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Development Specialists Inc. v. Kaplan

United States District Court, D. Maine

April 26, 2017

MICHAEL W. KAPLAN, et al., Appellees



         This is an appeal under 28 U.S.C. § 158(a)(1) from the bankruptcy court's final judgment in an adversary proceeding. That court found no fraudulent debtor transfers and no breach of corporate directors' duties. After oral argument on April 12, 2017, I now Affirm the bankruptcy court, although my reasoning differs somewhat.

         Standard of Review

         The parties agree on the standard of review. Appellant's Br. 6 (ECF No. 11); Appellees' Br. 2 (ECF No. 15). I accept the bankruptcy court's factual findings unless they are clearly erroneous. I review the bankruptcy court's conclusions of law de novo. Fed.R.Bankr.P. 7052; Fed.R.Civ.P. 52; In re Furlong, 660 F.3d 81, 86 (1st Cir. 2011).

         Factual and Procedural Background[1]

         The plaintiff/appellant Development Specialists, Inc. is the liquidating trustee for six related debtors in the leather business that entered chapter 11.[2]The trustee seeks to avoid certain transfers by some of the debtors and to recover damages from the former shareholders[3] and directors[4] of one of those debtors, Prime Maine.[5] The trustee's focus is a complex transaction that closed on November 20, 2007 and a later 2010 release related to that transaction.

         In 2007, like other U.S. companies in the leather tanning and finishing industry, Prime Maine experienced profitability challenges. Memorandum of Decision (Mem. of Dec.) 4 [App. 1329]. Meriturn Partners, LLC (Meriturn), a private equity firm that specializes in restructurings and that had recently acquired Irving Tanning, expressed an interested in Prime Maine, seeing an opportunity to merge Prime Maine with Irving Tanning and gain access to additional customers and markets. Id. at 6 [App. 1331]. Meriturn and Prime Maine began negotiations and exchanged multiple letters of interest, culminating in a May 31, 2007 letter that outlined a series of steps whereby Irving Tanning and Prime Maine would come under the common ownership of a new holding company, Prime Delaware.[6] Am. Joint Stipulation of Undisputed Facts ¶¶ 27- 29 [App. 1143]. Prime Maine, Irving Tanning, and Prime Delaware then entered into an August 15, 2007 Contribution Agreement, which was subsequently amended on the closing date, November 20, 2007. Id. ¶¶ 30-34 [App. 1143-44]. In the end Meriturn contributed about $3 million while Irving Tanning, Prime Delaware, Prime Maine, Prime Missouri, and Cudahy entered into substantial lien-secured loan agreements with Wells Fargo, N.A. (Wells Fargo) to complete the financing.[7] At the closing, Irving Tanning, Prime Maine, and Cudahy all came under the common ownership of Prime Delaware, and Prime Missouri remained a wholly owned subsidiary of Prime Maine.[8]

         At the closing, (1) Irving Tanning, Prime Delaware, Cudahy, Prime Maine, and Prime Missouri executed a $1, 860, 000 term note, a $40, 000, 000 revolving note, and a $25, 000, 000 revolving note, all payable to Wells Fargo, [9] Mem. of Dec. 10 [App. 1335]; (2) the debtors actually borrowed from Wells Fargo $1, 656, 785 under the term note and $28, 165, 000 under the revolving notes, Am. Joint Stipulation of Undisputed Facts ¶¶ 35-36 [App. 1141]; (3) Irving Tanning, Prime Delaware, Prime Maine, Cudahy, and Prime Missouri directed Wells Fargo to pay $10, 629, 459 in cash proceeds to Prime Maine's shareholders (the shareholder defendants) and $4 million in non-competition payments to Michael and Stephen Kaplan[10] (previously co-chairs of the Prime Maine and Prime Missouri boards); (4) Prime Delaware delivered a $3, 817, 000 promissory note to the Prime Maine shareholders; (5) Prime Delaware issued 40% of its shares to the Prime Maine shareholders; (6) Prime Maine delivered the $9 million cash value of life insurance policies to certain Prime Maine shareholders; and (7) Prime Delaware entered into employment and non-competition agreements with Michael and Stephen Kaplan. Mem. of Dec. 10-11 [App. 1335-36]; see supra note 10. Prime Maine's shareholders transferred all their shares, i.e., complete ownership of Prime Maine and its subsidiary Prime Missouri, to Prime Delaware. Mem. of Dec. 8-9 [App. 1333-34]; Am. Joint Stipulation of Undisputed Facts ¶ 51 [App. 1147].

         As a result, the Prime Maine shareholders collectively received in excess of $23.6 million in exchange for their stock and agreements. Mem. of Dec. 14 [App. 1339]. The trustee claims that the November 20 transaction amounted to a leveraged buyout (LBO), that the Prime Maine shareholders are responsible for fraudulent transfers by Prime Delaware, Prime Maine, and Prime Missouri, and that the directors of Prime Maine[11] breached duties of loyalty and care to that corporation.[12] The shareholders and directors dispute the LBO characterization, preferring to call the transaction a merger or roll-up, [13] and assert that there were no fraudulent transfers and no breaches of directors' duties. After a 5-day bench trial, the bankruptcy court filed a written opinion in favor of the shareholders and directors, finding that the trustee had not met its burden on any of the claims, [14] and entered final judgment accordingly. The trustee has appealed.[15]


         Fraudulent Transfers

         Maine has adopted the Uniform Fraudulent Transfer Act (UFTA), 14 M.R.S.A. § 3571.[16] It permits a creditor to challenge transfers where there was either actual or constructive intent to defraud. 14 M.R.S.A. § 3575.

         Actual Fraud in November 2007 Transaction[17]

         The trustee asserts actual fraud in the transfers made by Prime Maine and Prime Missouri on November 20, 2007.[18] According to Maine's UFTA, a transfer is fraudulent if the debtor “made the transfer or incurred the obligation . . . [w]ith actual intent to . . . defraud any creditor of the debtor.” 14 M.R.S.A. § 3575(1)(A). The statute also lists eleven factors that “may be given” consideration (along with other unidentified factors) in determining actual intent. Id. § 3575(2).[19] Maine's Law Court has stated: “The court may consider factors other than the [listed factors], and any combination of factors may support a determination of actual intent.” FDIC v. Proia, 663 A.2d 1252, 1254 (Me. 1995).

         The bankruptcy court in this case found that the shareholder defendants did not engage in actual fraud. Mem. of Dec. 13-18 [App. 1338-43]. The trustee correctly observes that the UFTA focuses not on the shareholders but on the debtors, the corporations that made the transfers. But it was the trustee that, in the relevant counts of the adversary complaint, focused on the noncorporate defendants to make the case for actual fraud.[20] That is understandable, because the individuals' intent could be attributed to the corporations. It would be a pointless exercise to send the case back to the bankruptcy court now to ask for findings about these two debtors (Prime Maine and Prime Missouri) as distinct from the shareholders on this issue.[21] And certainly on this record, an appellate court is not in a position to find the contrary, i.e., actual intent on the part of the debtors: that is for the factfinder.

         According to Maine law, actual fraud under the UFTA must be proven by clear and convincing evidence. Proia, 663 A.2d at 1254 n.2. I have read the trial transcript and the relevant exhibits. Although there is room for a difference of opinion over whose version of value in the transaction to believe, the bankruptcy court's factual findings that there was no actual fraud are not clearly erroneous. Therefore its conclusions on those counts must stand.

         Constructive Fraud in November 2007 Transaction[22]

         The trustee asserts constructive fraud in the November 20 transfers made by Prime Delaware, Prime Maine, and Prime Missouri. According to the statute, a transfer is fraudulent under this prong of the UFTA if the debtor:

made the transfer or incurred the obligation . . . [w]ithout receiving a reasonably equivalent value in exchange for the transfer or obligation and the debtor:
(1) Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or
(2) Intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as the debts became due.

Id. § 3575(1)(B). The cases and the commentators call this constructive fraud.

         Applying a preponderance of the evidence standard, [23] the bankruptcy court found that the trustee did not satisfy the first, underlying, element (“without receiving a reasonably equivalent value in exchange for the transfer”) because Prime Delaware did receive reasonably equivalent value in exchange for the transaction with Prime Maine's shareholders.[24] This finding lies at the heart of the LBO labelling controversy. The trustee demands and the shareholders/directors resist the LBO label because it generally intensifies the scrutiny of a transaction.[25] The trustee argues that once the LBO label is applied, the “reasonably equivalent value in exchange” element of the fraudulent transfer statute can almost never be satisfied.[26] In its decision, the bankruptcy court did not refer to the 2007 transaction as an LBO, calling it a “merger” and calling Prime Delaware “the resulting business” in light of testimony from Stephen Kaplan, Michael Kaplan, Moore, Goldberg, and Pombo. Mem. of Dec. 17 [App. 1342]. I respect the bankruptcy court's decision not to accept or reject the LBO label. Labelling too often is a substitute for analysis.[27] In the end, the bankruptcy court gave the transaction the scrutiny it deserved. Once again, there is room for a difference of opinion on whether fair value was exchanged between the shareholders and Prime Delaware, but the bankruptcy court's factual finding[28] that the exchange was fair is not clearly erroneous.[29]

         The trustee correctly points out that the bankruptcy court's opinion focuses on the value of what the shareholders received, and what they transferred in exchange for it, Mem. of Dec. 19-23 [App. 1344-48], not on the value of what any or all of the debtors transferred, the focus of the statutory language. If Prime Delaware is the debtor in question, however, the bankruptcy court's findings certainly suffice to show a fair value exchange.[30]

         But the bankruptcy court did not separately address what Prime Maine and Prime Missouri each transferred or gave up and what, if anything, each of them received in exchange.[31] Instead, the bankruptcy court addressed the transfers in their entirety:

There is no dispute that in consideration of the transfer of 100% of the shares of Prime Maine, the Shareholder Defendants received approximately $23.6 million at the closing in the form of the Cash Proceeds ($14.6 million) and the Insurance Proceeds [actually cash value] (approximately $9 million), and 40% of Prime Delaware.

Mem. of Dec. 20 [App. 1345].

         The shareholders argue that it was sufficient for the bankruptcy court to focus on Prime Delaware because these transfers collectively amounted to a “roll-up.”[32] But the trustee argues that the bankruptcy court had to assess the transfers from each debtor separately.[33] As part of the November 20, 2007 closing, Prime Delaware, Prime Maine, and Prime Missouri all signed notes to Wells Fargo, and each gave the bank a security interest in its respective assets.[34]Then all three directed Wells Fargo to pay the shareholder defendants $10, 629, 459 and Michael and Stephen Kaplan $4 million in non-competition payments under the line of credit. Mem. of Dec. 10-11 [App. 1335-36]. But the “exchange” from the shareholders-all their stock in Prime Maine-went only to Prime Delaware.[35]

         Appellate review might have been more straightforward if the bankruptcy court, in the precise context of assessing reasonably equivalent value for constructive fraud purposes, had focused on the individual debtors, their transfers, and the resulting benefits (direct, indirect, and/or synergy) expressly; or, alternatively, had explained why it concluded that such individual attention to each debtor was not required. Since I am not the factfinder, I cannot decide the factual issue of whether these two companies, Prime Maine and Prime Missouri, each received a fair return in exchange[36] as, for example, by access to a new and different line of credit[37] or other indirect benefits, or whether that individual attention was unnecessary. What I do observe is that the bankruptcy court did find synergy and indirect benefits in the transaction, albeit in a different portion of its decision, when it assessed reasonably equivalent value while dealing with actual fraud.[38] There, it rejected the trustee's argument that the trustee had established that “the value of the consideration received by the debtor was [not] reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred, ” 14 M.R.S.A. § 3575(2)(H) (a statutorily listed indicium of fraud). The bankruptcy court pointed first to the analysis of exchange value that came in its later Section IV.B of the decision involving constructive fraud, Mem. of Dec. 19-23 [App. 1344-48], but then proceeded to recount the evidence showing that the participants all expected success from the November 2007 transaction. The bankruptcy court found that “[directors] Stephen Kaplan, Michael Kaplan, Mr. Moore, Mr. Goldberg, and Mr. Pombo all testified that the merger had the potential to create efficiencies, expand markets, lessen costs and allow the Kaplan family to continue its connection with the Prime brand into another generation.” Mem. of Dec. 17 [App. 1342]. It is apparent that the bankruptcy court believed that this “synergy” was important[39] because, in a footnote to its statement in text that the parties expected success in the resulting business, it quoted a Third Circuit case for the proposition that:

[T]he mere expectation that the fusion of two companies would produce a strong synergy (an expectation that turned out to be inaccurate in hindsight) would suffice to confer “value” so long as the expectation was “legitimate and reasonable.” . . . Thus, so long as there is some chance that a contemplated investment will generate a positive return at the time of the disputed transfer, we will find that value has been conferred.

Mem. of Dec. 17 n.6 (quoting Mellon Bank, N.A. v. Official Comm. of Unsecured Creditors of R.M.L., Inc. (In re R.M.L., Inc.), 92 F.3d 139, 152 (3d Cir. 1996)) [App. 1342].[40] Thus, I conclude that the bankruptcy court, although it did not look at each debtor individually, did consider synergy and indirect benefits in its assessment of value exchanged.

         In any event, the bankruptcy court made other findings that lead me to affirm its decision that constructive fraud did not occur even if the focus is on transfers from Prime Maine and Prime Missouri. The bankruptcy court found that the trustee did not establish either of the other two elements of constructive fraud, i.e., either unreasonably small resulting capitalization or inability to pay debts as they came due.[41]See 14 M.R.S.A. § 3575(1)(B)(1) & (2). In this instance too, the bankruptcy court focused on Prime Delaware. But as to these two findings, the bankruptcy court's ruling ineluctably flows over to Prime Maine and Prime Missouri because, whatever label applies to the transaction, after the closing Prime Delaware was the sole shareholder of Prime Maine, which was in turn the sole shareholder of Prime Missouri; Prime Delaware was not an operating company.[42] There is no evidence in the record that would support a finding ...

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