Cruel Intentions: SDNY Bankruptcy Court Holds Mutual Intent Not Required to Plead State Law Actual Fraud

The Bottom Line:

On June 16, 2011, the United States Bankruptcy Court for the Southern District of New York (Judge Glenn), denied, in part, a trio of motions to dismiss filed by defendants in related adversary proceedings commenced by the Chapter 11 trustee of Dreier LLP (the “Trustee”) seeking to avoid and recover prepetition transfers made by Dreier LLP to the hedge fund defendants pursuant to the actual and constructive fraudulent conveyance provisions of the Bankruptcy Code and the New York Debtor and Creditor Law (the “NYDCL”).  See Gowan v. The Patriot Group, LLC (In re Dreier LLP), Adv. Proc. No. 10-03524, --B.R.--, 2011 WL 2412581 (Bankr. S.D.N.Y. June 16, 2011) (“Patriot”); Gowan v. Amaranth LLC (In re Dreier LLP), Adv. Proc. No. 10-03493, --B.R.--, 2011 WL 2412601 (Bankr. S.D.N.Y. June 16, 2011) (“Amaranth”); and Gowan v. Novator Credit Mgmt. (In re Dreier LLP), Adv. Proc. No. 10-04278, --B.R.--, 2011 WL 2412608 (Bankr. S.D.N.Y. June 16, 2011) (“Novator”).  The decisions addressed various case-dispositive issues involving (1) whether the transferred funds were property of the debtor at the time of each transfer due to a civil forfeiture order against Marc Dreier and Dreier LLP and (2) the allegation that the transferred funds were trust funds in which Dreier LLP had no equitable interest.  The Court denied the motions to dismiss on both issues.  Further, the Court denied the motions to dismiss the actual fraudulent conveyance claims finding that the “Ponzi scheme presumption” applies to the transfers made by Dreier LLP and – as discussed in more detail in this posting – “mutual fraudulent intent” by the transferor and the transferee is not required to state a prima facie actual fraudulent conveyance claim under the NYDCL. As to the claims for constructive fraudulent conveyance, the Court dismissed the complaints to the extent the causes of action sought the repayment of principal because the Trustee conceded that the repayment extinguished a common law claim, such as restitution, that defendants would have had against the estate, but permitted constructive fraudulent conveyance claims to go forward in Patriot and Amaranth as to the “fictitious profits” because the debtor did not receive “reasonably equivalent value” or “fair equivalent value”.

What Happened:

In re Dreier LLP is a Chapter 11 proceeding filed on December 16, 2008 after the arrest of Marc Dreier, the sole equity partner of the New York City law firm Dreier LLP, who was operating a massive Ponzi scheme through the sale of bogus promissory notes (the “Notes”).  The funds received and paid in connection with the Notes were deposited into and transferred from a so-called attorney escrow account maintained by Dreier LLP at JPMorgan Chase.

The Trustee commenced avoidance actions against the hedge funds that purchased the Notes.  The complaints against the defendants in the Patriot, Amaranth and Novator cases allege that defendants knew or should have known that they received the transfers as part of the Ponzi scheme and as a result the transfers are avoidable and recoverable by the Trustee.  The Patriot and Amaranth defendants are so-called “net winners,” i.e., they received repayment of the full amount of the principal invested and payment of interest on the Notes; the Novator defendants are “net losers,” i.e., they recovered less than the amount of principal invested.  The Trustee sought to avoid and recover the transfers under actual and constructive fraudulent conveyance theories pursuant to sections 544, 548(a) and 550 of the Bankruptcy Code and the corresponding provisions of the NYDCL.

While the decisions address a variety of issues, this blog posting focuses on one aspect in particular.  The defendants in the Patriot, Amaranth and Novator cases moved to dismiss the complaints alleging, among other things, that the actual fraudulent conveyance claims under the NYDCL could not survive because the Trustee did not allege fraudulent intent by the transferees.  The Court denied the motions to dismiss on this ground.

The Court acknowledged that the case law in the Second Circuit is divided on the issue of whether a plaintiff must plead fraudulent intent of both the transferor and transferee to state a claim under NYDCL § 276, but concluded that to state such a claim the complaint need only allege fraudulent intent by the transferor.  Patriot, 2011 WL 2412581, at *28-33.  The Court reviewed various opinions requiring only fraudulent intent by the transferor and other court opinions requiring fraudulent intent by the transferor and the transferee.  Id. at *29-30.  It attributes the split to the opinion in Gentry v. Kovler (In re Kovler), 249 B.R. 238, 243 (Bankr. S.D.N.Y. 2000), which stated that “[m]utual fraudulent intention on the part of both parties to the transaction is required in order to invoke the protection of the law prohibiting fraudulent conveyances; fraudulent intent on the part of one of the parties is insufficient.”  Patriot, 2011 WL 2412581, at *30.  However, the Court reasoned that both decisions relied upon by the Kovler court do not stand for such a proposition and further that “[p]erhaps in recognition of the fact that its statement of the law was without support, the Kovler court issued [a correcting opinion], five years after the initial decision, replacing the statement that ‘mutual fraudulent intention’ must be proved under NYDCL § 276.”  Id. at *30-31. “[B]ut by that time, the proverbial horse had left the barn,” the Court states, citing several decisions that picked up and repeated the holding from the original Kovler opinion, including a decision of its own.  Id. at *31. 

The Court further analyzed the statutory construction of Article 10 of the NYDCL (§§ 270-281).  It first compared the language of NYDCL § 276 (which makes no reference to actual fraudulent intent of the transferee) with § 276-a (which requires actual fraudulent intent of the transferee for the allowance of attorneys’ fees) concluding that “it is the transferor's intent alone, and not the intent of the transferee, that is relevant under NYDCL § 276.” Id. at *32.  The Court then analyzed the transferee's intent in connection with the affirmative defense of good faith, available under NYDCL § 278, which allows a bona fide purchaser for value who took without knowledge of the fraud to retain the challenged transfer.  As an affirmative defense, section 278 requires that “the transferee’s actual fraudulent intent [be] considered at the summary judgment phase or at trial on a full evidentiary record.  On a motion to dismiss, the trustee only needs to allege a prima facie case of actual fraud.  If the trustee meets the evidentiary burden of proving a prima facie case of actual fraud ... the burden shifts to the transferee to establish the affirmative defense. . . .” Id. at *32-33.  The Court concluded that the transferee’s good faith is an issue to be raised as an affirmative defense and need not be pled by the trustee in the complaint.  Id. at *33.

Accordingly, the Court held that to adequately plead a prima facie claim under NYDCL § 276, the Trustee must only allege the actual fraudulent intent of the transferor.  Id. at *33.   

Why the Case is Interesting:

In reaching its decision, the Court extensively analyzed the conflicting court opinions within the Second Circuit on the issue of whether mutual fraudulent intent by the transferor and the transferee is required to state a prima facie actual fraudulent conveyance claim under the NYDCL.  After explaining the reason for the split among the courts in existing case law, the Court concluded that a claim for actual fraudulent conveyance under the NYDCL requires only that the plaintiff plead the actual fraudulent intent of the transferor to survive a motion to dismiss.  This holding has subsequently been adopted by two of the bankruptcy judges who previously relied upon the original Kovler decision.  See Gowan v. Wachovia Bank, N.A. (In re Dreier LLP), 2011 WL 3319711 ­­at *8 ­­­­­(Bankr. S.D.N.Y. Aug. 3, 2011); Picard v. Cohmad Securities Corp. (In re Bernard L. Madoff Inv. Sec. LLC), 2011 WL 3274077, at *9 (Bankr. S.D.N.Y. Aug. 1, 2011).