Arguing Once, Arguing Twice… Gone. Bankruptcy Court Twice Determined that Transfer of LLC Interest Is Not Avoidable Under Preference or Fraudulent Provisions

February 13, 2014

The title is a mouthful, but it is much like the decision rendered by Judge Carla E. Craig of the Eastern District of New York. The decision was truly about a motion to reconsider the judge’s previous decision, but at the heart of the discussion was an individual Chapter 11 debtor’s desire to avoid a prepetition transfer of his LLC membership interests to the other members. Now, it is important to understand the background information before delving into the avoidance discussion.

 

The debtor in In re Garcia had membership interests in two different LLCs along with two other parties who happen to be his relatives. His relatives alleged that he took excessive distributions in the amount of $715,000. Because of this extra dipping into the cookie jar, the family adopted resolutions that ousted the debtor from the companies. But according to the operating agreements, they were required to pay him the value of his interests. Three months later, an involuntary petition was filed against the debtor. And the debtor, left without any ownership interests in the companies, sought to avoid the transfers (essentially, void his family kicking him out of the companies).

 

The debtor claimed the transfers were avoidable both as preference and fraudulent conveyances. In the court’s first decision, it dismissed the fraudulent conveyance claims because the debtor received the right to the value of his interests in the LLCs at the time of his expulsion from the companies. He didn’t contest this finding the second time. Although the value remains undetermined, he is still entitled to receive it (yes, I am deliberately ignoring the possible right to setoff discussion). But what he found unsettling was the judge’s decision that the transfer did not show preference to a creditor.The preference claims were dismissed because they were not “for or on account of an antecedent debt owed by the debtor” before the interests were transferred. The debtor attempted to invoke Bankruptcy Rule 9023 to reargue his position on this issue. I phrase it in this manner because he did not offer any new evidence; the law did not change; there was no oversight of controlling law, just a better argument. And I am referring to the argument other than the judge misunderstood the law regarding antecedent debt. I will admit, however, I do not fault the debtor for seeking his second day in court because it is a logical argument that his relatives could be preferred creditors (definitely insiders who are better positioned to collect on their claims, but that is another matter).

 

If the debtor unrightfully took an extra distribution here and there, then he became indebted to the other LLC members. When the other members expelled the debtor from the companies, they acquired the right to collect additional monies that they would not have received had it not been for the transfer of the debtor’s interests, which affords them repayment of the monies allegedly taken by the debtor without going through judicial process like his other creditors. In fact, the debtor likened the involuntary transfer of his memberships to the perfection of a security interest that deprives other creditors from receiving any economic benefit from the value of his interests (of course, because the other members are receiving it). The court was unmoved by this argument.  Judge Craig rejected the argument because the debtor received the right to receive the reasonably equivalent value of his interests, and she further noted that it could have been presented the first time (so no need to grant reconsideration).  Contrary to popular belief, a motion to reconsider is not an opportunity to reargue.

 

The court explained in detail the legal definition of “for or on account of an antecedent debt”. Without reciting that here, I will say that the facts of this case support a finding that the transfer was “for or on account of an antecedent debt” and thus avoidable as a preference. The debt owed to his relatives existed before the transfer. Had he not owed the debt his family would not have expelled him from the companies and transferred his interests. Without the transfer, the family members would have a claim against the debtor based on the previously owed debt.

 

But here is the problem. Even with the transfer, the family members still had a claim against him for the extra distributions. Even if the debtor received compensation for his membership interests, the family members’ claim still exists. The court noted that it is the effect of the transfer that controls whether a preferential transfer occurred. And no matter how many times the debtor argued his position or how he construed “on account of”, there was one fact that remained – his family members still had a claim based on the excessive distributions. And to succeed in the avoidance, that fact needed to be going, going, gone.

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