LLC That Pays Itself and Insiders to Exclusion of Creditor Plaintiff Violates Fraudulent Transfer Statute – Illinois Court

Applying Delaware corporate law, an Illinois appeals court in A.G. Cullen Construction, Inc. v. Burnham Partners, LLC, 2015 IL App (1st) 122538, reversed the dismissal of a contractor’s claim against a LLC and its sole member to enforce an out-of-state arbitration award.  In finding for the plaintiff contractor, the court considered some important and recurring questions concerning the level of protection LLCs provide a lone member and the reach of the Uniform Fraudulent Transfer Act, 740 ILCS 160/1 et seq. (“UFTA”), as it applies to commercial disputes.

The plaintiff sued  a Delaware LLC and its principal member, an Illinois LLC, to enforce a $450K Pennsylvania arbitration award against the Delaware LLC.  The plaintiff added UFTA and breach of fiduciary duty claims against the Delaware and Illinois LLCs based on pre-arbitration transfers made by the Delaware LLC of over $3M.

After a bench trial, the trial court ruled in favor of the LLC defendants and plaintiff appealed.

Reversing, the appeals court noted that the thrust of the UFTA claim was that the Delaware LLC enriched itself and its constituents when it wound down the company and paid itself and its member (the Illinois LLC) to the exclusion of plaintiff.

The UFTA was enacted to allow a creditor to defeat a debtor’s transfer of assets to which the creditor was entitled.  The UFTA has two separate schemes of liability: (1) actual fraud, a/k/a “fraud in fact” and (2) constructive fraud or “fraud in law” claims.  To prevail on an actual fraud claim, the plaintiff must prove a defendant’s intent to defraud, hinder or delay creditors.

By contrast, a constructive fraud UFTA claim doesn’t require proof of an intent to defraud.  Instead, the court looks to whether a transfer was made by a debtor for less than reasonably equivalent value leaving the debtor unable to pay any of its debts. (¶¶ 26-27); 740 ILCS 160/5(a)(1)(actual fraud), 160/5(a)(2)(constructive fraud).

When determining whether a debtor had an actual intent to defraud a creditor, a court considers up to eleven (11) “badges”of fraud which, in the aggregate, hone in on when a transfer was made, to whom, and what consideration flowed to the debtor in exchange for the transfer.

The court found that the Delaware LLC’s transfers of over $3M before the arbitration hearing had several attributes of actual fraud. Chief among them were that (i) the transfer was to an “insider” (i.e. a corporate officer and his relative), (ii) the Delaware LLC transferred assets without telling the plaintiff knowing that the plaintiff had a claim against it; (iii) the Delaware LLC received no consideration a $400K “management fee” paid to the Illinois LLC (the Delaware LLC’s sole member); and (iv) the Delaware LLC was insolvent after the  transfers.

Aside from reversing the UFTA judgment, the court also found the plaintiff should have won on its piercing the corporate veil and breach of fiduciary duty claims.  On the former, piercing claim, the court held that the evidence of fraudulent transfers by the Delaware LLC to the Illinois LLC presented a strong presumption of unjust circumstances that would merit piercing.  Under Delaware law (Delaware law governed since the defendant was based there), a court will pierce the corporate veil of limited liability where there is fraud or where a subsidiary is an alter ego of its corporate parent.  (¶ 41)

On the fiduciary duty count, the court held that once the Delaware LLC became insolvent, the Illinois LLC’s manager owed a fiduciary duty to creditors like the plaintiff to manage the Delaware LLC’s assets in the best interest of creditors. (¶¶ 45-46)

Afterwords:

A pro-creditor case in that it cements proposition that a UFTA plaintiff can prevail where he shows the convergence of several suspicious circumstances or “fraud badges” (i.e., transfer to insider, for little or no consideration, hiding the transfer from the creditor, etc.).  The case illustrates a court closely scrutinizing the timing and content of transfers that resulted in a company have no assets left to pay creditors.

Another important take-away lies in the court’s pronouncement that a corporate officer owes a fiduciary duty to corporate creditors upon the company’s dissolution.

Finally, the case shows the analytical overlap between UFTA claims and piercing claims.  It’s clear here at least, that where a plaintiff can show grounds for UFTA liability based on fraudulent transfers, this will also establish a basis to pierce the corporate veil.

 

Non-Shareholder Can Be Liable On Alter-Ego and Veil Piercing Theory – IL Bankruptcy Court (2015)

Buckley v. Abuzir, 8 N.E.3d 1166 (1st Dist. 2014) will probably be viewed as a watershed case in piercing the corporate veil litigation because of its exhaustive analysis of when and where a non-shareholder of a corporation can be held liable for corporate debts.  In that case, the court provides an extensive survey of how nearly every jurisdiction in the country has decided the non-shareholder/piercing question.

In re Tolomeo, 2015 WL 5444129 (N.D.Ill. 2015) is a recent Federal bankruptcy decision that considers the related question of whether a creditor can pierce the corporate veil of entities controlled by a non-shareholder debtor so that those entities’ assets become part of the debtors’ bankruptcy estate.

The answer: “yes.”  In their complaint, the creditors sought a determination that three companies owned by the debtor’s wife but controlled by the debtor were the debtors’ alter-egos.  The creditors of the debtor also sought to pierce the companies’ corporate veils so that the companies’ assets would be considered part of the debtor’s bankruptcy estate.  This would have the salutary effect of providing more funds for distribution to the various creditors.  After striking the debtor’s defenses to the complaint, the court granted the creditors motion for judgment on the pleadings.

In granting the creditors’ motion for judgment on the pleadings, the bankruptcy court applied some fundamental piercing principles to the situation where an individual debtor controls several companies even though he is not a nominal shareholder of the companies.

In Illinois, a corporation is a legal entity separate and distinct from its shareholders. However, this separateness will be disregarded where limited liability would defeat a strong equitable claim of a corporate creditor.

A party who seeks to set aside corporate liability protection on an alter-ego basis must make the two-part showing that (1) the company was so controlled and manipulated that it was a mere instrumentality of another entity or individual; and (2) misuse of the corporate form would promote fraud or injustice.

The mere instrumentality factors include (a) inadequate capitalization, (b) a failure to issue stock, (c) failure to observe corporate formalities, (d) nonpayment of dividends, (e) insolvency of the debtor corporation, (f) nonfunctioning officers or directors, (g) lack of corporate records, (h) commingling of funds, (i) diversion of assets from the corporation by or to a shareholder, (j) failure to maintain arm’s length relationships among related entities; and (k) the corporation being a mere façade for the dominant shareholders.

Promotion of injustice (factor (2) above)), in the veil piercing context, requires less than a showing of fraud but something more than the prospect of an unsatisfied judgment.

The court echoed Buckley and found that the corporate veil can be pierced to reach the assets of an individual even where he is not a shareholder, officer, director or employee.

The key question is whether a person exercises “equitable ownership and control” over a corporation to the degree that there is no separation between the corporation and the individual.  According to the court, making shareholder status a prerequisite for piercing liability elevates form over substance

Applying these standards, the court found the circumstances ripe for piercing. The debtor controlled the three entities as he handled the day-to-day operations of the companies. He also freely shifted money between the entities and regularly paid his personal bills from company bank accounts. Finally, the court noted a complete lack of corporate records and an obvious failure to follow rudimentary formalities. Taken together, the court found that the factors weighed in favor of finding that the three companies were the debtor’s alter-egos and supported piercing the three companies’ corporate veils.

Take-aways:

1/ A defendant’s status as a corporate shareholder will not dictate whether or not his assets can be reached in an alter-ego or veil piercing setting.

2/ If non-shareholder sufficiently controls a corporate entity, he can be responsible for the corporate debts assuming other piercing factors are present.

3/ Veil piercing can occur absent actual fraud by a controlling shareholder.  The creditor plaintiff must show more than a mere unpaid debt or unsatisfied judgment, though.  Instead, there must be some element of unfairness present for a court to set aside corporate protection and fasten liability to the individual.

 

 

Uniform Fraudulent Transfer Act: Actual Fraud, Constructive Fraud and Transfers for Insufficient Value: IL Law Basics

The Illinois Fraudulent Transfer Act (“FTA”) – 740 ILCS 160/1 et seq. – is a powerful creditor enforcement tool aimed at capturing assets transferred by a judgment debtor to elude a money judgment.  

In United Central Bank v. Sindhu, 2014 WL 3748555, the bank obtained a $4.3M judgment against the defendant.  After initiating various citations to discover assets, the bank learned that several months after the judgment, the defendant transferred three properties to his sister – including one residence property valued at over $3M.   He also received and turned over several rent checks on one of the transferred commercial properties.

 The plaintiff filed an FTA suit against the defendant and his sister seeking the turnover of the $3M property and the rent checks.  The defendants moved to dismiss all complaint counts.  The Court denied the bulk of the motion.

Operative Rules and Reasoning:

FTA Sections 5(a)(1), (2) and 6 govern claims based on actual fraud, constructive fraud and for pre-transfer claims, respectively.

The FTA’s actual fraud provision – Section 5(a)(1) – requires a plaintiff to plead that a debtor transferred property with actual intent to hinder or defraud a creditor, whether the claim arose before or after the transfer was made. 

Actual fraud factors include whether (1) the transfer or obligation was to an insider;

(2) the transfer or obligation was disclosed or concealed;

(3) before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit;

(4) the transfer was of substantially all the debtor’s assets;

(5) the debtor removed or concealed assets;

(6) the value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred. 

To plead FTA constructive fraud (Section 5(a)(2)), the plaintiff must allege that the transfer was made, before or after a creditor’s claim matured, and the debtor never received reasonably equivalent value in exchange for the transfer.

The constructive fraud plaintiff must also allege that the debtor engaged in or was about to engage in a transaction that left the debtor with zero or unreasonably small remaining assets, or should have believed that he (the debtor) would incur debts beyond his ability to pay as they became due. (*3).

FTA Section 6(a) applies only to creditor claims that arose before a debtor’s transfer of assets.  

An FTA Section 6(a) plaintiff must establish that (1) the debtor made a transfer without receiving a reasonably equivalent in exchange for the transfer; (2) that the debtor was insolvent at that time or became insolvent as the result of the transfer; and (3) the creditor’s claim arose before the transfer.  (*3).

The Court found that the plaintiff sufficiently alleged valid FTA claims under all three sections.

The thrust of the complaint was that (a) several months after the money judgment, (b) the defendant secretly transferred multiple million dollar properties and rent checks to a family member (an insider) and (c) received little or nothing in return for the transfers. 

Defendant’s sister (the transferee) argued that she retired over $1.5M in the debtor’s mortgage debt in return for the conveyance of the $3M residence property. 

However, since the property was worth more than twice the amount of the retired mortgage debt, the Court found that the defendant didn’t receive a reasonably equivalent value in exchange. 

Taken together, the Court found these allegations satisfied the pleading standards for an FTA actual fraud and constructive fraud claim for transfers made before or after a creditor’s claim arose. 

Take-aways:

Sindhu shows in sharp relief the fruits of aggressive post-judgment collection efforts.  

Had the plaintiff not so ardently pursued its claims, the defendant could have transferred substantial assets properties and likely escaped the judgment.