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Sixth Circuit: Bankruptcy Trustee’s Veil Piercing and Substantive Consolidation Claims Fail in Fraudulent Transfer Case

In the personal bankruptcy of a husband and wife, a bankruptcy trustee sought to avoid an allegedly fraudulent transfer between two third-party corporations. Debtors entered into a purchase agreement to purchase a farm, then assigned the purchase agreement to an LLC Debtors had formed. The LLC obtained a loan, guaranteed by Debtors, to purchase the farm. Debtors operated a horse farm and bed and breakfast on the property for the next three years. In November 2010, Debtors made a large payment on the LLC’s mortgage for no consideration, then, a month later, the Debtors’ LLC sold to the property to a third-party LLC, Beads and Steeds Inns, for roughly half of what Debtors’ LLC paid three years earlier. Debtors continued to operate the horse farm and bed and breakfast under a significantly below-market lease. Debtors filed for bankruptcy two years later. The bankruptcy trustee filed an adversarial action against Beads and Steads, asserting that the transfer from Debtors’ LLC to Beads and Steeds was fraudulent, done to evade Debtors’ creditors. Beads and Steeds moved for judgment on the pleadings, arguing that the bankruptcy trustee failed to state a claim because a fraudulent transfer requires a transfer of an interest of the debtor in property — while here the transfer was of an interest of the Debtors’ LLC in property. The bankruptcy trustee asserted that she could pierce the corporate veil in reverse and thereby treat Debtors’ LLC and the Debtors as a single entity. She also asserted that the Debtors’ LLC should be substantively consolidated with Debtors, such that they should be treated as one. The Sixth Circuit Court of Appeals ruled against the bankruptcy trustee. First, the court held that veil piercing under Kentucky law does not consolidate a debtor and its alter ego into a single entity; rather, Kentucky employs veil piercing as a form of vicarious liability, shifting liability from the debtor to its alter ego. “Because Kentucky veil piercing does not transform the alter ego’s property into the property of the debtor, but rather simply allows a creditor to pursue the alter ego under a vicarious liability theory, the trustee has not stated a claim under 544 and 548, both of which require that the debtor have an interest in the transferred property.” The court also rejected the bankruptcy trustee’s substantive consolidation arguments. The court employed the In re Owens Corning test to evaluate the bankruptcy trustee’s substantive consolidation claim because that was the test the parties propounded in the lower court, but, in a footnote, the court noted that the Sixth Circuit “has not adopted a test for evaluating a substantive consolidation claim.” The Owens Corning test requires that either (1) prepetition the entities sought to be consolidated disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity; or (2) postpetition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors. The court held that the bankruptcy trustee’s proposed amended complaint did not contain sufficient factual allegations under either standard. The case is Phaedra Spradlin v. Beads and Steeds Inns, LLC (In re Howland), Case No. 16-5499 (6th Cir. January 3, 2017), which the court indicated was not recommended for publication.

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