and actual fraudulent transfer, respectively.
Tune in tomorrow for part two where we learn whether the liquidating trustee was more successful on the other two causes of action – recharacterization and equitable subordination.
Brenda Funk is an Associate at Weil Gotshal & Manges, LLP in Houston.