Opinion ID: 690275
Heading Depth: 3
Heading Rank: 1

Heading: Clemence Frank's Mortgages

Text: 25 Clemence received her mortgages from Enterprises as security for contemporaneous advances to the corporation of $350,000 of her own funds. On the surface, then, Clemence appears to have given fair consideration for the mortgages, because they secured present advances of the same value. See DCL Sec. 272(b). Nevertheless, the District Court ruled on three somewhat related grounds that the mortgages should be voided under the constructive fraud provisions of DCL Sec. 273-a. We consider each of these grounds in turn, and then apply the resulting legal principles to the mortgage transactions. 26 a. Equitable subordination. Of the three grounds, it will be convenient to consider first the District Court's view that the mortgages could be voided under the doctrine of equitable subordination, without regard to the ultimate fate of the funds Clemence advanced. This conclusion was based on a finding that Clemence was an insider of Enterprises whose cash advances were deemed to be capital contributions rather than loans. The doctrine of equitable subordination, however, simply does not apply to state-law fraudulent conveyance claims. Equitable subordination is distinctly a power of federal bankruptcy courts, as courts of equity, to subordinate the claims of one creditor to those of others. See generally Scott M. Browning, Note, No Fault Equitable Subordination, 34 Wm. & Mary L.Rev. 487 (1993); Helen D. Chaitman, The Equitable Subordination of Bank Claims, 39 Bus.Law. 1561 (1984). This broad equitable power to disallow and reorder claims, first announced in bankruptcy case law, see Deep Rock, supra; Pepper v. Litton, 308 U.S. 295, 60 S.Ct. 238, 84 L.Ed. 281 (1939), and now codified in the Bankruptcy Code at 11 U.S.C. Sec. 510(c) (1988), derives from the Bankruptcy Court's role as administrator of the debtor's estate for the equal benefit of all creditors, see, e.g., Pepper, 308 U.S. at 303-05, 60 S.Ct. at 243-45. 27 Unlike the Bankruptcy Code, the UFCA is a set of legal rather than equitable doctrines, whose purpose is not to provide equal distribution of a debtor's estate among creditors, but to aid specific creditors who have been defrauded by the transfer of a debtor's property. See Boston Trading Group, Inc. v. Burnazos, 835 F.2d 1504, 1508 (1st Cir.1987). 8 Thus, the UFCA does not bestow a broad power to reorder creditor claims or to invalidate transfers that were made for fair consideration, at least where no actual intent to hinder, delay, or defraud creditors has been shown. As the definition of fair consideration in DCL Sec. 272 makes clear, even the preferential repayment of pre-existing debts to some creditors does not constitute a fraudulent conveyance, whether or not it prejudices other creditors, because [t]he basic object of fraudulent conveyance law is to see that the debtor uses his limited assets to satisfy some of his creditors; it normally does not try to choose among them. Boston Trading, 835 F.2d at 1509; see also Atlanta Shipping Corp. v. Chemical Bank, 818 F.2d 240, 249 (2d Cir.1987); Ronga v. Chiusano, 97 A.D.2d 753, 468 N.Y.S.2d 174, 175 (1983); 1 Garrard Glenn, Fraudulent Conveyances and Preferences Sec. 289, at 488-90 (1940). 28 New York courts have carved out one exception to the rule that preferential payments of pre-existing obligations are not fraudulent conveyances: preferences to a debtor corporation's shareholders, officers, or directors are deemed not to be transfers for fair consideration. See Farm Stores, Inc. v. School Feeding Corp., 102 A.D.2d 249, 477 N.Y.S.2d 374, 378 (1984), aff'd, 64 N.Y.2d 1065, 489 N.Y.S.2d 877, 479 N.E.2d 222 (1985); Southern Industries, Inc. v. Jeremias, 66 A.D.2d 178, 411 N.Y.S.2d 945, 949 (1978). This exception is indirectly relevant to Clemence's mortgages, because Enterprises used the proceeds from one of them to pay off antecedent debts to its principal shareholder, Hiram J. Frank; under Farm Stores, these preferential payments to a controlling shareholder would be fraudulent conveyances. But the Farm Stores preference exception cannot be applied directly to Clemence's mortgages, regardless of whether she was a corporate insider, because each of her mortgages secured a contemporaneous advance of funds, not a pre-existing debt. Unlike the preferential payment of pre-existing debts, the transfer of a debtor's property to secure a present advance of commensurate value does not ordinarily prejudice other creditors, because the debtor receives new value in exchange for the property conveyed. 29 In sum, Clemence Frank's mortgages may not be directly invalidated either under the doctrine of equitable subordination or as preferences to a corporate insider. If analyzed without regard to the ultimate fate of the funds she advanced, these mortgages could not be found to be fraudulently conveyed. They might be fraudulent, however, if analyzed as part of a larger transaction. This view underlies the District Court's second basis for voiding the mortgages, to which we now turn. 30 b. Collapsing the transactions. It is well established that multilateral transactions may under appropriate circumstances be collapsed and treated as phases of a single transaction for analysis under the UFCA. See, e.g., Orr v. Kinderhill Corp., 991 F.2d 31, 35-36 (2d Cir.1993). This approach finds its most frequent application to lenders who have financed leveraged buyouts of companies that subsequently become insolvent. See United States v. Gleneagles Investment Co., 565 F.Supp. 556 (M.D.Pa.1983) (Pennsylvania UFCA), aff'd sub nom. United States v. Tabor Court Realty Corp., 803 F.2d 1288 (3d Cir.1986), cert. denied, 483 U.S. 1005, 107 S.Ct. 3229, 97 L.Ed.2d 735 (1987); Crowthers McCall Pattern, Inc. v. Lewis, 129 B.R. 992, 998 (S.D.N.Y.1991) (New York UFCA); Wieboldt Stores, Inc. v. Schottenstein, 94 B.R. 488, 500-04 (N.D.Ill.1988) (Illinois UFCA); In re Best Products Co., 168 B.R. 35, 56-57 (Bankr.S.D.N.Y.1994) (New York UFCA). The paradigmatic scheme is similar to that alleged here: one transferee gives fair value to the debtor in exchange for the debtor's property, and the debtor then gratuitously transfers the proceeds of the first exchange to a second transferee. The first transferee thereby receives the debtor's property, and the second transferee receives the consideration, while the debtor retains nothing. 31 Under these circumstances, the initial transfer of the debtor's property to the first transferee is constructively fraudulent if two conditions are satisfied. First, in accordance with the foregoing paradigm, the consideration received from the first transferee must be reconveyed by the debtor for less than fair consideration or with an actual intent to defraud creditors. If, instead, the debtor retains the proceeds from the first exchange, reconveys them for fair consideration, or uses them for some other legitimate purpose, including the preferential repayment of pre-existing debts, and if the debtor does not make the subsequent transfer with actual fraudulent intent, then the entire transaction, even if collapsed, cannot be a fraudulent conveyance, because it does not adversely affect the debtor's ability to meet its overall obligations. See Atlanta Shipping, 818 F.2d at 249; see also 1 Glenn, supra, Sec. 275, at 471 ([W]here a transfer for value ... is put forward as a fraudulent conveyance, the test is whether, as a result of the transaction, the debtor's estate was unfairly diminished.). 32 Second, and contrary to the approach taken by the District Court, the transferee in the leg of the transaction sought to be voided must have actual or constructive knowledge of the entire scheme that renders her exchange with the debtor fraudulent. See Kupetz v. Wolf, 845 F.2d 842, 847-49 (9th Cir.1988); Atlanta Shipping Corp., 818 F.2d at 249; Tabor Court, 803 F.2d at 1296; Crowthers McCall, 129 B.R. at 998; Wieboldt Stores, 94 B.R. at 502-03. The case law has been aptly summarized in the following terms: 33 In deciding whether to collapse the transaction and impose liability on particular defendants, the courts have looked frequently to the knowledge of the defendants of the structure of the entire transaction and to whether its components were part of a single scheme. 34 In re Best Products, 168 B.R. at 56-57 (quoting In re Best Products Co., 157 B.R. 222, 229 (Bankr.S.D.N.Y. (1993)). The existence of a knowledge requirement reflects the UFCA's policy of protecting innocent creditors or purchasers for value who have received the debtor's property without awareness of any fraudulent scheme. Thus, an appropriate creditor may void or disregard a fraudulent conveyance to any person except a purchaser for fair consideration without knowledge of the fraud at the time of the purchase. DCL Sec. 278(1); see also FDIC v. Malin, 802 F.2d 12, 19 (2d Cir.1986); Farm Stores, 477 N.Y.S.2d at 379. 35 However, the transferee need not have actual knowledge of the scheme that renders the conveyance fraudulent. Constructive knowledge of fraudulent schemes will be attributed to transferees who were aware of circumstances that should have led them to inquire further into the circumstances of the transaction, but who failed to make such inquiry. See, e.g., Tabor Court, 803 F.2d at 1295 (lenders knew, or should have known that monies would not be retained by debtor). There is some ambiguity as to the precise test for constructive knowledge in this context. While some cases have stated that purchasers who do not make appropriate inquiries are charged with the knowledge that ordinary diligence would have elicited, United States v. Orozco-Prada, 636 F.Supp. 1537, 1543 (S.D.N.Y.1986), aff'd, 847 F.2d 836 (2d Cir.1988); see also Morse v. Howard Park Corp., 50 Misc.2d 834, 272 N.Y.S.2d 16, 22 (Sup.Ct.1966), others appear to have required a more active avoidance of the truth, see Schmitt v. Morgan, 98 A.D.2d 934, 471 N.Y.S.2d 365, 367 (1983) (test is whether subsequent purchaser who did not make serious inquiry was shielding himself from knowledge that a fraudulent conveyance had occurred); 1 Glenn, supra, Sec. 304, at 532 (transferee may be charged with knowledge only when there is conscious turning way from the subject). 9 36 c. Lack of good faith. The District Court bolstered its view that the mortgage transactions could be collapsed by deeming Clemence not to have acted in good faith. Petitioners attempt to assert lack of good faith as a ground for voiding the mortgages independent of the role that mental state plays in the analysis whereby the transactions are collapsed. This use of bad faith as an independent ground cannot be sustained. Though some New York cases have broadly construed the reference to good faith in DCL Sec. 272's definition of fair consideration, see, e.g., Southern Industries, 411 N.Y.S.2d at 949 (voiding preferences to corporate insiders), other authorities have cautioned against an expansive reading of the UFCA's reference to good faith, see, e.g., Boston Trading Group, 835 F.2d at 1512-13. We believe that where, as here, a transferee has given equivalent value in exchange for the debtor's property, the statutory requirement of good faith is satisfied if the transferee acted without either actual or constructive knowledge of any fraudulent scheme. See Atlanta Shipping, 818 F.2d at 249; 1 Glenn, supra, Sec. 295, at 512 (UFCA requirement of good faith refers solely to whether the grantee knew, or should have known, that he was not trading normally, but that ... the purpose of the trade, so far as the debtor was concerned, was the defrauding of his creditors). 37 d. Application of legal principles. In the application of this framework to Clemence Frank's mortgages, the initial question is whether Enterprises received fair consideration from the entire multilateral transaction surrounding each mortgage. With regard to the first mortgage, the $250,000 that Clemence advanced to Enterprises was immediately passed on to the company's majority shareholder, Hiram J. Frank, as a preference to a corporate insider. Because this preferential payment in the second stage of the transaction was a fraudulent conveyance under the holding of Farm Stores, supra, the net result was that Clemence received a mortgage from Enterprises while Hiram J. Frank received money from Clemence. Thus, at the end of the day Enterprises itself received nothing in exchange for the first mortgage. 10 38 With regard to the second mortgage, approximately $60,000 of the money that Clemence advanced went to the Attorneys to pay for legal services, while the remaining $40,000 was used for other corporate purposes. If both of these payments were legitimate corporate expenditures, then the second mortgage and the subsequent payments would not be fraudulent transfers even when viewed as a single scheme. Although the District Court found that the payments to the Attorneys were legitimate corporate expenditures, it voided the second mortgage in its entirety. This was error in two respects. First, since Petitioners have not even alleged facts that would render improper the portion of the proceeds not paid to the Attorneys, the transaction is not fraudulent, at least as it pertains to this much of the second mortgage. Second, we must remand the District Court's order as it pertains to the portion of the mortgage proceeds used to pay the Attorneys, because, as we conclude below, there is a genuine factual dispute as to whether these payments to the Attorneys were fraudulent transfers. 39 The second stage of the inquiry as to whether the transactions may be collapsed concerns Clemence's knowledge. Clemence was a director of Enterprises at least until the middle of 1990, if not longer. While she was a director, the corporation was frequently used by Hiram J. Frank as a conduit for various payments for family and other noncorporate purposes, and Clemence's fiduciary role charged her with constructive knowledge of these basic aspects of the company's financial affairs, see Hanson Trust PLC v. ML SCM Acquisition Inc., 781 F.2d 264, 274-75 (2d Cir.1986). In addition, Clemence concedes that she knew that Enterprises was a defendant in a RICO fraud action. She also concedes that she knew that her son, Hiram J. Frank, had made large loans to Enterprises, which put her on notice that he might cause the company to make preferential payments to himself with the proceeds from the mortgages. This information should have been sufficient to alert Clemence to the danger that Enterprises might improperly funnel to third parties the money she was advancing, and she should have made reasonably diligent inquiries into the use of the mortgage proceeds. Under the circumstances, her failure to inquire represented a conscious turning away from the subject. Thus, with regard to both mortgages, the undisputed facts are sufficient to charge Clemence with constructive knowledge of schemes in which her cash advances were expended by Enterprises for improper purposes.