Contributed by Rahul Sharma
On February 4, 2013, in Hoffman v. Lang, et al. (In re Swan), United States Bankruptcy Judge Alan Jaroslovsky, of the United States Bankruptcy Court for the Northern District of California, Santa Rosa division, issued a short but interesting decision more notable for the unusual facts of the case than for the decision itself. A would-be debtor had been fleeced of her vineyard by a “business acquaintance,” and the chapter 7 trustee filed suit to recover the property pursuant to section 548(a)(1)(B) of the Bankruptcy Code. While expressing extreme displeasure with the defendant’s actions and morals, the court found that “it does not appear that the law allows the court to undo the transaction, much as it would like to do so.”
Background and Facts
Santa Rosa is the county seat of beautiful Sonoma County, next door to Napa County and right in the heart of world-renowned Northern California wine country. The debtor’s story is set in Healdsburg, a small but rapidly gentrifying town on the northern reaches of Sonoma County.
In 2004, the debtor, a realtor named Hally Swan, purchased a vineyard property near Healdsburg, paying for the property with $400,000 in cash and a $375,000 mortgage from North Coast Bank. She leased a portion of the property to an operating winery. The mortgage was due in October 2008, but the double whammy of the housing bubble collapse and the global economic slowdown led to a sharp slowdown in Swan’s realty business. The bank was in no hurry to foreclose in such an inhospitable housing market and agreed to extend the mortgage until the spring of 2009. When a potential sale that spring fell through, the bank recorded a notice of default and set a foreclosure sale for September 16, 2009.
It was time for the story’s villain to enter the scene. Swan turned to Peter Lang, a business acquaintance whom she trusted, for advice on what to do. Unfortunately for Swan, and potentially unbeknownst to Swan, Lang was a close friend of the bank’s president. With Swan’s property on the verge of being foreclosed, Lang offered Swan a deal that she believed she could not refuse – but one that she probably should have. He offered to loan her the approximately $24,000 she needed to pay to the bank for past due interest and expenses on the mortgage, which would allow for a postponement of the foreclosure for about 6 weeks. The catch was that if Swan couldn’t cure the other mortgage issues during this time (leaving the sale still slated to go forward), and if at that time Swan could also not repay Lang the $24,000, then Swan agreed to deed the property over to Lang, for the value of the remaining mortgage debt, approximately $360,000. Note that different experts valued the property anywhere from $500,000 to $900,000, but clearly well over the debt of $360,000.
Given the still-depressed state of the realty business in 2009, Swan was unable to cure the other mortgage issues and attain a postponement of the foreclosure beyond the end of October 2009. And she was also unable to pay Lang back the $24,000. Thus, at that time, she deeded the vineyard property over to Lang, who paid off the $360,000 mortgage debt using cash on deposit at the bank, in account held by Safari West, Inc., a non-profit entity he controlled. The bank then refinanced the property immediately, at a lower interest rate – rates having declined significantly between 2004 and 2009 – thus allowing Lang to repay Safari West in full. The lower mortgage payments for Lang, together with the steady income from the winery lease, meant that the property was immediately cash flow positive. Later, the president of the bank left the bank to become the head of Safari West.
Swan’s monetary issues continued, and she filed for protection under chapter 7 of the Bankruptcy Code in March 2011. In January 2012, the chapter 7 trustee, Timothy Hoffman, filed an adversary complaint seeking to avoid the transfer and recover the property for the estate, pursuant to section 548(a)(1)(B) of the Bankruptcy Code, asserting that the $24,000 acquisition of the property was a constructively fraudulent transfer.
Fraudulent Transfers and Section 548(a)(1) of the Bankruptcy Code
The trustee sought to avoid the transfer under section 548(a)(1)(B), which governs constructively fraudulent transfers. For an obligation or transfer to be avoided under this subsection, it must meet a two-prong test. First, the debtor must have “received less than a reasonably equivalent value in exchange for such transfer.” Second, the debtor must have (I) been insolvent on the date of the transfer or became insolvent as a result of the transfer, (II) engaged in or about to engage in a business or transaction for which it was left with unreasonably small capital, (III) intended to incur debts beyond its ability to pay as they matured, or (IV) made such transfer for the benefit of an insider.
Unfortunately for Hoffman, the law on this subject is straightforward, and while the transfer clearly meets the first prong of the test, it fails the insolvency prong. Lang’s answers and other submissions did not just attempt to show that Hoffman’s action failed the insolvency test; they also attempted to cast an honorable light upon Lang’s prepetition actions and show that he did, in fact, pay reasonably equivalent value for the property.
In his response, Lang asserted that his payment of $24,000 was in fact “reasonably equivalent value” for the property. He believed that, though there were estimates of the value of the property as high as $900,000, the value needed to be discounted because foreclosure was imminent. Such argument was based on the presumption that in a foreclosure sale the only bid would have been the bank’s, but the court found that Lang “is not entitled to such a presumption” and that his was argument was “completely without merit.” The court did note that the Supreme Court had ruled in BFP v. Resolution Trust Corp. that, at an actual foreclosure sale, the price paid by the successful bidder is presumed to have been reasonably equivalent value if the sale was non-collusive, but the court said that Lang’s deal with Swan did not fall within this safe harbor, which requires an actual foreclosure sale. Her deed to him prevented any such sale from happening, meaning that there was no opportunity for other third parties to bid for the property.
The second prong that Hoffman needed to meet was to show that (a) Swan was insolvent on the date of the transfer or became insolvent as a result of the transfer, (b) Swan was engaged in or about to engage in a business or transaction for which she was undercapitalized, (c) Swan intended to incur debts beyond her ability to pay as they matured, or (d) Swan made such transfer for the benefit of an insider. Hoffman only attempted to make the second and third arguments – that Swan was undercapitalized, and that she intended to incur debts beyond her ability to pay as they matured. The court found both arguments unavailing. As to the first argument, Swan’s business was the realty business, for which her need for capital was small, and the sale of her property did not leave her undercapitalized, and as to the second argument, there was no showing of intent.
Though the court did not undo the transaction, it did finish with some choice words for Lang, leaving Lang “to his own conscience for his treatment of Swan.” Additionally, it rejected Lang’s justification that Swan’s property would have been lost to foreclosure anyway, noting that Lang himself had filed a chapter 11 petition and was well versed in bankruptcy protections. Because of the property’s substantial equity, a foreclosure sale might well have generated bidders and a higher sale price for Swan, whereas Lang’s “assistance” to her led to her losing her property, for which she had paid $400,000 in cash, in exchange for $24,000.
The moral of the story here may be that it is always important to choose your advisers carefully, but never more so than when you are in a state of distress. Otherwise, soon someone else will be enjoying your grapes and drinking your wine.