Wednesday, November 17, 2010

Debtor Wins Big Damages in Fraudulent Conveyance Case

When fraudulent transfer claims arise in bankruptcy, the debtor is usually accused of being the dishonest transferor. However, in a recent case from Chief U.S. Bankruptcy Judge Ronald King, the Debtor successfully pursued a claim against her disbarred ex-husband. Galaz v. Galaz, Adv. No. 08-5043 (Bankr. W.D. Tex. 11/12/10). The opinion can be found here.

A Tangled Procedural Web

The procedural context of the case is incredibly complex (but fortunately is not necessary to understand the 14 page opinion). Denise Vernon sued Lisa Galaz in a dispute over a company called Worldwide Subsidy Group, LLC. Lisa then filed chapter 13. Both Denise and Lisa's ex-husband Raul filed non-dischargeability complaints against Lisa. Lisa removed Denise's action to bankruptcy court. Lisa then sued Raul as a third party defendant relating to the WSG transactions. While this action was pending, Lisa also sued Raul, his father Alfredo and their company Segundo Suenos, LLC for transactions arising out of another company called Artists Rights Foundation, LLC ("ARF"). After mediation, Denise and Lisa settled their claims and those disputes were dismissed. Raul then tried to force Lisa to join Julian James, the other member of ARF. Instead, the Court allowed Raul to file a third party claim against Julian. Julian filed a claim against Raul. Thus, by the time the case went to trial, Lisa and Julian were asserting claims against Raul, Alfredo and Segundo Suenos, who asserted claims back against them.

The Underlying Facts

So what gave rise to all these dead trees? It all had to do with the right to collect royalties from the popular funk and soul group The Ohio Players. Raul and Julian formed ARF to collect royalties relating to The Ohio Players. When Raul and Lisa were divorced, Lisa was awarded 1/2 of Raul's interest in ARF. Raul then sent a notice to Julian seeking to remove him as a member due to failure to pay expenses related to ARF (including legal fees charged by Raul after he was disbarred as a California attorney). Raul sent this notice to the address designated in the LLC agreement even though he knew that Julian would not receive this notice. Raul then unilaterally conveyed the assets of ARF to Segundo Suenos, LLC and dissolved ARF.

The Issues

The issues at trial were:

1. Was the transfer from ARF to Segundo Suenos, LLC void for failure to be authorized by the company?
2. Was Raul collaterally estopped to deny the invalidity of the transaction?
3. Was the transfer a fraudulent conveyance?
4. Did Raul breach his fiduciary duty to Lisa and Julian?

A Short Course in LLC Law

The Court's ruling highlights the intricacies of limited liability company law. Under the LLC agreement, Raul and Julian were the members of the company. The divorce decree awarded Lisa 1/2 of Raul's interest. Under the LLC agreement, assignees were deemed to hold an "economic interest" in the LLC but would not be members unless agreed to by all of the members. By signing off on the Divorce Decree, Raul agreed to allow Lisa to be a member. However, Julian did not. As a result, Lisa held an "economic interest" but was not entitled to vote. Under the LLC agreement, if a member failed to respond to a written request for capital contributions within 10 days, his interest could be converted into an "economic interest." Raul sent a notice to Julian at the address specified in the LLC agreement and Julian did not respond. However, this was not surprising, since Raul knew that Julian would not receive a notice sent to this address.

Raul contended that he had carte blanche to convey the ARF assets because he was the only voting member. He contended that Lisa was never a member and that Julian ceased being a member by virtue of the notice. The Court held that he was half right. As an assignee, Lisa did not have the right to participate in management due to Julian's failure to approve her as a member. However, the notice sent to Julian was not sufficient to take away his vote because it did not identify any specific expenses to pay and was not received by him to boot. Thus, the transfer was not authorized.

The Court also found that Raul was bound by a California Court of Appeals opinion finding that Segundos Sueno had not established its entitlement to the Ohio Players royalties and found that the case contained sufficient badges of fraud to constitute a fraudulent transfer.

Relying on California law, the Court found that members of an LLC owed a fiduciary duty to each other, but not to persons holding an "economic interest" in the company. The California LLC statute expressly adopted the fiduciary standard applicable between general partners which did not reach assignees. As a result, Julian could recover for breach of fiduciary duty but Lisa could not. However, the Court ruled that Lisa and Julian could recover from Raul for fraud.

The Damages

Lisa was awarded actual damages of $250,000 and punitive damages of $250,000, while Julian recovered actual damages of $500,000 and punitive damages of $500,000. The Court ruled that the royalties would vest 50% in Julian, 25% in Raul and 25% in Lisa. It also ruled that Lisa and Julian could collect their damages out of Raul's share.

What Does This Mean for the Chapter 13?

One goal of BAPCPA was to expedite confirmation of chapter 13 plans. This case illustrates that there are some cases that just don't fit that mold. When the case was filed the Debtor scheduled her interest in WSG at $0 and did not list her interest in ARF. If the case had been confirmed at that time based on the facts known at that time, the Debtor would have been required to make a very low distribution to creditors.

However, apparently as the result of the extensive amounts recovered from litigation in the case, the Court ordered the Debtor to pay $200,000 to unsecured creditors plus amounts paid to secured creditors and attorneys. Since the Debtor is already required to effectively pay 100% to unsecured creditors, the recovery from Raul would not appear to increase her obligation to creditors except for one important point. The Debtor was required to make her payment to unsecured creditors in addition to her payments to attorneys. Since the attorney's fees required to litigate the matter were substantial (the court has already approved over $75,000 in fees), the cost to recover the asset is borne directly by the Debtor. It seems a cruel twist of fate that the harder the Debtor and her attorneys had to work to recover funds for the creditors, the more the Debtor is required to pay.

What Does It All Mean?

On one level, this is a case about California LLC law and the difference between a member and the holder of an economic interest. However, on a big picture basis, it is a testament to the perils of dealing with a case involving an ex-spouse and assets that could only be recovered through litigation. When the Debtor's counsel took this case, he most likely did not contemplate that a chapter 13 bankruptcy in San Antonio would generate 418 docket entries in the main case alone. The result of the hard work by Debtor's counsel and Special Counsel is that unsecured creditors will get paid in full.

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