Ninth Circuit Adopts Indirect Benefit Rule David A. Hatch Mark G. - PDF document

Ninth Circuit Adopts Indirect Benefit Rule David A. Hatch Mark G. Douglas A potential lender confronted with a borrower that cannot provide adequate independent assurance of its ability to repay a loan commonly demands a guarantee of the debt by related entities ( e.g. , affiliates, shareholders or partners). However, even a guarantee is not enough in some cases. Instead, the lender will agree to extend financing to a more financially sound, related entity, which in turn makes the funds available to the actual beneficiary — the original potential borrower. Albeit not at all unusual, a lending transaction structured in this way can become problematic if the ultimate beneficiary of the loan later files for bankruptcy. This is so because payments made by the beneficiary of a loan who is not the signatory under the loan agreement are routinely attacked by bankruptcy trustees as fraudulent transfers, which the Bankruptcy Code empowers a trustee to “avoid,” or invalidate, to the extent that the debtor did not receive reasonably equivalent value in exchange. A dispute of this nature was recently adjudicated by the Ninth Circuit Court of Appeals. In Frontier Bank v. Brown (In re Northern Merchandise, Inc.) , the Court adopted the “indirect benefit rule,” thereby allying itself with the other circuit courts of appeal that have weighed in on the question of what constitutes value in connection with a challenged transaction. Avoidance of Fraudulent Transfers in Bankruptcy Among the powers conferred upon a bankruptcy trustee or chapter 11 debtor-in-possession under the Bankruptcy Code is the ability to avoid asset transfers that are either actually or NYI-2168915v1 IndirectBenefitBRRArticleOctNov2004 JP003318 079983 - 041016

constructively fraudulent. Section 548 of the Bankruptcy Code provides that the trustee can avoid any transfer made by the debtor in the year preceding a bankruptcy filing, if effected with the actual intent to hinder, delay or defraud creditors. The statute also authorizes avoidance of transfers or obligations incurred in the absence of fraudulent intent. Specifically, section 548 provides that the trustee may avoid any transfer made or obligation incurred by a debtor in the year preceding bankruptcy if the debtor received “less than a reasonably equivalent value” in exchange and was insolvent, undercapitalized or unable to pay its debts generally as they matured (or became any of the foregoing as a consequence of the transaction). “Value” is defined in the Bankruptcy Code, but “reasonably equivalent value” is not. For purposes of section 548, “value” means “property, or satisfaction or securing of a present or antecedent debt,” but excludes a future promise to provide support to the debtor or a relative. “Reasonably equivalent value” is a factual determination that depends upon the circumstances of each individual transaction or group of related transactions taken as a whole. As expressed by one Court of Appeals, “[t]he touchstone is whether the transaction conferred realizable commercial value on the debtor reasonably equivalent to the realizable commercial value of the assets transferred. Thus, when the debtor is a going concern and its realizable going concern value after the transaction is equal to or exceeds its going concern value before the transaction, reasonably equivalent value has been received.” Courts have long recognized that value need not flow directly to the debtor to figure in the calculus under section 548. Instead, a debtor may benefit indirectly from a transaction even though it does not immediately receive cash or other property equal in value to an asset transferred, or obligation incurred, by the debtor. In determining whether the debtor received “reasonably equivalent value” in these cases, courts focus on the ultimate economic effect on the NYI-2168915v1 IndirectBenefitBRRArticleOctNov2004 JP003318 079983 - 041016

debtor and whether its creditors have been harmed as a consequence of the transaction. This was the inquiry undertaken by the Ninth Circuit in Northern Merchandise . The Ninth Circuit’s Ruling in Northern Merchandise Northern Merchandise, Inc. (“Northern”) was a merchandiser to grocery stores. In early 1998, Frontier Bank (“Frontier”) loaned $60,000 to Northern. The loan was secured by a lien on Northern’s inventory, chattel paper, accounts, equipment, and general intangibles. In October 1998, Northern requested a second loan in the amount of $150,000 from Frontier. Concluding that Northern’s performance and financials did not support an additional direct loan, Frontier denied Northern’s request, but agreed to loan $150,000 to Paul Weingartner, Paul Benjamin and Stephen Comer, Northern’s shareholders, based upon their individual creditworthiness. It was Frontier’s understanding that Northern’s shareholders would allow Northern to use the money to fund its business operations. To this end, Frontier deposited the funds directly into Northern’s checking account. This loan was evidenced by a promissory note signed by Northern’s shareholders. As collateral for the loan, Northern granted Frontier a security interest in Northern’s inventory, chattel paper, accounts, equipment and general intangibles. Northern ceased operating in 1999. The company transferred its inventory to a separate corporation also controlled by one of Northern’s shareholders, which in turn sold the inventory. This corporation then used the proceeds from this sale to pay down $125,000 of the $150,000 Frontier loan. The remainder was paid by a Northern customer from the proceeds of prior inventory sales. Northern’s creditors filed an involuntary chapter 7 against the company shortly thereafter. The chapter 7 trustee sued to avoid as fraudulent under section 548 the $125,000 payment to NYI-2168915v1 IndirectBenefitBRRArticleOctNov2004 JP003318 079983 - 041016

Frontier, as well as the lien granted to Frontier to secure the original loan to Northern’s shareholders. The bankruptcy court granted summary judgment in favor of the trustee, finding that a fraudulent conveyance occurred. The Ninth Circuit bankruptcy appellate panel upheld that determination on appeal. Frontier fared better before the Court of Appeals. Looking to the elementary mechanics of section 548, the Ninth Circuit explained that the trustee could avoid the payments and liens given to Frontier only to the extent that Northern failed to receive “reasonably equivalent value” in exchange for the transfer. However, the Ninth Circuit emphasized, value need not be given directly by the transferee, but can be conferred indirectly through one or more third parties. Observing that “the primary focus of Section 548 is on the net effect of the transaction on the debtor's estate and the funds available to the unsecured creditors,” the Court of Appeals endorsed the indirect benefit rule. It then examined whether the benefits indirectly received by Northern were reasonably equivalent in value to the payments it made and the obligations it assumed. The Ninth Circuit concluded that they were. According to the Court, because the loan proceeds were deposited directly into Northern’s checking account to fund ongoing operations and the security interest granted to Frontier did not result in a net loss to Northern, Northern received reasonably equivalent value in exchange for the transfers, and obligations incurred, to Frontier. It rejected the trustee’s contention that the loan proceeds were technically a capital contribution by the shareholders and that Northern was under no legal obligation to grant Frontier a security interest in its assets. The practical reality of the situation, the Ninth Circuit explained, was that Northern could not obtain financing directly, and the transaction that took place was devised to overcome that impediment. It accordingly reversed the decision of the appellate panel. NYI-2168915v1 IndirectBenefitBRRArticleOctNov2004 JP003318 079983 - 041016

Analysis The Ninth Circuit adopted the same approach employed by every other circuit court of appeals that has considered the propriety of quantifying value in the context of fraudulent conveyance litigation by looking at a transaction or series of transactions as an integrated whole rather than piecemeal. As commercial transactions become more sophisticated, complex and creative, courts assessing “value” under section 548 are increasingly called upon to consider the impact of circumstances and events that are outside of or only indirectly related to the transaction in question. Central to this inquiry is the net economic impact of a transaction or series of a transactions on the debtor and creditor recoveries, rather than the formalistic labels given to a transaction by the parties. ______________________________ Frontier Bank v. Brown (In re Northern Merchandise, Inc.) , 371 F.3d 1056 (9th Cir. 2004). Harman v. First American Bank (In re Jeffrey Bigelow Design Group, Inc.) , 956 F.2d 479 (4 th Cir. 1992). Rubin v. Manufacturers Hanover Trust Co. , 661 F.2d 979 (2d Cir. 1981). Mellon Bank, N.A. v. Metro Communications, Inc. , 945 F.2d 635 (3d Cir. 1991). NYI-2168915v1 IndirectBenefitBRRArticleOctNov2004 JP003318 079983 - 041016