Insiders who loot their corporate entities often dispose of the cash proceeds in transactions with third parties. A recent Seventh Circuit opinion, In re Equipment Acquisition Resources, Inc., 14-2174 (7th Cir. October 13, 2015) (the “EAR Opinion”) addresses a common risk faced by a third party who receives cash from the defrauding insider.
Generally, a debtor’s transfer of property to deter, hinder or defraud a creditor is a fraudulent transfer. In bankruptcy cases, a bankruptcy trustee is given the power to set aside fraudulent transfers to both the “initial transferee” of the property and to any “immediate or mediate transferee of such initial transferee” (referred to as a “subsequent transferee”). However § 550(b)(1) of the Bankruptcy Code protects a subsequent transferee who takes for value, in good faith, and without knowledge of the voidability of the transfer. The EAR Opinion provides guidance on how the phrase “without knowledge” should be applied to a subsequent transferee.
The trustee of the debtor, Equipment Acquisition Resources (“EAR”), alleged that EAR made fraudulent transfers of cash to Sheldon Player, who in turn transferred funds to the Horseshoe Casino. In 1997, Player established EAR, whose purported business model was to manufacture high-tech machines. However, from at least 2005 to 2009, EAR engaged in a scheme to defraud its creditors involving its financing of equipment. As a result of this scheme, Player received approximately $17 million in fraudulent transfers from EAR.
Player used the fraudulent transfers for his personal benefit. In particular, he spent large amounts at the Horseshoe Casino. Player was a frequent presence at Horseshoe, at times spending over fifty hours per week at the casino. From February 2007 to August 2009, Player paid Horseshoe over $8 million to satisfy his gambling debts. Player’s gambling activity at Horseshoe was often erratic. In addition to spending large sums at the casino, Player was known to “walk with chips.” Walking with chips is the practice of leaving a casino with chips rather than cashing them in. Similarly, Player was known by the casino to “pass chips.” Passing chips is the practice of giving chips to a third party to cash in. Neither walking with chips nor passing chips is illegal; however, both practices are potentially indicative of “structuring” transactions to avoid triggering the $10,000 reporting requirement, a federal crime.
Player also made false statements on his Horseshoe credit application. Horseshoe ran credit checks on Player showing that he had understated indebtedness by over $2 million. Although Horseshoe knew that Player’s application misrepresented his debt, it still extended credit to Player. Gradually, Horseshoe increased Player’s credit line from $25,000 to $450,000. As Player’s credit line increased, it exceeded the balance of his on‐file checking account. Player also overstated his salary by more than three times his actual salary and claimed to be the owner of EAR even though he was not actually a shareholder of EAR at the time of the credit application. Horseshoe did not try to verify these statements.
In addition to Player’s claimed ownership of EAR in his credit application, Horseshoe had other reasons to believe that Player’s money came from EAR. Because Player’s credit exceeded his personal checking account balance, Horseshoe kept an EAR account on file as a “reference account.” Moreover, Player paid some of his gambling debts from a bank account in the name of his wife “doing business as EAR.” Horseshoe identified this account as a business account, yet nonetheless accepted and deposited checks from the account. Finally, one of Player’s on‐file checking accounts listed EAR’s corporate address.
The trustee sued Horseshoe, alleging that EAR had made $17 million in fraudulent transfers to Player, and that Horseshoe was the subsequent transferee of $8 million of those transfers. Both parties agreed that Horseshoe lacked actual knowledge that the transfers from EAR to Player were voidable fraudulent transfers. However the trustee contended that the above facts placed Horseshoe on “inquiry notice” of the fraudulent transfers. The Seventh Circuit held that imputed knowledge may be sufficient under certain circumstances to render the subsequent transferee liable for the fraudulent transfers made to the initial transferee. The court wrote: “[K]nowledge in § 550(b)(1) means less than complete understanding of the facts and receipt of a lawyer’s opinion that such a transfer is voidable. Nevertheless, inquiry notice must be sufficient to enable the party to have gained actual knowledge by inquiring. If a reasonable inquiry would not have led to actual knowledge of voidability, a court cannot impute knowledge.”
The Seventh Circuit explained that although Horseshoe had some indication that Player’s money came from EAR, the casino had no reason to suspect that this money was obtained by fraud. Player claimed to be the owner of EAR and so the fact that Player’s money came from EAR would not have been of special significance to Horseshoe. A transfer of money from a company to one of its executives “does not hint at a fraudulent conveyance by a firm on the brink of insolvency” according to the court.
The court further observed that even if Horseshoe had investigated, it was unlikely that Horseshoe would have uncovered the fraud or EAR’s financial distress. According to the court, when a subsequent transferee’s reasonable inquiry “would have turned up nothing pertinent to voidability, the [transferee’s] failure to make it does not permit a court to attribute to it the necessary knowledge.” Even assuming that Horseshoe was put on inquiry notice of a fraudulent transfer, a reasonable inquiry would have turned up nothing indicating that the transfers were voidable. At the time of these transfers, EAR’s creditors and advisors, who had complete access to EAR’s books and records, were unaware of the ongoing fraud and financial distress, and it even took FTI Consulting (a forensic accounting firm) three months to uncover the fraud.
Notwithstanding the trustee’s “where there’s smoke, there’s fire” type argument, the Seventh Circuit concluded that the facts of this case, even the supposed red flags identified by the trustee, were insufficient to impute Horseshoe with “knowledge of the voidability” of EAR’s fraudulent transfers to Player. Nevertheless parties must remain diligent as the law may impose liability on them for accepting payments from a customer known to be defrauding his creditors. While difficult to prove, knowledge of the voidability can be imputed.