Opinion
Case No. 17-31030 Adv. No. 19-3046 Adv. No. 19-3047
08-04-2020
In re: GYPC, INC., Debtor DONALD F. HARKER, III, TRUSTEE, Plaintiff v. CHRISTOPHER F. CUMMINGS, Defendant DONALD F. HARKER, III, TRUSTEE, Plaintiff v. ERIC WEBB, Defendant
Copies to: Patricia J. Friesinger Zachary B. White Daniel J. Gentry (Counsel for the Plaintiffs, electronically served) Casey M. Cantrell Swartz Michael L. Meyer W. Timothy Miller (Counsel for the Defendants, electronically served) Alfred J. Weisbrod, 111 W. First Street, Dayton, Ohio 45402 (Counsel for the Defendants)
Chapter 7
Decision Granting in Part and Denying in Part Motions of Defendants Christopher Cummings and Eric Webb to Dismiss Plaintiff's First Amended Complaints
The Chapter 7 Trustee, Donald F. Harker, III (the "Trustee"), has filed amended complaints against the only officers and shareholders of GYPC, Eric Webb and Christopher F. Cummings (collectively, the "Defendants"). The Complaints include both preference and fraudulent transfer allegations. As with the original complaints, the Defendants moved to dismiss the Complaints for the failure to state a claim. The court's previous decision determined that the original complaints were not pled with the required specificity as to the factual allegations, but granted the Trustee's motion for leave to amend. The Trustee amended his complaints; however, the Defendants assert that the Complaints remain insufficiently pled as to the factual allegations underlying the Complaints. The Trustee has opposed the motions to dismiss, but alternatively sought further leave to amend as needed.
Doc. 54 (19-3047); Doc. 53 (19-3046). The amended complaints were filed in redacted form and the unredacted versions, upon motion and order, were filed under seal. Docs. 54 & 60 (19-3046) and Docs. 55 & 61 (19-3047). For simplicity, the court will cite to the amended complaints collectively as the "Complaints."
Doc. 59 (19-3047); Doc. 58 (19-3046).
The Defendants also asserted that the special counsel for the then-Chapter 11 debtor, GYPC, Inc., lacked the corporate authority to file the complaints and, as a corollary, the two-year statute of limitation to file such litigation had expired under § 546(a)(1)(A) of the Bankruptcy Code. The court treated that discrete issue on summary judgment initially, but ultimately determined the special counsel's authority was clear as a matter of law, vacated that order, and denied the corporate authority issue as part of the ruling on the first round of motions to dismiss. The Defendants moved for reconsideration, which the court has denied by a separate decision entered concurrently with this decision. As the Defendants incorporated those arguments into these latest motions to dismiss, the court rejects them for the reasons stated in its prior decision and its decision denying the motions to reconsider.
Doc. 45 (19-3047); Doc. 44 (19-3046).
I. Background
For purposes of a motion to dismiss, the court accepts the allegations in the amended complaints as true. In the pre-petition period from 1996 until January 2016, the debtor's name was General Yellow Pages Consultants, Inc. ("Consultants"). Complaints ¶5. The company did business as Marquette Group. Id. This portion of the business consisted of, among other things, Consultants acting as a "Certified Marketing Representative" that assisted firms in placing advertisements in Yellow Pages directories and similar on-line resources. Id.
Additionally, Consultants, prior to January 2016, was the sole shareholder of US Motivation, Inc. ("USM"). Complaints ¶6. USM was a separate business line that engaged in "incentive promotions, meeting, and event management", as well as communications, marketing, and "on-line fulfillment award administration." Id. USM entered into contracts with firms for its "Travel and Awards divisions" and had access to those customers' funds, which USM held on deposit to pay for incentives, or expenses for conventions, as became due. Complaints ¶6. However, these funds were not held separately, but instead deposited into accounts subject to agreements with USM's primary secured creditor, Alostar Bank of Commerce ("Alostar"). USM also paid for various expenses with American Express cards. Complaints ¶8.
Consultants' consolidated financials, as of December 31, 2014, included liabilities that exceeded assets by $20,855,769. Complaints ¶9. In addition, Consultants' auditors believed that the goodwill for the company was overstated. Id. The auditors believed that Consultants' financial condition raised the uncertainty of whether it could continue as a going concern. Id. The consolidated debtor was insolvent as of the end of 2014. Id.
In January 2016 Consultants entered into an Asset Sale and Purchase Agreement (the "APA"). Consultants was the seller; the Defendants were the principals; Mindstream Media, LLC ("Mindstream") was the buyer, and Eastport Holdings, Inc. was the parent company of Mindstream. Complaints ¶10. The APA provided for the sale of substantially all the assets of Consultants but excluded USM. Complaints ¶11. Post-closing, Consultants' name was changed to GYPC, Inc. ("GYPC"). Complaints ¶15. Among other consideration, GYPC received quarterly payments through the APA on or about May 13, 2016, September 6, 2016, and November 28, 2016 (the "Quarterly Payments"). Complaints ¶27.
USM's audited 2015 financials prepared in January 2016 showed USM's liabilities exceeded current assets by $11,253,336. Complaints ¶16. Assets were $9,089,202 and current liabilities $20,342,538. Id. In addition, USM's liabilities exceeded total assets by $447,592. Id. These total assets may include inter-company payables owed to USM. Id.
In the time period beginning the month of the closing of the APA, specifically January until September 2016, Alostar froze GYPC's line of credit, negatively impacting GYPC's cash flow. Complaints ¶20. From November 1, 2016 until the end of December 2016, the Alostar line of credit went from zero to "a high of $1,901,160.33." Complaints ¶32. From December 2016 to March 2017, the line of credit was paid down through consumer deposits that were not Alostar's collateral. Complaints ¶34. The Defendants were guarantors on this line of credit. Complaints ¶33.
In January 2017 GYPC merged with USM and USM ceased to exist as a separate corporate entity. Complaints ¶21. In this same time period, GYPC hired Restructuring Advisors. Id.
On February 1, 2017 Cummings "purportedly made" a change in his revocable trust that may have disqualified GYPC from being entitled to Subchapter S tax status. Complaints ¶22. That revocable trust may be an undisclosed owner of GYPC. Id. The change may have been to disqualify GYPC as an S Corporation in anticipation of the bankruptcy filing. Id. On February 3, 2017 GYPC ceased doing business and terminated substantially all its employees. Complaints ¶23.
An involuntary bankruptcy petition was filed against USM on March 7, 2017 in the Bankruptcy Court for the District of Delaware, but that case was dismissed following the voluntary petition filed by GYPC in this court on March 30, 2017. Complaints ¶24; est. doc. 1.
II. Jurisdiction
This court has jurisdiction pursuant to 28 U.S.C. § 1334(b) and this is a core proceeding pursuant to 28 U.S.C. § 157(b)(2)(F) & (H).
III. Motion to Dismiss Standard
A motion to dismiss an adversary proceeding for "failure to state a claim upon which relief can be granted" is governed by Federal Rule of Civil Procedure 12(b)(6) (applicable by Federal Rule of Bankruptcy Procedure 7012(b)). To survive a motion under Rule 12(b)(6), the factual allegations of a complaint must put the defendant on notice as to the claims being alleged and provide a sufficient factual predicate to make the allegations plausible, and not merely possible. Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009). Federal courts are not obligated to accept as true legal conclusions couched as factual allegations. Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 555 (2007). While detailed factual allegations are not necessary, the allegations must be sufficiently detailed to create more than speculation of a cause of action. Id. A claim is plausible if the factual allegations are sufficient to allow "the court to draw the reasonable inference that the defendant is liable for the misconduct alleged." HDC, LLC v. Ann Arbor, 675 F.3d 608, 611 (6th Cir. 2012) (citations and internal quotation marks omitted). See Fed. R. Civ. P. 8(a)(2) (applicable by Fed. R. Bankr. P. 7008, which requires "a short and plain statement of the claim showing that the pleader is entitled to relief[.]").
IV. Analysis
The Defendants' motions to dismiss raise the following issues: (1) whether the Trustee has sufficiently plead GYPC's insolvency during the relevant periods in order to avoid the Quarterly Payments; (2) whether the Trustee can recover the Alostar payments when he has only plead a date range rather than specific transfer dates for the re-payments at issue; (3) whether the Trustee's voluntary dismissal of a separate preferential transfer adversary proceeding against Alostar precludes the Trustee's pursuit of those same transfers against the Defendants, as guarantors of the Alostar debt; (4) whether GYPC's tax status is a property interest of GYPC such that the conversion of GYPC from an S Corporation to a C Corporation may be pursued as an avoidable preferential or fraudulent transfer; (5) whether the Miscellaneous Transfers were properly plead as fraudulent transfers, and if so, whether the claims based upon those transfers should be dismissed on account of the defenses of ordinary course of performance or subsequent new value provided by 11 U.S.C. § 547(c)(2) and (c)(4); (6) whether the Unknown Transfers were properly plead with no factual specificity having been provided; and (7) whether the actual and constructive fraudulent transfer allegations lack sufficient factual specificity.
The Quarterly Payments were payments from Eastport Holdings, Inc., pursuant to the terms of the APA. Following the closing of the APA, GYPC received payments from Eastport of $106,875 on or about May 13, 2016, September 6, 2016, and November 8, 2016. In turn, the Defendants received $49,426.68 each of the Quarterly Payments (the "Quarterly Transfers"). Those Quarterly Transfers were treated initially as "dividends or distributions," but in March 2017, the payments were re-classified as wages. The Trustee has asserted these Quarterly Transfers constitute preferential or fraudulent transfers to the Defendants.
The Alostar payments refer to payments to Alostar Bank by GYPC on a line of credit that was guaranteed by the Defendants.
The Miscellaneous Transfers were other transfers to each of the Defendants detailed in this decision.
A. Pleading Requirements
The Defendants argue that the Complaints are insufficiently plead. Pleadings must contain "a short and plain statement of the claim showing that pleader is entitled to relief[.]" Fed. R. Civ. P. 8(a)(2) (applicable by Fed. R. Bankr. P. 7008). A complaint may not just list the elements of a cause of action but must contain sufficient factual allegations to state a plausible claim. Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 556 (2007). When pleading fraudulent or preferential transfers, the complaint should identify the transfers to be avoided, including the transferor, transferee, and the dates of the transfers. State Bank & Trust Co. v. Spaeth (In re Motorwerks, Inc.), 371 B.R. 281, 292-93 (Bankr. S.D. Ohio 2007). The complaint must contain sufficient information in order to allow a defendant to respond with appropriate affirmative defenses. Id. In addition, actual fraud claims must be plead with particularity pursuant to Federal Rule of Civil Procedure 9(b). In re Licking River Mining, LLC, 565 B.R. 794, 809 (Bankr. E.D. Ky. 2017). See also Harker v. I.R.S., Case No. 16-32161, Adv. No. 18-3008, doc. 32 at 12 n. 11 (Bankr. S.D. Ohio Aug. 30, 2018) (noting that several court decisions have concluded that Rule 9(b) does not apply to constructive fraud claims).
Rule 9(b) requires that "[i]n alleging fraud or mistake, a party must state with particularity the circumstances constituting fraud or mistake. Malice, intent, knowledge, and other conditions of a person's mind may be alleged generally." Fed. R. Civ. P. 9(b).
B. Insolvency is Sufficiently Pled
Section 547(f) of the Bankruptcy Code creates a presumption of insolvency for pre-petition preferential transfers within 90 days of the petition date. Preferential transfers may be pursued against insiders for up to one year prior to the petition date, but the presumption of insolvency does not apply outside the 90-day window. For fraudulent transfers, no presumption of insolvency applies at all. 11 U.S.C. § 548. The Defendants assert that the Trustee has failed to plead insolvency sufficiently for any of the applicable transfers. "Insolvent" is defined by the Bankruptcy Code as the "financial condition such that the sum of such entity's debts is greater than all of such entity's property at a fair valuation[.]" 11 U.S.C. § 101(32)(A). This section of the Bankruptcy Code provides a balance sheet test to determine insolvency. Spradlin v. East Coast Miner, LLC (In re Licking River Mining, LLC), 603 B.R. 336, 392 (Bankr. E.D. Ky. 2019). Insolvency is determined at the time of transfer, not the petition date. Id. at 393.
The Complaints address the financial state of Consultants as of December 31, 2014 and show Consultants was insolvent on its balance sheet. In addition, the Complaints describe USM's financial state of as of December 31, 2015 based on its audited financials, one year prior to the merger with Consultants in January 2017. The Complaints also allege that the Alostar line of credit was frozen from January to September 2016. An involuntary bankruptcy petition was filed against USM in the Bankruptcy Court for the District of Delaware shortly before this bankruptcy petition was filed.
However, the Defendants assert that none of these allegations show that GYPC was insolvent for the crucial period from March to December 2016, the nine-month pre-petition period preceding the 90-day preference window for which insolvency is presumed. See 11 U.S.C. § 547(f). Specifically, the Defendants point out the Trustee is focusing on USM's pre-petition insolvency, which, prior to the merger in January 2017, was a separate corporate entity. The Defendants further state that GYPC's equity interest in USM as a wholly owned security would be without value but could not render it insolvent because an equity interest cannot have a negative value. Of course, it is elementary corporate law that that the shareholders are generally not responsible for the debts of the corporation.
But excepting USM, substantially all the assets of Consultants were sold through the APA to Mindstream in January 2016. USM merged with GYPC as of January 2017 and USM ceased to exist. Also, it is alleged that intercompany debt may have existed between USM and GYPC prior to the merger and this debt was not included in the APA. The December 2015 audit of USM would be probative of the status of GYPC in the post-merger/pre-petition transfer period because USM was all that was left of GYPC following the merger. At a minimum, at this early pleading stage, all these allegations raise the specter that GYPC may have been insolvent both before and after the USM merger and GYPC merged with an apparently wholly- owned insolvent subsidiary. The Trustee is entitled to explore the relationship between USM and GYPC, including any intercompany debt, to determine GYPC's insolvency at the specific time of the transfers. Insolvency does not need to be proven at this point in time. Rather, the Trustee need only plead sufficient facts as to insolvency to establish a plausible claim. The Trustee has sufficiently pled insolvency in these specific circumstances.
The Defendants argue that the Trustee is misapplying the doctrine of retrojection by relying on financial records prior to the alleged transfers. See Limor v. Anderson (In re Scarbrough), No. 18-8028, 2019 WL 1418698, at *6 (B.A.P. 6th Cir. Mar. 29, 2019) (citing Daneman v. Stanley (In re Stanley), 384 B.R. 788, 807 (Bankr. S.D. Ohio 2008)) (retrojection is used indirectly to determine insolvency). The Defendants are correct that retrojection, as its denotation suggests, looks at a financial condition "and extrapolates back in time in an attempt to show that the debtor must have been insolvent at some earlier relevant time." Id. But placing the definition of retrojection aside, the Defendants appear to recognize the past financial records prior to a transfer also can be highly relevant to a target's insolvency at the time of a transfer. Retrojection is not an exclusive method of calculating the insolvency of a corporate entity.
Finally, the Defendants point out that GYPC received its preferred membership interest in Eastport Holdings, LLC as part of the APA. Indeed, it is a matter of record that GYPC valued such interest on its schedules at $4,750,000. But the court's review of the Complaints, including all the redacted language within the Complaints, suggest that insolvency is sufficiently pled, even considering GYPC's interest in the preferred membership interest.
C. The Alostar Preference Claims are Sufficiently Pled
The Complaints allege that a transfer of funds from GYPC to Alostar Bank from customer deposits occurred pre-petition between December 2016 and the March 30, 2017 petition date. GYPC paid Alostar $1,901.160.33, which benefited the Defendants as guarantors on the Alostar line of credit. Defendants assert the Trustee is required to plead a specific date of the transfer and this date range violates basic pleading requirements of Federal Rule of Civil Procedure 8(a). But none of the cases cited by the Defendants suggest that the failure to include the exact date of the transfer of funds is fatal under Twombly or Iqbal. Defendants stretch notice pleading, even under the higher standard since Twombly, beyond its requirements. Waldschmidt v. Mid-State Homes, Inc. (In re Pittman) merely states as a general principle of law that the date of the transfer is critical in evaluating a preference but does not state the exact date must be provided for pleading purposes. 843 F.2d 235, 238 (6th Cir. 1988). See also In re Blanton Smith Corp., 37 B.R. 303 (Bankr. M.D. Tenn. 1984) (date of transfer important in preference litigation). Neither of these decisions involves an analysis of the sufficiency of the allegations in a complaint. Similarly, the last decision cited by the Defendants involves the failure to provide the specific dates of transfers after a trial. Burtch v. Opus, LLC, 528 B.R. 30, 93 (Bankr. D. De. 2015). The Defendants are on sufficient notice to respond to the allegations concerning the Alostar transfer of funds. The Defendants, as guarantors and insiders of GYPC, would be familiar with the transfer of these funds.
The Defendants also argue that the claim relating to the Alostar payments or transfer of funds should be dismissed because of GYPC's dismissal of a separate preference action against Alostar. See Adv. No. 19-3024 (doc. 19). The basis for the dismissal, besides "the disclosure of information provided by the Defendant," is not a matter of this court's records. Id. Nevertheless, based on this dismissal, the Defendants assert that the Trustee did not have a valid claim against Alostar because Alostar held a security interest in GYPC's assets. See 11 U.S.C. § 547(b)(5) (requiring, to establish a preference claim, that a creditor receive more than it would receive in a Chapter 7 case if the transfer had not occurred). And, if Alostar is not pursuable as a preference target, the Defendants argue, as guarantors of the Alostar debt, they may not be pursued as well. The Trustee asserts that the legal principle that a guarantor can assert the same defenses as the transfer recipient only applies to the subsequent new value defense. Harrison v. Brent Towing Co. (In re H & S Transp. Co.), 939 F.2d 359, 360 (6th Cir. 1991). But regardless of the legal implications of the H & S Transportation decision, the pleadings do not explain the specific reason for the dismissal of the Alostar adversary proceeding and what challenges to the elements of a preference claim Alostar would have asserted under § 547(b), or affirmative defenses under § 547(c). Therefore, the court has no legal basis to dismiss the Complaints solely based on a legal argument about the reason the Alostar adversary proceeding was dismissed. In addition, the claims against the Defendants are also raised under a fraudulent transfer theory not pursued in the Alostar adversary proceeding.
One bankruptcy court explained H & S this way:
Thus, Harrison appears to mean, at least, that in an action seeking avoidance of a preferential transfer under § 547 and recovery of the transfer under § 550(a)(1) against an alleged transfer beneficiary, the transfer beneficiary can avoid liability: (1) if the court has already determined in a separate action against the initial transferee that the transfer cannot be avoided, because the initial transferee has a complete defense under § 547(c)(4); or (2) in the absence of such a prior determination, to the extent the initial transferee gave subsequent new value to or for the benefit of the debtor that meets the requirements of § 547(c)(4); or (3) if the trustee has already received full satisfaction from the initial transferee, as a result of a settlement with the initial transferee, or otherwise, thereby providing the transfer beneficiary with a defense under § 550(d).In re Shapiro v. Art Leather, Inc. (Connolly North America, LLC), 340 B.R. 829, 841 (Bankr. E.D. Mich. 2006) (footnote omitted).
Harrison may also mean, more broadly, that the alleged transfer beneficiary in a preference case may preclude avoidance of the transfer by demonstrating that the initial transferee has any of the eight defenses to avoidance under § 547(c). Art Leather's summary judgment motion, however, does not require the Court to decide whether Harrison has that broader meaning, or whether in the alternative, Harrison is limited to the initial transferee's defenses, if any, under § 547(c)(4).
Of course, denial of the motion to dismiss as to the claim relating to the Alostar transfer of funds is without prejudice to a later motion for summary judgment after all of the relevant facts can be presented. The Sixth Circuit recognizes the single transfer theory. Under that theory, transfers are not considered as separate and distinct transfers as to the different creditors from whom the transfers may be recoverable under § 550.Thus, even though an avoidable transfer may be recoverable from different creditors, such as Alostar and the Defendants, if the transfer is not avoidable because it does not meet the elements of an avoidable transfer under § 547(b) or on account of a defense under § 547(c)(4) or § 550(d), it would appear that under H & S it is not avoidable as to any of the creditors. Under the single transfer theory and the broader interpretation of H & S described in the preceding footnote, if the subject transfer is not avoidable as to Alostar on account of any defense under § 547(c), then it is not an avoidable transfer and one never reaches the issue of whether the transfer may be recovered from the Defendants under § 550. See Harrison v. Brent Towing Co. (In re H & S Transp. Co.), 939 F.2d 355, 359 n. 7 (6th Cir. 1991) and Ray v. City Bank and Trust Co. (In re C-L Cartage Co., Inc.), 899 F.2d 1490, 1494-95 (6th Cir. 1990). As noted in H & S, the C-L Cartage decision adopted the single transfer theory in the context of claims against non-insiders which benefit insiders. However, for the reasons stated, there are not sufficient facts based upon the pleadings for the court at the present time to: a) determine what defenses, if any, under §§ 547(c) and 550(d) may be available to the Defendants and are applicable under the facts to this proceeding; and b) make a determination as to the breadth of H & S.
D. S Corporation Tax Status is Not a Property Interest of GYPC
The Defendants assert the alleged conversion of GYPC from an S Corporation to a C Corporation (the "S to C Conversion") is not an interest in property that may be avoided as a preferential or fraudulent transfer. The court has written on a somewhat related issue, finding in an unreported decision that a complaint asserting the waiver of a net operating loss ("NOL") carry forward is a property interest potentially subject to a fraudulent transfer. Harker v. IRS (In re Citro), Case No. 16-32161, Adv. No. 18-3008, doc. 32 (Bankr. S.D. Ohio Aug. 30, 2018). In this adversary proceeding, the Trustee asserts that the pre-petition conversion of GYPC from an S Corporation to a C corporation was both a preference and a fraudulent transfer. The Defendants may have benefitted from such a conversion because tax liability that would flow to the shareholders as an S corporation instead would be paid by GYPC if it was a C corporation. Gitlitz v. Comm'r, 531 U.S. 206, 209 (2001). In order to qualify as an S Corporation, the corporation must be a "small business corporation." 26 U.S.C. § 1361(a). Among other requirements, a small business corporation must have less than 100 shareholders and only one class of stock. 26 U.S.C. § 1361(b).
Subsequent to denying the IRS' motion to dismiss, the district court granted a motion of the IRS to withdraw the reference. The litigation is pending in the United States District Court for the Southern District of Ohio. Case No. 3:19-cv-139.
Property of the estate is defined to include "all legal and equitable interests of the debtor in property as of the commencement of the case." 11 U.S.C. § 541(a)(1). Property is broadly defined to include various types of intangible property. Of course, property rights are not expanded by the filing of a bankruptcy, and generally state law defines property rights. Butner v. United States, 440 U.S. 48, 56 (1979). In the context of tax law, the Internal Revenue Code does not create property rights, but "attaches consequences, federally defined, to rights created under state law." United States v. Bess, 357 U.S. 51, 55 (1958). However, once state law establishes an interest - in this case a valid Delaware S corporate entity - "the tax consequences thenceforth are determined by federal law." Aquilino v. United States, 363 U.S. 509, 513 (1960). See also Arrowsmith v. United States (In re Health Diagnostic Lab., Inc.), 578 B.R. 563 (Bankr. E.D. Va. 2017) ("State law created 'sufficient interests' in the taxpaying entity by affording it the requisite corporate and shareholder attributes to qualify for S corporation status[.]"). The Supreme Court concluded that federal law determines if a taxpayer has a beneficial interest in property subject to levy. Drye v. United States, 528 U.S. 49, 57 (1999). The Bankruptcy Code itself recognizes that the Internal Revenue Code governs whether a bankruptcy estate is separately taxable from the debtor. 11 U.S.C. § 346(a). See In re Majestic Star Casino, LLC v. Barden Dev't (In re Majestic Star Casino, LLC), 716 F.2d 736, 751-52 (3d Cir. 2013) (concluding the Internal Revenue Code, not state law, "governs the characterization of entity tax status as a property interest for purposes of the Bankruptcy Code.").
The Third Circuit, taking an opposing view from a series of prior decisions, determined that such a transfer is not a recoverable property interest. Majestic Star Casino, 716 F.3d at 763 (concluding that a subchapter S corporate status is not a property interest). Another recent decision finding that a change in corporate status is not a property interest is Arrowsmith v. United States (In re Health Diagnostic Lab., Inc.), 578 B.R. 552 (Bankr. E.D. Va. 2017). See also Berit Galesi, Shareholders' Rights Regarding Termination of a Debtor Corporation's S Status in a Bankruptcy Setting, 10 J. Bankr. L. & Prac. (Jan./Feb. 2001) (criticizing the theory that a change in a S Corporation's tax status is a fraudulent transfer). Perhaps the leading case taking the opposite view is In re Trans-Lines West, Inc., 203 B.R. 653 (Bankr. E.D. Tenn. 1996), the only case in the Sixth Circuit that apparently has addressed the question. See also Halverson v. Funaro (In re Funaro, Inc.), 263 B.R. 892, 898 (B.A.P. 8th Cir. 2001) (citing Parker v. Saunders (In re Bakersfield Westar, Inc.), 226 B.R. 227, 232-33 (B.A.P. 9th Cir. 1998)) ("[A]corporation's right to use, benefit from, or revoke its Subchapter S status falls within the broad definition of property of the estate.").
After reviewing the relevant case law, the court is convinced that, unlike a NOL carryforward that the court addressed in Citro, the estate has no interest in the conversion of GYPC from an S corporation to a C corporation. An election as an S corporation is protected until that status is terminated. 26 U.S.C. § 1362(d). "An election may be revoked only if shareholders holding more than one-half of the shares of stock of the corporation on the day on which revocation is made consent to the revocation." 26 U.S.C. § 1362(d)(1)(B). As noted in Majestic Star, "the tax status of the entity is entirely contingent on the will of the shareholders." 716 F.3d at 755. Although property of the estate is a broad term, tax law provides that the shareholders hold the unfettered right to maintain or terminate an S corporation's status. Id. Outside of bankruptcy, an S corporation's income passes through to the shareholders, and the shareholders then must pay the corresponding tax liability. The Trustee seeks to return GYPC to an S corporation, which would benefit the estate's creditors because any income derived from the estate's assets would flow not to the shareholders, but to the creditors, but the shareholders would pay the taxes on any such income of the estate.
An S Corporation could also lose its status because it ceases to be a small business corporation or has more passive investment income then the statute allows. 26 U.S.C. § 1362(d)(2) & (3).
The counterargument to allowing such avoidance is based on the faulty premise that the S corporation's status is a property interest that the corporation controls. Certainly property interests in bankruptcy are sometimes rights that are "novel or contingent." Segal v. Rochelle, 382 U.S. 375, 379 (1966). But the estate cannot hold a greater interest then what existed prior to the bankruptcy. See 11 U.S.C. § 541(d) and Ohio Farmers Ins. Co. v. Hughes-Bechtol, Inc., 249 B.R. 735, 740 (S.D. Ohio 1998). While it is true that the estate can use an S corporation status to pass through tax liability from the estate to shareholders, that fact alone does not create a property right. The estate lacks the ability to control or dispose of an S corporation status under federal tax law. That right can only be exercised by the election of the shareholders and, thus, lies with the shareholders and not the corporation. It is true that the corporation undergoes the ministerial act of deciding to elect Subchapter S status. But "[i]t is unrealistic to suggest that a corporation would ever revolt against its shareholders by refusing to file the revocation form." Health Diagnostic, 578 B.R. at 567.
The court, as noted, has recognized a property interest in a NOL carry forward. But as explained in Health Diagnostics, a corporation's tax status cannot be equated to an NOL:
Contrary to the Liquidating Trustee's assertions, a corporation's tax status differs markedly from a corporation's net operating losses ("NOL"). NOLs have several "essential property rights" that are absent in S corporation status. See Virginia Historic Tax Credit Fund, 639 F.3d at 141 (citing Craft, 535 U.S. at 283, 122 S.Ct. 1414; Drye, 528 U.S. at 60-61, 120 S.Ct. 474). First, a taxpayer corporation has the right to exclude others from an NOL,
while a corporation cannot exclude others from using S corporation status. Second, the taxpayer has much more control over an NOL than over S corporation status. NOLs cannot be revoked or terminated by another party, unlike S corporation status, which can be terminated by shareholder action that causes the corporation to cease to qualify as a small business corporation. See 26 U.S.C. § 1362(d)(2). Third, an NOL is transferable to other entities, while S corporation status cannot be transferred. See, e.g., In re A.H. Robins Co., 251 B.R. 312, 315, 320-21 (upholding the validity of a confirmation order that transferred NOLs from the debtor to a successor corporation); see also In re Majestic Star Casino, 716 F.3d at 756 ("A corporation that does not expect to generate sufficient future earnings to use its NOLs may be purchased by another more profitable corporation which may then use the NOLs to shelter its own income, a transaction expressly contemplated by the I.R.C." (citing 26 U.S.C. § 382)).Health Diagnostic, 578 B.R. at 568-69 (footnote omitted).
The distinction between a corporation's ability to control and transfer NOLs, as opposed to the shareholders' ability to control the Subchapter S election, is the distinction which the Trans-Lines court failed to recognize in its determination that revocation of a Subchapter S election is an avoidable transfer of a property interest.
Outside of bankruptcy, it would never be understood that a corporation could force a Subchapter S corporation to convert to a C corporation. The rights to be a S Corporation are strictly defined and inure to the benefit of shareholders that are eligible for such corporate status. Bankruptcy cannot expand property rights and turn over control over Subchapter S corporation status to a trustee in derogation of federal tax law. Health Diagnostic, 578 B.R. at 570 ("The Liquidating Trustee cannot use the fraudulent transfer provisions of the Bankruptcy Code to maneuver around the strict requirements of the Tax Code."). For these reasons, the allegation that the conversion of GYPC from a Subchapter S corporation to a C corporation is preferential or fraudulent transfer must be dismissed.
The Trustee argues it is premature to dismiss this claim until discovery has occurred. But the claim lacks a basis as a matter of law and discovery would serve no useful purpose. Alternatively, the court fails to see any purpose to grant leave for the Trustee to attempt to further amend how this alleged transfer is pled.
E. Miscellaneous Transfers as Preferences
The court will separately address the adequacy of the Complaints as to all of fraudulent transfer claims.
The Cummings' Amended Complaint, at paragraph 36, seeks recovery of a $1,592.24 January 3, 2017 unspecified expense reimbursement to Cummings, recorded on January 27, 2017. The Webb Amended Complaint, at paragraph 36, raise a series of transfers to Webb:
| Date | Amount | Accounting Reference |
| 01/13/17 | $2,188.73 | Travel to USM Expenses |
| 01/27/17 | $975 | USM 2016 Franchise Tax Return |
| 02/8/17 | $2,473.36 | Expenses |
| 02/15/17 | $5,000.00 | Paid through Restructuring Advisors |
| 02/22/17 | $5,000 | Paid through Restructuring Advisors |
| 02/28/17 | $2,978.89 | 022417 Trip |
| 03/01/17 | $5,000 | Paid through Restructuring Advisors |
| 03/08/17 | $5,000 | Paid through Restructuring Advisors |
| 03/22/20 | $10,000 | Paid through Restructuring Advisors |
| TOTAL | $36,616.18 |
|---|
The Defendants assert that the Miscellaneous Transfers were either ordinary course payments or the Defendants provided subsequent new value. See 11 U.S.C. § 547(c)(2) & (4). Subsequent new value and ordinary course are affirmative defenses that can defeat a prima facie preference claim. The Defendants assert that the Trustee has failed to do the reasonable due diligence required to assert these claims. However, an affirmative defense generally is not a basis to grant a motion to dismiss. Antioch Litig. Trust v. McDermott Will & Emery LLP, 738 F. Supp. 2d. 758, 772 (S.D. Ohio 2010) (a defense cannot be basis to dismiss a complaint if it involves a factual inquiry and cannot be determined conclusively from the complaint).
However, the Defendants raise, albeit with little argument, whether the Trustee met the "reasonable due diligence" requirement which was enacted subsequent to the filing of the Complaints as part of the Small Business Reorganization Act of 2019 ("SBRA"). That legislation became effective on February 19, 2020. Pub. L. No. 116-54, 133 Stat. 1079. This law which created a new vehicle for small business reorganization in the bankruptcy courts, also added language to the preference statute. See 11 U.S.C. § 547(b) ("[T]he trustee may, based on reasonable due diligence in the circumstances of the case and taking into account a party's known or reasonably knowable affirmative defenses under subsection (c), avoid any transfer of an interest of the debtor in property . . . .") (SBRA amended language in italics). Assuming it applies to this adversary proceeding at all, the court cannot determine from the pleadings this issue as a matter of law. Such a determination, along with determinations of the applicability of any affirmative defenses such as ordinary course of business and subsequent new value, require factual determinations based upon an evidentiary record which does not exist at this pleading stage of the proceedings.
The due diligence requirement does not appear to have been addressed in any case law the court found. Some decisions have concluded that a case filed prior to the enactment of SBRA can proceed under those provisions. See e.g. In re Bello, 613 B.R. 894, 896 (Bankr. E.D. Mich. 2020). This decision expresses no view on this legal issue.
F. Fraudulent Transfer Allegations are Sufficiently Pled
The Trustee is pursuing claims for actual fraud pursuant to § 548(a)(1)(A) and constructive fraud pursuant to § 548(a)(1)(B). Claims for intentional fraud trigger the heightened pleading standards of Federal Rule of Civil Procedure 9(b) but claims for constructive fraud do not. Gold v. Winget (In re NM Holdings Co., LLC), 407 B.R. 232, 258-59 (Bankr. E.D. Mich. 2009); State Bank & Trust Co. v. Spaeth (In re Motorwerks, Inc.), 371 B.R. 281, 295 (Bankr. S.D. Ohio 2007). The Defendants argue that the Complaints do not allege any facts in support of these allegations. Degirolamo v. McIntosh Oil Co. (In re Laurel Valley Oil Co.), Bankr. No. 05-64330, Adv. No. 12-6014, 2012 WL 2603429, at *3 (Bankr. N.D. Ohio July 5, 2012) (the complaint should provide specific facts, or indicia of fraud and cannot rely on bare bones pleading of elements of § 548).
(a)(1) The trustee may avoid any transfer (including any transfer to or for the benefit of an insider under an employment contract) of an interest of the debtor in property, or any obligation (including any obligation to or for the benefit of an insider under an employment contract) incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily—
(A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or
(B)(i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and
11 U.S.C. § 548(a)(1).(ii)(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation;
(II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;
(III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor's ability to pay as such debts matured; or
(IV) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.
As to the constructive fraud claims, the court has addressed the insolvency issue and finds the claims sufficiently pled to raise insolvency and capitalization issues at the time the transfers occurred. As to actual fraud, allegations in the Complaints are sufficient under the basic notice pleading requirements of Rule 8(a) and the heightened standard of Rule 9(b). The Quarterly Transfers were given to the Defendants as wages, after being initially classified as dividends or distributions, all during a period when GYPC may have been insolvent. Those allegations are sufficient. The Alostar transfer is alleged to have been paid from consumer deposits, which were not collateral of Alostar, on a line of credit guaranteed by the Defendants. Those details again are sufficient for pleading purposes.
The Miscellaneous Transfers were classified for trips, expenses, and in the case of Webb, merely as "Paid through Restructuring Advisors" and the Trustee is entitled to explore whether any and all those transfers were fraudulent under § 548. The accounting is insufficient to conclude these payments benefitted GYPC. The allegations of the Complaints, including the introductory factual allegations and the allegations contained within the Second Claim for Relief - Avoidance of Section 548 Fraudulent Transfers, identify the who, what, where, when, and why with respect to those transfers. Further, the Complaints allege several "badges of fraud," including the allegations that the Defendants were insiders of GYPC at the time of the transfers, the insolvency of GYPC, and the incurring of obligations in excess of amounts which GYPC could pay. In addition, the Trustee has alleged that he has not been privy to the information which was under the control of the Defendants as the principals of GYPC and, therefore, unable to determine additional facts supporting the claims. See Moore v. Mars Petcare US, Inc., Case No. 18-15026, 2020 U.S. App. LEXIS 23747, at *21-22 (9th Cir. July 28, 2020) (quoting Concha v. London, 62 F.3d 1493, 1503 (9th Cir. 1995) ("Even in cases where fraud is alleged, we relax pleading requirements where the relevant facts are known only to the defendant.")); Bell v. Kokosing Indus., Case No. 19-53-DLB-CJS, 2020 U.S. Dist. LEXIS 129400, at *49-50 (E.D. Ky. July 22, 2020) (citing Coffey v. Foamex L.P., 2 F.3d 157, 162 (6th Cir. 1993)) ("The purpose of the particularity requirement is to give the defendant sufficient notice of the alleged misrepresentation to allow them to adequately respond to the plaintiff's claim; it should be interpreted liberally."); Alsbrook v. Concorde Career Colleges, Case No. 2:19-cv-02583, 2020 U.S. Dist. LEXIS 111551, at *70 (W.D. Tenn. June 25, 2020) ("In an unpublished opinion, the Sixth Circuit has stated that '[i]t is true that pleading on information and belief may be permissible in certain circumstances,' such as when 'a plaintiff may lack personal knowledge of a fact, but ha[s] sufficient data to justify interposing an allegation on the subject or [is] required to rely on information furnished by others.'") (quoting Starkey v. JPMorgan Chase Bank, NA, 573 Fed. App'x 444, 447-48 (6th Cir. 2014) (quoting 5 Charles A. Wright et al., Federal Practice and Procedure § 1224 (3d ed. 2012)) (internal quotations marks omitted).
One of the transfers alleged to have been made to Webb appears to be a post-petition transfer of $10,000. Another transfer from January of 2017 is listed as related to "USM 2016 Franchise Tax Return." Any issue about these transfers can be addressed in discovery.
Under these allegations and circumstances, the Trustee is entitled to explore the details of such payments. The transfers are sufficiently described to put the Defendants on notice as to the transfers sought to be avoided and the descriptions meet the standards of plausibility and particularity.
G. Unknown Transfers
Finally, the Defendants seek to dismiss the claims as to "unknown transfers" as not being pled with any specificity. Certainly because the Complaints do not describe those transfers in any manner, they do not state claims for which relief may be granted. In order for the Trustee to recover on any such alleged "unknown transfers," the Trustee will need to amend one or both of the Complaints to describe any such transfers after they become known through discovery. If the Trustee seeks to amend the Complaints to include claims based on discovery, the Defendants can respond as appropriate to such a motion, and the court will rule on whether such claims may be included in any further amended complaint at that time. As currently plead, no claim for which relief can be granted is stated as to the "unknown transfers," but this conclusion is without prejudice to any future motion by the Trustee seeking to amend one or both of the Complaints to add any discovered transfers and without prejudice to any objections or responses which the Defendants may assert to any such motion at that time.
V. Conclusion
For all these reasons, the Defendants' Motions to Dismiss are granted in part and denied in part. The claims seeking to avoid the Subchapter S tax election revocation as a preference or a fraudulent transfer are dismissed. The allegations of Unknown Transfers are dismissed without prejudice to the determination of any motion to amend the Trustee may file at a later date. The motions to dismiss are otherwise denied. The Trustee's alternative motions to amend the Complaints are also denied, without prejudice to future motions seeking to amend the Complaints after discovery. The court will enter separate orders in the respective adversary proceedings.
This document has been electronically entered in the records of the United States Bankruptcy Court for the Southern District of Ohio.
IT IS SO ORDERED.
/s/ _________
Guy R. Humphrey
United States Bankruptcy Judge
Dated: August 4, 2020
Copies to: Patricia J. Friesinger
Zachary B. White
Daniel J. Gentry
(Counsel for the Plaintiffs, electronically served) Casey M. Cantrell Swartz
Michael L. Meyer
W. Timothy Miller
(Counsel for the Defendants, electronically served) Alfred J. Weisbrod, 111 W. First Street, Dayton, Ohio 45402 (Counsel for the Defendants)