Tuesday, May 14, 2019

Texas Bankruptcy Court Rejects Claim That Attorneys Were Non-Statotory Insiders

Last year, the Supreme Court ruled on a case involving a claim that a party was a non-statutory insider without ever deciding what legal test should apply.   U.S. Bank National Association v. The Village at Lakeridge, LLC, 138 S.Ct. 960 (2018).    Bankruptcy Judge Craig Gargotta was not able to dodge the issue and has written an opinion which is helpful in applying the non-statutory insider test.   Case No. 18-5238, Hornberger v. Davis Cedillo & Mendoza (Bankr. W.D. Tex. 4/16/19)

Under 11 U.S.C. Sec. 547, a preferential transfer made to an ordinary vendor can be recovered if it was made during the 90 days prior to bankruptcy.   However, if made to an insider, the period expands to one year.   11 U.S.C. Sec. 101(31) has a list of persons who are automatically considered insiders, such as the officers of a company.  The statute uses the word "includes" prior to the list.  This means that the list is not exclusive.  Persons who who are not specifically defined to be insiders but have a sufficiently close relationship to the debtor are referred to as non-statutory insiders.
  
 What Happened

Larry Struthoff was a majority shareholder of Olmos Equipment, Inc. ("OEI")..   He was also an officer, shareholder and director of SWL Enterprises, Inc.  ("SWL").   SWL had two other shareholders, Long and Weynand.   OEI acquired the assets of SWL.   Weynand became concerned that Struthoff had cheated him out of his share of the sales proceeds.   Weynand sued OEL, SWL, Struthoff, Long and another shareholder of OEI named Janecke for $6 million.

As trial approached, OEI's longtime counsel became concerned that he did not have the bandwidth for a "bet the company" trial.   OEI hired Davis, Cedillo & Mendoza, Inc. ("DCM").   Where OEI and the insiders previously had separate counsel, DCM represented all of the defendants.   OEI paid the law firm $400,000.   Other parties paid the firm $225,000.

DCM was not able to rescue the company.  After trial, judgment was entered against OEI for $5.3 million. (Judgment was also entered against Struthoff and Janecke). OEI filed chapter 11.  It confirmed a plan which which created a litigation trust.  Ronald Hornberger, the trustee of the litigation trust, sued DCM to recover $400,000 in payments made by the Debtor during the period which was more than 90 days before bankruptcy but less than one year.  The litigation trustee brought claims to recover preferential transfers and fraudulent transfers.   

In order for the preferential transfer complaint to state a claim, the trustee needed to make plausible allegations that DCM was a non-statutory insider of the Debtor. This required Judge Gargotta to answer the question that the Supreme Court had dodged:  what is the test for a non-statutory insider?

The Test

 Judge Gargotta looked to Browning Interests v. Allison (In re Holloway), 955 F.2d 1008 (5th Cir. 1992) to find the proper test.   Holloway was a case under the Texas Uniform Fraudulent Transfer Act.    The definition of an insider under TUFTA is identical to the one contained in the Bankruptcy Code.   Tex.Bus.&Com. Code Sec. 24.002(7).   Thus, the case involved a federal court interpreting a Texas statute which was based on a federal statute.  On top of that, it relied on precedents under the Bankruptcy Code.   The Court in Holloway said:
The cases which have considered whether insider status exists generally have focused on two factors in making that determination: (1) the closeness of the relationship between the transferee and the debtor; and (2) whether the transactions between the transferee and the debtor were conducted at arm's length.
Holloway at 1011.   Judge Gargotta also discussed the Tenth Circuit opinion in Austine v. Carl Zeiss Medical, Inc., 513 F.3d 1272 (10th Cir. 2008) which relied on similar reasoning.

The Ruling

 The litigation trustee argued that DCM exercised control over the Debtor because it persuaded the Debtor to pay for the attorneys' fees of Struthoff and SWL in addition to the Debtor.   The Court rejected this argument, stating:
The Court agrees with DCM that Plaintiff has not met the plausibility requirements of showing that DCM is a non-statutory insider of Debtor. Under the two-prong test of U.S. Medical, Inc, and Holloway, the Plaintiff has not shown that DCM had a sufficiently close relationship with OEI or that DCM exercised control or influence over the Debtor such that the transaction at issue was not done at arm’s length. The facts as deemed true only allege a contractual relationship between DCM and OEI and the course of dealing between the parties was that of an attorney-client. DCM represented OEI in complex civil lawsuit in state court that resulted in an adverse judgment. Plaintiff’s argument that Debtor’s By-Laws or other corporate documents precluded DCM from representing Debtor is unavailing—Struhoff had the requisite authority to engage DCM. Plaintiff has not cited with any specificity as to which corporate provisions were violated. Plaintiff’s assertion that DCM had access to OEI’s internal documents is insufficient to support a finding that DCM exercised control or influence over OEI. The fact that Debtor made payments to DCM for services performed is precisely what any other legal counsel would have requested in the allegations raised here. The payments, based on Plaintiff’s allegations, comport with what was required under DCM’s engagement letter. In sum, there are no facts to indicate that the transaction between the Parties’ was anything other than arm’s length.
Opinion, pp. 21-22. 

An attorney representing a client in high-stakes litigation, whether it is a state court lawsuit or a chapter 11 proceeding, necessarily has a lot of influence over the client.  Because the client is counting on the attorney to guide it through legal peril, the attorney will have more impact on the client's decisions than say, the company's paper vendor.   The arms-length inquiry should focus, as the Court did here, on how the attorney's behavior comported with what attorneys normally do.   

Because this case found that the transactions were done at arms-length, it did not answer the question of what "not arms-length" would look like.   I tried to think of exampleswhere an attorney could exercise sufficient control to take the relationship outside of arms-length status:

1.  The attorney takes the wife of the Debtor's CEO hostage and threatens to kill her if payments are not timely made.  Admittedly, this would be a criminal violation as well.

2.  The client gives the attorney the password to its accounting software and allows the attorney to approve which bills get paid and which bills do not.

3.  The attorney requires that all funds belonging to the corporation be paid to a lockbox controlled by the attorney and the attorney only allows the client to use its funds after the attorney has deducted its fees.

These were extreme examples.   Here is one that is a bit closer:

The attorney and the company's CEO attend the same church and have gone on mission trips together.   The attorney and the CEO regularly dine at each other's home.   At one of these dinners, the attorney tells the CEO that the attorney's wife is receiving cancer treatment and that without the revenue coming in from the litigation, he would not be able to pay for her treatments.   Each week, the CEO asks the attorney how much money he needs and he pays that amount regardless of what the firm billed.     While the attorney in this hypothetical did not exercise improper influence over the generous CEO, the personal bond between the two men led the CEO to give the attorney treatment he would not provide to a third party vendor.  If you tweak the hypothetical slightly and the CEO paid each invoice the same day it was received, then it probably goes back to being arms-length.  While the relationship no doubt would influence the prompt payment, it is still within the range of ways that clients interact with their attorneys.




 

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