Case No. SV 98-15561 GM, Adv. No. SV 02-01797 GM.
October 3, 2005
MEMORANDUM OF OPINION RE PLAINTIFFS' MOTION FOR SUBSTANTIVE CONSOLIDATION
This decision arises out of an adversary proceeding in which Kamiar Simantob, Kamran Simantob and Nasser Lahijani ("Plaintiffs") moved to substantively consolidate two non-debtor corporations, Elan Enterprises, Inc. ("Elan"), an entity created pre-petition, and Vista Lane, LLC ("Vista"), an entity created after the bankruptcy filing, with the bankruptcy estate of Kaveh Lahijani ("Debtor"). This opinion addresses the following issues: 1) whether creditors have standing to bring a motion for substantive consolidation, 2) whether the two non-debtor corporations may be substantively consolidated with the bankruptcy estate, and (3) whether nunc pro tunc consolidation as of the petition date is appropriate.
The amended second amended complaint filed by Plaintiffs on July 23, 2003, identifies Vista as "630 Vista Lane LLC." However, the motion for substantive consolidation filed on November 5, 2003, identifies Vista as "Vista Lane LLC." It appears that this is one and the same entity because it is described as being the owner of 630 Vista Lane, Laguna Beach, California. However, Plaintiffs are ordered to clarify this fact in their supplemental evidence regarding the date of Vista's formation (as discussed below and as required in the order accompanying this memorandum).
II. PROCEDURAL HISTORY
On April 22, 1998, Debtor filed a voluntary petition under chapter 7 of the Bankruptcy Code. The Debtor was granted a discharge on August 7, 1998, and the case was closed as a no-asset case on August 3, 1999.
This case was initially assigned to Judge Greenwald. Upon Judge Greenwald's retirement, the case was reassigned to me on June 1, 2005.
The Debtor had a preexisting business relationship with the Plaintiffs in connection with two real estate developments financed by Plaintiffs in 1987 and 1988 for which Debtor served as developer and manager. Plaintiffs allege that Debtor engaged in fraud and embezzlement and that his conduct resulted in approximately $7 million worth of losses to Plaintiffs.
When Debtor filed bankruptcy in April 1998, he did not list Plaintiffs on his schedules and they did not make an appearance in the case. In May 2000, Plaintiffs sued Debtor and others in the Los Angeles County Superior Court, alleging intentional misrepresentation, fraudulent concealment, rescission, conspiracy to defraud, breach of fiduciary duty, imposition of constructive trust, and conversion. Debtor filed a cross-complaint and, on March 20, 2002, brought a motion to reopen the bankruptcy case to include the cross-complaint as an asset of the bankruptcy estate. Peter C. Anderson was appointed chapter 7 trustee ("Trustee").
Plaintiffs first discovered the alleged fraud in late 1999 (see Amended Second Amended Complaint, ¶ 30), and admit to knowing about the bankruptcy when they filed their state court complaint (see Joint Status Report filed on June 17, 2005, p. 6, 1.19), at which point the Debtor had already received his discharge and the bankruptcy case had been closed.
After the bankruptcy case was reopened, Plaintiffs tried to have the state court action removed to the bankruptcy court. However, pursuant to an order entered on December 23, 2002, Judge Greenwald remanded the matter, allowing the Debtor to defend the state court action and proceed with his cross-complaint. Despite this order, on February 13, 2003, the Debtor filed a motion for relief from stay to be allowed to proceed with his cross-complaint in state court, stating that Plaintiffs still maintained the position that Debtor was not authorized to do so. In response, Plaintiffs asserted that the Debtor was not authorized to prosecute the cross-complaint until it had been abandoned by the Trustee. Relief from stay was granted on June 11, 2003, retroactive to June 6, 2002, the date the bankruptcy case was reopened. In addition, the order provided that relief from stay was not necessary for the Debtor or the Trustee to proceed with prosecution of the cross-complaint.
On September 3, 2002, Plaintiffs filed (1) an unsecured proof of claim in the sum of $9,786,000 and (2) an adversary complaint to determine dischargeability of debt pursuant to §§ 523(a)(2)(A) and (a)(4) and to revoke debtor's discharge pursuant to § 727(a)(4). Following the entry of an order granting Debtor's motion to dismiss for failure to state a claim, the original adversary complaint was amended on January 31, 2003 to include an additional cause of action under § 523(a)(6). Debtor moved to dismiss Plaintiffs' first amended complaint and, at a hearing held on March 6, 2003, Judge Greenwald dismissed Plaintiffs' § 727 cause of action on the ground that it was time-barred pursuant to § 727(e). The court further granted Plaintiffs leave to amend their allegations in accordance with § 523(a)(3)(B) regarding Plaintiffs' lack of notice or actual knowledge of Debtor's bankruptcy filing in time to file a proof of claim and dischargeability complaint.
After the Debtor filed an objection to Plaintiffs' claim, Judge Greenwald consolidated the objection with the instant adversary proceeding pursuant to order entered on September 25, 2003. Six (6) other proofs of claim were filed in this case and approximately 20-25 creditors are listed on the creditor matrix.
All "section" references are to 11 U.S.C. 101 et seq. and all "rule" references are to the Federal Rules of Bankruptcy Procedure.
This order was affirmed by the District Court but is now on appeal at the Ninth Circuit Court of Appeals.
On March 24, 2003 Plaintiffs filed a second amended complaint which included an additional five causes of action and new non-debtor defendants. Debtor moved to dismiss and at a hearing on May 29, 2003, Judge Greenwald granted the dismissal of several of Plaintiffs' claims. The claims for conspiracy to defraud, conspiracy to convert and breach of fiduciary duty were dismissed with prejudice, while the §§ 542 and 548 claims were dismissed without prejudice. Judge Greenwald also dismissed all non-debtor defendants
Plaintiffs' second amended complaint included causes of action pursuant to §§ 523(a)(2)(A), (a)(4), and (a)(6), as well as conspiracy to defraud, conspiracy to convert, breach of fiduciary duty and requests to avoid fraudulent transfers under § 548 and for turnover under § 542. The new named defendants were: Bahman "Brian" Mashian, Micha Mottale, Safie Mirsafavi, Elan Enterprises, Inc., 630 Vista Lane LLC, and First Fairview, Inc.
Further, at a continued hearing on July 18, 2003, Judge Greenwald ruled as follows: (1) the claims under §§ 523(a)(2), (a)(4) and (a)(6) contained in the second amended complaint had been validly pleaded and (2) Plaintiffs were ordered to file an amended second amended complaint wherein they were to delete the remaining causes of action and the word "defendant" when referring to parties other than the Debtor. On July 23, 2003, Plaintiffs filed an amended second amended complaint that included the remaining causes of action and named Debtor as the sole defendant.
See Notice of Ruling and Order on Defendant Kaveh Lahijani's Motion to Strike Under Rule 12(f), on the Defendant's Motion to Compel, on the Multiple Motions to Quash by Third Parties and on the Status Conference, entered on November 17, 2003, para.1 and 2.
Plaintiffs also filed a motion for substantive consolidation to add Elan and Vista as parties and estates to the adversary proceeding. However, Judge Greenwald abstained from hearing the motion and all matters relating to this adversary proceeding pending the outcome of the state court action. The state court entered its judgment on January 20, 2004, disposing of all causes of action in favor of the Debtor, Mottale and Mashian, and ordering that the Plaintiffs take nothing and that the Debtor, Mottale and Mashian be deemed the prevailing parties entitled to recover costs and attorney's fees stemming from the action.
The motion to substantively consolidate Elan and Vista as parties and estates in the adversary proceeding was filed on November 5, 2003.
See Order, etc., entered on January 8, 2004 (referencing December 15, 2003 hearing date).
See Exhibit 5 to the Supplement to Joint Status Report filed by the Debtor on June 27, 2005. Plaintiffs have appealed the state court judgment and the appeal is still pending.
In addition, Plaintiffs sought to purchase the estate's avoidance claims which the Trustee had decided not to pursue. The Trustee had initially filed a motion for permission to assign his avoiding powers to Plaintiffs, subject to overbid, but later determined that a competing bid would be more beneficial to the estate. At an auction held on June 2, 2004, the Trustee accepted an offer by Claims Prosecutor of $175,000 in cash and rejected Plaintiffs' bid which did not offer as much cash but included additional percentage recoveries for the estate. An order granting the Trustee's motion to sell the avoiding powers and all other assets of the estate to Claims Prosecutor was entered on July 1, 2004 but was subsequently appealed.
Debtor's brother-in-law, Bahman Mashian aka Bashan Mashian aka Bryan Mashian aka Brian Mashian ("Mashian"), an attorney, formed Claims Prosecutor, LLC ("Claims Prosecutor") to acquire these causes of action. Mashian is the sole holder of Claims Prosecutor.
On May 6, 2004, Mashian and Micha Mottale aka Micha Mottalle ("Mottale"), a friend of the Debtor, joined the Trustee's motion to assign the avoiding powers to Claims Prosecutor subject to overbid.
On July 14, 2004, the sale order was appealed to the Bankruptcy Appellate Panel ("BAP"). In a decision dated April 21, 2005, the BAP concluded that the bankruptcy court abused its discretion when it decided to approve the sale of the estate's avoidance claims to Claims Prosecutor without appropriately evaluating Plaintiffs' bid and considering the fair and equitable settlement standard. In re Kaveh Lahijani, 325 B.R. 282, 292 (9th Cir. BAP 2005). Although the BAP reversed and remanded, the BAP's ruling is now on appeal at the Ninth Circuit Court of Appeals.
Due to Judge Greenwald's abstention order, the adversary proceeding was in abeyance until the case was reassigned to me. I treated the order of abstention as a stay order and, with agreement of the parties, heard oral arguments on the motion for substantive consolidation and submitted the matter for written decision.
After having reviewed the evidence submitted by Plaintiffs in this matter and the objections raised thereto, I made evidentiary rulings which were distributed to the parties at the July 14, 2005 hearing and entered on the case docket on September 20, 2005. Debtor presented no facts to rebut Plaintiffs' evidence. The following statement is thus based on Plaintiffs' facts which have been admitted into evidence.
The basis and outcome of this motion rests on the nature of Debtor's involvement in two non-debtor corporations, Elan and Vista. Plaintiffs allege that Debtor controlled and acted as alter ego of these entities, while Debtor, Elan, and Vista contend that these entities exist independently of Debtor.
1. Debtor's Participation in Elan
In 1991, Debtor incorporated Elan, a corporation involved in the management of real estate. The articles of incorporation signed by the Debtor and filed with the Secretary of State on September 12, 1991 show that Debtor was the initial agent for service of process and do not contain the names of any other individuals. On December 4, 2002, the Debtor testified that he played a limited role in Elan from 1995 forward and remained employed only as a project supervisor who was paid $3,000 per month and given use of a car, but was not an officer. On April 4, 2003, the Debtor declared under penalty of perjury that in 1995, he sold all of his ownership interest in Elan to his friend Mottale but was still intermittently authorized to act as Elan's president. For example, he signed off on the September 1999 purchase of real property on Moorea in Laguna Beach, California ("Moorea"), obtained various building permits in connection with the construction of a residence on Moorea, and acted as a signatory on some of Elan's bank accounts.
See Exhibit 8 to Declaration of John R. Fuchs in Support of Plaintiffs' Motion for Substantive Consolidation, filed on November 5, 2003 ("Fuchs Declaration"). Exhibit 31 to the Fuchs Declaration shows that Elan was suspended in June 2001 for nonpayment of taxes and that the suspension was still in effect on January 14, 2003.
See Fuchs Declaration, ¶ 3.
See Exhibit 6 to Fuchs Declaration.
See Exhibit 7 to Fuchs Declaration (containing Declaration of Kaveh Lahijani).
See Exhibit 9 to Fuchs Declaration.
The Debtor's testimony as to his limited involvement with Elan after 1995 is contradicted by the Statement By Domestic Stock Corporation signed by the Debtor and filed with the California Secretary of State on April 18, 1997 which indicates that two years after the purported transfer, Debtor was the president, sole officer and director, and agent for service of process for Elan. In addition, the Debtor's involvement in Elan after 1995 was not disclosed in his schedules filed in 1998, despite the fact that Debtor was required to list all businesses in which he was a director or officer within two years prior to filing bankruptcy.
See Exhibit 8 to Fuchs Declaration. The Debtor does not contest the authenticity of his signature on this document.
See Exhibit 2 to the Fuchs Declaration. The Debtor's involvement in "Lahijani Laundromat" was also not disclosed in his schedules, despite Plaintiffs' introduction into evidence of a check in the amount of $4,990.57 dated August 27, 1997 (within eight months of filing bankruptcy) payable to the Debtor dba Lahijani Laundromat and deposited in Elan's account. See Exhibit 28 to Supplemental Declaration of John R. Fuchs in Support of Plaintiffs' Motion for Substantive Consolidation filed on December 9, 2003 ("Supplemental Fuchs Declaration").
2. Transfer of Residence and Formation of Vista
Also in 1995, the Debtor sold real property located at 630 Vista Lane in Laguna Beach, California ("Vista Lane") to his brother-in-law Mashian. However, despite the purported sale, the Debtor continued to fund construction on Vista Lane through Elan's checks which were signed by the Debtor.
See Fuchs Declaration, ¶ 3; Exhibit 7 to Fuchs Declaration.
See Exhibits 11-14 and 18-27 to Fuchs Declaration; see also Exhibits 2, 4-5, 8-10, 19, 26, 28-29, and 31 to Supplemental Fuchs Declaration.
Debtor's schedules filed on April 22, 1998 and signed under penalty of perjury reflect that he lived in an apartment in Sherman Oaks, California, owned no real property, had personal property worth $1,600, had been self-employed since 1995, and had earned $9,000 per year in 1996 and 1997. Plaintiffs allege that the Sherman Oaks apartment listed in Debtor's schedules is a false and fraudulent address at which the Debtor has never resided, but have not presented admissible evidence to support this contention.
See Exhibit 2 of Fuchs Declaration; see also Schedules and Statement of Financial Affairs, filed on April 22, 1998.
In 2000, after Debtor received his discharge and the case was closed, Mashian transferred Vista Lane into the newly-created Vista. Debtor testified that by 2001, he had resumed residence at Vista Lane rent-free because he could not afford to pay rent.
See Fuchs Declaration p. 3, 1.3-7; p. 21, 1.21-22. Debtor confirmed this information in response to questions by Fuchs at the § 341(a) meeting held after the bankruptcy case was reopened. Based on Fuchs' personal knowledge of Debtor's statements at the § 341(a) meeting, these facts have been admitted into evidence.
3. Debtor's Financial Transactions
Debtor's participation in Elan and Vista is elucidated through various bank transactions, the vast majority of which took place before or after, but not during, the pendency of the bankruptcy case. For example, between March 1997 and December 1997, Elan's account at Sanwa Bank (on which the Debtor was an authorized signatory) shows deposits of $1,268,000 and checks of $1,238,000. Yet, between April 1998 and June 1998 (immediately before and during the first two months the bankruptcy case was pending), the same account shows a maximum balance of $89 with no activity. From September 1998 through December 1998, the account shows deposits of $245,000 and withdrawals of $182,000, with a balance of $118,000.
Out of 191 Elan checks produced by the Bank of the West (successor to Sanwa Bank) for the period from May 1998 to December 31, 1999 (while the bankruptcy case was pending and for several months after it was closed), 189 were signed by the Debtor. A stream of checks made payable to Debtor, Debtor c/o Elan, Debtor/Elan, Debtor dba Lahijani Laundromat, and Debtor c/o Kamiar Simantob was deposited into Elan's accounts from December 1996 through July 1999, including checks from L.A. Cellular (coded "BRO"), tenant rent checks from a property owned by Elan, checks from the Los Angeles Department of Water and Power, and a check from Symbolic Motor Car Company.
See Fuchs Declaration p. 9-10; Exhibits 11-14, 18-27 of Fuchs Declaration.
See Exhibit 31 to Supplemental Fuchs Declaration.
See Exhibit 26 to Supplemental Fuchs Declaration.
See Exhibits 28-29 to Supplemental Fuchs Declaration.
See Exhibit 19 to Supplemental Fuchs Declaration, check #18873. In May 1997, Symbolic paid Elan $99,000 and in September 1997, Symbolic paid Elan $82,000 (referencing "Daytona Cpe").
Further, from mid-1998 through December 1999 withdrawals were made from Elan's accounts for Debtor's personal use, including checks in the sum of $87,700 made payable to cash and cashed by the Debtor, checks in the sum of $35,880 made payable to Debtor's mother, checks in the sum of $42,000 made payable to Debtor's wife, checks to purchase a car for the Debtor in the amount of $47,828, checks to pay repairs on two Ferraris, checks to pay Debtor's lawyer and Mashian's law firm, and a check showing the payoff of a car loan owed by the Debtor's brother.
See Exhibits 11-14 and 18-27 to Fuchs Declaration; see also Exhibits 2, 4-5, 8-10, 19, 26, 28-29, and 31 to Supplemental Fuchs Declaration.
See Fuchs Declaration p. 9-10 and Exhibits 11-14, 18-27.
In addition, from January 1997 through October 1997, Elan paid $2,295.21 per month to World Savings Bank with checks referencing a number that matched a loan Mashian had obtained for Vista Lane and, in April 1997, Elan paid the Orange County Tax Collector $3,273.70 in funds referencing the Vista Lane assessor's parcel number. The Debtor also signed Elan checks for construction work on Vista Lane, including $79,000 worth of checks between January 1997 and October 1997, and $21,176 worth of checks between mid-1998 and December 1999. Further, from May 1997 to November 1997, Debtor was paid a draw or cash from Elan in the total amount of approximately $110,000. Also during 1997, Debtor signed checks which transferred approximately $310,000 to Sanwa Bank for an unspecified purpose.
See Exhibit 8 to Supplemental Fuchs Declaration.
See Exhibit 9 to Supplemental Fuchs Declaration.
See Fuchs Declaration p. 9; Exhibit 10 to Supplemental Fuchs Declaration.
See Exhibit 5 to Supplemental Fuchs Declaration. Five of these seven checks were signed by the Debtor.
See Exhibit 4 to Supplemental Fuchs Declaration.
It appears that Plaintiffs filed the instant motion for substantive consolidation as an alternate means of recovering Debtor's alleged fraudulent transfers. Plaintiffs contend that Debtor fraudulently transferred funds and assets into and out of Elan and Vista, thereby skirting his personal liability to Plaintiffs, an allegation denied by the Debtor. Elan and Vista argue that Plaintiffs are not entitled to substantive consolidation because (1) Plaintiffs lack standing and (2) unusual circumstances, such as the existence of alter egos, are not present to warrant substantive consolidation. The Court will deal with each of these arguments below.
A. Standing to Bring Motion for Substantive Consolidation
While no Ninth Circuit Court of Appeals case holds that a creditor has standing to move for substantive consolidation, numerous district and bankruptcy courts have held it is proper for creditors to bring this type of motion. Thus, based on a number of persuasive authorities in this area, I hold that Plaintiffs do have standing to bring a motion for substantive consolidation.
See cases listed and discussed in In re Bonham, 226 B.R. 56, 83-89 (Bankr. D. Alaska 1998), aff'd, 229 F.3d 750 (9th Cir. 2000); In re Stone Webster, Inc., 286 B.R. 532 (Bankr. D. Del. 2002) (granting consolidation motion filed by Official Committee of Equity Security Holders); In re New Center Hospital, 187 B.R. 560 (E.D. Mich. 1995) (granting nunc pro tunc consolidation on creditors' motion); In re Baker Getty Fin. Serv., Inc., 78 B.R. 139 (Bankr. N.D. Ohio 1987) (allowing substantive consolidation on creditors' motion); In re Crabtree, 39 B.R. 718 (Bankr. E.D. Tenn. 1984) (granting creditors' motion for substantive consolidation); In re 1438 Meridian Place, N.W., Inc., 15 B.R. 89 (Bankr. D.C. 1981) (finding substantive consolidation appropriate following creditors' motion).
However, to provide a more complete analysis reflecting the parties' positions, I will also discuss the cases cited by Elan and Vista in support of their position that Plaintiffs lack standing, in response to which Plaintiffs contend that these cases are not applicable because the standing issue was neither raised nor adjudicated. Further, Plaintiffs assert that commingling of funds and/or alter ego doctrine was not established in at least three of these cases, and thus a denial based on the merits implies that the creditors had standing. 1. In re Doctors Hospital of Hyde Park Hyde Park does not support the contention that creditors lack standing to pursue substantive consolidation. In that case, the court stated that generally substantive consolidation has been ordered at the request of a trustee or debtor-in-possession, not a creditor. However, the court did not deal with whether a creditor could ever have standing because the court found that the creditor's allegations were insufficient to establish standing.
These cases include the following: In re United Stairs Corp., 176 B.R. 359 (Bankr. D.N.J. 1995); In re Doctors Hospital of Hyde Park, Inc., 308 B.R. 311 (Bankr. N.D. Ill. 2004); In re Lease-A-Fleet, Inc., 141 B.R. 869 (Bankr. E.D. Pa. 1992); In re Andonis Morfesis, 270 B.R. 28 (Bankr. N.J. 2001); and In re Fas Mart Convenience Stores, Inc. 320 B.R. 587 (Bankr. E.E.D. Va. 2004).
See Plaintiffs' Supplemental Memorandum of Points and Authorities in Support of Motion for Substantive Consolidation, filed on July 21, 2005.
See 308 B.R. at 323.
2. In re United Stairs Corp. United Stairs also does not support the argument that creditors lack standing to bring a motion for substantive consolidation. In that case, the court referenced other courts that applied a qualification test before allowing a creditor to file a motion for substantive consolidation. However, the court stated that the qualification test was inapplicable to that particular case and, thus, found that the individual creditor did not have standing. 3. In re Lease-A-Fleet, Inc.
See 176 B.R. at 368.
The standing issue was not raised in Lease-A-Fleet where a creditor commenced an adversary proceeding against defendant, a business entity, to substantively consolidate the business with the debtor. Instead, the court granted defendants' motion for summary judgment and dismissed the creditor's adversary proceeding on the grounds that the entities to be consolidated continually stood alone as totally distinct entities (i.e., no alter ego finding) and no basis for relief was stated. 4. In re Morfesis
See 141 B.R. at 877-878.
The standing issue was not raised in Morfesis, where a creditor filed an adversary proceeding and, later, a cross-motion seeking to substantively consolidate debtor's ex-wife's estate with the bankruptcy estate. The court denied creditor's motion for substantive consolidation because no showing was made that the ex-wife operated as an alter ego of the debtor or the debtor's business entities. In particular, there was no evidence of commingled assets. Furthermore, the creditor did not establish that if consolidation were granted the estate would greatly benefit. The ex-wife's only asset was her home and there was no evidence of equity above the ex-wife's exemption; thus, the creditor would not receive a greater recovery on its claim through consolidation because the inclusion of the ex-wife's house would not greatly increase the consolidated estate. Finally, the court noted that substantive consolidation should be considered with extreme caution when dealing with nondebtors, and movant did not show that any benefits of consolidation would outweigh the ex-wife's due process rights. 5. In re Fas Mart
See 270 B.R. at 31-32.
Standing was not raised in Fas Mart where the creditor, who had filed eight identical proofs of claim, argued that the court should substantively consolidate the bankruptcy estate with a nondebtor affiliate. The court found that substantive consolidation was inappropriate because the case did not involve unusual or compelling circumstances to justify consolidation of a nondebtor entity. Furthermore, the court held that substantive consolidation was not warranted because the affairs of the debtor and the nondebtor affiliate were not so entangled that consolidation would benefit all creditors. B. Standard for Granting Substantive Consolidation
Id. at 595.
The bankruptcy court's authority to substantively consolidate has evolved under § 105(a) of the Bankruptcy Code. Historically, "substantive consolidation was fashioned as a device to combat the commission of fraud upon creditors which might go uncorrected in its absence." However, substantive consolidation was also used for practical reasons in cases involving intermingling of assets, disregard of corporate formalities, and where inadequate or incomplete financial or corporate records had been kept.
226 B.R. at 77, citing Sampsell.
In the seminal case of Sampsell, the Supreme Court sanctioned the bankruptcy court's power to substantively consolidate the estate of an individual debtor with the assets and claims of a nondebtor corporation wholly owned by the debtor and his family. Subsequently, numerous courts, including the Ninth Circuit, have applied § 105 to allow the consolidation of a non-debtor estate into that of a debtor estate; however, this form of consolidation is cautiously used only under unusual circumstances. Generally, the determination to substantively consolidate is fact-driven and sparingly applied with the aim of avoiding inequity among creditors.
See 313 U.S. at 219.
See cases listed in Bonham, 226 B.R. at 83-84, citing cases allowing substantive consolidation of non-debtors, including In re Creditors Serv. Corp., 195 B.R. 680 (Bankr. S.D. Ohio 1996); Matter of New Center Hospital, 187 B.R. 560 (E.D. Mich. 1995); In re Munford, Inc., 115 B.R. 390 (Bankr. N.D. Ga 1990); In re Tureaud, 45 B.R. 658 (Bankr. N.D. Okla. 1985), aff'd, 59 B.R. 973 (1986); In re Crabtree, 39 B.R. 718 (Bankr. E.D. Tenn. 1984).
See Bonham, 226 B.R. at 59, 74-75 (citing cases denying substantive consolidation of non-debtors).
See 226 B.R. at 59-60; 83-93.
When substantive consolidation is granted, the assets and liabilities of two or more related entities are pooled to create a single fund from which the creditors of the combined estate may be paid. Various circumstances regarding the related entities form a basis on which substantive consolidation has been allowed, including entanglement of financial affairs, commingling of funds, and/or the finding that the debtor is an alter ego of the entities.
See 229 F.3d at 764 (cit. omitted).
See 226 B.R. at 96-97 (cit. omitted).
The Ninth Circuit in Bonham decided to follow the test applied by the Second Circuit, namely whether (1) the creditors dealt with the consolidated entities as if they were the same and did not rely on their separate identity in extending credit, or (2) the affairs of the debtor are so entangled that consolidation will benefit all creditors. In either circumstance, "the bankruptcy court must in essence determine that the assets of all the consolidated parties are substantially the same." And although the presence of only one factor is sufficient, "[c]onsolidation under the second factor, entanglement of the debtors affairs, is justified only where `the time and expense necessary even to attempt to unscramble them [is] so substantial as to threaten the realization of any net assets for all the creditors' or where no accurate identification and allocation of assets is possible."
Id. at 771.
Id. at 767, citing 860 F.2d at 519.
The Bonham bankruptcy court allowed substantive consolidation of the debtor with the estates of two closely held corporations (formed pre-bankruptcy) in order to enable the trustee to pursue avoidance claims in bankruptcy. As requested by the chapter 7 trustee who filed the motion, the consolidation order was effective nunc pro tunc to the date of the filing of the involuntary petition, so that the trustee could take advantage of the time frame for filing avoidance actions, since virtually no assets were available for distribution to Bonham's creditors. And because the avoidance claims arose from the investment operations of the debtor and her two related companies, the court found it was equitable to pool the assets of all three entities and fairly allocate them among the creditors. Due to the importance of the Bonham decision in my ruling, it is useful to conduct a detailed analysis of the circumstances giving rise to substantive consolidation, as initially described in the opinion of the bankruptcy court, and later as examined in the more narrowly tailored opinion of the Ninth Circuit Court of Appeals.
Discussed in more detail at 226 B.R. 61-75.
Bonham, an individual debtor in a bankruptcy arising from an involuntary chapter 7 bankruptcy, operated a Ponzi scheme through investment contracts issued in the name of two corporations, WPI and APFC, in the four to five years prior to the involuntary filing. Absent consolidation, debtor's creditors who held approximately $50 million in claims, would recover nothing.
Debtor incorporated WPI and was its registered agent and sole director. The only other officer of WPI was debtor's husband who denied any significant involvement in the corporation's affairs. Although debtor was the sole shareholder of WPI, the corporation never issued stock certificates or otherwise recorded ownership of its stock. Further, there was no evidence that WPI ever held shareholder meetings and there were no minutes of director meetings. WPI never filed any income tax returns and the trustee had not been able to discover any financial statements. WPI was involuntarily dissolved a few months before the bankruptcy filing.
The other closely held corporation, APFC, was also incorporated by debtor pre-petition. Although initially APFC did not have any shareholders, officers or agents, debtor eventually identified herself as the president of APFC. Debtor also opened a bank account in her name "dba APFC," making the initial deposit with a check drawn on a WPI account (which also contained debtor's name). At one point, debtor "sold" APFC to a third party for $1,000, and the third party became APFC's director. However, within a few months, the third party was removed and debtor was named the sole director of the corporation. A few months thereafter, debtor identified herself as the president, secretary and treasurer of the corporation. Debtor's husband denied any significant role in APFC's operations and claimed that debtor ran the business by herself. In fact, APFC had no employees, stock certificates, documentation regarding capitalization, financial statements, was not registered in the state where it was doing business, and never filed income tax returns.
The trustee in Bonham determined that WPI routinely transferred investment funds to APFC. However, he found no records setting forth the relationship between the two corporations, reflecting the transfers of funds between them, or showing any basis for the transfers. In addition, the trustee found that debtor would also deposit investment funds from the corporations into her personal account which she held jointly with her husband. The court concluded that debtor used the corporate funds to finance her personal expenses, including credit cards, housing, food, travel, and entertainment.
In addition, the court took judicial notice of evidence offered by the trustee in other proceedings showing that WPI or its predecessor made a $200,000 transfer to a proprietorship owned by debtor's husband. The court also found that debtor was the sole person responsible for WPI's and APFC's business operations. As a result of the "indiscriminate and arbitrary" intermingling, the trustee was unable to arrive at a clear financial picture of the structure and operations with respect to the debtor and the two corporations. Further, it was impossible to separate the assets and liabilities of the debtor and the two entities given "debtor's indiscriminate use of the corporations." Coupled with "debtor's lack of cooperation and apparent untrustworthy testimony in various proceedings before the court," the court found that substantive consolidation was proper.
226 B.R. at 69.
Id. at 74.
Id. at 69.
C. Whether Substantive Consolidation Is Appropriate In This Case
Plaintiffs base their argument on the second prong of theBonham test, i.e., commingling. Relying on the equitable principle that substantive consolidation should be applied sparingly, particularly when non-debtor entities are at issue, Elan and Vista contend that insufficient unusual circumstances exist to grant Plaintiffs' motion for substantive consolidation. In effect, Elan and Vista argue that the Debtor is not the alter ego of Elan or Vista and, thus, the time and expense necessary to unscramble any commingling of funds is insubstantial and does not warrant substantive consolidation. Plaintiffs, however, argue that Debtor is the alter ego of both Elan and Vista; therefore, substantive consolidation is appropriate.
First, substantive consolidation must be distinguished from state law alter ego remedies. Although elements of the alter ego doctrine may provide grounds for substantive consolidation, the law of substantive consolidation is federal bankruptcy law and is not dependent upon state law concepts. Thus, the term "alter ego" does not have to meet the definition under any state law but instead is used loosely to indicate that a corporation is the instrumentality of the debtor used to conduct the debtor's financial affairs. To more throughly explain this concept, it is worthwhile to restate a quote found in the Bonham bankruptcy court opinion:
See Bonham, 226 B.R. at 76.
See id. at 77; 96-97.
Id. at 77.
See id. at 85, 96 (cit. omitted).
2. Misplaced Analogy to Corporate Law The factors evaluated on a motion for substantive consolidation appear similar to an analysis of piercing the corporate veil. Like piercing the corporate veil, substantive consolidation ignores artificial structures legally defining the consolidated entities. Ultimately, however, such an analogy is misplaced because the corporate law doctrine of limited liability is not involved. Rather, substantive consolidation is more like the corporate law notion of enterprise liability because substantive consolidation does not seek to hold shareholders liable for the acts of their incorporated entity. [footnote omitted] Substantive consolidation more closely resembles the bankruptcy rule of subordination because competition for the consolidated assets is between creditors alone. Thus, substantive consolidation ignores artificial legal structures but looks only to the combined assets of the consolidated entities for satisfaction of all claims against the collective group. [footnotes in original omitted]Further, "[w]hile the remedy of substantive consolidation is similar to the state law remedy of piercing the corporate veil based on a finding that the entities are alter egos," it is not the same. "The bankruptcy remedy of substantive consolidation ensures the equitable distribution of property to all creditors, while on the other hand, piercing the corporate veil is a limited merger for the benefit of a particular creditor."
226 B.R. at 77, quoting J. Stephen Gilbert, Note:Substantive Consolidation in Bankruptcy: A Primer, 43 Vand L Rev 207, 218 and fn 77-81 (cit. omitted).
226 B.R. at 89.
Id., quoting Creditors Service Corp., 195 B.R. at 689 (cit. omitted).
With these principles in mind, I turn to an analysis of the facts at hand.
1. As to Elan
In this case, approximately one year before the bankruptcy filing, the Debtor signed an official document representing to the California Secretary of State that he was the president, sole officer, sole director, and agent for service of process for Elan, although he failed to disclose this in his schedules. Debtor freely used Elan's funds for personal expenses, including paying a draw or cash to himself from Elan totaling approximately $110,000 between May and November 1997. Debtor's use of Elan's funds for various cash transactions benefitting himself, his wife and his mother illustrates the free flow of funds without a legitimate business purpose, commingling and failure to segregate. Such extensive use of Elan's funds for a vast array of personal reasons leads to the conclusion that Debtor used Elan's assets as if they were his own with the purpose of shielding them from creditors.
2. As to Vista
Regarding Vista, Plaintiffs have not submitted evidence showing that Debtor was the principal officer, director, or stockholder of Vista. However, Plaintiffs have established that Debtor used Vista Lane, the title to which was held by Mashian and then by Vista, for personal benefit. Further, Plaintiffs have established that money from Elan was freely flowing into Vista Lane: the Debtor signed Elan checks for construction work on Vista Lane, including $79,000 worth of checks between January 1997 and October 1997, and $21,176 worth of checks between mid-1998 and December 1999.
Although Debtor testified that he sold Vista Lane to Mashian in 1995, he was allowed to reside there from 2001 forward without paying rent, thereby deriving a substantial personal benefit from Vista. Further, from January 1997 through October 1997, Elan paid $2,295.21 per month to World Savings Bank with checks referencing a number that matched a loan Mashian had obtained for Vista Lane and, in April 1997, Elan made a payment to the tax collector in connection with Vista Lane.
As stated by the court in Bonham, "one can infer a corrupt purpose" when faced with facts such as the initial transfer of Vista Lane to Mashian and the subsequent transfer from Mashian to Vista, an entity created for the specific purpose of holding Vista Lane, at a time when the Debtor faced litigation with Plaintiffs. This type of conduct, coupled with Debtor's personal use of Vista Lane as his residence without paying rent, leads to the conclusion that Debtor treated Vista's asset as his own and that Vista was used as a vehicle to shield Debtor's assets from creditors.
226 B.R. at 96.
3. Asset Transfers
Debtor also engaged in asset transfers which appear to have been orchestrated to prevent any possible recovery by creditors and are potentially fraudulent. First, Debtor transferred Vista Lane to Mashian in 1995, although he continued to fund construction improvements, a loan and property taxes on Vista Lane through Elan before and after filing bankruptcy. Then, Debtor resumed residence at Vista Lane in 2001, rent-free, after Mashian had transferred the property to Vista in 2000.
Second, also in 1995, Debtor transferred Elan to Mottale but continued to act as Elan's president, sole director and officer, agent for process of service, and was an authorized signatory on Elan's bank accounts. Yet, in his bankruptcy, the Debtor failed to disclose his interest in the corporation. Debtor also commingled personal funds with Elan, thereby confusing his personal assets with that of Elan, and contributed to Vista's net worth by funding Vista Lane's improvement through Elan.
4. Summary of Debtor's Activities
Based on the commingling of funds and transfers between the Debtor, Elan and Vista, I conclude that the assets of the Debtor and the two entities are substantially the same. As stated by the Ninth Circuit in Bonham, substantive consolidation is appropriate where no accurate identification and allocation of assets is possible. Specifically, the various factors this case shares in common with other cases where substantive consolidation was allowed, including Bonham, are (1) commingling, including the use of corporate funds to pay personal expenses and without an identifiable business purpose; (2) disregard of corporate form in that, despite the fact that the Debtor transferred Elan to a third party, records signed by the Debtor and filed with the California Secretary of State two years after the transfer took place show Debtor as the sole director, officer, agent for process of service, and a signatory on Elan's bank account; (3) Debtor acting as a principal who dominated Elan and used Vista's sole asset for his personal benefit; (4) purported transfers of assets to the corporations to place them out of reach of Debtor's creditors; (5) the use of the corporations for a corrupt purpose; (6) failure to disclose the existence of Elan and the various transfers made to and from Elan by the Debtor in his bankruptcy, despite the fact that the transfers took place before and during the time the bankruptcy was pending; (7) the entanglement of financial affairs between the entities without any justifiable reason, resulting in the inability to trace the funds and to find a specific purpose for the various transfers; and (8) the untrustworthy testimony by Debtor regarding his involvement in Elan after 1995.
See 226 B.R. at 84-88, 96-97 (cit. omitted).
"The case law uniformly holds that substantive consolidation should be sparingly used, with an eye to possible negative effects on creditors." In this case, no evidence was presented as to any negative effect on creditors of the debtor, Vista or Elan, and no negative impact is apparent to the Court. As in Bonham, there is no evidence that the creditors of Vista and Elan could recover any significant assets outside of bankruptcy, and no evidence that consolidation would diminish the recovery for Debtor's creditors. Plaintiffs have represented to this Court that they are fully committed to recovering additional assets for the benefit ofall creditors.
Id. at 59.
226 B.R. at 73.
See Plaintiffs' Supplemental Memorandum, page 4, footnote 1.
Extraordinary circumstances required for substantive consolidation are present where the debtor and non-debtor entities are alter egos of each other and where the debtor uses corporate assets as if they were his own. This Court is convinced that injustice would occur absent consolidation in that the Debtor would be allowed to retain his discharge and keep enjoying his assets, while his creditors would walk away with nothing. D. Whether A Nunc Pro Tunc Order Should Be Entered
United Stairs Corp., 176 B.R. at 369 (cit. omitted).
See Bonham, 226 B.R. at 76.
Plaintiffs request that the consolidation order be effective as of April 22, 1998, the date of the original bankruptcy filing.
Although the Ninth Circuit in Bonham ratified nunc pro tunc consolidation, it did so pursuant to a different test then the one employed by the Bonham bankruptcy court. Following the reasoning of the Sixth Circuit which "concluded that `[t]he order of consolidation rests on the foundation that the assets of all of the consolidated parties are substantially the same,' and that the earliest filing date is the controlling date," the Ninth Circuit decided to leave it up to the discretion of the bankruptcy court to determine whether nunc pro tunc consolidation is appropriate in each case without having to apply a specific test. As with granting substantive consolidation, this power must be exercised sparingly and with caution.
In re Baker, 974 F.2d 712, 720-21 (6th Cir. 1992).
In Bonham, the Ninth Circuit found that the bankruptcy court's order allowing nunc pro tunc consolidation was appropriate because Bonham commingled her personal assets with those of the two closely held corporations and failed to maintain any corporate distinction between the entities. Therefore, since the Bonham trustee wanted to exercise his avoidance powers, the date of the involuntary petition was found to be the controlling date from which to measure the limitations period.
Id. at 769.
In this case, the issue of avoidance powers which Plaintiffs sought to purchase from the estate is currently on appeal at the Ninth Circuit Court of Appeals. If the BAP's ruling is affirmed, I will have to deal with the avoidance powers on remand. However, although the issue of avoidance powers may have been the underlying reason for bringing a motion for substantive consolidation in other cases, it is not the sole consideration. In fact, based on the facts of the cases cited by the Ninth Circuit in Bonham, the issue of avoidance powers usually does not come up in granting substantive consolidation but instead arises when a party requests a nunc pro tunc order.
Claims Prosecutor (the buyer of the avoidance powers) and its holder Mashian were served with the motion for substantive consolidation through their counsel Steven T. Gubner (who also represents the Debtor), but have not raised any issues regarding the potential effect of this memorandum and the accompanying order on the pending appeal.
See 229 F.3d at 768-69 (stating that "[a]bsent express preservation of the trustee's avoidance power, an order of substantive consolidation would ordinarily eliminate that power" and citing In re Giller, 962 F.2d 796, 798-99 (8th Cir. 1992) for the proposition that "ordinarily substantive consolidation would eliminate justification for exercise of trustee's avoidance power"); 226 B.R. at 95 (categorizing creditors into "claimants" and "targets" depending on whether they will recover through substantive consolidation or whether they will have to give up assets previously transferred to them, and stating that the "targets" are not always subject to avoidance actions but may see their recovery diluted by having to share it with additional creditors).
As to Elan, admissible evidence has been presented that substantial commingling did take place from 1996 through 1999, including during the time when Debtor filed his bankruptcy petition. Thus, due to the fact that Elan was being treated as one with the Debtor at the time of the original filing, it is appropriate to order nunc pro tunc consolidation with Elan as of the date of the petition (April 22, 1998).
As to Vista, this entity did not come into being until after the bankruptcy case was filed and I have been unable to find any cases which specifically address this type of scenario. However, it is clear that the corporation was formed in order to transfer the Vista Lane property out of the reach of creditors in the same year as Plaintiffs initiated litigation against the Debtor in state court. The fact that the Debtor lived at the property several years before bankruptcy was filed and then transferred the property to his brother-in-law but funded renovations with money from Elan supports this conclusion, as does evidence showing that Debtor continued to live at Vista Lane after it was transferred to Vista, and still lives there. Thus, it is clear that Debtor has treated Vista's only asset as his own at all applicable times. Therefore, it is appropriate to order nunc pro tunc consolidation with Vista as of the date of its formation in 2000.
The Debtor was served at the Vista Lane address with papers served by his counsel in June 2005.
The exact date of Vista's formation has not been put into evidence; therefore, the order entered concurrently herewith requires that Plaintiffs supplement the record with the specific date. Further, to satisfy notice requirements, the order also requires that Elan and Vista file a list of their respective creditors. Thereafter, the Court's order will be served on all creditors of the Debtor, Elan and Vista.
Based on all of the above factors, I find that unusual circumstances required for substantive consolidation are present in this case and that injustice would result absent the substantive consolidation of Elan and Vista with this bankruptcy estate. I also use my discretion to enter a nunc pro tunc order as discussed above.