By Richard Marshack and Ed Hays
The recent 9th Circuit Schwarzkopf opinion ((Robert L. Goodrich v. Juan Briones (In Re: Alexis Hill Schwarzkopf), No. 08-56974, (Nov. 23, 2010, 9th Cir); 2010 U.S. App. LEXIS 24046.)) reads a little like a travelogue about a Chapter 7 trustee that sees outrageous harm to creditors and sets out in search of a remedy that will make things right. Our firm includes one panel trustee in the Central District of California, so we sympathize with the trustee and his journey. And it was a bumpy road to recovery since the debtors had set up two trusts to protect assets using different methods for each trust—and all of it occurred many, many years before the petition was filed. So like any good travelogue, there are odd pictures that require explanation, but eventually the bankruptcy trustee makes it safely home to recover the dusty trust assets for the benefit of the estate.
Richard Marshack has served as a panel trustee in the Central District of California for over 25 years. His writings should not be taken or used as statements of policy or position on any specific case or future case where he serves as the trustee or as counsel of record. Mr. Marshack also manages an active reorganization and bankruptcy practice–providing representation to debtors, creditors, creditor committees, bankruptcy trustees and troubled asset purchasers and sellers. He provides insolvency and reorganization counseling to businesses and their principal owners when prudent planning requires a strategy to deal with business and personal debt challenges.
The “odd pictures” in Schwarzkopf were two separate trusts—referred to as the “Apartment Trust” and the “Grove Trust”—which the trustee no doubt found offensive since the facts clearly suggested that each was set up to hide or protect valuable assets from creditors at times when the debtors were just as clearly insolvent. Ultimately, the 9th Circuit upheld a ruling by the District Court that the Apartment Trust was “invalid” and then went further and reversed the District Court (affirming the Bankruptcy Court’s ruling on this issue) in finding that the Grove Trust was the “alter ego” of the debtor. The effect of these rulings was to give ownership of allegedly $4 million in trust assets to the estate.
Ed Hays specializes in business litigation and bankruptcy. He has over 18 years of experience in complex litigation, business litigation and bankruptcy matters. Over the years, Mr. Hays has represented businesses, creditors and bankruptcy trustees in complex core and non-core bankruptcy proceedings. He has also served in the past as a Judge Pro Tem in the Los Angeles Superior Court. Mr. Hays now manages a busy litigation practice that crosses over frequently between State and Federal Courts. With numerous published cases in both the State and Federal Court systems, he is a tenacious and sought-after litigator.
The bankruptcy petition was filed in 2003 and the two irrevocable trusts were formed in 1992, with separate asset transfers into the trusts occurring in 1992 and 1997. The trustee sued for fraudulent conveyance and sought to recover the trust assets for the estate despite the heavy veneer of creditor protection attempted with each trust. All the parties agreed, as did the Court, that California law applied in determining the underlying issues relevant to the trusts. Our interest in the holdings flows from the use of the procedural claim of “alter ego,” especially as it relates to the more complicated facts arising from the “Grove Trust” (see below). ((Just weeks before Schwarzkopf, a different 9th Circuit panel , in Ahcom, Ltd. v. Smeding et al., No. 09-16020, (Oct. 21, 2010), limited a bankruptcy trustee’s ability to allege “alter ego” as a claim for relief. Although Ahcom, Ltd. presented a different question than Schwarzkopf, its lesson for bankruptcy trustees is that, under applicable California law, there is no such thing as a “substantive alter ego claim”—i.e., that alter ego can only be used as a procedural claim or remedy when joined with an underlying cause of action such as fraudulent conveyance, conversion or theft. In Schwarzkopf, there was no such issue since the trustee apparently was able to use the substantive claim of fraudulent conveyance in order to justify his reliance on the procedural claim or remedy of alter ego. But after Ahcom, Ltd., when it comes to questions of when and how courts in our 9th Circuit will apply “alter ego”, trustees are definitely paying attention.))
Although our focus is somewhat limited here, we note in passing that the bankruptcy trustee was able to overcome a potential problem with the statute of limitations, despite the long periods of time between the formation and funding of the two trusts and the bankruptcy case. ((The 9th Circuit applied the seven year limitations period in Calif. Civ. Code Sec. 3439.09(c) and reasoned as follows: When an express trust fails under California law, the trustee of the trust becomes a voluntary trustee holding legal title to the property on a resulting trust for the trustor and his heirs; and further, the limitations period does not begin to run until the voluntary trustee “repudiates” the trust. In this case, Briones, the trustee of each trust, did not repudiate his role as a voluntary trustee until he answered the trustee’s adversary proceeding and “denied that the [trust’s] assets are property of the estate.” See Schwarzkopf, No. 08-56974 at 18718.))
The Apartment Trust was set up in 1992 with a minor child of the debtors as the beneficiary. The trust was funded with all of the stock in a corporation owned by the debtor/husband (herein the “debtor”). That corporation owned the Kokee Woods Apartments and a good friend (Briones) was installed as the trustee. Given the existence of a lawsuit and judgment against the corporation in 1992, the insolvency of the debtors and the fraudulent intent of the debtors to avoid or delay collection actions, it was easy to find a fraudulent purpose behind the transfer. Strangely, however, the debtor ultimately prevailed in the lawsuit that prompted the creditor fraud, and even won a verdict of over $8 million. Evidence showed that the Apartment Trust was treated like the personal asset of the debtors and the corporate stock supporting ownership of the Kokee Woods Apartments remained an asset of the Apartment Trust.
In the case of this Apartment Trust, the Court noted that California law is well-settled that “a trust created for the purpose of defrauding creditors or other persons is illegal and may be disregarded.” ((Schwarzkopf, No. 08-56974 at 18718, quoting from In re Marriage of Dick, 18 Cal. Rptr. 2d 743, 752 (Cal. Ct. App. 1993); and referencing Cal. Prob. Code § 15203.)) And it quickly went on to uphold the ruling of the District Court that the Apartment Trust was an “invalid trust” and should be disregarded (based on the Bankruptcy Court’s findings concerning the fraudulent intent of the debtor in the asset transfer into the Apartment Trust). No alter ego issues were raised with regard to the Apartment Trust presumably because the corporate stock and the apartment assets simply became assets of the estate once the trust was deemed “invalid” at its formation.
Turning to the Grove Trust, the Court had to deal with a new twist to the layers of creditor protection installed by the debtor. Despite its formation in 1992, it wasn’t until 1997 that the debtor used a shell corporation to acquire four lots of land and then caused the corporation to transfer title to those assets directly into the Grove Trust. The bankruptcy court found that the assets used by the shell corporation to purchase or acquire the lots actually belonged to the debtor and that the whole charade was arranged as a fraud on creditors since, once again, the debtors were insolvent at the time of the acquisition and the title transfer.
The problem presented to the courts at each level, however, was that the debtor did not directly transfer his assets into the Grove Trust. An allegedly separate corporation transferred the assets. So if the trust were simply held “invalid” (as with the Apartment Trust), it appears that the “resulting trust” remedy would not be enough to bring the assets into the estate.
So a different procedural claim was asserted by the bankruptcy trustee in order to bring the assets into the estate—and that claim or remedy was “alter ego.” The bankruptcy trustee alleged that the debtor was the “equitable owner” of the Grove Trust and that this “equitable ownership” of the debtor was enough to confer alter ego liability. ((The fact that a corporation transferred the assets into the trust loses focus in the opinion as an issue because of the “equitable ownership” discussion. The focus turns to whether, under California law, when a trust is set up by a person (who may not even be a beneficiary), with a fraudulent purpose in mind, and is then treated and used like it belongs to that person, can alter ego be used as a collection remedy by that person’s creditors.))
As you might guess, the debtor argued—with all the chutzpah you’d expect from the designer of a fraud on his own creditors—that allowing an alter ego claim in these circumstances would amount to “reverse piercing” which is prohibited under California law. ((Citing Postal Instant Press, Inc. v. Kaswa Corp., 77 Cal. Rptr. 3d 96, 97 (Cal. Ct. App. 2008).)) Yes, we know; it’s getting a little confusing. But the concept of reverse piercing simply means that while a creditor of a corporation may pierce the corporate veil to reach assets of the shareholders in order to satisfy corporate debts, a creditor of the shareholders may not reach the corporate assets to satisfy the debts of the shareholders. And that is precisely what the trustee needed to do since he stood in the shoes of a creditor of the “shareholder”/debtor. He needed to reach the assets of the Grove Trust (received from a sham corporation controlled by the debtor) in order to pay the debts of the shareholder and now debtor. Messy.
But the 9th Circuit noted that there are exceptions under California law to the prohibition on “reverse piercing,” saying that, “[i]n the context of trusts, however, the California Supreme Court has allowed alter ego claims where a trust is alleged to be a debtor’s alter ego.” ((Schwarzkopf, No. 08-56974 at 18720.))
So the Court proceeded to analyze the two conditions required under California law for alter ego liability in this “trust” context—first, where there is a “unity of interest;” and second, where “adherence to the fiction of separate existence of the corporation would sanction a fraud or promote injustice.” ((Id., at 18719.))
Of course, the debtor steadfastly asserted that “unity of interest” requires actual “ownership” since S.E.C. v. Hickey ((322 F.3d 1123 (9th Cir. 2003).)) found, in the context of a corporation, that stock ownership is a requirement for alter ego liability. But the Court noted that Hickey “did not foreclose the possibility that equitable ownership might be sufficient in some contexts.” ((Schwarzkopf, No. 08-56974 at 18721.)) Instead, the Court reviewed California law and found that it “suggests that equitable ownership is sufficient,” particularly in the context of trusts, where equitable interests are traditionally sufficient to confer ownership rights. ((Id.))
It’s not surprising then that the Court concluded as follows: “Given that the bankruptcy court called the acquisition of the Grove Lots ‘a fraud on the creditors of the Debtors,’ failure to find alter ego liability would sanction a fraud or promote injustice. The bankruptcy court did not err in finding that the Grove Trust is Michaels’s [debtor’s] alter ego.” ((Id. at 18723.))
So while the journey for Grove Trust assets was tinged with suspense, ultimately the Court allowed the procedural claim of alter ego to melt away the confusing layers of supposed creditor protection for the benefit of the bankruptcy estate.
We’ll add couple of practice notes for practitioners here and we hope that you consider posting your comments as well. The discussion in the Court’s opinion of “intent to defraud creditors” is a reminder that creditors (and trustees) using California fraudulent conveyance law don’t have to be linked in any way to the aggrieved creditors. Stated differently, the intent to defraud any creditor at the time of the transfer satisfies the intent component of the fraudulent conveyance cause of action. In Schwarzkopf, for example, the first transfer occurred in 1992, and the debtor’s intent was to create delay and collection difficulty for a judgment creditor that eventually lost on appeal (and became a debtor in an $8 million judgment).
As a final practice note, debtors engaging in creditor protection planning should take caution when using trusts as a protection mechanism. The 9th Circuit showed some flexibility under California law in applying the “alter ego” claim in the context of trusts. Perhaps this indicates a willingness to ignore layers of creditor protection in other contexts that would allow bankruptcy trustees to reach assets where there has been a concerted and long term effort to protect assets in obvious and flagrant ways.
What do you think?