A powerful tool afforded to a bankruptcy trustee or a chapter 11 debtor-in-possession ("DIP") is the power to recover pre-bankruptcy transfers that are avoidable under federal bankruptcy law (or sometimes state law) because they were either made with the intent to defraud creditors or are constructively fraudulent because the debtor-transferor received less than reasonably equivalent value in exchange and was insolvent at the time, or was rendered insolvent as a consequence of the transfer. To avoid an intentionally fraudulent transfer, a trustee or DIP must show that the debtor transferred its property with the intent to hinder, delay, or defraud its creditors. When the debtor-transferor is an entity rather than an individual, the entity's intent to defraud is typically derived from the intent of individuals or a governing body acting on its behalf (e.g., a board of directors). But if, unbeknownst to the debtor's board, its members approve a transfer based on fraudulent information provided by an officer, has the entity acted with fraudulent intent for purposes of avoidance?
The U.S. Bankruptcy Court for the District of Delaware recently addressed this issue in In re Cyber Litigation Inc., 2023 WL 6938144 (Bankr. D. Del. Oct. 19, 2023). In granting summary judgment in favor of a trustee seeking to avoid payments made as part of a pre-bankruptcy tender offer as a fraudulent transfer, the court held that the intent of a fraudster-officer can be imputed to the board and, in turn, the debtor, where the fraudster manipulated the board through deceit. The court also considered, and rejected, application of the "earmarking" defense to avoidance.
Avoidance of Fraudulent Transfers in Bankruptcy
As noted, fraudulent transfers that can be avoided by a trustee or DIP include: (i) actual fraudulent transfers, which are transfers made with "actual intent to hinder, delay, or defraud" creditors (see 11 U.S.C. § 548(a)(1)(A)); and (ii) constructive fraudulent transfers, which are "transactions that may be free of actual fraud, but which are deemed to diminish unfairly a debtor's assets in derogation of creditors." Collier on Bankruptcy ("Collier") ¶ 548.05 (16th ed. 2023); 11 U.S.C. § 548(a)(1)(B).
Due to the difficulty in proving actual fraud based on an avoidance defendant's subjective state of mind, some courts consider "badges of fraud" in assessing whether a transfer or obligation was made or incurred with intent to defraud, including, among other things, the adequacy of the consideration involved, the relationships between the parties, whether the transferor continued to use the property even after the transfer, and the transferor's financial condition at the time of and after the transfer. See, e.g., In re TransCare Corp., 81 F.4th 37 (2d Cir. 2023); see generally Collier at ¶ 548.04[1][b][i] (citing cases); see also Section 4(b) of the Uniform Fraudulent Transfer Act (the "UFTA") and its successor, the Uniform Voidable Transfer Act (the "UVTA") (listing 11 separate badges of fraud to be applied in determining whether an actual fraudulent transfer should be avoided under state law) (discussed below).
A transfer is constructively fraudulent if the debtor received "less than a reasonably equivalent value in exchange for such transfer or obligation" and was, among other things, insolvent, undercapitalized, or unable to pay its debts as such debts matured. Collier at ¶ 548.05; 11 U.S.C. § 548(a)(1)(B).
Fraudulent transfers may also be avoided by a trustee or DIP under section 544(b) of the Bankruptcy Code, which provides that, with certain exceptions, "the trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor by a creditor holding an unsecured claim that is allowable under section 502 of [the Bankruptcy Code] or that is not allowable only under section 502(e) of [the Bankruptcy Code]." 11 U.S.C. § 544(b)(1). This provision permits a trustee to step into the shoes of a "triggering" unsecured creditor that could have sought avoidance of a transfer under applicable non-bankruptcy law (e.g., the UFTA or its successor, the UVTA). See generally Collier at ¶ 544.06. Section 544(b) is an important tool, principally because the reach-back period for avoidance of fraudulent transfers under state fraudulent conveyance laws (or even non-bankruptcy federal laws, such as the Internal Revenue Code) is typically longer than the two-year period for avoidance under section 548. Id.
If a transfer is avoided under either section 548 or 544(b), section 550 of the Bankruptcy Code authorizes the trustee or DIP to recover the property transferred or its value from the initial or subsequent transferees, with certain exceptions.
Fraudulent Intent of Business Entities
If a debtor-transferor is a legal entity, as opposed to an individual, the question of intent can be complex. For example, as a threshold matter, in the Third Circuit, courts construe federal statutes in which an entity's mental state is an element by looking to the law of the state in which the entity is incorporated. Belmont v. MB Inv. Partners, Inc., 708 F.3d 470, 494 (3d Cir. 2013).
For a business entity in Delaware (which lies within the Third Circuit), "a basic tenet of [Delaware] corporate law, derived from principles of agency law, is that the knowledge and actions of the corporation's officers and directors, acting within the scope of their authority, are imputed to the corporation itself." Stewart v. Wilmington Trust SP Servs., Inc., 112 A.3d 271, 302–03 (Del. Ch. 2015). If an action is subject to the approval of a board of directors, the intent of the majority of the board is imputed to the corporation. Dieckman v. Regency GP LP, 2021 WL 537325, at *36 (Del. Ch. Feb. 15, 2021) (because "it is the Board that governs and manages" the entity in question, the relevant intent was that of a majority of the board).
Defense to Fraudulent Transfer Claim: The Earmarking Doctrine
For a trustee to avoid a transfer made by a debtor, the debtor must have an interest in the property transferred. See 11 U.S.C. § 548(a)(1)(B) (providing in relevant part that the trustee may avoid "any transfer of an interest of the debtor in property" if the transfer is actually or constructively fraudulent). One instance where courts have held that a debtor lacks a sufficient interest in transferred property is where the property is said to have been "earmarked" for transfer to another party, such as where the debtor incurs new debt specifically for the purpose of repaying existing debt. See In re Chuza Oil Co., 88 F.4th 849, 855 (10th Cir. 2023) ("The earmarking doctrine is a judicially created mechanism to determine whether the debtor had an interest in transferred property. It allows a debtor to borrow money to pay an existing creditor without the payments being avoided and the money becoming part of the bankruptcy estate, but only if the borrowed money was 'earmarked' for that purpose.") (citation omitted).
For example, in the Third Circuit, the "earmarking" defense applies if:
- An agreement exists between the new lender and the debtor that the funds will be used to pay a specific antecedent debt;
- That agreement is performed according to its terms; and
- The transaction viewed as a whole does not result in any diminution of the debtor's estate.
In re Winstar Commc'ns, Inc., 554 F.3d 382, 400 (3d Cir. 2009) (citing In re Bohlen Enters., Ltd., 859 F.2d 561, 565 (8th Cir. 1988)). In other words, the debtor must act as a mere conduit through which the funds are transferred and not have the ability to exercise discretion over how to use the funds. See In re USA United Fleet, Inc., 559 B.R. 41, 65 (Bankr. E.D.N.Y. 2016); see also Chuza, 88 F.4th at 856–57 (earmarking applies if the debtor does not exercise dominion or control over the property transferred and the transfer does not diminish the estate).
Cyber Litigation
NS8, Inc. ("NS8"), cofounded by Adam Rogas in 2016, purported to be a fraud prevention service company that would help consumers avoid risks associated with online transactions. The company was instead a fraudulent scheme perpetrated by Rogas, who ultimately pled guilty to federal securities fraud charges.
Rogas's scheme was to create the appearance of a successful business by fabricating NS8's bank statements and other business records showing grossly inflated annual revenue and an exaggerated customer base. Rogas maintained the scheme through his exclusive control of the company's operating account and the data and metrics underlying NS8's purported sales revenue and customer counts.
Relying on these falsified business records, NS8 obtained capital from outside investors through several securities offerings. These included an offering whereby $123 million was raised in 2019 and early 2020 through the sale of preferred shares (the "Series A Financing"). The Series A Financing comprised two separate tranches: $50 million in September 2019 and $73 million in April 2020 (the "April 2020 SPA").
On account of their investment in the initial $50 million tranche, the three lead investors in the Series A Financing each had representatives who served on the NS8's board. The other two seats were held by cofounder and CEO Rogas and an executive vice president.
In April 2020, the company sought to consummate a tender offer whereby it would use the proceeds of the April 2020 SPA to purchase its own shares from earlier investors, including Rogas, who would receive $17 million in exchange for his shares. While negotiations over the April 2020 SPA were ongoing, however, the company disclosed to the three board members appointed by the Series A Financing investors that certain of the company's employees had received subpoenas from the Securities Exchange Commission in connection with a 2019 whistleblower complaint.
The board, in light of this development, elected to delay the April 2020 SPA to permit an independent party to determine whether the company had engaged in any wrongdoing. To investigate the whistleblower complaint, the board retained an accountant, a forensic investigator, and attorneys (collectively, the "advisors"). The advisors, apparently deceived by Rogas's scheme, reported no instances of fraud or wrongdoing.
Satisfied with the advisors' findings, NS8's board decided to go forward with the April 2020 SPA. On April 15, 2020, the board formally approved the transaction following a presentation by Rogas on the company's growth and financial performance, the substance of which would later be determined to be entirely false.
Following approval of the April 2020 SPA, the board, relying again on a fraudulent presentation from Rogas, unanimously voted to approve the tender offer. On June 23, 2020, NS8 funded $72 million of payments to the shareholders, including $17 million paid to Rogas.
Shortly after the tender offer, Rogas's fraud unraveled when NS8's new president sought access to the company's bank accounts. Rogas abruptly resigned as CEO and, on September 17, 2020, was arrested and charged with securities and wire fraud.
On October 27, 2020, the debtor filed a chapter 11 petition in the District of Delaware. In April 2022, the bankruptcy court confirmed a liquidating chapter 11 plan creating a litigation trust empowered with investigating and pursuing estate causes of action for the benefit of creditors. In May 2023, the litigation trustee brought an adversary proceeding against former NS8 shareholders to avoid, under section 548 of the Bankruptcy Code, the 2020 tender offer payments made to them by NS8 as actual and constructive fraudulent transfers. The trustee moved for summary judgment on the claims.
The defendants cross-moved for summary judgment. They argued, among other things, that: (i) the payments were unavoidable under the earmarking doctrine; and (ii) although Rogas may have engaged in fraudulent conduct, NS8's board of directors had the authority to approve the transaction and a majority of the board of directors lacked fraudulent intent, such that Rogas's fraud could not be imputed to the board or the company for purposes of section 548.
The Bankruptcy Court's Ruling
The bankruptcy court granted the trustee's motion for summary judgment on its actual fraudulent conveyance claim and denied the defendants' cross motion. The court did not consider the constructive fraudulent transfer claim (or a related unjust enrichment claim) as those claims sought recovery of the same damages as the actual fraudulent conveyance claim.
U.S. Bankruptcy Judge Craig T. Goldblatt first considered the earmarking defense to the litigation trustee's actual fraudulent conveyance claim. The defendants argued that the April 2020 SPA proceeds were "earmarked" for use in the tender offer because the April 2020 SPA required "[NS8] to use its proceeds to purchase and redeem up to approximately 4,292,525 shares" in a subsequent tender offer, and NS8 did, in fact, use these funds in the tender offer. The defendants further argued that NS8 lacked discretion to use the proceeds for any other purpose.
The bankruptcy court rejected this argument. It found that NS8 retained discretion on how to use the funds under the April 2020 SPA. Judge Goldblatt explained that the agreement required NS8 to repurchase "up to approximately 4,292,525 shares," but did not obligate the company to repurchase any minimum number of shares. Thus, under the April 2020 SPA, the court determined that NS8 had the discretion to purchase anywhere from one to the 4,292,525 shares. Cyber Litigation, 2023 WL 6938144, at *6. The court also pointed to a provision in the agreement that permitted NS8 to use proceeds left over from the tender offer "for general corporate purposes, in accordance with the directions of the Company's Board of Directors." Id. Because NS8 had the discretion to determine how many shares to purchase and how to use the balance of the proceeds, the bankruptcy court held that the funds were not "earmarked" for use in the tender offer and thus were property of the debtor's estate that could be fraudulently transferred. Id. at *7.
The bankruptcy court then turned to the merits of the litigation trustee's actual fraudulent conveyance claim. At the outset, Judge Goldblatt found, and no party disputed, that Rogas actually intended to defraud NS8's creditors by raising money through fabricated financial statements and then transferring that money beyond the reach of creditors through the tender offer in exchange for shares he knew to be worthless.
Next, the court considered whether Rogas's fraudulent intent could be imputed to NS8. In construing the intent element with reference to Delaware state law, the court determined that, because the decision-making body was the board of directors, the relevant inquiry was the intent of the majority of the board. But after surveying relevant Delaware case law, the court concluded that an officer's malintent can be imputed to a board (and thus to the corporation) where the officer controlled the board through deception. Id. at **9–13. To determine whether an officer controlled the board through deception, Judge Goldblatt explained that the "touchstone of the analysis" is whether the deception caused the board to make the decision. Id. at *12.
Judge Goldblatt rejected the defendants' argument that the majority of NS8's board did not have fraudulent intent that could be imputed to the company because, although Rogas clearly had fraudulent intent, the rest of the board was ignorant of Rogas's fraud and had validly relied on the advisors' reports. The bankruptcy court focused on the cause of NS8's decision, i.e., whether the tender offer was approved because of Rogas's fraud or because of the independent board members' uncorrupted view of the transaction and reliance on the advisors' reports. The court reasoned that the cause was necessarily Rogas's fraud, because NS8 was deeply insolvent and the only way the board or its advisors could conclude otherwise was by relying on Rogas's fraudulent financial statements. As such, the court wrote, "[b]ecause Rogas' fraud was the sine qua non of the tender offer, his intent to hinder, delay or defraud creditors is imputed to the debtor." Id. at *13.
Outlook
Cyber Litigation is an unusual case. First, the malfeasance giving rise to events that led to the avoidance litigation was extreme and undisputed. This meant that the bankruptcy trustee did not bear the onerous burden of proving actual intent to defraud. Other actual fraud cases are unlikely to be so uncomplicated on this point.
Other key takeaways from the ruling include: (i) if a debtor has the discretion to determine how funds it receives from a third party are to be disbursed, the recipient of the funds cannot rely on the earmarking doctrine as a defense to avoidance of the transfer; (ii) the court looks to applicable non-bankruptcy law (usually state law) to determine whether fraudulent intent can be imputed from the governing body of a business entity to the entity itself; and (iii) under certain circumstances, such as those presented by Cyber Litigation, fraud may be imputed even if that governing body is unaware of the fraud, but is deceived by someone in a position to influence the governing body's decisions.
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