Section 548 of the Bankruptcy Code provides that a transfer made within two years of a bankruptcy filing is fraudulent if the debtor received less than “reasonably equivalent value” in exchange for the transfer and (i) the transfer rendered the debtor insolvent or was made at a time that the debtor was already insolvent or; (ii) the debtor had an unreasonably small amount of capital; or (iii) the debtor intended to incur, or believed that it would incur, debts that it would be unable to pay as they matured. The fraudulent transfer laws of most states, made applicable in bankruptcy proceedings by section 544 of the Bankruptcy Code, contain substantially similar provisions.
While courts generally express the view that the value received by a debtor in exchange for a transfer needs only to be “reasonably equivalent” for the purposes of a fraudulent transfer analysis, what constitutes fair value is often an issue of fact that is determined on a case-by-case basis. Nonetheless, a developing body of case law has begun to address the extent to which benefits conferred on a debtor-transferor in connection with a transaction that is later challenged as constructively fraudulent will be deemed to be reasonably equivalent as a matter of law. The Eleventh Circuit’s recent decision in Crumpton v. Stephens (In re Northlake Foods), 2013 U.S. App. LEXIS 9142 (11th Cir. May 6, 2013) is the latest addition to this growing body of jurisprudence.
The debtor in Northlake Foods is a Georgia corporation that owned approximately 150 Waffle House restaurant locations in Georgia, Florida and Virginia at the time of the bankruptcy filing. The relationship between Northlake and Richard Stephens, one of its primary shareholders, was governed by a Shareholders Agreement dated as of May 1, 1991. At the time of the agreement, Northlake was a “C” corporation that was required to pay taxes on the income it earned. Northlake’s shareholders were obligated to pay taxes on any dividends paid by the company. The agreement provided that in the event that the debtor elected to become an “S” corporation (an entity that is not taxed at the corporate level and passes the responsibility for the payment of taxes through to its shareholders in order to avoid double taxation), Northlake would pay a dividend to Stephens in the year following any year in which income was passed through to him in an amount equal to the amount of taxes incurred by Stephens as a result. In 2005, Northlake designated itself as an S corporation and passed through taxable income to Stephens. In 2006, the company paid Stephens a cash dividend in the amount of approximately $95,000 to cover his tax liability in accordance with the terms of the Shareholders Agreement.
After Northlake filed a chapter 11 petition in 2008, a trustee appointed in the case commenced a lawsuit against Stephens seeking to avoid the 2006 dividend as a constructively fraudulent transfer. Stephens subsequently moved for judgment on the pleadings on the grounds that Northlake received reasonably equivalent value for the transfer. The bankruptcy court agreed, determining that (i) Stephens’ performance under the Shareholders Agreement created an antecedent debt, (ii) the transfer was in satisfaction of the debt and (iii) the satisfaction of the debt constituted reasonably equivalent value. The bankruptcy court also ruled that Northlake received reasonably equivalent value by virtue of Stephens’ agreement to allow the debtor to make the subchapter S election, noting that without the designation, Northlake would have been required to pay the income tax directly. The district court affirmed the bankruptcy court’s ruling that Northlake’s election as a subchapter S corporation constituted reasonably equivalent value for the dividend without reaching the antecedent debt issue.
On appeal, the Eleventh Circuit agreed that Northlake received a benefit from the flexibility granted to it under the Shareholders Agreement to elect to become an S corporation. The court noted that Northlake also enjoyed the benefit of freeing up cash that would otherwise have been dedicated to paying its tax liability until a year after shareholders like Stephens had incurred Northlake’s tax liability. Notably, the court rejected the trustee’s argument that the record was devoid of evidence on which a court could determine the value of the S-corporation election or if the election even constituted a benefit of the estate, determining that a fact-intensive inquiry that considered the totality of the circumstances was not required in order to grant judgment to Stephens. In so doing, the court ruled that because it was clear that the Shareholders Agreement conferred benefits on Northlake, the trustee was not entitled to an evidentiary hearing to consider whether these benefits were reasonably equivalent in value to the difference between the dividend paid to Stephens and the tax burden that would have been incurred by Northlake had it remained a C-corporation.
The court’s unwillingness to grant the trustee the opportunity to probe the relative value of the apparent benefits conferred on Northlake under the Shareholders Agreement is noteworthy. Indeed, in addition to re-affirming the well established principle that “reasonably equivalent” value need not be “equivalent”, this decision can be interpreted as supporting the conclusion that any value received by a debtor that is not de minimis can be deemed reasonably equivalent as a matter of law without the need for the fact intensive inquiry that is typically associated with such case specific issues. Time will tell whether the Northlake decision represents an emerging trend that raises the bar for plaintiffs seeking to establish a prima facie case for constructively fraudulent transfer.