There has been a notable increase in litigation regarding loan defaults since the onset of our nation’s financial crisis. Apart from private sector actions brought forth in both state and federal courts, there has also been an increase in adversary proceedings arising in Bankruptcy Courts. Many of these disputes involve allegations of fraudulent transfer and conveyance in the commercial lending industry. Pursuant to section 9017 of the Bankruptcy code, the Federal Rules of Evidence apply to Bankruptcy proceedings. As such, the use of expert testimony in such proceedings is not only permissible, but is a common method of presenting evidence, whether for supporting or negating purposes. In consideration of recent decisions on this subject matter, this article explores the role of experts in Bankruptcy proceedings involving loan defaults in the commercial setting.
Adversary proceedings alleging fraudulent transfer, brought pursuant to 11 U.S.C. 548, can be based upon two theories. The first involves actions falling under 11 U.S.C. 548(a)(1)(A), which provides for relief where the debtor “made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted.” This is referred commonly referred to as actual fraud.
The second type of fraudulent conveyance action involves constructive fraud. These actions are brought pursuant to 11 U.S.C. 548(a)(1)(B), which provides for relief where the debtor:
(i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and
(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation;
(II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;
(III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or
(IV) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.
The majority of fraudulent transfer cases are based upon constructive fraud theories, as opposed to actual fraud. Actions alleging constructive fraud, by their very nature, can be highly complex due to their reliance on a theory which lacks the elemental requirement of scienter. Put simply, actual fraud is more simplistic in that it either exists, meaning it is actually present, or it does not; while constructive fraud can be described as a perception based finding, and therefore relies heavily on the presentation of evidence, typically in the form of expert testimony.
A common central focus of these actions involves the court’s interpretation of ‘value,’ both in terms of ‘reasonably equivalent value’ pursuant to 11 U.S.C. 548(a)(1)(B)(i), and for purposes of subparts (I) through (IV) of 11 U.S.C. 548(a)(1)(B)(ii) in assessing ‘fair value of assets’ and liabilities. In a recent and highly controversial Eleventh Circuit ruling, In re TOUSA, INC, 680 F.3d 1298 (2012), the Circuit Court overturned the District Court’s ruling which had reversed the Bankruptcy Court’s ruling, and in doing so, discussed in detail, the role of expert testimony in reinstating the prior ruling. In regard to fair value of assets in the analysis of liabilities, ability to pay, and timing of insolvency, the Court stated:
“The bankruptcy court credited expert opinion testimony that the Conveying Subsidiaries were insolvent both before and after the transaction of July 31, 2007. Experts in real estate value, public accounting, and insolvency examined the financial records of TOUSA and the Conveying Subsidiaries and concluded that the liabilities of each of the Conveying Subsidiaries exceeded the fair value of their assets before the transaction. The bankruptcy court found that the Conveying Subsidiaries became even more deeply insolvent after incurring additional debt through the transaction. The bankruptcy court also credited expert opinion testimony that, after the transaction, the Conveying Subsidiaries had unreasonably small capital and were unable to pay their debts as they came due.” Id. at 1303.
Further, in discussing an alternate interpretation of reasonably equivalent value through defining value in its broadest application, the Circuit Court, quoting the Bankruptcy Court’s prior ruling, stated:
“The bankruptcy court found that, even if all the benefits highlighted by the Transeastern Lenders and New Lenders were legally cognizable, their value “considered … as a whole, … f[e]ll[ ] well short of `reasonably equivalent’ value.” Id. at 869. The bankruptcy court determined the value the Conveying Subsidiaries lost in the transaction and compared that value with the value of the benefits they received. The bankruptcy court determined that the tax benefits, property, and services that the Transeastern Lenders and New Lenders proffered did not provide reasonably equivalent value to the Conveying Subsidiaries. The bankruptcy court also found that the transaction could not have provided substantial value predicated on the opportunity to avoid bankruptcy because the filing of bankruptcy became “inevitable.” Id. at 846. The bankruptcy court credited the expert opinion testimony of an accountant who had calculated that the Conveying Subsidiaries had incurred $403 million of obligations when they granted liens to help secure $500 million of loans from the New Lenders.” Id. at 1304 (quoting In re Tousa, 422 B.R. 783 (Bankr. S.D. Fla 2009)).
Also notable in the TOUSA matter is the District Court’s deference to market evidence, as opposed to expert testimony provided from a solvency expert, who was secured pursuant to a substantially high contingency fee agreement, and was able to make his determinations in a relatively short amount of time. However, as previously stated, the decision of the District Court was subsequently reversed. Although the Circuit Court failed to comment on the expert’s contingency agreement, an implication can be made that this portion of the District Court’s reasoning was also rejected. Even so, practitioners are cautioned to avoid making broad assumptions—certainly an expert secured on a contingency basis of $2 million, given that other experts were available for a quarter of that amount, and the expert, perhaps impetuously, arrives at his decision in a short period of time, the reliability of such testimony appears questionable, at best.
Given the uniqueness of each individual fraudulent conveyance action, coupled with the interpretive nature of actions based upon constructive fraud, it is unlikely that definitive evidentiary standards can or will be set forth. What can be gained from prior rulings, is that the overwhelming majority of decisions have relied heavily on the analytical findings of experts in conjunction with their subsequent testimony.
By: Alicia McKnight, J.D.