Why Avoidance Actions Are Difficult to Dismiss by a Rule 12(b)(6) Motion

Traditional avoidance actions under the Bankruptcy Code, i.e., preferences and fraudulent transfers, have laudable goals: (a) to provide equal treatment to creditors of an insolvent company and (b) to claw back otherwise unavailable assets for the benefit of creditors.  It is no wonder then that the governing provisions of the Bankruptcy Code and applicable state law are drafted so broadly.

For example, a “transfer” under section 547 (governing preferences) and section 548 (governing fraudulent transfers) can include, among other things, the creation of a lien or “each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property; or (ii) an interest in property.”  11 U.S.C. § 101(54) (emphasis added).  This provision has been interpreted as covering any type of loss or transfer of a property interest.

Another prime example is the first element of a preference, which requires a transfer to be “to or for the benefit of a creditor.”  11 U.S.C. 547(b)(1).  Courts have almost universally held that this element does not require that the creditor actually receive the transfer; only that a creditor (including a third-party) benefit from it.  Yet, under section 550(a)(1) of the Code the trustee or debtor may recover the transfer or its value from either (a) the transferee or (b) the creditor who benefitted from the transfer.

And, of course, in addition to the broad statutory scheme under the Bankruptcy Code, is section 544(b)(1) of the Code, which allows a trustee or debtor to avoid transfers under any applicable state law that allows an unsecured creditor to avoid such transfers outside of bankruptcy.  Among other statutes, the Uniform Fraudulent Transfer Act, as adopted by most states (“UFTA“), is often utilized by a debtor or trustee to avoid transfers, because it provides for a longer claw back period (i.e., 4 years as opposed to 2 years under the Code).

Notwithstanding the broad avoidance powers under the Bankruptcy Code, defendant transferees in an avoidance action still commonly attempt to dismiss avoidance claims, as a matter of law, pursuant to Federal Rule of Civil Procedure 12(b)(6) (which is incorporated into the Bankruptcy Rules).  Some times a Rule 12(b)(6) motion can be strategic in nature, e.g., to commit the debtor or trustee to a position in the lawsuit, and some times a movant actually expects to prevail on the merits.

As the recent case of Ronald J. Summers v. Anixter, Inc. (In re Trailhead Engineers LLC), Adversary No. 20-3094 (Bankr. S.D. Tex. December 21, 2020) (Rodriguez, J.) illustrates, it is difficult for a movant to dismiss an avoidance lawsuit on a facial attack, because of the generic language set forth in the avoidance provisions of the Code and applicable state law and because of the deference provided to plaintiffs under the Federal Rules of Civil Procedure.  The Anixter case is typical of the challenges facing movants tagged with potential avoidance liability.

Facts

Prior to its chapter 7 bankruptcy, Trailhead Engineers LLC (“Debtor“) was the general contractor on a construction project (the “Project“) for a developer and property owner, Targa Southern Delaware, LLC (“Property Owner“).  The relationship between the Debtor and Property Owner was governed by a Engineering, Procurement and Construction Agreement (“EPC“).  As is generally the case with a construction project, the Debtor subcontracted with several parties, including DanCar Energy Construction LLC (“DanCar“) and Benchmark Electrical Solutions, Inc. (“Benchmark“), to perform certain aspects of the Project.  Benchmark, in turn, subcontracted with Anixter, Inc. (“Transferee“) to perform some of its services.   The relationship between the parties looked something like this:

Several months prior to the bankruptcy, the Transferee sent a demand to the Property Owner for unpaid invoices, in the amount of $867,620.28, and threatened to place statutory mechanics and materialsmen liens (“M&M liens“) on the Project if the past-due amounts remained unpaid.  The demand copied the Debtor (as the General Contractor) and DanCar and Benchmark (as the subcontractors who contracted with the Transferee).  Shortly after this demand was made, the Debtor–not DanCar or Benchmark–paid $867,620.28 (the “Transfer“) to the Transferee directly, even though it had no contractual obligation to the Transferee.

After the Debtor filed bankruptcy several months later, the chapter 7 trustee (“Trustee“) initiated an adversary proceeding against the Transferee and Benchmark, seeking to recover the Transfer as a fraudulent conveyance and preferential transfer, pursuant to sections 547 and 548 of the Code and the Texas version of UFTA (“TUFTA“), Tex. Bus. & Com. Code § 24.001, et seq.

In response, the Transferee moved, early on, to dismiss several of the Trustee’s avoidance claims pursuant to Federal Rule 12(b)(6), which allows the dismissal of a complaint, without any evidence, for the failure to state a claim.  The Court’s opinion addresses the legal argument’s made in the dismissal motion and demonstrates why the cards are stacked against a defendant transferee obtaining an early dismissal of an avoidance action.

Analysis

Fundamentally, the Trustee took two seemingly contradictory positions in its complaint against the Transferee.  His first position was that the Debtor paid the Transfer to the Transferee, even though it was not obligated to do so.  According to the Trustee, only subcontractors DanCar and Benchmark were contractually obligated to pay the Transferee for its services.  This argument supported the Trustee’s fraudulent transfer claim, by demonstrating that the Transfer did not provide reasonably equivalent value to the Debtor, which was not directly on the hook with for the Transferee’s invoices.

If the Transfer did satisfy a debt owed by the Debtor, the Transfer would have provided dollar for dollar equivalent value to the Debtor.  See Jalbert v. Wessel GMBH (In re Louisiana Pellets, Inc.), No. 19-31009 (5th Cir. Dec. 4, 2020) (unpublished) (“When a debtor makes a payment on an antecedent debt and receives a dollar-for-dollar reduction of that debt, however, the question is easy because the debtor by definition receives reasonably equivalent value—indeed, exactly equivalent value, assuming, of course that the debt itself was based upon value.”); see also 11 U.S.C. § 548(d)(2)(A) (defining “value” to include “satisfaction . . . of a present or antecedent debt”).

Alternatively, the Trustee claimed that if the Debtor did satisfy a debt the Transfer constituted a preference, even though the preferential transfer was not received by the Debtor’s actual creditor.  According to the Trustee, as long as one of its creditors (i.e., the Property Owner) benefitted from the Transfer, it was avoidable as a preference and the Trustee was entitled to recover the Transfer from the Transferee.

The permissive pleading rules allowed the Trustee to take such alternative and seemingly contradictory positions.

Deferential Rule 12(b)(6) Standards

The Court first noted that “motions to dismiss are disfavored and therefore, rarely granted.”  Citing Test Masters Educ. Servs., Inc. v. Singh, 428 F.3d 559, 570 (5th Cir. 2005).  In reviewing a Rule 12(b)(6) motion, a court “accept[s] all well-pleaded facts as true and view[s] those facts in the light most favorable to the plaintiff.” Citing Stokes v. Gann, 498 F.3d 483, 484 (5th Cir. 2007) (per curium).  The facts plead in a compliant “need only be sufficient ‘for an inference to be drawn that the elements of the claim exist.'” Quoting Harris v. Fidelity Nat’l Info. Serv. (In re Harris), Nos. 03-44826, 08-3014, 2008 Bankr. LEXIS 1072, at *11 (Bankr. S.D. Tex. Apr. 4, 2008) (citing Walker v. South Cent. Bell Tel. Co., 904 F2d 275, 277 (5th Cir. 1990)).

To defeat a motion to dismiss pursuant to Federal Rule 12(b)(6), a plaintiff must meet Federal Rule of Civil Procedure 8(a)(2)’s pleading guidelines, which only require a plaintiff to plead “a short and plain statement of the claim showing that the pleader is entitled to relief.” Quoting Fed. R. Civ. P. 8(a).

However, in Ashcroft v. Iqbal, 556 U.S. 662, 679 (2009), the Supreme Court held that “[o]nly a complaint that states a plausible claim for relief survives a motion to dismiss.”  ““A claim has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.” Quoting Iqbal, 556 U.S. at 679.  “The plausibility standard is not akin to a ‘probability requirement,’ but it asks for more than a sheer possibility that a defendant has acted unlawfully.”  Id.

Elements of Constructive Fraud

The Transferee challenged the Trustee’s constructive fraud claims under TUFTA.  The elements of actual fraud under TUFTA are:

  1. There is a creditor;
  2. There is a debtor;
  3. The debtor transferred assets shortly before or after the creditor’s claim arose; and
  4. The transfer occurred with the intend to hinder, delay, or defraud the debtor’s creditors.

Citing In re Life Partners Holdings, Inc., 926 F.3d 103, 117 (5th Cir. 2019); Tex. Bus. & Com Code § 24.005(a)(1). While the Trustee asserted claims for both actual fraud and constructive fraud, the Transferee only challenged the constructive fraud claims.

The elements for constructive fraud under TUFTA are the same as actual fraud except that instead of pleading fraudulent intent, the plaintiff must plead facts demonstrating (a) a lack of reasonably equivalent value for the transfer and (b) the transferor was “financial vulnerable” or insolvent at the time of the transaction. Citing Life Partners at 120.  The Transferee attacked both of these prongs.

a.     Reasonably Equivalent Value

The Transferee’s argument was simple.  The Transfer was a dollar-for-dollar satisfaction of the debts the Debtor owed either to (a) subcontractors DanCar or Benchmark pursuant to direct contractual obligations owed to them or (b) the Property Owner under the EPC, which required the Debtor to indemnify the Property Owner for any M&M liens filed against the Project.

In essence, the Transferee argued that the Court should not neglect the value provided by the Transferee to the Project, which benefitted the Debtor.  These were compelling arguments.

Focusing on only one part of the Texas Property Code, the Trustee essentially argued that the Property Owner’s liability was capped at the statutory retainage levels and the claims to the retainage amounts had already been exceeded (essentially leaving the property owner with no liability). Of course, as pointed out by the Transferee, this argument ignored the statutory liens that subcontractors are entitled to against property owners, which are in addition to the statutory retainage levels.  These liens generally entitle subcontractors to payment in full, as secured parties.

Setting aside the reality of why the Debtor would ever make such a large payment other than under some type of obligation to either the Property Owner or its subcontractors, the Court held that the Trustee had cast sufficient doubt on whether the Debtor (a) was ever obligated to make such Transfer, since the Debtor was not in privity with the Transferee (see Diagram above), and (b) received any benefit from the Transfer (as opposed to the Property Owner).

b.     Insolvency Prong

The Transferee also argued that the Trustee’s complaint did not adequately demonstrate that the Debtor was insolvent at the time of the Transfer.  Insolvency is one of the elements of a constructive fraud claim.  See, e.g., 11 U.S.C. § 548(a)(1)(B)(ii); Tex. Bus. Com. Code § 24.006(a),(b).  According to the Transferee, “[the] Trustee’s allegations in the Complaint provide ‘at best, a snapshot of a selected subset of Trailhead’s assets (receivables) and liabilities with no detail relating those assets or liabilities to the time of the Transfer that would allow one to conclude [that] the liabilities exceeded the assets.'”

However, relying on the case of In re Brown Med. Ctr., Inc., 552 B.R. 165, 169-70 (S.D. Tex. 2016), the Court found that a plaintiff could meet its pleading requirements–even under the heightened standards of Federal Rule 9(b)–if it merely alleges in it complaint that the debtor was either insolvent or became insolvent as a result of the transfers.  This result is in accordance with the standard that a plaintiff’s complaint is presumed to be true for purposes of a motion to dismiss under Federal Rule 12(b)(6).

As such standard applied to this case, the Court held that the Trustee sufficiently pled insolvency by merely stating in a conclusory manner that:

  • the Debtor was insolvent “as the market value of its assets exceeded its liabilities”;
  • the Debtor’s accounts receivable were uncollectible; and
  • the Debtor was liable to its customers for million of dollars in damages because it was incapable of completing work on projects.

According to the Court, such allegations were sufficient to put the Transferee on notice that the Debtor was insolvent.  The Transferee could not obtain dismissal of the complaint based on these arguments, however persuasive they appeared.

Elements of a Preference

The Transferee next challenged the Trustee’s preference claims.  The elements of a preference are:

  1. a transfer of interest in the debtor’s property;
  2. such transfer was to or for the benefit of a creditor;
  3. such transfer was for or on account of an antecedent debt owed by the debtor;
  4. such transfer was made while the debtor was insolvent;
  5. such transfer was made within (a) 90 days before the petition date or (b) 1 year before the petition date, in the case of a transfer to an insider;
  6. such transfer enabled the creditor to receive more than it would have received in a hypothetical chapter 7 case.

11 U.S.C. § 547(b).  Through the recent enactment of the Small Business Reorganization Act of 2019 (“SBRA“), effective February 19, 2020, Congress also added language to section 547 seemingly requiring a trustee, before bringing a preference claim, to use “reasonable due diligence in the circumstances of the case” and “tak[e] into account a party’s known or reasonably knowable affirmative defenses under [section 547(c)].”  11 U.S.C. § 547(b).

Whereas the Trustee previously took the position that the Transfer provided no value to the Debtor because it did not cancel a debt, the Trustee now argued that the Transfer did cancel a debt owed by the Debtor to the Property Owner, thereby meeting one of the elements of a preference.

The Transferee challenged the preference claim on several grounds, including that the Trustee’s complaint did not properly plead that:

  • the Trustee exercised reasonable due diligence before bringing his claims;
  • the Transfer was made for the benefit of one of the Debtor’s creditors;
  • the Transfer was made on account of an antecedent debt; and
  • the Property Owner received more than it would have received in a hypothetical chapter 7.

The Court readily dismissed these arguments.

a.    Reasonable Due Diligence

Citing a leading Bankruptcy treatise, 5 COLLIER ON BANKRUPTCY ¶ 547.02A (16th ed. 2020), the Transferee argued that the SBRA added a new element to preference claims; that the trustee must demonstrate it exercised reasonable due diligence and considered claims and defenses of a transferee.

The Court found no case law supporting the Transferee’s position and distinguished COLLIER on  grounds that it only mentions that it is “unclear” whether the SBRA’s amendment to section 547(b) changed the traditional elements of a preference claim. Furthermore, the Court found that the SBRA’s amendment contains qualifying language that a trustee’s “reasonable due diligence” must be “in the circumstances of the case.”  11 U.S.C. § 547(b).

In the end, the Court held that under the circumstances the Trustee’s complaint survived a facial attack, because it demonstrated that the Trustee had reviewed sufficient material (including banking records, invoices, correspondence and contracts) to satisfy the SBRA’s new requirement.

b.     Benefit to a Creditor

The Transferee argued that the “to or for the benefit of a creditor” prong was not satisfied, because the Trustee’s complaint did not sufficiently allege that a creditor benefitted from the transfer.  In this respect, the Transferee refuted the Trustee’s argument that the Property Owner was, in fact, a creditor in light of the Debtor’s breaches of the EPC.  Specifically, the Trustee pointed to the EPC’s requirements that the Debtor (a) indemnify the Property Owner of any M&M liens and (b) pay all M&M claims even before a lien arises.

The Transferee countered that the indemnification obligation never arose, because it never filed a M&M lien against the Project or Property Owner.  It also argued that, instead of the Property Owner being a creditor, the Debtor was actually a creditor of the Property Owner for the performance of obligations by the Transferee, which benefitted the Project and entitled the Debtor to reimbursement from the Property Owner.

The Court sided with the Trustee, finding that the broad language in section 547(b) and the definition of  “creditor” in the Bankruptcy Code:

implies that a transfer of an interest of the debtor’s property to or for the benefit of  virtually every kind of creditor may be avoided as a preference.

Citing 5 COLLIER ON BANKRUPTCY ¶ 547.03 (16th ed. 2020) (emphasis added); 11 U.S.C. § 101(10) (defining creditor as a party holding any type of claim, whether unliquidated, contingent, unmatured, disputed, etc.).  As such, the Court held that, whether or not the Property Owner had merely a contingent, disputed or unmatured claim against the Debtor, it was a “creditor” under the Bankruptcy Code who benefitted from the Transfer because its claim was satisfied.

c.     On Account of an Antecedent Debt

Similar to the prior argument, the Transferee also argued that there was no antecedent debt owed to the Property Owner, because the Transferee had not yet filed a lien against the Property Owner and thus the indemnification obligations under the EPC had not kicked in.

The Court quickly rejected this argument, by noting that there was no issue that the Transferee held unpaid invoices prior to the Transfer and the Transferee had made demands on the Property Owner for such unpaid invoices.  Thus, according to the Court, the Property Owner would have held, at a minimum, a contingent indemnification claim against the Debtor at the time of the Transfer, which claim was sufficient to meet the antecedent debt requirement under section 547(b).

d.     Hypothetical Liquidation Test

The Transferee lastly argued that the Trustee’s complaint did not meet, as a matter of law, section 547(b)(5) of the Code, which requires a showing that a transferee of a preference received more than it would have received in a hypothetical chapter 7 case.  Here, the Transferee’s arguments were twofold:

  • Because the Property Owner had no claim against the Debtor (as the Transferee filed no lien), it would have received the same treatment in both a chapter 11 and chapter 7 case–which is zero; and
  • The Trustee ignored the effects of the construction trust statutes, which would have compelled the Debtor to pay the subcontractor’s claims under criminal penalties.

The Court agreed with the Transferee, finding that the Complaint merely recited the elements of a preference claim, which recitations did not meet the plausibility requirements under Supreme Court precedent.  Citing Iqbal, 556 U.S. at 69; Bell Atlantic v. Twombly, 550 U.S. 544, 555 (2007).

But, while finding the Trustee’s complaint was inadequate, the Court granted the Trustee permission to file an amended complaint to cure the deficiency, pursuant to Federal Rule 15(a)(2).  Also citing In re Giant Gray, Inc., No. 18-31910, 2020 WL 6226298, at *3 (Bankr. S.D. Tex. Oct. 22, 2020).  Thus, the Trustee’s preference claim lived to see another day.

Conclusion

Avoidance laws are broadly written to provide the Court, and litigants, with ample room to claw back pre-bankruptcy transfers.  Procedural rules are similarly drafted to permit, within the Court’s discretion, parties to amend and cure inadequate pleadings. Under the broad regime created by these laws and rules, it is no wonder that trustees often aggressively attempt–even to the point of taking contradictory positions–to claw back transfers that might not readily appear as being avoidable.

This will not change until either the Bankruptcy Code changes or more higher court opinions are rendered.  In the meantime, a defendant in an avoidance suit should generally not expect that a motion to dismiss will be readily granted.  The so-called cards are stacked in favor of avoidance plaintiffs.

Partner at Dorsey & Whitney LLP